Research & Advice

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Economic Outlook for 2010.

Wednesday, December 30, 2009

 

 

 

The Economy

 

  • After twenty months of recession, as measured by Gross Domestic Product (GDP), the economic recovery began around July 31, 2009.

  • After a nearly 3% growth rate in the second half of 2009, Berkshire Money Management expects something closer to 2% in the first half of 2010 and a mild increase to 2.5% in the second half of 2010.

  • Over the last sixty years there has been, on average, a recession every six years (almost two per decade). While it is an almost certainty that another recession will occur in this new decade of the 00’s, it is unlikely that one would occur soon enough to call it a double-dip recession (i.e. not before 2012, and certainly not in 2010).

  • While it is a large risk in the future, inflation, as measured by the Consumer Price Index (CPI) will not be a threat in 2010.

 

The Recession Has Ended

On July 1, 2009 we posted the “Second Half Update for Economic Outlook for 2009” on BerkshireMM.com. In that article we wrote that “the recession will be over by the end of Summer.” The official arbiters of the beginning and ending dates for recessions, the National Bureau of Economic Research (NBER) typically take about one year to assign official dates. This is not because they are slow or lacking sufficient data. Rather, they want to be completely sure as to their labeling. After all, their efforts are to properly date – not to properly forecast.

In retrospect, on July 1, 2009 it paid to go against the consensus and position investment portfolios according to an expected economic recovery (actually, Berkshire Money Management had began doing so about four months prior). It was not an economic call many were willing to take at that time – and in retrospect that may have not been so prudent, but it was brave. After all, GDP moved from a negative 6.4% contraction, to a 2.2% growth rate – an 8.6 percentage-point swing! Prudence would have had the risk-averse sit on the sidelines for a little longer. The brave – well, the brave profited.

Back to the NBER, unlike that group Berkshire Money Management does not have the luxury of waiting a year to make such economic calls. So, when it seemed the darkest, we had to look past the nation’s collective dark fear and try to see sunlight.

With only five months of potentially revisable data on hand (as opposed to the NBER’s year’s worth of already revised data), it appears as if the recession (as measured by Gross Domestic Product, or GDP, not necessarily by any material improvement of human pain and suffering) ended by the end of July 2009. Adding validation to that claim is the performance of the S&P 500 stock market index from July 31, 2009 through the rest of the year. For the first five months of stock market returns after a recession’s end date, the historical average is 10.4%; the current run is about 14%. (We’ll have more on this in the Risks & Rewards section below.)

  

 

 

Five Months After Recessions’ End

         
 

Gain 5 Months

Hypothetical S&P 500

 

After Recession Ended

12/31/2009 Equivalent

         

1949

 

10.29%

 

1,089

1954

 

9.42%

 

1,080

1958

 

14.32%

 

1,134

1961

 

5.15%

 

1,042

1970

 

19.99%

 

1,193

1975

 

0.72%

 

1,000

1980

 

11.23%

 

1,103

1982

 

17.63%

 

1,166

1991

 

4.97%

 

1,040

 

That, of course, is the good news. The bad news (not as if this is the only bad news, there is plenty to go around) is the growth of GDP relative to historically expected growth has been woefully slow. The GDP growth rate for Q3 2009 was 2.2%. However, the historical growth rate for the first quarter of growth following a recession has been closer to 6%. The logical response might be to question the timing of the recession’s end. Perhaps the recovery started in September, not July, thus balancing some growth versus some contraction. Accepting that premise (which we do not) for the sake of argument, we would then still have to expect a near 6% GDP growth rate for Q4 2009 – about twice the expected rate.

Still, only a quarter of the $787 billion dollar federal stimulus package has been spent. The bulk of the remainder will be spent next year. This public spending crutch is a safety net that should successfully assist the GDP rebound, even if the efforts from the private sector prove to be feeble. Globally, the G20 put remains (more on that in the Risks & Rewards section.)

