We begin with the necessary disclaimer. These are one set of possible subjective analyses and do not constitute professional investment advice. No investment decisions should be made on the basis of this information. Financial investment is an inherently risky activity and must be undertaken with a competent investment advisor.

Having said that, as a matter of my personal opinion, it looks as if the equity markets are signaling an important change in tone to the upside. Has the bond theme reached its natural conclusion?

First consider the CRB index, which is weighted towards industrial raw materials.  Here we see a definite surge in activity suggesting that there might be an actual demand for them. It appears that it might be snapping out of a five month long holding pattern…

Next we see the broker dealers rebounding. These are the guys who directly profit from increased market activity. Somebody is getting rapidly interested in them.

If we look back to Wednesday’s trading, we see the composite market (this chart is a hybrid of the SPX and NASDAQ and seems to give a very nice picture of the meaningful market activity) we see the close above a critical resistance line.

Also,  high tech, which was supposed to be a trouble spot, has sharply rebounded. This may be in anticipation of a new round of financing.

On the other end of the economic balance, the retail sector has powered out of a slump as well.

Even the aerospace and defense sector, which is probably suffering from a military wind-down syndrome, has shown signs of life.

And if we look overseas at Thailand, we see a market in simply explosive growth. This in no way is a picture of global slowing.

Overall, it looks as if the equity market is regaining its vigor and a slow but potentially powerful deep rooted recovery may be underway.

A year ago, with the world on the brink of a total economic collapse, we were told buy & hold investing was dead, earnings would take years to recover and the economy would languish for years to come. Of course the experts were wrong, and anyone who didn’t listen and bought stocks is sitting on exceptional gains.

The rebound has indeed been stellar. The Dow Jones Industrial Average ended 2009 up 19% (having gained 60% from March lows), S&P 500 is up 24% and the Nasdaq up 43% – the best year for the US markets since 2003.

In the UK the FTSE 100 gained 22% last year (54% since the year’s lows) – its best annual performance since 1997.

Lost decade… for some

Of course, as positive as that is, it’s only half the story. When we look at the performance over the last decade, the picture is quite different. Little wonder the last decade has been labeled the ‘lost decade’. Instead of holding stocks over the last 10 years investors could as well have stuffed the money under a mattress. Or so it seems.

From the end of 1999 through 2009 the Dow has seen its second worst performance on record (down by 9%). The 1930s and the 00’s were also the only decades during which the Dow ended lower than where it started. The S&P has fallen by 24% in the 10 years since the end of 1999 and the Nasdaq by about 44%.

The UK and Europe haven’t fared any better. Investors in the FTSE 100 would have lost 23% over the last decade; the German Dax has fallen by 14% and the French CAC-40 by 34% over the same period. Even accounting for dividends investors would still have lost out. Naturally, when we take into consideration inflation and falling currencies, the decline in asset values has been even sharper.

The awful performance over the decade is of course somewhat skewed as 2000 saw the peak of the dotcom bubble with stock markets at historic highs. The past decade saw not just one but two market crashes. It’s therefore my belief this was an abnormally bad period for equities and the next decade will be much more in line with historic performance.

Great decade for others…

More importantly, when we talk about a ‘lost decade’, we’re forgetting the other parts of the world, outside the US and Europe. Investors in emerging markets have seen rather extraordinary gains over the last 10 years – despite the sharp declines in 2008.

While emerging markets were hit hard by the flight to safety (the Shanghai Composite slumped by 65% in 2008, Russia’s Micex by 67% and Brazil’s Bovespa by 41%), they rebounded just as fast. The Micex index gained 121% in 2009, the Shanghai Composite index rose 80% (and Shenzhen Composite 117%), Bovespa added 83% and India’s Sensex 80%.

Compare the 10-year losses in the main developed markets with the emerging markets performance over the same period. The Shanghai Composite gained 140%, Sensex 30 went up by 249%, Bovespa by 301% and Russia’s Micex has surged a staggering 802% since the end of 1999.

