With a tumultuous 2009 ending with stronger markets than at its start, there remain miles to go and promises still to keep for normality to actually be in place. At various levels from governments/ central banks to financial institutions to individual corporations and not just amongst investors, there remains a reluctance to accept that part of the solution for normality lies in not detachment but recognizing their participation in the build-up of the credit crisis. In addition to funding massive deficits, markets are likely to have to operate with differing challenges for authorities ranged from inflation and deflation as well as the efficacy of prior funding, all insidious. Financial institutions systemically remain crucial but are still in a required reversal required from management for better balance between being marketers of securitized products and being bankers. Such evolution could take years and as a central theme, we expect to favor quality in operations/services as well as balance sheets. Such a stance may appear innocuous but in fact represents a radical departure from the market behavior of the cycles since the 1980s which progressively ratcheted upwards, albeit with hiccups, on accelerated credit and lowered standards. For both the S&P 500 and globally the MSCI World index, valuations are not low. Post their 1990s’ debacle, Japanese corporations may have exacerbated duress by forcible cost savings from struggling suppliers. Now and globally, we expect farsighted companies to eschew such pressures—another dimension to our favor for quality. Sector wise, we see the financials as crucial and favor as well amongst operating sectors the industrials; the information technology space especially communications; healthcare especially pharmaceutical/biotech restructuring; large cap energy and gold/precious metals in materials as hedge.

At central bank/government levels, we differ from the prevailing sentiment amongst central banks of a firefighting analogy. In fact, if a broader perspective of the buildup to and the flare-up of the credit crunch continuing into 2009 were taken, central banks were active participants in the conflagration. The deep skepticism among the populace at large on issues like quantitative ease and its value at the grass roots has as much to do with central banker surrealism about past actions as it with the very real issues of funding channeling down from the largest institutions into the real economy. This skepticism is being reflected in the intense grilling for instance of Federal Reserve chairman Bernanke at his conformation hearings. As a second dimension, while 2008 and a large part of 2009 may have been about providing largesse in the form of quantitative ease, even in this mass of liquidity, very different challenges appear and we highlight the three extremes of deflation, inflation and efficacy of utilization of the ease provided. In Japan, despite years of providing liquidity and with distortive effects on government finance, deflation remains a very issue. In India, inflation especially in food appears too high to ignore especially with its impact on the very poor. While clearly not at that extreme, from the large economic zone of Europe to smaller countries such as Australia and Israel, worries exist about the risks of inflation increases. Last but not least, in the form funding to assuage crisis, in the aftermath of its over half trillion dollar injection fears exist within China that further distortion of the economy may have taken place while in the United States and at a far larger scale than the yen carry trade, quantitative ease and zero interest rates have unleashed a dollar carry that may be distorting finance already. Incidentally, despite decades of largesse by the Bank of Japan, the yen carry trade has yet to seamlessly evolve into improved credit availability at the small company level. In addition to funding deficits that are massive by any standards, markets are likely to have to operate with differing challenges ranged from inflation and deflation as well as the efficacy of prior funding, the effects of all of which can be insidious.

Financial institutions systemically remain crucial but are still in the early stages of a demographic reversal required from management for better balance between being marketers of securitized products and being bankers. For too long as seen in Freudian slips, financial institutions have been more concerned with peer comparisons rather than in the absolute lessons of banking. While as political bodies, governments from the United Stares to Europe to Asia did play a role in encouraging lower quality lending, by the standards of past actions such as pre war Germany, bankers were not under duress to participate but did so willingly. From being bastions of capitalism in many economies and not just on Wall Street, and notwithstanding the payback of TARP capital, finance essentially turned in 2007/9 to being a ward of the state. We believe the undercurrent of the current bonus debate has to do with still belated transition into re-absorbing the lessons of human hubris that were built into an earlier model of finance. Increased favor in Washington for re-installation of Glass-Steagall separation and globally of reducing the size of individual institutions to promote diversity appears very different from the populist anger of prior crises. It nonetheless requires leadership from financial institutions that evolves beyond the hitherto actions of circling the wagons and lauding the value of the securitization model. Financial management is likely to have to beyond the comfort zone of its experience of securitization and volume and into the realm of higher efficiency as well as stronger capital ratios that were the hallmark of the leading financial institutions of the 1950s and 1960s in a wide range of countries from war ravaged Japan/Germany to developing economies to the United States. Further capital and more focused businesses will be required with dilutive impact initially compared to the high leverage model of this decade for finance.

Last but not least, equity markets have in the last several weeks turned into trading zone like activity. For both the S&P 500 and globally the MSCI World index, valuations are not low. As in prior cycles, often committed fallacies we endeavor to avoid include comparisons of current P/E ratios on anticipated earnings with those historically generated and generally based on trailing released earnings-- for the simple reason that expectations built in the past for instance in the 1930s or that matter in the 1960s were unknown. On equity risk premiums based on dividend discount rates as well, narrower spreads are likely from movements upwards of long dated government bond yields to reflect both normality and the new realm of massive budget deficits. While our operating earnings estimate for 2010 of 75 for the S&P 500 appears now within consensus, we believe that the underling issue for both equity and credit markets is likely to be one of sharp bifurcation at the country, industry and company levels. Post its credit debacle in the 1990s, much has been made about misjudgments by the authorities in Japan, but Japanese corporations may equally have exacerbated ongoing systemic duress by deviating from their successful models of nurturing smaller suppliers and moving to models in which cost savings were forcibly extracted from struggling smaller companies. While such actions may have stabilized near term results for large companies, the longer term systemic consequences have likely also been those of weak employment and domestic demand. Globally, we expect the more farsighted companies to eschew such pressures and instead strengthen suppliers ( much like German and Japanese companies of the 1950s)—another dimension to our favor for quality in the broader sense. Sector wise, we see the financials as crucial and favor as well amongst operating sectors the industrials; the information technology space especially communications; healthcare especially pharmaceutical/biotech restructuring; large cap energy and gold/precious metals in materials as hedge.