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.

Closed-end funds are funds with a fixed number of shares outstanding and, as a result, trade more like a share of common stock than their open-end fund cousins which trade at their net asset value (”NAV”). Shares of closed-end funds can trade at a price that is either a discount or a premium to their net asset value based upon market demand. This condition can often lead to much greater volatility and price dispersion for closed-end funds when compared to open-end funds.    For example, according to the Stifel Nicolaus October 2009 Closed-End Funds Monthly Review report, closed-end funds have traded at an average discount to their NAV of 4.52% over the last ten-year period.

The historic market downturn of 2008, and early 2009, brought the average discount of closed-end funds to as high as 11.35% at the beginning of 2009. This created some very interesting valued oriented opportunities for investors looking to take advantage of these deep discounts. The performance of the closed-end fund marketplace reflects this heightened investor demand as, according again to the Stifel Nicolaus October 2009 Closed-End Funds Monthly Review report, the average year-to-date price return for all closed-end funds was 36.60%, the average year-to-date NAV return for all closed-end funds was 25.58% and the average discount level has returned to a more historically typical level of 4.66%.

We, at Hennion & Walsh, believe that the current average discount level of closed-end funds may increase as investors look to implement year-end tax selling strategies. This belief does not mean that all investors should start flooding to closed-end funds for these reasons alone as closed-end funds contain their own unique set of risks, as previously discussed, and may not be appropriate for all investors or the best available investment security type for all asset classes or sectors.

Last week, prior to the Thanksgiving holiday, the Dubai government announced that it will look to restructure Dubai World; a government owned conglomerate, and asked creditors for a six-month delay on outstanding debt payments. The total liabilities of Dubai World are estimated to exceed $60 billion with existing creditors spread across much of the developed and emerging world markets. The announcement took much of the world by surprise and caused the U.S. stock market to open over 200 points lower although the drop was essentially cut in half by the close of the shortened trading day last Friday as traders and investors put the announcement into perspective. Additionally, as I write this post, the United Arab Emirates has indicated that it would step in, as needed, to support local banks through a special liquidity facility. This should help to stem fears of a potential run on the local banks that could have negative ramifications throughout the region.

More than anything, we, at Hennion & Walsh, believe that this event should serve as a reminder of the risks that are present in emerging markets and in the global capital markets as a whole, notably the financial sector, as the global economy continues to try and find its legs following the demise of the credit markets worldwide in 2008. It is clear to us that the global economy has not yet recovered and many potential bumps in the road to recovery still exist.

However, this has not stopped the rapid ascent of the emerging markets thus far in 2009. In fact, according to Emerging Global Advisors, the Dubai announcement had a negative weekly impact on emerging market sectors such as financials, energy and industrials according to the Dow Jones Emerging Markets Sector Titans Index. Yet, for 2009 year-to-date, all of the covered sectors, including the three previously mentioned sectors, have experienced double-digit returns.

It is often said that risk drives return when investing. However, investors should always first make sure that they fully understand the risks that they are assuming with any particular investment before making such an investment. After understanding the underlying risks, investors should then feel comfortable with the return that they are receiving on an ongoing basis for accepting the associated risk while also balancing the accepted risk within a diversified portfolio commensurate with one’s personal risk appetite.

We have all heard the age-old wisdom that gold can provide for a hedge against inflation. The Federal Reserve has recently contended that inflation is not an immediate threat or concern to them. In fact, Ben Bernanke, Chairman of the Federal Reserve, said in a speech earlier this week that “…the U.S. economy still faces considerable challenges but the most likely outcome is moderate growth with subdued inflation.” Despite this, Gold has rallied significantly in 2009 - noticeably in recent weeks. What then is accounting for rising Gold prices?

We, at Hennion & Walsh, believe that it is due to a number of factors. The first factor would have to be the value of the U.S. dollar. As the value of the U.S. dollar has weakened, given record low interest rates, U.S. dollar based investments, such as U.S. Treasuries, have become less appealing to investors - including foreign governments. These investors are now looking to Gold for its perceived safety and return potential.

Secondly, we believe, to a degree, that it is due to traditional supply/demand pressures. The actual worldwide supply of Gold is limited, and, despite the efforts of many mining companies, new sources of Gold ore are becoming increasingly difficult to find. As with any commodity, limited supply and increased demand leads to an increase in price.

Lastly, we do believe that investors, despite the comments of Bernanke and others in the media, sense that the threat of inflation is upon us and the future direction of the market is unclear. This is likely also the reason why we have seen equity and bond markets both rise in recent weeks despite the historical negative correlation that has existed between these two asset classes. For these types of investors, Gold appears to be an adequate investment at this inflection point for a portion of their investment portfolio.

Other metal based commodities are also benefiting from the Gold euphoria. Silver, Palladium and Platinum have also seemingly grabbed onto the coattails of the run-up in the price of Gold. The return of Silver, in particular, which actually has more industrialized uses than Gold, has outpaced Gold by more than 2-times thus far in 2009. To help better illustrate the performance of Gold and Silver in 2009, a chart, which shows the Year-to-Date performance of two ETF’s that attempt to track these two commodities, is provided below.  The two ETFs used in this analysis are as follows:

SPDR Gold Shares Trust (Ticker: GLD)
iShares Silver Trust (Ticker: SLV)

While a rise in U.S. interest rates may strengthen the value of the U.S. Dollar and thus lessen the attraction to metal based commodities such as Gold, we don’t believe that this will happen anytime in the near future and an allocation to commodities, whether through a basket of commodities or collection of single commodities, in most investment portfolios is worthy of consideration.

*The above information is for illustrative purposes only and does not reflect a recommendation by Hennion & Walsh or any of its representatives to buy or sell.