After a brief pullback to start the third quarter of this year, the global markets continued higher, again turning in one of the best quarterly performances in over 10 years after a significant rally in the second quarter. The quarter was marked by town hall meetings on health care reform, speculation concerning Iran’s actual nuclear capabilities, and the Cash for Clunkers program, which helped drive sales at the automakers. The Federal Reserve held interest rates at zero, while the dollar continued its decline against most major currencies.
To be perfectly honest, we have been very surprised by the 50% move in the U.S. markets in the past 6 months – the sharpest on record. We underestimated the sharpness of the recovery off the March lows and the liquidity impact of government stimulus in the capital markets. For what it’s worth, after the October 1987 crash (which could be considered similar to October 2008 in terms of magnitude and impact), it took the market about 21 months to move 50%.
As we move toward 2010, many of the same uncertainties regarding consumer demand and global economic growth are still with us. However, it is important to remember that markets can disconnect from economic fundamentals if there is a collective perception the global economy is recovering and corporate earnings are improving; which is currently happening. This doesn’t signal economic improvement is certain or uncertain for that matter. It is the collective perception of improvement or non-improvement that typically moves markets at any given time. At the moment any possible fundamental concerns have been put aside by most market participants who seem to be placing more emphasis on bottom line cost cutting, which has improved short-term profits. Whether companies are able to achieve longer term profitability growth remains to be seen and will be important to watch moving into 2010.
In addition, both the stock and bond markets are benefiting from a surge of liquidity into those markets, based on a Federal Reserve zero interest rate policy on cash, which essentially forces market participants to accept more risk in order to earn any return.
Our current assessment is that the US market averages (based on S&P 500) are at the higher end of fair valuation based on current earnings estimates for 2009 and forward estimates for 2010. As we move toward the end of a given year, focus tends to move to earnings in the following year – in this case 2010. As of October 1, 2009 earnings estimates for the S&P 500 are $54.75 for 2009 and $73.50 for 2010 – a 34% increase. While we do believe earnings will likely increase in 2010, a 34% increase in factoring for a very sharp, robust recovery and significant revenue growth. While this result is certainly achievable, we should keep an open mind toward other possible outcomes. Analysts tend to be most optimistic regarding future earnings estimates at the end of the preceding year and adjust accordingly as the year progresses. Earnings estimates for 2010 have remained in a rather tight range over the past few months; estimates are not being raised, but they are also not being lowered.
Going forward, we are likely entering a highly complex and unpredictable period with various possible outcomes - both positive and negative. What makes the environment difficult is that the most obvious concern may not be the one that we actually need to watch for. Given this environment, while we can certainly hope for one, it is highly unlikely we will see another 50% rally in the markets over the next 6 months. The overall direction of the stock markets will likely be impacted by which outcome ultimately plays out.