However, that safety net, while comforting, is not likely to be necessary. American corporations, fearing a depression, have cut too many employees and reduced inventory levels too far. They will need to raise levels on both counts. Capital spending, in particular, will need to be restored. Companies cut capital spending 16% in 2008 and another 32% in 2009. Now the cash levels are high enough to support inventory building and other spending – cash now makes up 9.7% of public company assets, above the historical level of 6.2%. Combined with an improving credit situation, there are a lot of indicators moving in the right direction.

While all of these positives are necessary, they are not sufficient. What is missing is some level of corporate confidence. Cash levels and available credit are necessary, but optimism about the future is what moves the money that advances economic growth. That confidence is being restored, but it is a slow process.

The economy is slowly but steadily recovering, in large part because the job market is finally stabilizing after two years of massive losses. On a relative basis, the recent employment data is especially encouraging. Not only are job losses moderating in the presence of improving leading indicators, but one of those improving indicators is an increase in temporary job hiring (a precursor to an increase in full time job hiring).

Job growth is expected to resume by mid-2010 and to be strong enough this time next year to begin reducing the unemployment rate (which is a kind way of saying that the unemployment rate will continue to tick up in the first half of 2010, to an estimated 10.6%). Even with that improvement, the economy will still come back at something far less robust than a much hoped for V-shaped recovery. But by the end of 2010 this currently fragile economy, addicted to fiscal stimulus and fraught with risk, will evolve into self-sustaining recovery.

Given that government releases of GDP data are only made final after several months and several revisions, you can understand how difficult it is to actually forecast the trend of GDP growth, much less the magnitude. Nonetheless, a positive trend appears obvious to Berkshire Money Management. Regarding magnitude, after nearly a 3% growth rate in the second half of 2009, we expect something closer to 2.0% in the first half of 2010 and a mild increase to 2.5% in the second half of 2010.

The Bond Market is Smarter Than the Stock Market – The Yield Curve

The yield curve is the difference between short-term rates and long-term rates on government bonds, typically the 2-year and the 10-year notes. It’s an indicator Berkshire Money Management has used, along with others, in forecasting the two previous economic downturns (2001 and 2008). When the short-term yield exceeds the long-term rate, it’s called an “inverted yield curve” and, all other things being equal, it is an ominous phenomenon.

For example, last year investors piled into government bonds as the financial panic got underway. That demand – that buying – drove up prices of government bonds, thus driving down the yields to record lows.

Today, though, the opposite is true. Instead of being inverted, the curve is “steep”. A steep yield curve is one where the 10-year note is substantially higher than the 2-year note.

 

 

The yield curve steepens when the Federal Reserve, which controls short-term interest rates, keeps them low to spur the economy. But at the same time investors, expecting growth to resume, sell longer-term government bonds, which sends their prices down and yields up (especially relative to short-term bond yields).

As of mid-December, the yield curve now is at record levels and is signaling that investors are expecting a stronger economic turnaround ahead. Before this year, this yield curve was last stretched to more similar levels in July1992 (a 268 basis point spread) and August 2003 (a 274 basis point spread). In both instances, the economy was pulling out of recession and staged sustained recoveries.

With so many indicators available to write about, why spend time on this one? In the 1990s, while the nation’s economy was still contending with the damage caused by the savings & loans crisis, a steep yield curve helped the healing process, making it much easier for financial institutions to borrow money at a lower rate, lend it at a higher rate, and put the difference in their pockets. The current yield curve spread is good for today’s banks, which are borrowing at nearly zero percent rates and are lending at rates closer to five percent. As some would say, in that type of interest rate environment, even a banker can make money! And as bank profitability is restored, they hire, they spend, and they make loans – all positives for the sustainability of the US economic recovery.

 

 

The Double-Dip Debate

 

Recessions are frequent. Since 1949 there have been ten; that’s almost two per decade. So to suggest that we’ll have one or two more recessions between 2010 and 2020 is not all that outlandish. It’s pretty much to be expected if only because that sort of occurrence is common. What are uncommon, both domestically and internationally, are double-dip recessions.

The 1980-1982 case seems to be the poster child as a possible model for a 2009-2011 double-dip recession. The prospect for such a thing is possible, but there is no sense in comparing today to then to make the case. The first dip in 1980 lasted only six months, while this recession lasted about twenty months. As such, a greater amount of excesses have been worked off.

