February 2010

Fourth-Quarter Market Update and Outlook

The Economic Environment

As expected, the U.S. economy returned to growth in the third quarter of 2009. Marked down from the original estimate of 3.5 percent, the final revision to real GDP growth was 2.2 percent.1 The impact of government stimulus programs on consumer spending was apparent in these results. The “cash for clunkers” program was a catalyst for automobile sales, while residential investment was strengthened by temporary government incentives for homebuyers.

However, other forces also contributed to growth. After the economy declined rapidly in late 2008 and early 2009, inventory levels became lean as businesses reacted to a significant slump in demand. As the economy improved in the latter half of 2009, a considerable rebuild of inventories took place, which contributed nearly one percentage point to growth in the third quarter. Also, exports continue to be strong as the weak dollar and more rapid rate of rebound in certain foreign economies have resulted in an increase in U.S. goods and services sold abroad.

The peak in U.S. unemployment so far in this cycle was reported in October, with the rate rising to 10.2 percent, the highest level since 1983. However, the November and December rate unexpectedly fell and steadied at 10 percent, as employers cut the fewest jobs since the start of the recession. Meanwhile, the number of temporary workers hired increased for a fifth straight month in December. Significant and consistent increases in temporary hiring are typically a precursor to gains in permanent employment, implying job growth may return to the economy as early as the first quarter of 2010. Yet given the magnitude of job losses during this recession, it could be mid-decade or later before prior levels of employment are reached.

Growth in productivity, simply defined as the amount of output per unit of labor, continues to be very strong at
6 percent since the recession began. In the short run, this is negative for job growth, as the increase in worker productivity allows companies to defer new hiring longer into a recovery. However, in the long run, productivity is the primary engine of economic growth. Greater productivity lowers costs and increases the standard of living of workers. The primary drivers of gains in this measure are technological advancement and innovation, areas in which U.S. companies excel. This factor will play an important role in how well our economy heals from the troubles of the past two years and grows in the future.

Economic growth expectations for the fourth quarter of 2009 are currently in the range of 3 percent to 4 percent. The Christmas selling season was decent for retailers, stimulus measures continue to provide a boost and year-over-year comparisons are pretty easy given the poor state of the economy during the fourth quarter of 2008. For the full year of 2010, expectations are in a similar range of about 4 percent, with strength in the first half of the year fading somewhat as the stimulus effect wanes. Although not as robust as the typical first year of recovery, the return to growth is welcomed as we enter 2010.

The Stock Market

Stock markets around the globe continued to advance during the fourth quarter, albeit at a more modest pace than in the two prior quarters. Still, the rebound from March lows was astounding, with gains of more than 60 percent from those depressed levels. The year of 2009 ranks as the second-best performance year of the decade, with the S&P 500’s 26 percent gain trailing only the 28 percent return in 2003. Here are the fourth-quarter and full-year results for the major global stock market indexes:

Index	4Q2009	2009 YTD
S&P 500	6.04%	26.46%
S&P Mid-Cap	5.56%	37.38%
Russell 2000	3.87%	27.17%
MSCI EAFE	4.06%	31.78%
MSCI Emerging Markets	8.58%	74.14%
Sources: Standard & Poor's, Morningstar, Inc.

The 2009 market environment proved to be the antithesis of 2008, with every equity asset class around the world advancing, most by a significant amount. The improvement in 2009 began as a “relief rally” from oversold levels and was led by the most risky and lowest-quality investments. This is not atypical coming out of a deep recession, with the rising tide lifting all ships in dramatic fashion. However, stocks offering favorable valuation, strong cash flows and higher-quality balance sheets are likely to become more coveted in 2010.

Companies aggressively reduced staff and expenses in late 2008 and early 2009 due to imploding business conditions. Consequently, there will likely be a surprisingly strong rebound in corporate profits in the coming year. While the economy is expected to grow by roughly 4 percent, profits are expected to grow by as much as 25 percent to 35 percent largely due to lean expense structures currently in place across corporate America. Based on analyst estimates, 40 percent of S&P 500 companies will be within 5 percent of all-time peak earnings levels in 2010. Given current price levels, this would result in a reasonable market valuation by historical standards.2

Owning international stocks proved to be rewarding in 2009, with developed markets returning more than 30 percent to U.S. investors and emerging markets north of 70 percent. The weakening dollar was a significant driver. As the dollar stabilized during the fourth quarter, the performance of U.S. and foreign markets converged. Although the majority of the positive currency effect may be behind us, international stocks (particularly the emerging markets) will continue to play an important role in portfolios as the incremental growth in the world economy continues to shift away from the U.S.

