2010 Market Outlook by Briefing

Overall, we expect 2010 to be a shareholder-friendly year.
Strong earnings growth and conservative spending plans by corporate America should produce healthy levels of free cash flow that allow for increased stock buyback activity, dividend hikes, and a jump in M&A activity.

With the stock market having achieved its best year since 2003 during one of the most turbulent political and economic periods in U.S. history, it is fair to say expectations are on the optimistic side of things for 2010. (Can't believe that 2009 went that well for US equities after a near armageddon just a year before 2008)

It is very unlikely, though, that the stock market will have the kind of year like it did in 2009. Expectation is that the S&P 500 will achieve a low single-digit to low double-digit percentage return, with the first half of the year looking better than the second half of the year in terms of performance.

Easy earnings and economic comparisons will be sustaining factors in the first half of the year, as will low interest rates (the Good News). However, (a) the specter of interest rates eventually going up, (b) the extraction of stimulus measures, and (c) income and capital gains tax rates set to move higher as of Jan. 1, 2011, should be persistent headwinds that curtail the market's bullish bias as the year unfolds (the Bad News).

The economy will be on better footing in 2010, if it is not exactly on sound footing. We are projecting:

- 2.5% to 3.0% average real GDP growth for the year,
- unemployment rate, a little above 10.0% on average for 2010,
- total CPI, between 1.9%-2.2% y-o-y,
- core CPI, which excludes food and energy, between 1.8% and 2.0%.

Subdued inflation readings and the weak labor market should allow the Federal Reserve to refrain from raising rates in 2010. Inflation expectations, however, will be closely monitored and could force a tightening in 2010 even if CPI is in the Fed's comfort zone.

A weak labor market, continued credit losses, and regulation angst should be among the factors that leave banks feeling closely tied to their excess reserves.

Credit standards may not be as tight in 2010 as they were in 2009, but they are still expected to remain tight. That should help keep inflation at bay since money will be slow to turn over, yet it will be an impediment to a more robust economic recovery.

Continued excess capacity on both the labor and production fronts should keep inflation under control.

More importantly, corporate profit growth is anticipated to be robust in 2010.

With all of the cost-cutting done in late-2008 and throughout 2009, companies will have a good deal of operating leverage that can lead to double-digit profit growth with only modest increases in sales.

By way of example, S&P operating earnings for Q4 2009 are projected to spike 203% while revenue growth is expected to be up just 7%, according to Thomson Reuters.

The consensus operating earnings estimate for calendar 2010 is $77.56, which is a 30%increase from calendar 2009.

The forward four quarter consensus earnings estimate is $72.18. At current levels, we believe that leaves the market fairly valued at 15.4x forward four quarter earnings.

With the 10-year note yield at 3.84%, the current earnings yield of 6.5% still supports a value-based argument in accordance with the Fed model. However, with the risk premium in Treasuries expected to subside as the economy stays on a growth trajectory, supply issues lingering, and investment grade corporate bond yields at 5.86%, the relative value in stocks is less in our estimation than it appears based on the Fed model.

Consensus earnings estimates are generally expected to move higher, so further stock price appreciation is expected, yet we do not expect to see multiple expansion as price appreciation should be more closely aligned with the pace of estimate revisions.