Significant factors in sparking the 1982 recession were high inflation and high interest rates.

The annual Consumer Price Index (CPI) for 1979, 1980, and 1981 were 11.3%, 13.5%, and 10.3%, respectively. This crushed corporate profit margins. Annual inflation for 2007, 2008, and 2009 has been 2.8%, 3.8%, and non-existent, respectively.

In regards to interest rates, in 1979 the Federal Funds rate was between 10-15%, in 1980 it was between 8-20%, and in 1981 it was between 12-20% in 1981. This severely constrained growth and consumption. Today the Fed Funds rate is between 0-0.25%.

While 2010 and 2011 will have their own unique set of challenges, a double-dip recession does not appear to be one of them.

Inflation

We can’t have inflation (as measure by the components of CPI) without wage pressure, rental demand, and an economy running at capacity. There are 15 million job seekers, five million vacant apartments, and an economy running at 71% capacity (well below the forty year average of 81%). This is not the recipe for rampant inflation in 2010.

Even with GDP growth running at trend rates, these negatives will linger for some time. An optimistic scenario for 2010 GDP would be a 3.5% (trend-like) rate of growth.

Foreclosure Crisis

 

Our Economic Outlook for 2008 report was all about housing and how the foreclosure crisis could bring us to our knees. In retrospect, it was much worse than feared. Since we wrote that report, the media has picked up on and covered all of the negatives. The negatives remain, and they are well known. Instead of redundantly repeating what is known, we will briefly (because, regarding this subject, brief is all we can be) point out some positive developments.

At the peak, there was roughly a twelve month supply of homes on the market. Compared to the nationwide average of 6.6 months of supply in the 1990s, this was a troublesome glut. While the housing market is not yet healthy, it is a positive that the inventory levels have been reduced to about 8.5 months worth of supply.

 

The Stock Market

 

  • Measured in nominal terms (i.e. not adjusted for inflation), the most recent calendar-decade was the worst in history. Looking forward, after a decade of declining prices, the cost of entering the market is substantially less than it was at the beginning of the decade.

  • While the stock market is cheaper now than it was ten years ago, it has not yet reached levels that are coincident with the start of previous secular bull markets.

  • The stock market’s rally from the March 2009 low is expected to advance into the first half of 2010, approaching the Reward Level of 1,350 points on the S&P 500. Weakness is expected in the second half of 2010, as the S&P 500 corrects toward 950 points. (Note: The levels are extremes; the direction is more important than the levels in determining asset allocation.)

 

The Lost Decade

Despite enormous problems, prospects are good that the next decade will be better than this one.

Of course, that isn’t saying much. The last decade was the worst on record for U.S. stocks since the 1820s. The S&P 500 entered the year 2000 at 1,469.25 points. You can make all arguments you wish regarding the stock market being overpriced at those levels at that date. But it doesn’t take away from the fact that the market, ten years after December 31, 2009, in nominal terms is down over twenty percent! Like the 1930s, this has been a lost decade for stocks.

 

 

 

For buy-and-hold investors (fortunately, not for Berkshire Money Management clients – not by a long shot), this was a frustrating decade– especially since many invested expected (nay, felt entitled to) double-digit returns after the raging bull markets of the 1980s and 1990s, when stocks rose on average 16.6% and 17.6%, respectively.

The good news, for those who need a little cheering up, is that there have never been two consecutive decades of negative returns in U.S. stocks. Let’s look at it a little differently, let’s look at the returns of the stock market (using the S&P 500 as a proxy) and then subtract the rate paid on Treasury bills, so as to give you a perspective as to where your money might have been better placed.

