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Third Quarter 2009 Update

2009 Third Quarter Review

Will we have a double-dip? I think I will.
Dear Friends,
Greetings – we hope you are enjoying the beauty of autumn! 
Back in our First Quarter Review we discussed the Four Indisputable Reasons the Economy will ReboundOur assertion was the recession would likely end sometime from May-July and, so far, data continues to indicate our thesis is right on, confirming our belief the market rally was sustainable. But will the economic recovery last?
3rd Quarter Review
The third quarter produced 10-15% gains in the equity markets, bringing the total rally (since March 10) to over 50%, as the end of the recession is all but official. But fears of a double-dip recession seem to be growing, as many in the media seem to be promoting the idea. Due to the strong market rally, it is increasingly likely we will have a 5-15% pullback in the next 6 months, which will fuel the double-dip fears. Let’s update some of our thoughts from last quarter then address the double-dip question.
  • Investor Sentiment – Despite a massive rally, investor sentiment numbers are still relatively week, indicating many are not convinced the recovery is sustainable. In fact, as of this writing, some sentiment numbers are as weak as they have been since March. We believe this is a great sign!
  • Consumer Sentiment – While improved from the lows in February, consumer sentiment has struggled to gain any momentum, which is probably a direct result of the employment picture. 
  • Economy – Announced GDP growth of 3.5% for the third quarter indicates the end (at least temporarily) of the recession, confirming the assertion in our last letter, “we believe the recession is probably over at this point.” There is certainly no shortage of naysayers, but positive economic news continues to grow. Consumer spending, corporate profits, housing prices, home sales, and jobless claims have continued the improvement we detailed last quarter. 
  • Healing in the Financial System – Healing has continued as many week banks have failed while the strong have announced positive earnings, allowing them to earn their way out of the massive credit losses still plaguing the system. As the system is coming back from a near-death experience, the healing process will still take several more years.
  • Inflation – While the threat of inflation exists, we believe the greater threat in the short term is deflation. If inflation becomes a serious issue, it won’t likely be for 2-3 years. Please refer to our 2nd Quarter Review for a more detailed discussion. 
  • Unemployment – As we expected, the unemployment rate jumped over 10% in October, but job losses continue to fall, indicating an improving trend. Since unemployment typically peaks about 6 months after the end of a recession, we believe job growth is likely to resume in the Nov-Jan time period.
Economic Recovery – Sustained or double-dip?
Since our last update, questions regarding the sustainability of the market & economic recovery have easily outpaced any others. Naysayers and pundits in the media continue to pound us with reasons why the recovery is not sustainable, filling Americans with fear and doubt that, we believe, extended the recession and will slow the recovery – which may be healthy, creating a stronger foundation for sustained growth.
The most common arguments for a double-dip are based on the high unemployment rate and the assertion the economic growth in the 3rd quarter was a result of government stimulus.
There is no question the job situation in America is tenuous and disheartening. But these arguments ignore the fact it is normal for unemployment to peak roughly 6 months after the recession. To argue the economy can’t recover without job growth is valid, but somewhat narrow minded and premature. The economy can start to recover without job growth – it has already started, according to 3rd quarter GDP. Economic growth will likely trigger job growth, not the other way around. 
Despite the headlines, we have heard many employers say they have jobs available, but can’t find qualified candidates. The last 12-18 months has seen a spike it college enrollment as displaced workers are going back to learn new skills to fill these jobs. As this wave starts to complete their programs, many of the available positions will find qualified candidates and will be a catalyst for unemployment recovery.
We agree with the assertion the economic growth over the summer was impacted by government stimulus, just as we indicated it would in our 1st quarter letter. Without the stimulus, we believe the economy would have still grown, but at a slower rate. Just like the recession became self-perpetuating, economic growth tends to feed itself. Growth leads to more jobs, which leads to more growth, which leads to more jobs. You get the picture. 
There is also still a significant amount of fiscal & government stimulus in the pipeline, so we believe the fears of a back draft are misplaced. We applaud the way Federal Reserve Chairman Ben Bernanke has handled this crisis and believe he will maintain appropriate fiscal stimulus (low interest rates) until the danger of economic relapse is unlikely.
When it comes to economics, there are no certainties, only probabilities. Due to the severity of the economic collapse last year, the risk of a double-dip is very real. But we believe the more likely scenario is sustained growth. We estimate the likelihood of a double-dip at 30% and of sustained growth at 70%. This means the likelihood of continued growth is twice as likely as a double-dip in our estimation.
The key will likely be job growth. If we start to see job growth by January as we expect, the likelihood of a double-dip will wane. If job growth fails to materialize, the risk of double-dip will increase dramatically.
A wildcard in this scenario is the global economy. If the global economy continues to build momentum (which we believe is likely), our economy may still grow even if job growth does not materialize for a few more months.
Many other wildcards and factors exist, including the expected surge in mortgage defaults, commercial real estate trouble, bank failures, & corporate bankruptcies. All of these have been researched and factored into our analysis. But since we don’t have a crystal ball (it broke in our move last year), one or more of these factors will likely deviate from our current expectation, causing economic growth to be higher or lower than we now expect. 
By now you see that making economic projections is kind of like nailing jell-o to a wall. In the end, all this talk of double-dips simply makes me hungry for ice cream. I hope it does the same for you. I think I will go for a chocolate/peanut butter combination.
We understand this is one of many complicated issues or concerns we are all facing. Rest assured, we stay well informed on all of them, researching them from many different perspectives. We understand the importance of your goals and dreams and are honored to help you achieve them. That is our passion!
Have a wonderful Thanksgiving, a Merry Christmas, and a happy New Year!
Kind Regards,
Darren T. Munn, CFA

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