Here’s a chart comparing 10-year returns in emerging vs. developed markets:  See chart.

Emerging markets in 2010 and beyond

I believe the emerging markets will continue to outperform in the long term. Yes, they are highly volatile and there will be plenty of bumps, but the long term trend has been up and I see few reasons to doubt it will continue.

Much of the developing world’s growth in the last decade has been fueled by a reduction in poverty rates, fast expansion of the middle classes and resulting consumption. These trends will continue and support robust economic growth for years to come. While China heavily depends on exports and is therefore linked to the strength of western economies (for now), that is less the case for the likes of Brazil and India.

That’s not to say that the strong rebound of 2009 wasn’t partly due to the massive fiscal stimulus (particularly in China) and speculative money inflows. Just like the cheap money supported the rally in the US and Europe.

According to IMF predictions, in 2010 the developed economies will see a 1.3% GDP growth vs. 5.1% in the emerging markets. In 2011-2014, the IMF estimates average annual growth of 2.5% and 6.4%, respectively.

Over the last two decades developed nations have seen a strong loss of economic influence. The US, Europe and Japan controlled approx 64% of the global economy in 1990; that is now down to 52%. The events of 2008/9 can only help to accelerate this process.

Furthermore, the four BRIC nations now hold approximately 42% of the world’s foreign exchange reserves. The G7 hold 17%, and if we take out Japan they come to a mere 4% of the world’s reserves. Over the last 10 years, while the BRICs accumulated reserves, the West went amassing debts.

For the UK, US and many EU economies ballooning fiscal deficits and spiraling public sector debt will present major problems in 2010 and beyond. Most Asian economies (excl. Japan) do not have the problems of government and household debt that the West has.

Where is the economy heading?

We won’t see a double dip recession, but economic growth in the US is likely to be subdued. Even that could be threatened should interest rates rise too much, too early (which, however, is unlikely to happen). Some analysts expect the US economy to heal more quickly and post stronger than the generally forecast 2.5-3% growth.

The budget deficit is an obvious problem. Huge amounts of private sector debt have been shifted to the government. The bill will eventually come due. The scale of the deficit will place an upward pressure on interest rates.

On top of that, high levels of consumer indebtedness, as well as unemployment, are likely to keep consumer spending weak. Higher taxes, which seem to be a certainty in the US and UK, will also inhibit growth.

The UK is in an even more precarious position. The obvious issue being its enormous deficit, as well as the 2010 general election, which could, in the worst case, see a hung parliament (and resulting uncertainty for the markets and economy). As in the US, recovery will also depend on improvement in employment and the property market.

Importantly, the withdrawal of the stimulus will have an impact on the markets and economy. If done too early it could cause a double dip recession, if too late it is likely to lead to a spike in inflation. Interest rates are likely to stay very low this year as the Bank of England won’t want to risk a relapse into recession.

2010 – A good year for equities?

Despite previous warnings, it seems the 2009 rebound in the markets wasn’t so unusual after all (once it became clear that Armageddon was no longer likely). The markets frequently recover before there is any sign of improvement in the economy or corporate earnings.

After last year’s surge in equity prices, 2010 performance will largely depend on earnings growth, fueled by productivity gains and maybe a return of the consumer. If the expected earnings don’t materialize, stocks could see a significant correction.

Coming out of recessions equities have traditionally performed quite well, and we could well see the markets end 10-15% higher in 2010. The large amount of cash still sitting on the sidelines and waiting to be invested is also likely to help prop up equity prices.

The exit from the monetary and fiscal stimulus that fueled last year’s rally may have a negative impact. A genuine recovery (with self-sustaining growth in jobs, earnings and spending) has to kick in before government stimulus is withdrawn. If private sector demand doesn’t step in by that time, we will see a reduction in output.

