Entering the last month of Q1/2010, uncertainty appears to drive pinball behavior in markets. Alongside credit shock, we believe key to be the unfolding of standards both at the macroeconomic/government level and in market valuation. To quarter end, developments lie not just from Europe and sovereign risk epitomized by Greece but also on global pathways to deficit control targets of 3% of GDP as being stable as highlighted by Fed Chairman Bernanke that we believe applicable broadly and not least by a traditional release of objectives by China at its National People’s Congress. For equities, not just growth in Asia but also turnaround in Europe is key. As the cycle turned lower, companies with focus on basic products demonstrated resilience. >From a cycle view point, as well as the massive housing and auto industries, the focus next in North America should be to look for signs of recovery of more upscale spending, with the latest results still indicating business interregnum. Using the S&P 500 as benchmark, we have long espoused a 15-18x P/E range as appropriate and we illustrate ranges using a subjective tier of the type favored for risk by many financial regulators. Applying 18x to the delivered base earnings of 50 that were part of 2009 results would give downside risk now of 900; to the next slab of contribution for 2010 of 10 to S&P 500 earnings with an uncertainty discount of 10% and a multiple of 16x emerges an incremental market contribution of 145; with the final potential 15 in earnings (for a potential total of 75 for 2010 dependant on realized early revenue gains and cost cut maintenance) accruing our subjective uncertainty reduction of 20% and a 15x P/E for an incremental point contribution of 180 or in sum, optimistic upside of 1225. This subjective tiered approach to valuation as well as uncertainty on issues like credit risk buttress our assessment of a quality focus in markets overall, range bound risk for the first half portion of the year from present levels (S&P 500 of 1,118 as of March 2, 2010) and greater potential for gain later in 2010 as 2011 comes into focus.

Capital markets appear still to be chasing individual data points ranged from consumer confidence and industrial activity worldwide to U.S. unemployment specifically with angst We do believe that despite the need to nurture recovery, central banks also need to provide the monetary cover, even if further on, for difficult political decisions on deficit reduction. Angst now over sovereign credit, well beyond Greece, indicates as much. Despite the decline in junk bond yield spreads and the equity market gains that marked the nine months to year end 2009, the daily and even intraday split in activity, some days geographically, underscore considerable uncertainty. Compared to prior cycles, since 2000, one difference has been the behavioral propensity of markets to react concomitantly to data releases, in contrast to capital market traditions of forward looking behavior. Heightened focus can be expected to remain especially with developments still unfolding in a broad range of arenas from earnings delivery to sovereign deb t to central bank policy.

Europe has had to endure particularly anemic growth and large deficits. A recent example of belated focus has been for Greece whose deficit duress has been well known but bond yields for which flared soon after a successful new issue. Such developments may be derivative of new financial technologies driven by higher order flow capacity but issues beyond those of momentum need currently to be considered. On European fixed income specifically, the trials and tribulations over Greece and other countries with extended finance have crucial funding and deficit management issues of long duration beyond mid March. Still, we are reminded that late 1989 and the early 1990s were punctuated by the issue of Brady bonds to address crisis in Latin American deb t finance. In the Brady bond plan and historic ambivalence notwithstanding, both U.S. Treasury and Federal Reserve authorities, as lead interlocutors, recognized the wisdom of including the IMF. We believe that similar ambivalence linked to newness of the euro zone notwithstanding now, European authorities likely need to include a role for the IMF in Greek or other country package or risk accentuating global financial stability fears related to transparency. Weakness in sterling, continued crisis in Iceland and substantive discussions about European financial integration are likely to force tough political choices.

For the United States , a McKinsey Quarterly analysis on market recovery (see chart below, released February 15, 2010 ) makes the noteworthy point of resiliency and the need for companies to pre-plan increased capital spending. However, concomitant jobless data in the United States has been volatile and unemployment high enough to be of concern about the amplitude of recovery.

Chart Source: McKinsey

In semi-annual monetary policy reports and testimony to Congress, Federal Reserve Chairman Bernanke highlighted recovery but the Fed long term GDP growth potential target appears closer to 2 ½-3%, not the close to 3 ½- 4% that in the last cycle appeared to be the anticipation. Importantly, Chairman Bernanke pointed to 3% deficits as a percentage of GDP as being stability goals, well below the current and anticipated levels of near term deficits. In our hypothesis of smaller well managed zones having flexibility within the larger space of the Americas, Europe and Asia, the monetary policy of the Bank of Canada (albeit with rates still flat) as well as the medium term perspectives of the upcoming Canadian federal budget, ahead of an election, may provide future global cues of potential return to standards. In Latin America , the Chilean earthquake tragedy and the Argentinean monetary deb acle also point to the importance of maintaining contingency reserves.

