Stock market recovery rational but fragile

So what now, and what to expect?

There was huge damage to the economy. The most serious injury was that net worth in the United States fell from $60 trillion to $46 trillion in less than a year. Thus, the average household was poorer by 25%, equivalent to an entire year's worth of economic output.

The consumer was in trouble and needed help.

Government influence cannot be overstated. Three policies are foremost: keeping interest rates low through debt repurchase programs and easing of funding requirements, serving as lender of first resort to financial institutions, and putting stimulus plans in place. These policies have generally been successful. But the balance is fragile and palliative rather than remedial.

To understand better, let us look at the economy, the credit and stock markets.

The economy has shown progress in recent months, but with caveats. First, for every positive leading indicator, there have been equally strong negative indicators. Incentives such as Cash for Clunkers and a first-time homebuyer's credit have helped the headline numbers but have not changed the underlying downward trends. Disconcertingly, we have also seen reported economic indicators revised downward. But the biggest concern remains unemployment — or, more accurately, underemployment. The headline number of 10.2% is understated. Once we count those on furlough or reduced hours or working part time and those no longer seeking work, the figure is closer to 16%.

In that light, it will be some time before the economy recovers fully.

Money has been artificially cheap this year. Short-term rates have not risen above 0.2%, allowing banks to rebuild capital at attractive terms. The Federal Reserve has confirmed its intent to maintain an “accommodative” monetary policy for some time and is continuing its $1.3 trillion mortgage-backed-securities repurchase program. This, along with an equally expanding fiscal policy, means that there remains a large supply of government debt.

Normally, this spells upward pressure on interest rates and inflation. But we remain confident about the credit outlook for two reasons. First, buyers are plentiful. Aside from pension plans' looking to match underfunded liabilities with fixed-income investments, banks are rapidly expanding their securities purchases.

Second, inflation remains low. Traditional signals, such as gold, the yield on Treasury inflation-protected securities and the spread between two- and 10-year government bond yields, suggest calm on inflation.

The stock market gains from the March lows have been impressive. This is due to two very solid reasons and one disconcerting reason. First, companies showed a resolve to cut costs. They ran inventories down, reduced capacity and work forces, and produced remarkable productivity gains. They also rebuilt balance sheets and improved cash flows, most notably in the financial sector.

To some extent, however, the government is fueling the rally by producing close to zero financing, making shares extremely attractive. All sectors seem to be enjoying a boom, and those with exposure to emerging markets, even more so.

We see valuations as reasonable but no bargain. Sentiment remains fragile, and some consolidation around the 1,000 to 1,100 level in the S&P 500 seems likely. We would place our trust in companies that have reliable cash flows, defensible franchises, visible earnings and strong management. There are plenty of companies trading with well-covered dividends. Cash in hand should provide an important part of total return.

About 70% of global growth came from emerging markets this year. The theme of global re-balancing means a gradual and inevitable tilt toward seconomies that have low debt, thriving companies and coordinated public policy and private enterprise. China, for example, has led the way, showing gross-national-product growth in excess of 7%, and foreign stock markets have had a strong year. Even with a gain of 21.6% year-to-date through Nov. 11, the U.S. market trails many Asian, Latin American and European emerging markets by a long measure. There may be continued strong opportunities in selected international markets.

Christian W. Thwaites is president and chief executive of Sentinel Asset Management Inc.