The nascent cycle of recovery and capital market sustenance requires substantively more changes. Investors are likely to need and indeed should demand (even more than ever) concrete signals from imminent deluges of government budgets and corporate earnings releases. For portfolios, if not counteracted by both governments and corporations, we find a cycle of dependency a risk which more is usually associated with other socio-economic endeavors such as native communities, ghettos and farm subsidies. Even by prior experience, aspirations and standards now need to be higher than self-congratulation about softening required restructuring by spending trillions of dollars of other peoples’ and other generations’ money. We remain watchful that instead of underscoring confidence in their own abilities, in high growth countries like India and in recession ravaged Europe/United States alike, business organizations appear still weighing in on the desirability of maintaining government stimulus. We are also watchful that deficit control appears not to be given its rightful profile even amongst the more right wing authorities, with central banks equally continuing to signal low administered rates as being desirable. Re-establishment of risk premiums would be concrete indications of change after months of momentum behavior. In turn, we believe those countries and companies co-opting such change are likely to competitively benefit and hence have a quality advantage to be favored by investors. There is likely to be a stream of extraordinary budgets with pressure points already evident in recent weeks from Japan to Greece to Venezuela to Argentina with President Obama’s budget likely to have far higher scrutiny than his first one. In momentum since early 2009, versus a benchmark of 5% for 10 year U.S. T-Notes (incorporating a base with inflation and uncertainty premiums), its present yield is 3.78% with yields of BBB corporate bonds only 5.11% for instance. At the cusp of earnings reporting, investors need to be cognizant of the valuation impact of potential bond yields and the nature of the delivery content of the corporate earnings releases themselves. Our good friend Vincent Catalano (www.bluemarbleresearch.com) points to expectations of 80 for S&P 500 operating earnings for 2010 which if realized, would be well above ours of 75 and in our experience, one of the most rapid moves during a recovery of consensus from below to above our expectations. We have maintained a normality benchmark range of 15-18x for P/E ratios for the S&P 500 with the current market (1145) on annualized concurrent Q4/2009 slightly above this and on 80 slightly below this range. It seems to us that bifurcation could well characterize both markets and earnings delivery in the upcoming reports, even leaving aside the issue of write-downs and dilution in the financials.

After all, well within the memory of current decision makers in government and in corporations and less than two decades ago, even politicos like James Carville reportedly expressed a desire about being reincarnated as the bond market in tribute to its early 1990s role of enforcing capital market and political discipline via essentially three components namely normalization of a risk free rate in light of prevailing inflation levels, a security specific risk premium and then as a newer phenomenon then, an uncertainty premium. We expect such discipline to be re-introduced as one of the many valuation changes still to occur and about which many, including academic financial circles, appear relatively silent when compared to the debates of that time. In the first few weeks and months of 2010, the upcoming budgets of governments and earnings releases by companies need to be closely monitored on real, not cosmetic change, in positioning. Without such change, we believe capital markets and portfolios will be vulnerable to renewed volatility and severer than necessary valuation contraction. In turn, we believe those countries and companies co-opting such change are likely to competitively benefit and hence have a quality advantage to be favored by investors.

Previous decades have not been without munificent change. At start of 2010, ahead of budgets and earnings, it is relevant to benchmark against those decades. We consider as a present day canard, the surfeit of references to the Great Depression. The valuation benchmarks that have already been experienced and to which we would hold as standards are as follows. The three decades ended 1980 were ones in which incremental change failed in that for every major cycle, administered rates at peak ended up higher than the prior cycle but both public financial policy and public bond markets remained behind the curve. This cycle was broken by both central banks led by Chairman Volker and bond markets in the form of both investment bank as well as individual investors demanding a real return to capital, hence James Carville’s comment. The next change engineered politically by President Reagan and others essentially in forcing open the economic contradictions of Marxism and by corporations engineering extensive rolling restructuring globally in our view drove up globally valuation in stocks and bonds alike that was buttressed by quality and earnings on improved delivery well into the new millennium.