It is unlikely that we’ll see significantly higher interest rates in 2010. That’s good for the markets – low rates support earnings as well as steering yield seeking capital into equities. The concern is that if the Fed doesn’t move fast enough on rates, we are going to have excess demand for many goods and commodities, resulting in a rampant inflation. It would, in fact, be surprising if the trillion dollar stimulus didn’t trigger inflation down the road.

What seems certain is that 2010 will be a much more ordinary year for the stock markets, compared to the last two. Investors will have to earn their returns which will stem from individual investments rather than a general market momentum. Even if the markets stay largely flat or range bound, there will be opportunities to outperform.

Should US equities perform well next year, it is likely that many foreign markets (excl. Japan and Western Europe) will do even better amidst stronger economic growth. Given that many S&P (and FTSE) companies now derive a significant part of their revenues overseas, blue chips with strong foreign sales could also benefit from global economic growth.

Emerging markets, in particular Asia and Latin America, will, in my view, continue to outperform in 2010 and over the next decade. Just be prepared for the volatility and short term hiccups.

All that said… nobody knows what exactly will happen in the markets in 2010 (or any other year). The only thing certain is that there will be opportunities for proactive and selective investors to achieve healthy returns. And that’s where investment talent will come in.

The roller-coaster year that started with the possibility of a financial Armageddon is nearly over and finishing on an upbeat note. After a vigorous nine months rally the markets enter the final days of trading at the highs for the year.

Although the equity markets are still well below the 2007 highs, the rebound came with unexpected speed. Since the beginning of the year the Dow has gained 19.9%, S&P 500 is up by 24.7% and the Nasdaq by a stunning 44.95%.

The last trading days of December are traditionally characterized by low trading volume and positive mood, with prices mostly heading up – a so called Santa Claus rally.

Santa Claus rally?

Um, yes. And it’s not just a myth either. It is an uplift in stock prices that starts around, or a few days before, Christmas and typically ends in the first two or three trading sessions of the new year. Historically, during this week or so of trading, the S&P advanced by an average of about 1.5% (since 1950).

While the year-end rally tends to be quite reliable, it’s worth noting that in the years when the markets registered a loss instead, the next year often saw a bear market. So a lack of a Santa Claus rally can be a warning signal for the coming year. (E.g. a lack of a year-end rally in 1999 was followed by a market fall in 2000. A year-end decline in 2007 preceded a disastrous 2008.)

Yesterday the Dow ended up by 0.5%, closing off the holiday week with a 1.85% gain (to 10,520.10). The Nasdaq rallied 3.35% to 2,285.69 and the S&P gained 2.18% to 1,126.48. Expectations are for further advances until the first days of January.

Generally the last few months to the year end tend to be bullish. December is frequently the best single month and November-January tend to represent the best three-month period for equities. 12 of the last 15 year end periods saw stock prices moving up.

There are also several theories or patterns related to January. It is often said that the first four or five trading days of January set the course for the month and often for the first quarter. A selloff in the first days indicates big money (that tends to be reallocated at the time) withdrawing its support from stocks. However, this pattern doesn’t seem to have much historical validity.

January ending higher does frequently mean a good chance for the year to end higher (‘January barometer’; ‘as January goes, so goes the year’). On the other hand, a down January has proven to have less prediction quality as to where the markets will end the year. Overall, the January barometer has been significantly more accurate in bull markets.

Then there is also the so called January effect - a tendency for small cap stocks to rally during January. (The theory is it is due to investors selling at the end of the year to create tax losses, and re-entering positions in January, resulting in a bounce. The effect is visible in the less liquid small and micro caps.) However, the January effect has been significantly weaker in recent years.

Finally, it is said that when the Dow closes below its December low during the first quarter of the next year, it is often a warning sign of lower levels to follow.

The Santa Claus rally is not unique to the US markets. It has also been observed in the FTSE and a number of other stock markets throughout the world.

To end this post, I wish you all….

Merry Christmas and a Happy & Profitable New Year!