The current bull market will mark its official 1 year anniversary this week - March 9th to be specific. History suggests that this is a critical milestone and one in which investors should pay attention to. According to Bespoke Investment Group, of the 26 bull markets - with bull markets defined as at least a 20% rally that was preceded by at least a 20% decline in the S&P 500 -  that have taken place in the history of the S&P 500, 13 of them (i.e. 50%) have lasted for more than one year. The average length and gain of bull markets that pass the one year anniversary mark is 4.4 years and 152.81% respectively. Furthermore, only two of the previously highlighted 13 one year + bull markets lasted fewer than 2 years.

Given this consistent string of historical data, Bespoke Investment Group concluded that, “Bull markets that pass the one year mark have almost always lasted two years or more.” We, at Hennion & Walsh, agree with this sentiment and believe that this particular bull market should likely follow suit although it will likely face many more global economic and political impediments than previous bull markets faced.

As part of our annual portfolio reconstitution process at Hennion & Walsh, we strive to build forward looking, asset allocation-oriented portfolios based on our internal views of where we believe both the markets and economy are heading for the next year. For your benefit, I have provided our five potential scenarios for 2010, based upon information available to our research team at this point in time, with an internal probability assigned to each, below:

Scenario 1:
Transition Year
Probability Assigned:
40%
Scenario Description:
This scenario is predicated on the understanding that the year following the initial recovery year from a bear market is often characterized by a pause, more volatility and uncertainty. These years may often coincide with a mid-term or election year - which is the case this year. Unwinding quantitative easing measures and possible interest rate hikes create intermittent starts and stops throughout the year. Overall market results are probably close to conventional market returns, similar to the trendless volatility we have witnessed with respect to the S&P 500 index over the most recent 10 year trailing time frame.

Scenario 2:
Deflationary Stagnation (i.e. “L” shape recovery)
Probability Assigned:
20%
Scenario Description:
This scenario would occur if the economy proves too weak to resume sustainable growth in the absence of, or prospect of, less government support but not so weak as to fall into a “double-dip” recession. Under this scenario, unemployment remains high, real estate prices do not fully recover on a national basis, and consumer demand remains soft. The velocity of money would also remain muted and commodity prices slowly decline.  All of these factors threaten a “Japanese style” protracted, anemic economy.  

Scenario 3:
Bullish Recovery Surprise (i.e. “V” shape recovery)
Probability Assigned:
15%
Scenario Description:
This scenario follows our belief that economists generally are not successful in calling market turns in advance. Markets traditionally recover strongly from strong declines. As a result, there is a “boomerang effect” not easily detected until after it happens. Following this effect, inventory draw-downs lead to an increase in orders which further leads to an increase in hiring and eventually, an all-important increase in consumer spending.

Scenario 4:
Return of Inflation
Probability Assigned:
15%
Scenario Description:
Under this scenario, the economy recovers and more dollars are chasing fewer goods causing prices to rise and inventory shortages to develop. Inflationary pressures intensify as the Federal Reserve either acts too late, does too little or adds even more money to the system through yet another stimulus package. In considering this scenario, one should remember that the technical definition of inflation is when money enters the system at a quicker pace than it is leaving the system.

Scenario 5:
Double-Dip Recession (i.e. “W” shape recovery)
Probability Assigned:
10%
Scenario Description:
The scenario is the extreme version of scenario #2: Deflationary Stagnation; where the economy proves much too weak in the absence of, or prospect of, less government support and/or a Sovereign Debt, Credit, Geopolitical  or Real Estate related crisis occurs and pushes the economy into a dreaded double-dip recession.

What to make of the Fed’s Recent Interest Rate Hike

The Federal Reserve surprised virtually everyone after the markets closed yesterday by announcing their intentions to raise the Discount Rate by 0.25% (i.e. 25 Basis Points) from 0.50% to 0.75%.  This marks the first time that the Federal Reserve has raised the Discount Rate since June of 2006.

Perhaps more importantly, the Federal Reserve also curtailed the duration of the loans from the “discount window” from 28 days to overnight.  So what does this recent action suggest about the direction of interest rates and the status of the economic recovery? Let’s examine each these two interrelated areas separately.

The Discount Rate is the interest rate the Federal Reserve charges to commercial banks and other depository institutions from the discount window at the Federal Reserve. These loans are generally short term, emergency loans.  This rate historically has ranged between 0.25% - 0.50% above the more recognized Federal Funds Rate. It is the Federal Funds Rate, which many other rates of credit rely upon for direction that has more of a direct impact on the U.S. economy as the Federal Funds Rate which is the interest rate at which depository institutions lend their balances at the Federal Reserve to other depository institutions. Through their open market operations that Fed attempts to implement their current monetary policy towards an intended Federal Funds Rate. This rate was not part of the recent Federal Reserve action although many individual investors probably thought that it was and remain confused by the distinction between the two interest rates. While the increase in the Discount Rate does not guarantee an increase in the Federal Funds Rate, and the Federal Reserve even suggested in an accompanying statement their move will not necessarily lead to a change in monetary policy through adjustments in the intended Federal Funds Rate, history suggests that it is almost a foregone conclusion and given that the Federal Funds Rate is currently close to 0%, it is reasonable to suggest that the rate certainly cannot go any lower. The question then becomes when and to what extent.

