Outlook

In the aftermath of a painful 2008 for equity markets, 2009 begins with powerful forces at work. We believe it is possible markets will begin the recovery process in earnest by the second half of the year. This expectation is based on the raw power of the enormous resources being brought to bear on the financial crisis in every country. Already there is a staggering amount of fiscal and monetary stimulus in the pipeline with more to come.

While these solutions typically operate with a lag of about six months to a year before being felt in the economy, the monetary and fiscal stimulus measures announced thus far – the Troubled Assets Relief Program (TARP), low interest rates, central banks funding, and plans for a massive government stimulus – are forces that we believe will aid economic recovery and that capital markets will discount ahead of the increased growth they cause.

We remain optimistic about the prospects for equity-market investing and see potential for a rally that will begin making up for ground lost last year. The market discounted dire outcomes for the fourth quarter of 2008 and sent equity valuations to a very low base in a variety of sectors. Expectations have come down significantly for a lot of those companies whose stocks fell most in the fourth quarter. As a result, valuations are attractive and earnings hold potential to surprise on the upside beginning in early 2009.

The slide in stock prices last year has presented attractive opportunities. The potential for price appreciation is high, given today’s level of valuation on the S&P 500.

Particulars

• Recoveries in the economy and markets will be highly dependent on improvement in the financials sector and in the credit market. This means we need to see banks and businesses willing to loan and people willing to borrow. Businesses will only invest if they feel reasonably confident about the future, otherwise they’ll move to lockdown mode. At the margin, we think individuals and businesses will be conservative with discretionary cash flow given the current state of the economy. But as the economy picks up and confidence improves, the purse strings will begin to ease.
• Given the magnitude of crisis and loss in 2008, financial conditions have gone so bad that even the best intentioned efforts of virtually every country and all of their leaders have been discounted as potentially failing. We don’t think they will. We believe the biggest issue will be the timing of massive global stimulus. While it’s possible the effects of the stimulus could take longer than people expect, ultimately things will get better. On a cautionary note, we see a risk that the enormous stimulus won’t gain traction, that credit conditions won’t improve and that countries turn protectionist. This would severely undermine recovery.
• The market may already be undergoing a bottoming process. Our view is that, somewhere along the line, markets will discount the future and begin to move higher, even when unemployment rates are rising and the macro environment still is disappointing.

Opportunities and Threats

• We believe, in the current environment of scarce growth, companies that can deliver consistent earnings, those with strong balance sheets and are stable growers will have a performance advantage for all of 2009.
• We see opportunity in cyclical companies in the second half of 2009. While these companies may be down and out today, other consumer discretionary stocks are poised to do much better as the economy improves.
• Our health care exposure declined as we entered the first quarter for a couple of reasons. First, we see growing pressure on hospital capital spending plans given the recession. Projects are being pushed back and cancelled to the detriment of some of the big hardware companies in health care. Second, managed care companies warrant caution as enrollment declines along with rising unemployment rates.
• Over the course of the fourth quarter, we lowered exposure to energy and industrials stocks. We’re modestly underweight information technology.