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Second Quarter 2009

The stock market has been in a trading range since the beginning of May after a sharp rally and now stands 39% above its lows of March 5th, having clawed back what it lost in the first quarter. It is nonetheless still relatively unchanged on the year. We are currently in a period of profound uncertainty with any stimulus coming solely from government spending. In the last two months, more than 150 central bank policy interventions around the world have taken place. The dislocation created in the wake of Lehman’s bankruptcy seems largely over for now. Risk assets have rallied while measurements of risk (implied volatility levels, corporate bond spreads) have declined to their lowest levels since September of last year. Stock valuations have normalized, and are now building in the certainty of a good rebound in 2010. For proof of that, consider that the P/E level of the S&P 500 now stands around 15.1* for 2009 and 12.6* for 2010, which is not cheap, either on an absolute basis or when compared with 10 year treasury bonds, whose yields have climbed from just over 2% early this year to just over 3.5% where they stand now.

GDP growth looks to be subpar going forward, given that consumer debt levels still remain unsustainably high. The U.S. personal savings rate has now grown to 6.9% of income (from nearly zero only 15 months ago) as consumers rebuild their own personal balance sheets out of fear. Since our economy relies on consumer spending for its growth, don’t expect the consumer to provide any stimulus for some time. Most Americans have been hit by a negative wealth effect which may impact their behavior for years. Consumer confidence in the month of June fell to levels far below analysts’ expectations. Unemployment, now at 9.4% is the highest in 25 years, and may soon bypass 1981 levels (10.8%) to become the worst since the Great Depression. This puts further pressure on the housing market, where 12% of all mortgages are now at least one month past due, and 22% of all U.S. homeowners are in “negative equity,” meaning that they owe more than the value of their homes. This is no longer a “subprime” problem, as delinquency rates on “prime” mortgages more than doubled in the first quarter from a year earlier. Meanwhile the banks which repossess these homes are not yet putting the inventory on the market because they fear this will depress the real estate market further, which will have negative consequences on their balance sheets. Investors should expect a second wave of foreclosures beginning in the third and fourth quarter of this year based on “recasts” or recalculations of adjustable rate mortgages, particularly “Option ARM” mortgages. These are mortgages which reset after five years, whose monthly payments typically increase by as much as 65%. Some $750 billion of them were sold and their default rates will certainly be at a higher rate than seen already for subprime mortgages. The pernicious impact of these mortgage resets will last through 2011.

Is the overall economy really “deleveraging?” The net effect of the Federal Reserve’s programs has been to absorb some of the losses of households, corporations, and banks, and to socialize them, attempting to delay the problem. This may be said of the $9.7 trillion spent so far on bailouts. The adjustment to a lower level of spending relative to income is being subsidized by the government. This is being achieved through lower taxes as well as increases in social benefits which count as income. Americans should be lauded for their efforts to save more of their income; however the savings rate probably needs to head toward a 9% or 10% rate before the adjustment is over. When it hits that level and stabilizes, this will permit spending to resume growth at the same rate as personal income. At this point, and not before, the recession will be over. Until then, spending will continue its decline and the stock market will continue to be vulnerable to decreased corporate earnings. The current economic adjustment will be longer and more painful than many people now anticipate. While the economic recovery may be “U” shaped, the stock market will likely be “W” shaped as the investors come to realize this.

For the first six months of 2009, the Dow fell 3.8%, the S&P 500 rose 1.7%, and the Nasdaq gained 16.4%.
Grant Rogers Elizabeth Allen

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