In terms of the implications of the move on the status of the U.S. economic recovery, the Federal Reserve is standing by their previous contentions that they intend to leave the Federal Funds Rate low for an extended period of time in an effort to continue to try to stimulate a struggling U.S. economy. While this may be accurate, we, at Hennion & Walsh, also believe that the Federal Reserve recognizes the imposing threat of inflation and perceive this as a first step along a longer-term, measured exit strategy with the ultimate goal of returning the credit markets to a more normal state of operations.

While the market generally does not like surprises, this one may very well have been a welcomed one.

If you have been wondering what specifically has been one of the main culprits in the stock market devaluation in recent days, look no further than to a group of countries in Europe affectionately known as the P.I.I.G.S. The countries, which many believe are the weaker components of the Euro-zone, include Portugal, Ireland, Italy, Greece and Spain.

There has been mounting concern that these countries will continue to struggle to control their own budget deficits. Such a struggle could lead to rating downgrades or even, in the most extreme case, defaults on interest payments related to the sovereign debt that each of these countries have outstanding. Such a credit action could send shivers through the global capital markets especially at a time when frozen credit markets are just beginning to thaw.

Based on the information available to us, we, at Hennion & Walsh, do not believe that this negative domino effect will come to fruition but do believe and understand the concern that many investors have when the topic of a potential sovereign default arises.

Using the Effective Federal Funds Rate as a proxy for interest rates, it is reasonable to conclude that interest rates are at historic lows and likely to only go higher. 

With the understanding that interest rates will not/cannot go any lower (i.e. the Effective Federal Funds Rate now stands at close to 0%) , the question then becomes when will interest rates start to creep upward again? We, at Hennion & Walsh, do not believe that there is a high likelihood that the Federal Reserve will raise interest rates in 2010 due to their publicly stated position of continuing to prioritize the stimulation of the economy, lingering difficulties in the credit markets, and the political effect of mid-term elections along with the expected low levels of economic growth.  

However, there is a chance that the Federal Reserve may raise rates in a measured fashion by the end of the year if, in fact, their own Real GDP Growth rate forecasts (n.b. the Federal Reserve recently revised their Real GDP forecast to an annual growth rate between 2.5% - 3.3% for the new year) come to fruition and, in so doing, put economic growth over the unofficial Federal Reserve inflation target of 1.5% - 2.0%. If this does not occur, record low interest rates will continue to serve as an anchor to the strength of the U.S. dollar and present investors with intriguing overseas and alternative investment opportunities.

The Commerce Department today reported a 5.7% increase in gross domestic product (”GDP”), at an annual rate, during the fourth quarter of 2009 - 5.7%!  This exceeded the 4.8% consensus median forecast by close to 20% on a relative basis. It also followed a 2.2% GDP growth rate in the third quarter of 2009. So why is the U.S. stock market barely reacting to this seemingly positive trend? The answer to this question lies in some of the significant data components underlying this most recent GDP report.

As you will see from the chart above, the all-important personal consumption expenditures (”PCE”) figure actually decreased from the previous quarter. In our opinion, if consumers are not spending in a meaningful fashion, the economy cannot continue to grow minus any external stimulus.   Further, excluding the change in inventories, GDP would have only grown at about 2.2% (annualized) during the fourth quarter. Hence, while we never want to look past any positive economic data, the most recent GDP data does not, by itself, add any support for the belief that a sustainable economic recovery is developing.

Even with the healthy second half of the year, as measured by the GDP growth rates in the 3rd and 4th quarters of 2009, the U.S. economy still shrank by 2.4% overall in 2009 and unemployment currently stands at over 10%. Until job creation begins to kick-in and consumers, and businesses, start to make more capital outlays, we, at Hennion & Walsh, feel that significant GDP growth in 2010 will be challenging.

Earlier this morning, credit rating service Standard & Poor’s (”S&P”) revised its credit outlook on Japan to “negative” from “stable.” This could seemingly pave the road to a future downgrade to Japan’s current AA long-term rating. As part of rationale behind the revision to their credit outlook for the country, S&P cited concerns over amount of Japanese government debt outstanding. Japan’s government debt is already among the highest in the world and S&P thinks the debt burden might peak at a level as high as 115% of their Gross Domestic Product (”GDP”) over the next few years.

After reviewing this report, our minds, at Hennion & Walsh, immediately turned to the United States to see if a similar rating action could be possible for the U.S. given the size of debt outstanding vs. our own GDP.  While the projections are not as alarming as those of Japan, they still paint a concerning picture.  According to the Office of Management and Budget, the following table provides the recent and projected Gross Federal Debt to GDP ratios.  Please recognize that these figures contain projections and are as of a point in time.