While this has been a terrible decade for stocks (a negative annualized return of about 3.4%, when adjusted for Treasury rates), it is not unprecedented. There have been three other ten-year stretches where equities had failed to deliver returns relative to risk-free assets. Specifically, the ten years leading to:

  • 1939 (minus 5.7%)

  • 1974 (minus 4.8%)

  • 1982 (minus 3.6%)

 

Serving as a positive omen, the ten years following each of those unfortunate ten year stretches were great for stocks, even without the comparison to Treasury rates. After 1939, the S&P returns in the next decade were 9.2%, 15.6% after 1974, and 19.2% after 1982 (unlike the above chart, these numbers are not adjusted for inflation). (It is worth noting that from 1974-1982, the stock market was extremely volatile.)

This is not even close to a perfect forecasting tool (nothing with a sample size of three occurrences is). And even if it were a very good forecasting tool for what to expect over the next decade, that does not eliminate the certainty of short-term stock market crashes (there is, after all, on average a twenty percent drop in stock prices every three-and-a-half years). However, this does suggest the reduction of a lot of bigger risks (like not making money for the better part of the last ten years; a problem that has plagued a lot of our competition). After a decade of declining prices, the cost (read: risk) of entering the market is less.

 

The Other Decade (an Eerie Similarity to the1970s)

On multiple occasions Berkshire Money Management has made comparisons of the 2000s the 1970s. Specifically, when the crash of 2000-2002 occurred we pointed out that it felt eerily similar to the 1969-1970 crash. The 1969-1970 crash was a big, big deal. But somehow nobody remembered it. Why? Because it was overshadowed by the crash of 1974. All of the variables and indicators that were available at the time suggested that there would be a similar 1970s-style replay.

So what did Berkshire Money Management do? We started selling equity and started buying CDs and started shorting the market. It turned out to be a good move since 2008-2009 was so bad that it has overshadowed the big deal that was the 2002 tech-implosion (sound eerily familiar?).

As we have also written about, perhaps ad nauseum, is that the run-up in the stock market since the March 2009 low is also eerily similar to the run-up from the 1974 low (see the chart below).

While significant risks remain (including having entered into the mature phase of this rally and including the likelihood of a meaningful short-term pullback at any time), there is little historical analog to suggest that the primary upward trend will end soon.

A Shout Out to Short (DShort.com)

As we are talking about decades worth of history (and a decade worth of expectations), we would like to introduce you Doug Short. His website is a fun trip and worth a perusal. Once of the charts Doug created tracks what is called the P/E10, which is the price-to-earnings ratio of the stock market based on an average of ten years’ worth of earnings. There are a lot of reasons to consider the P/E10 over the traditional P/E ratio, but instead of getting into the geekiness behind it, let’s just say that it was devised by the legendary economists and value investors Benjamin Graham and David Dodd (aka Graham & Dodd).

Not yet impressed? If those names are unfamiliar to you and thus don’t conjure up as much confidence in this tool as we would like for it to, then 1) telephone us on it, and/or 2) ask Warren Buffet about it because he is a disciple of Benjamin Graham (that’s right – the co-creator of the P/E10 is the Master’s Master!).

Some things to know about the P/E 10: the historic P/E10 is 16.3 and it currently stands at about 20.0 after dropping to 13.4 in March 2009. The chart below gives us a historical context for these numbers.

 

The good news is that the current P/E10 isn’t as stretched as many other instances. At 1,125 points on the S&P 500, the “E” of the P/E10 represents about $56.25 worth of S&P 500 company aggregate earnings. Moving from a P/E10 multiple of 20 to the 24.1 multiple puts the S&P 500 at 1,350 points (that number of 1,350 points on the S&P 500 will be highlighted again in the Risks & Rewards section).

Moving back down to the low-end of the 2nd quintile (see the box in the lower left hand corner of the chart) to a P/E10 multiple of 17 puts the S&P 500 at 950 points (that number of 950 points on the S&P 500 will be highlighted again the Risks & Rewards section).

Now, the bad news. Doug Short’s chart is a great graphical tool to point out where we might stand on whether or not we have embarked on a new secular (i.e. long-term) bull market, or if this current rally is simply a cyclical (i.e. short-term) bull market occurring within the context of secular bear market. Over the last 130 years, long-term bull markets have begun when the P/E10 was in its 5th quintile and in single digits. Doug references a couple of ominous points. First, that “every time the P/E10 has fallen from the first quintile to the fourth quintile, it has ultimately declined to the fifth quintile and bottomed in single digits.” For example, in 1966 (like in 2000), the P/E10 reached the 1st quintile, dropped considerably in 1974 (similar to 2009), and then rebounded (like now) only to fall back to single-digits in 1982 (in the not-too distant future?).