The Bond Market

Returns in the bond market were well above average in 2009. Credit concerns abated as the year progressed, causing bond prices to improve across most sectors. The result was impressive total returns. The BarCap Municipal Bond Index returned nearly 13 percent in 2009, while the Morningstar Corporate Bond Index gained more than 17 percent.

The one area struggling in 2009 was the U.S. Treasury market. The yield on the benchmark 10-year Treasury note started the year at 2.2 percent, as investors chose safety of principal over opportunity for return. However, record new issuance of Treasury debt (to fund the various stimulus efforts), coupled with a decrease in risk aversion pushed the yield of the 10-year note up to 3.84 percent by year’s end. When yields rise, bond prices fall, causing the Treasury segment to be the only portion of the bond market to post negative total returns in 2009. The result was a more pedestrian gain for the broad BarCap Aggregate Taxable Bond Index, which was up about 6 percent in 2009 due to its significant allocation to government debt.

Returns from bonds are likely to be much more modest in 2010, as rates have normalized and may be more likely to rise than fall in the intermediate term. Although the Federal Reserve Board is likely to be on hold with short-term interest rates in the first half of the year, the Fed may begin to wind down its purchases of Treasury and mortgage bonds (instituted last year to provide liquidity to these markets) which would cause some upward pressure on rates in these sectors. A total return similar to average coupon rate should prove to be a good result in 2010.

The Investment Outlook

Despite the gains of the past year, stocks remain 25 percent below peak levels of late 2007, reflecting an economy in repair. The 10-year average annual return for the S&P 500 index is now slightly negative, which is relatively rare in market history. For investors with a sizeable investment in stocks, this challenging market environment has proven to be a significant roadblock toward achieving financial objectives. Committing to an investment strategy at the appropriate level of risk will be an important success factor in the coming decade, as history suggests decades of particularly poor performance are usually corrected by a “reversion to the mean,” or an improvement in future returns. The Treasury bill and cash “safe havens” of the tumultuous periods in late 2008 and early 2009 are no longer poised to contribute much toward achieving financial goals, as both yield under 1 percent. The rotation away from these extremely low-yielding investments was a significant factor in the performance of asset classes worldwide in 2009. This trend should continue as we move forward, although in a less exaggerated manner.

In the near term, significantly improved profits should continue to support stock prices. Year-over-year comparisons are easy for both the economy and specific companies through the first half of 2010. In the back half of the year, the focus will be on improvements in employment trends and momentum in the world economy as primary drivers of sustained growth.

Inflation should be relatively contained in 2010. With unemployment at 10 percent and factories operating at 70 percent capacity, there is plenty of slack in the system. However, as conditions continue to improve around the world, inflation may begin to rise. This, combined with the unwinding of the Fed’s quantitative easing program mentioned earlier, could put upward pressure on interest rates later in the year. If rates rise for the right reason, meaning an increase in economic activity, stocks should perform better than bonds in the short run.

In summary, 2009 was a year of tremendous progress toward the recovery of value lost during the brutal bear market that began the year before. The key changes we instituted in portfolios during the first half of 2009, which all proved to be productive in enhancing participation in the market recovery, included:

1. Increased allocation to international investments
2. More focus on emerging markets within the international allocation
3. Increased exposure to alternative investments
4. Addition of satellite bond components

In recognition of the significant progress made since March, our portfolio management team has begun to actively rebalance portfolios to capture gains and reduce risk as we enter 2010. This is not due to a pessimistic view of the market going forward, but simply an acknowledgement of the magnitude of the gains experienced in 2009 and the realization that returns will likely be more gradual in the year ahead. Thank you for the confidence that you have placed in your BKD Wealth Advisor team and best wishes for a healthy and prosperous 2010!

---

1 Source: ISI Group
2 Source: JP Morgan

The views presented in this Market Commentary are those of the Investment Committee of BKD Wealth Advisors, LLC and do not represent any specific investment returns or promises of performance in the future. The comments in this Market Commentary are not to be construed as investment advice or the recommendation to buy or sell any specific investments. Before making changes to your current portfolio, please consult with your advisor for a personal consultation.