Moody’s and Fitch, two other credit rating services, went on further recently to suggest that Japan’s debt burden was “relatively moderate” and expressed confidence that “the market will finance them without putting big upward pressure on yields.”  We believe this to be the case for the U.S. as well although we may very well reach at point where the overall debt burden in the United States is too high for certain foreign investors and credit rating services.

U.S. existing home sales fell by 16.7% in December 2009, to 5.54 million units, which was far worse than many analyst expectations. This report follows much better than forecasted existing home sales results this past Fall season - which culminated in a 26% surge over the three months prior to December.  

The hit to existing-home sales in December suggested to many that perhaps there is more downside risk in residential real estate. We, at Hennion & Walsh, do not believe this to be entirely realistic and still contend that there is more downside risk in commercial real estate than residential real estate at present. We would suggest that many of the positive results observed in the housing market during the Fall season can primarily be attributed to distortions created by consumers believing that the 1st Time Home Buyer Credit program was about to expire. Since many of those earlier sales were essentially “front loaded” it should not be too surprising that current sales are pulling back.

However, on a positive note, a careful review of the underlying data shows that residential real estate is still on the path to recovery while recognizing that different areas of the country are recovering more quickly than others. The chart from the National Association of Realtors provides credence to this viewpoint.  Further, first time home sales remain 15% above December 2008 levels.

In addition to the home buyer program incentive previously discussed, the recent poor housing numbers are likely just a lingering impact of high unemployment, general consumer spending apathy and an overall sluggish U.S. economy.  The continued recovery in the housing market is contingent upon future growth in the job market.  This becomes even more of a concern when one factors in a 2010 consensus unemployment rate forecast of 10.1% (vs. a 2009 year-end unemployment rate of 10.3%), according to Blue Chip Economic Indicators.

According to the Bureau of Labor Statistics, the current official unemployment rate is 10%. The official unemployment rate, often referred to as the U-3 rate, represents the total unemployed as a percentage of the civilian labor force.  

However, the statistic does not include all Americans that are currently unemployed. For example, the statistic that we, at Hennion & Walsh, often look to for a broad assessment of the employment picture in the United States is the U-6 rate which measures the total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all marginally attached workers. At present the U-6 rate stands at 17.5%, which according to Jeff Cox of CNBC.com in a Nov, 19, 2009 article entitled, “The ‘Real Jobless Rate: 17.5% of Workers are Unemployed,” is the highest this rate has been since becoming an official labor statistic in 1994.

Hence, the question becomes where will all of the new jobs come from to put America back to work again? As this question is pondered, one should remember that America is no longer defined by its manufacturing prowess.  Rather, the U.S. economy is now more of a service oriented economy driven on the heels of innovation. As a result, we will not be able to depend on a surge in manufacturing jobs that historically have accompanied economic recoveries. New jobs will likely just be recycled finance industry jobs or completely new jobs resulting from innovative companies focusing on developing areas such as alternative energy. Regardless, we do not expect to see a significant dent made into unemployment in 2010 and it may take several years and a major shift in the global economy to get America back to full employment - which many academics believes lies somewhere between a U-3 unemployment rate of 3% and 4%.

In the annals of Wall Street lore, many professional investors believe that the ‘January effect” has a positive impact on stocks during the initial weeks of a new year. The belief holds that investors who sold stock at the end of the previous year for tax reasons look to buy back stocks at the beginning of the new tax year, thus driving stock prices higher. In addition to tax-related trading, we believe that the January effect may be more pronounced this year than in previous years given the amount of money still sitting on the sidelines and in bond funds.

Further to this end, according to the Stock Trader’s Almanac, the last 36 times the first five trading days of a new year were positive, the stock market ended the year positive in 31 of these 36 years. This equates to an 86.1% accuracy ratio.

As a result, many investors are focusing on these first few trading days of January for potential 2010 stock market outlook indications. While this kind of analysis may be interesting, we, at Hennion & Walsh, tend to be skeptical of relying solely on these kinds of statistics. One would only have to look back to last year to find a violation of these widely accepted beliefs. As you will recall, January 2009 was a very difficult month for stocks but then the stock market improved considerably, notably after the bottom of this particular bear market was reached on March 9, 2009.

We believe that economic growth will likely be muted in the U.S. in 2010 and that a significant dent into the existing high level of unemployment will not be accomplished. As a result, the Federal Reserve will find it challenging to raise interest rates although inflationary concerns may present cause for them to do so. Low interest rates will continue to serve as an anchor to the U.S. Dollar and create opportunities overseas - particularly in certain emerging markets.

Following this line of reasoning, having a portfolio that consists primarily of U.S. large cap stocks, as many investors tend to, may present unnecessary risk to the growth portion of an investment portfolio following a decade where, according to MarketWatch, the U.S. large cap dominated Dow Jones Industrial Average (”DJIA”) lost 9.3% - the second worst decade performance in history. In our opinion, investors should sit with their financial advisors and consider a wide range of asset classes and investment strategies when conducting their annual portfolio reviews and re-balancings given the uncertainty and expected volatility in the markets in the months and quarters ahead.