Seeing how secular declines last about 17.6 years, on average, this cycle’s “1982” (the end of a great bear and the beginning of a great bull) could occur about in 2016-2017. That doesn’t necessarily mean that the stock market will go straight down for the next six or seven years. But it does mean that what Berkshire Money Management has done for clients over the last decade will likely continue to be what we needs to be done for much of the next decade.

Risks & Rewards

 

When we talk to investors that are not clients of Berkshire Money Management, and they start talking about the huge returns for the stock market since the March 2009 lows – and how they have not participated, they feel as if they would have been better served adhering to the buy-and-hold method of investing. And if they were spooked out of the market at the lows, then that could very well be true. But the fact is that even after the eye-popping rally since March 2009, the S&P 500 still needs to advance roughly 40% to get back to its October 2007 high. The point is, no matter what the long-term prediction (or reality) of the stock market may be, investors are best served to align themselves with a manger that will be flexible in their strategy, as opposed to clinging to the “buy-and-hold” and the “never sell” mentality as if it were religion.

 

This is oversimplifying it, but the movement of the stock market in 2010 will largely come down to how two important questions are ultimately answered. First, will public companies continue to generate profits that meet and beat expectations (we believe they will)? Second, after being burned by stocks for the entire decade, will retail investors move from huge sums of cash back into the stock market (we are afraid that they won’t)?

We can make a very positive case for the business cycle. But, ultimately, the movement of the stock market may be more correlated to a psychological cycle than to the business cycle. Investors don’t trust this stock market’s advance. They feel betrayed – many had finally restored their losses from the 2000-2002 crash only to, again, lose half of their portfolio. As a consequence, many investors are unwilling to accept that any positive growth – either economic or in the capital markets – is sustainable. Thus, they remain on the sidelines.

The Reward Level, especially in the first half of 2010, is more probable than the Risk Level. But for that to be accomplished, in a world where anything can go wrong, everything must go right.

In “A Shout Out to Short” we defined some upward and downward expected limitations. Specifically, using the S&P 500, 1,350 points is our upside Reward Level; 950 points is our downside Risk Level.

We further confirm those levels by assessing possible valuations applied against the consensus of Generally Accepted Accounting Principles (GAAP) earnings of $55.62 for S&P 500 companies’ aggregate earnings in 2010. According to Ned Davis Research, the historical norm of the S&P 500’s P/E has been 17 since 1926. The average P/E over the last twenty-five years is 24. Applying the lower multiple of 17 to $55.62 of expected earnings you get an S&P 500 of about 950 points (the Risk Level). Applying the higher multiple of 24 to $55.62 of expected earnings you get and S&P 500 at about 1,350 points (the Reward Level).

While we anticipate a continued stock market advance for the start to 2010, we are concerned about a more defensive finish. The defensive finish is due to something that can go wrong, actually going wrong. Take your pick – monetary tightening, higher taxes, or restrictive trade policies.

Should a correction occur in 2010, that would not be unexpected. In our February 10, 2007 article “Charts & Graphs (Indicators & Interpretations for 2007)”, there is a ten percent stock market correction about once per year (each such correction lasting about 114 days). Coming up with the timing of when we might expect that correction to begin is a little more difficult than just admitting the obvious. Nonetheless, it is our job to go through that exercise. In the context of an established and on-going bull market, it is common for traders and value investors alike to look for a pullback toward the 200-day moving average, since that is often a technical entry point for new stock purchases. But what may have been frustrating for those particular investors, those sitting on the sidelines in cash, is that such a pullback has not yet occurred since the S&P 500 crossed its 200-day moving average on July 10, 2009. And, as shown in the table below, investors waiting in cash may have to wait a few more months.

