Pullback? More Gains Are More Likely

This is not to suggest that the U.S. economy and stock market have clear sailing ahead. The massive government borrowing requirements and the Fed's need to unwind its balance sheet (the Fed must find buyers for well over $1 trillion of government securities) could potentially lead to substantially higher real interest rates and derail a nascent economic recovery. In fact, there is a real risk that the massive government borrowings, leveraged consumer and rising health care costs will impair the U.S. economy over the medium to long term. The U.S. government must get its fiscal situation under control or risk the distinct possibility of an even larger financial crisis.

Looking forward, there is no doubt that high unemployment, the credit-constrained and over-leveraged consumer, excess spare production capacity, rising interest rates and higher taxes will result in a sluggish recovery. Just as it took time to get into our current situation, so too will it take time to get out. IN the near term, we may see a trading pullback, particularly since the economic data is unlikely to be uniformly positive, implied volatility is low and earnings expectations are higher. But this market rally has been built on more than the absence of a potential 'doomsday' event, but also on improving real fundamentals. Yet many still question this recovery and market rally (and retail investors are not rushing in), which from a contrarian viewpoint is a strong positive for additional gains. Finally, the consumer, while battered, is stronger than many pundits believe and the economy has prospered historically despite tax increases and much higher interest rates (such as in the 1990s)

Absent any significant deterioration in the U.S. treasury market or employment situation, the stock market appears to have support from both a valuation perspective as well as the improving macroeconomic trends. Further market gains are not only dependent on near-term corporate earnings and revenue growth, but also an improvement in the labor market, continued stabilization in housing, renewed government fiscal discipline and consumer ability and willingness to spend again, even if judiciously. Finally, perhaps the most important variable will be the ability of the government bond market to absorb both the massive new supply as well as the Fed's secondary securities sales. Clearly there are more challenges ahead than at any time since the Great Depression, yet the U.S. economy has somehow always managed to eventually return to growth and prosperity.

We remain cautiously optimistic that the economy and the stock market will continue to gradually improve.

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