Stocks took a tumble again today on concern regarding European government debt. Since the beginning of the year stock indexes across the globe are in negative territory by 6-8%. Meanwhile, reports about the global economic recovery continue to be very positive. Do stocks prices know something about future economic growth that the rest of us don’t? Or is this just a normal stock market correction after the tremendous run up in 2009?

Let’s recall a simple truth – in the intermediate and long term, the business cycle drives the price of financial instruments be they stocks, bonds or real estate. However, over the short term, market psychology rules the day – making investing a real challenge. Our research suggests that we are at the very beginning of the business cycle. A period when economic recovery should be, and fortunately is, in full swing. Our leading indicators for future economic growth continue to move firmly to the upside. This research was validated this week when it was reported that economic growth in the 4th quarter soared to a 5.7% annualized rate. Moreover, corporate profits, the real driver of recoveries, have improved substantially. In the past few weeks, 76% of companies that have reported earnings have posted better than expected earnings and productivity growth has risen to 6.2%, a level not seen since 1993. This combination of data confirms that the Great Recession is over and that a new global economic expansion has begun in earnest. This has important implications for stock, bond and real estate prices.

Though stocks have begun the year on the downside, we view this pull back as a healthy, if not overdue correction. Keep in mind that, during economic expansions, stocks often correct by 8-10%, making this recent correction somewhat mild so far. Over the intermediate and longer term, our research suggests that stocks should outperform bonds and real estate. However, the path to these higher returns will be bumpy and somewhat unpredictable.

There is a laundry list of risks to our view that stocks will outperform This list includes: the onset of a double dip recession, a significant decline in the US dollar, further deterioration in the commercial real estate market and geopolitical unrest. We will be monitoring these risks closely. Keep in mind that we continue to use asset allocation, sector management and stoploss orders to manage market, sector and company specific risk.

The global economic recovery should continue to push interest rates higher, sending money market rates to much higher levels and providing us with a better opportunity to buy higher yielding, quality bonds. Additionally, though we do not forecast a “V” shaped recovery in residential real estate, we do believe we have seen the bottom in this market and that prices should remain stable for quite a while.

You have probably noticed that your stock exposure is now much higher than a year ago. We will continue to fine tune this exposure based on your investment policy statement or wealth planning. If for any reason you feel that you should have significantly more or less stock exposure, please let us know at your earliest convenience.
We hope this note finds you and your family well. Please let us know if you have any questions.

Sincerely,

James E. Demmert
Managing Partner