Hypothetical 2009-2010 Pullbacks

 

If 2009 is similar to:

Pullback to 200-Day MA would start

Calendar Days to Pullback

               

1942-1943

7/17/2010

     

372

 

1970-1971

2/11/2010

     

216

 

1974-1975

12/22/2009

     

165

 

2003-2004

6/3/2010

     

328

 

 

Consistent with our expectation of for a strong start to 2010, a correction, on average, could be expected to begin on April 6, 2010 (fairly close to the Sell-in-May-and-Go-Away seasonal pattern). The rationale for this view is straightforward, and explained in more detail in “Cash For Stocks”. After another quarter or two of the stock market rallying, the advance will become vulnerable to corrections of more than the 4-7% nature we have experienced since the March 2009 bottom. A probable worst-case scenario would be a 1977-like decline of about 21% after “only” reaching 1,200 points on the S&P 500 (which would rival the 1975 advance) in April of 2010 (bringing the market down to our Risk-Level of 950 points sometime in September of 2010).

But for the first half of the year, stocks will benefit from the economic sweet spot of GDP growth, low inflation, and low interest rates. This sweet spot is further fueled by what has been called the “G-20 put”. The G-20 is a group of twenty finance minister and central bankers of some of the largest nations (including the likes of the U.S. and the European Union). The G-20 met in Pittsburgh in September 2009 and committed to continue keeping in place their stimulus programs until their economies turned around and began showing signs of self-sustainable growth. Even within the context of a still weak economy, in an environment of unprecedented market intervention and coordinated global stimulus, we could very likely experience rising capital market prices.

 

P/E Deflators

 

The aforementioned Risk Levels and the Reward Levels are based not only on the historical means of valuations (in particular, the price-to-earnings ratio), but also on possible stretches of those valuations to the upside or the downside. In other words, to use statistical parlance, the extremes of that range represent standard deviations from the mean (especially if consensus earnings are off the mark in either direction).

We do interpret the data as more bullish, that the Reward Level of 1,300 points should be approached before the Risk Level of 950 points. We had begun moving out of cash and back into the capital markets back in March 2009, and we maintain a fully invested position in reflection of those expectation. Still, we do acknowledge that for that trend to continue, everything must go right in a world where anything can go wrong. And when things go wrong, that deflates the P/E level. (For example, if the S&P 500 has a P/E of 20 at 1,200 points, the P/E could be deflated down from 20 to 15 which would be equivalent the index trading at 900 points – even if earrings remained unchanged.)

What could cause such P/E deflation? Of course the credit shock continues to leave its mark on the US economy. The risk is that while the credit markets are improving, and at an admirable clip, the pace of improvement may stall or even flat-line.

Similarly, the housing market has stabilized, but it’s still in critical shape. There are risks to the removal of certain fiscal policies (homebuyer tax credits). Like with the cash-for-clunkers program, demand has been substantially pulled forward thus leaving a demand void that would need to be filled, but only can be filled if everything else goes right. And, in a similar category, one of the things that is most likely to go wrong is the commercial real estate market. Not that it will get much worse (could it?), but rather that it won’t provide any contribution to growth.

Aside from free-market risks, we also have to consider the woes of municipalities and states. Both historically have provided economic stability in tough times through hiring to support “actual” projects as well as those some might call “pork barrel spending.” Broadly, municipalities and states are in disrepair. If they cannot find a way to increase revenues and (dare we suggest it?) cut needless spending, then the risk is that instead of being growth drivers, they will be constraints.

Last in this incomplete list, but certainly not least, is that current fiscal policy is becoming considerably less investor-friendly while at the same time placing tremendous cost-burdens on an already overtaxed small-business community. It’s a dangerous paradox – while in the short-term the private sector requires substantial assistance, in the longer-term the cost of public policy will be substantially higher taxes. This is not a Republican vs. Democrat opinion – it is an economic reality (and neither party has got all of the answers we need).