While much focus for angst has lately been on Europe and for policy on the United States , reports from strong growth in Asia are currently important but a mix of both hopes and fears. In terms of the latest developments first, the increase by the Reserve Bank of Australia of rates by 25 basis points on March 2, 2010 brings increases up to 100 basis points since last October but equally important is likely a signal that another 75 basis points could occur before neutrality is achieved. Along with Canada in the Americas and Norway in Europe , Australia appears potentially signaling more policy bifurcation in favor of the smaller currency zones. In Asia with strong growth but also with risk of inflation, among the larger countries, India and China need to be watched closely. Growth in India has been strong but the Reserve Bank of India has so far only increased reserve requirements but not rates. The Indian government has proposed a fiscal stability agency with some obfuscation on actual policy. Both are likely to change. For China , March 3-5 will mark the annual National People’s Congress (NPC) meetings that are important not from a parliamentary sense but more so for markets from the perspective of upcoming policy perspectives. On monetary policy, Chinese bank reserve requirements have been raised and bank lending targets curbed, with fears especially of excess in the provinces but rates have also yet to be increased. After many measures over 2008/9 of Chinese government success in a tough global environment, we have keen interest on fiscal policy relationships to not just growth targets but also to domestic angst among ordinary people about asset, especially housing, price increases.

On equity markets, it is clear that concurrent gains took place in the nine months to year end 2009 with focus on low quality as a particular beneficiary of relief. Fixed income rates are not yet high enough for relative valuation pressures to develop of the type seen in prior cycles. However, we see quality of delivery and its amplitude as being of importance through the duration of this cycle. Leverage from Asia growth is likely to be a stimulus globally but recovery from Europe is also needed, industrial activity notwithstanding. Separately interesting, we have been watching the United States from the perspective of consumer confidence and delivery. In the most recent earnings delivery releases by corporations, we have been intrigued by cost bifurcation among staples indicating the importance of leadership in operations even in relatively less cyclical businesses. As the consumer cycle turned lower, tightly managed companies with focus on basic products demonstrated resilience. From a consumer cycle view point, as well as on longer run housing and auto recovery, the upcoming focus in North America should be to look for signs of recovery of more upscale spending. On the issue of upscale leverage, the latest results indicate to us that the retail business may now be in the interregnum in which companies are preparing for more upscale spending that has yet to flourish while those companies more exposed to basics have started to achieve less than hoped for gains. In the equity markets, we believe to be instructive, the two charts below using relative plots of luxury performance versus the Dow Jones Industrial Average (DJIA). In the latest three months, the DJIA and luxury have basically vacillated together while in the twelve months to March 2, 2010 both recovered with aspirations of smooth transition carrying the luxury segment that much more. The earnings reports and actual equity market behavior indicates continued uncertainty on trajectory even as recovery unfolds.

DJ Luxury versus DJIA: 3 Mos. to Mar. 2, 2010

DJ Luxury versus DJIA: 12 Mos. to Mar. 2, 2010

Chart Source: Wall Street Journal Data

The first two months of 2010 have been noteworthy for the reporting of a turn for the better in earnings for the prior quarter that was driven by substantive cost cutting, growth in Asian economies like China and India as well as in North America . European growth as well as that in export dependant Japan and Singapore was weak. Credit risk concerns also increased but interest rate risk premium pressures on equities still remain modest. However, revenue growth has generally been bifurcated. Regulators especially in finance appear increasingly coalescing around concepts of tiered capital requirements. With range bound market behavior, we thought to take a tiered and subjective approach to earnings valuation as well. Using the S&P 500 as benchmark, we have long espoused a 15-18x P/E range as appropriate. With Q4/2009 results mostly released, S&P 500 annual earnings in the 50 range represent a strong base formed by companies ready and able to cut costs sharply as well as formed by central banks and governments ready to provide easy money to cushion duress. Applying 18x to the delivered base earnings of 50 that were part of 2009 results would give downside risk now of 900; to the next slab of contribution of 10 to S&P 500 earnings for 2010, we would ascribe an uncertainty discount of 10% and apply a multiple of 16x for incremental market level contribution of 145; with the final 15 in earnings ( for a potential total of 75 for 2010 that depends on realized early revenue gains and cost cut maintenance) accruing our subjective uncertainty reduction of 20% with an application of a 15x P/E for an incremental point contribution of 180 or in sum optimistic upside of 1225. This subjective tiered approach to valuation as well as uncertainty over issues such as credit risk buttress our assessment of a quality focus in markets overall, range bound risk for the first half portion of the year from present levels (S&P 500 of 1,118 as of March 2, 2010) and greater potential for gain later in 2010 as 2011 comes into focus.