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Stock markets in the U.S. continued their strong recovery during this year’s first quarter. The S&P 500 Index generated returns of 5.4% for the quarter ending March 31, 2010 and has advanced 75.8% since the bottom of the market on March 9, 2009. Clearly, those investors who stayed the course during the market panic have seen a substantial recovery in their portfolios over the past year. However, even with its stellar performance, the S&P 500 would have to rise another 34% to match its previous all-time high set in October 2007.

As the following table indicates, while recent results have been outstanding, annualized total returns for the 3, 5, and 10-year periods remain significantly below most investors’ long-term expectations for stocks, which are in the 9% to 10% range.

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The strong recovery of the stock market has surprised many, especially considering that numerous economic statistics continue to indicate significant problems. Foremost among the negative numbers is an official unemployment rate of 9.7% - the unofficial rate, which includes those who have quit looking for jobs, is probably much higher. The housing market remains weak despite low interest rates and government incentives for new home buyers. The U.S. budget deficit exceeded $1.4 trillion in 2009, surpassing the previous record deficit by more than $1 trillion. A report issued by the Congressional Budget Office forecasted that the Social Security Administration will pay out more in benefits in 2010 than it receives in payroll taxes – a crossover that was not expected to occur until 2016. Most other western economies are in even worse shape than the U.S., as they struggle with large budget deficits due to an increase in spending on stimulus programs combined with lower tax revenues. Worries over Greece, Portugal, and several other European economies caused both stock and bond markets to falter early in the quarter.

Many in the U.S. worry about the increased role of government in the economy. Indeed, government outlays in 2009 equaled about 28% of GDP, significantly higher than the average of 20% for the last twenty years. While this percentage is expected to decline as the economy recovers and the government unwinds its stimulus and bailout programs, the recent signings of healthcare and student lending bills have many concerned that the government’s role in the economy will continue to expand. Most experts predict higher tax rates in the near future to offset increased government spending.

So while it would be difficult to categorize the current economic environment as positive, it is possible to point to signs of improvement. Gross domestic product is expected to rise in the first quarter of 2010 by at least 3%, marking the third consecutive quarterly increase. The Conference Board Leading Economic Index has risen every month since last March, signaling further momentum for the recovery. Earnings for S&P 500 companies are expected to grow more than 30% in the first quarter of 2010. It will be the second quarter in a row of earnings growth, following nine consecutive quarters of negative comparisons. Emerging markets are proving to be an engine of growth for the world economy. In fact, China and India have both taken steps recently to slow their growth in an effort to head off possible future problems.

The recovering stock market and stabilization in the housing sector have helped to restore investor wealth and confidence. In March, the Federal Reserve reported that consumer net worth stood at $54.2 trillion at the end of 2009. This measurement of consumer wealth (which includes homes and investments, less consumer debt) has increased for three consecutive quarters. It is up by $5.5 trillion from its low point in March 2009 – and will likely show another strong increase after this quarter’s numbers are reported. In addition to recovering asset values, consumers reduced their outstanding debt by 4.1% in 2009, in spite of the worst recession in decades. As consumers feel better about their household balance sheets, they are more likely to spend on major purchases and discretionary items.

There is an old investment adage that says the stock market climbs a wall of worry. It refers to the observation that most major bull markets occur during periods of economic uncertainty and a considerable amount of negative news. In a bull market’s early stages, the economic indicators are generally contradictory and many investors have a concern that the recovery will stall or reverse. This old saying seems to aptly describe current market conditions. The market’s skepticism regarding a recovery is considered to be healthy, since it keeps speculation in check.

Fixed income securities produced modest returns in the first quarter as most interest rates held steady. The Barclays Capital Aggregate Bond Index, which reflects the entire taxable bond market, produced total returns of 1.8% for the quarter ending March 31, 2009. The yield on the benchmark 10-year Treasury note was unchanged, ending the quarter at 3.8%. Yields on fixed income investments remain below historical averages, primarily due to the government’s effort to keep rates low and strong demand for bonds as many investors remain fearful of the stock market. With the likelihood that interest rates will eventually move higher as the economy improves, longer-term bonds appear to be somewhat risky (since bond prices decline when interest rates rise).

While the economy and stock market still have a long way to go for full recovery, there are many signs that indicate business fundamentals are finally moving in the right direction. Although there are still many serious economic issues facing governments, corporations, and consumers, there is tremendous upside potential for investors, if these concerns are resolved favorably.

Disclosure: No individual stocks mentioned

Source: Market Review - Q1 2010