In the aftermath of deregulation of 2000s numerous debacles have certainly taken place and rescue necessitated. However unlike the end of the 1990s that had benefited from globally concerted movements away from ever rising deficits, the present series of budgets start from a far higher plane of deficit finance. There is likely to be a stream of extraordinary budgets with pressure points already evident in recent weeks. The budget cycle commenced with that of Japan with its debt to GDP ratio close to two but with government bond yields chronically low alongside low administered rates and internal discord including change of Finance Minister. In Latin America, budget stress has already led to severe devaluation in Venezuela as well as an attempt by Argentina to access central bank reserves that led to ouster of the central bank governor. In Europe the larger country budgets are still to be announced but in credit downgrade, Greece received little succor from the European Central Bank and Iceland has effectively postponed its bank failure obligations. Last but not least and unlike 2009, the upcoming budget of administration of U.S. President Obama is likely to undergo intense domestic and international scrutiny over transparency and assumptions. Over the spring, similar scrutiny is likely for those of Canada and the major European nations as well as those of emerging nations with that for instance of India due in a month as well. In the momentum markets since early 2009, compared to our base benchmark of 5% yield for 10 year U.S. T-Notes (as incorporating a base with inflation and uncertainty premiums as did occur in the 1980s to well into the 1990s), its present yield is only 3.78%. The yield of BBB corporate bonds of 5.11% is scarcely above our target 10 year Treasury note yield. The CCC corporate bond yields of 11.94% and a high yield blend rates of 7.14% can scarcely be considered high even leaving aside recent peak yields of 41.89% for CCC and for BBB of 9.55% as well as risk aversion low yields in government bonds generally. It seems to us that budgets and corporate earnings have the potential to move up rates during recovery.

At the cusp of a new earnings reporting season, we believe investors need to be cognizant of the valuation impact of potential bond yield and spread increases as normal criteria are re-introduced as well as the nature of the delivery content of the corporate earnings releases themselves. We have maintained a normality benchmark range of 15-18x for P/E ratios for the S&P 500. The price momentum of the market has been clear but that of earnings and their quality has also to be considered. The markets appear anticipating seamless recovery as opposed to the rolling restructurings more characteristics of the 1990s and part of our present expectation, notwithstanding fast growth in Asia. In many ways, the drop of earnings was severe from the S&P 500 operating earnings peak of 87.8 for 2006. Over this drop into mid 2009 which included a revenue component, one of the most wrenching adjustments was in the form of corporate cost cutting. We have been steadfast in expecting increased bifurcation even within sectors with target S&P 500 operating earnings of 75 for 2010 and close to the prior 2006 peak only in 2011 with our earnings target of 85. Our good friend Vincent Catalano (www.bluemarbleresearch.com) points to expectations of 80 for S&P 500 operating earnings for 2010 which if realized, would be well above ours of 75. If the higher number became consensus, in our experience it would mark one of the most rapid moves during a recovery of consensus from below to above our expectations. The delivery of earnings upcoming for Q4/2009 are likely to be crucial in this regard as revenue growth remains key and is in our view lackluster as well as bifurcated. Valuation multiples follow a cycle in expanding as turnaround is expected from low points and contracting as earnings peak approach. In addition, equity risk premiums above government bond yields as benchmark can be volatile. On valuation, annualizing consensus for operating earnings of close to 15 for Q4/2009 for the S&P 500 puts the concurrent multiple at 19x also not that different from the earnings recovery year of 2002 which presaged fast global expansion and financial deregulation. Even on the above- our- expectations figure of 80 for 2010 operating earnings for the S&P 500, the multiple becomes only marginally under our lower end range. It seems to us that bifurcation could well characterize both markets and earnings delivery in the upcoming reports, even leaving aside the issue of write-downs and dilution in the financials.