 

Cash For Stocks – Quantifying Sentiment

 

Data released by the Federal Reserve show private cash holdings by households and companies as a percentage of nominal US GDP is just shy of 72 percent, or about $10.12 trillion, as of the second quarter of 2009. (The household sector accounts for $7.76 trillion). The last time cash levels were this high was in the mid-1980s. For the next decade-and-a-half after the mid-1980s, some of that cash went into economic activity (consumers buying, companies building, etc.) and a lot of that went into stocks and bonds.

Particularly encouraging is that $3.2 trillion of that cash is in money market mutual funds, the most likely form of cash to find its way back into the stock market. While encouraging that this is a full trillion dollars more in money markets than three years ago (early 2007), it is certainly up for debate as to when (if?) that cash will find its way back into the stock market. Since March 2009 some $560 billion has flowed from these money market mutual funds, but the bulk of that flow has been to emerging market stocks and corporate bonds. Also complicating the forecast of “when” and “if” is that in recent months flow-of-funds data has actually seen a modest decline from (and not to) U.S. equity mutual funds.

That’s likely a temporary condition, but it does exemplify the reluctance of investors to commit to U.S. stocks after a decade of going nowhere but down. This is important information for Berkshire Money Management because, as contrarians, we use many survey tools to measure investor optimism (which, at extremes, is bearish for stocks) and investor pessimism (which, at extremes, is bullish for stocks). The surveys show a growing optimism – but that’s based on answers to questions such as “do you feel that the stock market will be up over the next twelve-months?”. Most such surveys are very optimistic (a negative for stocks). But there is clearly a difference between what people are saying (“I feel good and I’m buying”) versus what they are doing (they are nervous and they are not buying).

Some recent sentiment reports have shown a very high level of bulls versus bears (the type of optimism that is bad for stocks since the crowd is typically wrong at extremes). In fact, in one poll, the spread between bulls and bears (52.2% vs. 16.5%, respectively) was the widest since October 10th and October 17th of 2007. Obviously, those days did not mark the start of any prominent bullish move for stocks. But as is often the case in life, it is often best to judge by what people are doing than by what they are saying. Using this standard, the crowd’s bullishness (a negative for stocks) may not be as rampant as suggested by some sentiment polls.

As the timing remains a question, the lingering skepticism on the part of investors is bullish for stocks – the cash on the sidelines represents pent-up demand for stocks. There is some psychology to consider behind all of that cash. Slowly, as stocks have continued to move higher since their March 2009 lows, more and more market participants have accepted the possibility of a new bull market – even if it only represents a cyclical bull move.

However, many of the market participants who have now accepted the notion of a new bull market – either cyclical or secular – remain in cash as they wait for a correction to enter the market. What has been happening in 2009 (and what has happened in past years following major market bottoms) is that corrections are short-lived and/or shallow since many investors are looking for any glimmer of a correction to enter the market. Then, when the corrections do not last, many buy fearing that that they are going to be left behind. Corrections of any magnitude tend not to occur in the early stages of a new bull market because there is so much cash looking for an opportunity to enter. Until cash positions move closer to bull market norms, which is not the case today, stocks will likely continue to surprise to the upside. We expect that continuation to last into the first half of 2010.

 

Bottom Line: On a GDP basis, the U.S. recession has ended and the recovery has begun. It is disappointing that even with the benefit of massive global fiscal stimulus the, first quarter of U.S. GDP growth was a mere 2.2% – historically, a number closer to six percent would have been expected for the first quarter coming out of a recession. The economy remains fragile, but the baton is being successfully passed from the government to the private sector. This will keep the US economy from slipping into a double-dip recession.

The stock market’s advance is maturing, but is not yet ready to stall. Berkshire Money Management expects the rally to continue into the first half of 2010, but that it will contend with concerns (stretched valuations, rising tax rates, higher interest rates, etc.) that will manifest itself in the form of a stiff correction – in terms of both magnitude and duration.

Longer-term, beyond 2010, while the stock market lows of March 2009 represented a generational low (much like the stock market crash of 1974), secular bear markets typically last over seventeen years. Valuations, either by way of declining prices or increasing earnings, have not yet reached levels low enough to mark the start of a new secular bull market. The means and methods used by Berkshire Money Management for clients over the last ten years will be the same ones required to make money over the next decade.