March 5th, 2010
The Standard & Poor's 500 Index advanced by 26.57% and the NASDAQ Index by 45.4% in 2009. In the year-to-date period ending February 28, 2010, the Standard & Poor's 500 and NASDAQ Indices declined by .61% and 1.2%, respectively, which includes declines of 3.6% and 5.3% for the Standard & Poor's 500 and NASDAQ, respectively, in January. Notwithstanding the strong stock market recovery in 2009, the Standard & Poor's 500 and NASDAQ remain 28.8% and 20.1%, respectively, below their peaks of October 2007. The stock market gains during 2009 propelled an increase in household net worth in the United States to an estimated $53.4 trillion, or by 5%, in the third quarter of 2009. Holdings of common stocks increased to $7.4 trillion, or by approximately 17% according to the Federal Reserve's Flow of Funds report. The net worth increase was also enhanced by an increase in real estate values of 2%, to $16.5 trillion, in the third quarter. Notwithstanding this recovery, household net worth remains well below the high of $65 trillion achieved in the second quarter of 2007.
Revised fourth quarter 2009 real GDP advanced by 5.9%, or meaningfully above the 2.2% rate of growth experienced in the third quarter and the decline of .7% in the first quarter of 2009. The acceleration of growth in the fourth quarter can be attributed to the resumption of business investment, especially of equipment and software, continued inventory replenishment, improvements to personal consumption expenditures and slowing of imports. Real GDP for the year 2009 declined by 2.4%, which included a second half recovery in which the economy expanded by approximately 4.0%. The decline in 2009 GDP reflected negative contributions from nonresidential investment, together with lower exports, inventory investment and personal consumption expenditures in the first half of the year.
The economic data continues to indicate that the economy is improving. Positive third and fourth quarter GDP; continued expansion in manufacturing, with the ISM manufacturing survey recording its seventh consecutive monthly expansion in February; the Conference Board's Leading Economic Indicators increasing for the tenth consecutive month by .3% in January; improving consumer confidence and the decline in the unemployment rate to 9.7% from 10.2%, all continuing to indicate increasing levels of stability. Global manufacturing continues to recover as manufacturing activity expanded in February and represents eight consecutive months of expansion. Manufacturing in the euro zone, which includes 16 nations, recorded good activity. China reported record activity, while India, South Korea and Taiwan also experienced very strong industrial activity for the month.
While the economy appears to have stabilized and resumed growing in late 2009, the unemployment rate, which is a lagging indicator, steadily increased reaching a high of 10.2% in late fall prior to declining slightly in December to 10.0%. The labor market experienced considerable weakness in 2009 as employers sharply reduced their work forces commensurate with a reduction in sales. Although it is plausible that the unemployment rate could increase in 2010 should businesses remain tepid with investment spending, some recent indicators suggest that the labor market is stabilizing. A stabilizing job market could suggest that payrolls were reduced more drastically than required or disproportionate to the decline in output during the recession. Indeed, job losses have slowed more recently and initial claims for unemployment insurance have begun to trend lower. In addition, temporary hiring services, which are a good barometer for the employment outlook, have expanded their activity since October, 2009. Further economic expansion will require an increase in real final demand. The combination of increasing final demand and inventory restocking should cause a recovery in jobs in 2010. This could cause the unemployment rate to return to a level consistent with the decline in output during the recession, or approximately 9.0%. It is projected that 2010 real GDP will advance by a solid but moderate 3% to 3.5% rate. Should 2010 GDP growth advance at a faster pace than currently projected, the unemployment rate could be potentially lower than 9.0% by year end.
Standard & Poor's 500 companies have $3.2 trillion, or 11%, of their total assets in cash reserves, which is well above the long-term average of 8%. Excluding financial companies, cash reserves total $1.05 trillion. Further, the ratio of excess cash flow to capital spending rose to 1.17 as of September 30, 2009, from 0.88 the prior year and is the highest it has been in the past 50 years. A similar accumulation of cash appears to be occurring globally, especially in Europe, Asia, India and Brazil. These strong cash positions could unleash corporate spending for plant and equipment, acquisitions, share repurchases and dividend increases. In fact, stock repurchases by corporations in the third quarter of 2009 advanced by 44% to $34.8 billion from $24.2 billion in the second quarter, which was the lowest level of repurchases since the first quarter of 1998. These repurchases are positive but remain well below peak levels of $172.0 billion in the third quarter of 2007. Repurchases are projected to increase by 10% in the fourth quarter of 2009 over the third quarter, and 2010 should reflect continuing increases. These share repurchases, together with increasing merger and acquisition activity, further enhances the outlook for common stocks as the supply of stocks outstanding continues to be reduced.
The Federal Reserve is unwinding the special liquidity facilities it created during the credit crisis based on substantial improvement in the functioning of most financial markets. In early February 2010, several facilities, including credit for primary dealers, lending programs to stabilize money market mutual funds, the commercial paper market and temporary liquidity swap lines with foreign central banks, were allowed to expire. The one remaining lending program open, the Term-Asset Backed Securities Loan Facilities (TALF), is scheduled to close at the end of March for loans backed by collateral except newly issued commercial mortgage-backed securities. In addition, the Federal Reserve is normalizing its lending to commercial banks through the discount window. Discount window loans, which were increased to as much as 90 days during the crisis, are returning to overnight loans for most banks. Moreover, the Federal Reserve increased the discount rate by .25% to discourage banks from relying on the discount window for their short term credit needs. Although the Federal Funds rate is likely to remain exceptionally low for an extended period, the Federal Reserve will carefully monitor short term monetary conditions to mitigate inflationary pressures.
Our investment outlook remains reasonably constructive for 2010. Common stock valuations appear fairly attractive, in our judgment, notwithstanding the strong price performances in 2009. Operating earnings for the Standard & Poor's 500 could increase 30% in 2010 as significant expense reductions by corporations provide the basis for considerable operating leverage in 2010 as revenue growth recovers from very depressed levels. In addition, the Federal Funds Rate should remain at historically low levels as the economy continues to recover. This is supported by the Federal Open Market Committee which believes the current environment likely warrants exceptionally low levels of the federal funds rate for an extended period. Lastly, inflation pressures do not currently prevail in the current environment, especially in consideration of the existing output gap and lack of wage pressures. It remains our judgment that common stocks will provide patient long-term investors with attractive investment returns.
