What a difference a year makes. Last year, in the third quarter of 2008, the market dropped 8% and more trouble was on the way. The government had just seized Fannie Mae and Freddie Mac. We were in the midst of the Lehman Brothers bankruptcy, the AIG bailout, and the shotgun wedding of Merrill Lynch to Bank of America. Other financial institutions were in triage. A prominent money market fund “broke the buck” and a run on money market funds ensued. The financial panic was in full bloom. Markets fell 17% in October followed by another 8% decline in November. It took until March of this year for markets to stop going down.

In contrast to last year, the stock market in 2009 recorded a second consecutive 15% quarterly gain this September. Investors have concluded that global economies are not in free fall but are actually stabilizing. Although economic growth may be subdued, it surely beats the mess we were in last fall and winter. Some signs of stabilization that investors have seen include:

• The rate of decline in Gross Domestic Product (GDP) for the U.S. has slowed. The economy declined 5.4% in the fourth quarter of 2008; 4.6% in the first quarter of this year; and less than 1% in the second quarter. Third quarter GDP is likely to be positive.
• Goods inventories are considerably lower than the beginning of the year, implying a need for higher production. The “cash for clunkers” program has helped auto dealers clear inventories and production rates for manufacturers have increased.
• Sales of new and existing homes have improved, particularly in formerly weak areas such as California.
• Chain store sales have picked up since their low point in February.
• Several key international economies, such as Germany and China, have shown renewed growth.
• Financial institutions reported better than expected profits and their stocks have responded favorably. The issuance of commercial paper has increased while prices to insure against financial company defaults has declined.
• Consumer and business confidence improved from very low levels.

The belief that economies had stabilized was sufficient to ignite the powerful rally that we have seen since March, particularly on the heels of a stock market that had declined so far and so fast. As we have mentioned in previous Investment Outlooks, many investors were betting on further market declines and have been forced to buy stocks to cover their wrong way bets. Some large institutional investors that had underweighted publicly traded equities were forced to increase their allocations.

Two segments of the market have enjoyed especially strong performance. The technology sector has led the market all year. Broadly speaking, technology companies possess defensive qualities such as strong balance sheets and high profit margins along with exposure to a cyclical economic recovery. Once the economy stabilized in late Spring, another group of stocks led the way. Companies with weak balance sheets and volatile earnings but also with heavy exposure to a cyclical recovery rebounded. The lowest quality companies in terms of S&P ratings have increased well over 30% this year, whereas many of the highest quality companies are actually down in value (see graph). One reason for this is that lower quality companies declined the most last year and many were in difficult financial straights. Conversely, the higher quality companies that investors retreated to during the financial crisis were deserted in March once the Armageddon scenario vanished.

Even after the powerful rally of the past two quarters, we think investors will essentially take a wait-and-see attitude with respect to the strength of the economic recovery. It is possible, but unlikely in our view, that we will see a strong recovery in 2010. Consumers continue to retrench by paying down outstanding loans and by limiting discretionary spending. Although new home inventories are down, existing home inventories remain high and many homeowners have mortgages that exceed the value of their homes. Additionally, not only is unemployment still high and wage gains low, higher income taxes are also on the way.

We continue to find very little value in bond market yields, particularly with the overhang of large deficits, an expensive healthcare bill, and uncertainty regarding defense spending. We expect the outperformance of lesser quality companies to dissipate and higher quality issues to gain ground if the recovery proves to be as subdued as we expect. We think the market can still work higher as the economy improves. However, a substantial move in the market appears unlikely until the economy can produce stronger revenue growth.

The enclosed report, Clean Technology: An Emerging Trend, But an Investing Challenge, summarizes our research on an interesting emerging area of industry and the stock market.

October 2009