As the economy paces through extraordinary times, it can sometimes seem that the market is simply a tide that moves all boats—and the unfortunate swimmers—in the same direction.  The market has been in this mode from 2007 and 2008 as the markets and economy deteriorated; and, it has clearly continued through the market gains of 2009. 

In 2008 it seemed that all investments—stocks, bonds, commodities and real estate—all fell together.  The supposed diversification benefits had disappeared.  From March 2009, it seems that any investment you could throw a dart at has gone up 50% or more.  While this has clearly been the case for the past few years, the markets, in the long run, don’t behave this way—the market rewards some winners and punishes some losers.

As the market cycles through good times and bad, times of extreme economic and market stress are evidenced by traditional asset classes moving together in a single direction.  Core market growth periods—which tend to dominate over longer time horizons—are evidenced by some assets doing markedly better than others.  As the economic cycle goes—assuming government policy doesn’t get in the way—2010 should see a transition from the extreme market movement period, of the past three years, into a more “core growth” oriented period which hopefully will dominate the next few years.

As a continuation, the recent market moves have a biased view of fundamental economic announcements—when good news is announced, the market rallies; when bad new is announced, the market rallies.  This is the inverse of the evidence of 2008. 

In fact, just this morning, the ADP Employment Data report was much worse than expected and the market rallied 1%.  Yesterday, on the heels of a very disappointing retail sales report, the market rallied 1.5%.  As one analyst said, “It seems that flat to slightly disappointing is the new up for this market.”

This is an indication that there is more going on than simple traders paying attention to fundamental economic information.  Over time, the market will begin to react appropriately to market and economic fundamental information.  As the market begins to react appropriately in the next year, (i.e. rallies on good news and sell-offs on bad news) we expect that the market would be entering a normalized period which may persist through an extended recovery.

While I make it a practice to not give financial advice in a column such as this, as we head into the end of the year, it is a good time to visit with your financial advisor and reflect on your investment, tax and financial plan objectives. 

Given that the market has improved significantly, it is a great time to balance risk versus return and to re-visit your stated investment objectives.  In the past three years, the volatility has given all of us an opportunity to assess our own tolerance for risk.  Although I don’t think the market will crash in 2010, the market is due for a healthy pause and a transition away from the extreme markets of the last three years.  With where we have been and a better understanding of risk tolerance, this is a good time to make sure you are accomplishing your goals.

Although the financial markets have recovered significantly, the business environment, employment situation and bank lending capacity seem to indicate that we have not yet recovered from the economic downturn.  In addition, as we face increasing uncertainty about healthcare, environmental policy and taxation, we look at the current economic environment we have to ask, is this really a recovery?

As the Commerce Department calculates the GDP statistics, specifically the rate of growth in GDP, the calculation is relatively simple.  GDP is the simple addition of Consumer Spending + Business Investment + Government Spending + Net Exports.

The initial GDP statistic is an estimate based on limited information and slowly over the subsequent months, the statistics are revised based on new information which makes the statistics more reliable as they incorporate more data and less estimation.  If we think about the data as a sum of the parts, the parts probably tell more of the story.

The consumer spending part of the equation has fallen significantly in the last two years.  The economic crisis has clearly taken a toll.  The result of the unemployment situation and the pending increases in taxes would have us believe that a recovery for the consumer is not yet on the horizon.  There is nothing that impacts a consumer’s willingness or ability to spend more than having a job and this is clearly shown in the data.  In addition, the foreshadowing of future tax increases by the current administration is a significant deterrent to current consumption.  All combined, the environment for the consumer is difficult and shows no signs of getting better any time soon.

Business investment has also seen a significant decline in the last two years.  Businesses, in many cases, are unable to gain access to credit because of the financial crisis; this forces businesses to cut back on less profitable parts of their business.  In addition, over the next 36 months, a large amount of business debt is coming due, most of it issued during times of low interest rates and better economic times.  This debt will have to be repaid without the prospect of being able to re-issue that debt on favorable or even affordable terms.  Combined with an increasing tax load and health care obligations being proposed, business investment is on the decline and will probably continue to decline for the next few quarters in most parts of the economy.

Net exports, as a calculation net of imports tend to be a smaller part of the equation; however, as a net importer of goods and services, the United States tends to experience an economic drag as a result of this aspect of the calculation.

Government spending seems to be the only part of the GDP equation that is growing; and, in most parts of the economy it is growing quickly.  In fact, it grew so much in the last quarter that it completely overshadowed the declines in consumer spending and business investment to create positive GDP growth.  The long-term challenge to government spending programs is that they can only help in the short term.  In the long-run, the government doesn’t produce or create anything as effectively or efficiently as the private sector.

In the long run, an economy cannot spend its way to recovery, it must produce its way to recovery.  In order to recover, the United States must produce...not spend.

The answer to the question, “Is this a recovery?” is based on the calculation above and yes, moving from negative growth to positive growth is technically a recovery.  Unfortunately, this means little to the majority of Americans who are working longer hours for less money, facing increasing tax loads and dealing with significant uncertainty about healthcare, environmental issues, safety and taxation. 

The reality is that while this may be a technical economic recovery, it may not feel like a recovery for most Americans for several quarters to come. 

Fortunately, or unfortunately depending on your portfolio profile, the stock market rally is for real and it has several things going for it that can cause it to maintain its current levels.

Generally, as an economy comes out of a recessionary period, the stock market will anticipate the recovery and will start to rally six to nine months ahead of the recovery.  Now that this has clearly happened, the economy has started to show signs of life and recovery.  These signs have been and will continue to be “I told you so” moments for the stock market bulls.  Unless we see signs of the economy weakening again, the recovery is positive for stocks.

Another characteristic of strong bull markets is that nobody believes in the rally and most investors are caught on the sidelines holding cash or other more conservative securities.  In the current environment there are a large number of investors representing a large volume of assets that are looking for a pullback in the market so that they can get in.  The mere fact that this condition exists will cause the market to be priced above a long term fundamental price until the condition relaxes.  The truth is that the market can stay this way for a very long time as investors look for an opportunity to buy in.

As analysts and pundits continue to assert that the rally is not based on any fundamental logic, they assume that the market should always be based on fundamental logic.  This is clearly a false assumption. 

Historically, the markets have seen long periods of time where market prices and market multiples have only a loose connection to business fundamentals.  Because these conditions can exist for such a long period of time, an investor cannot reasonably expect the market to revert to fundamentals anytime soon.

In fact, the mere fact that many investors would like the market to pull back causes the market to go higher.  The laws of supply and demand of equity securities dictate that the market will move away from the hopes and expectations of the majority of the participants.

The question investors should be asking now is, “Given that the market has run so far, what should I do now?”

With all this being said, the market is clearly at an above average price and the risk is high relative to expected rates of return.  Despite the loose short-term connection between market prices and company fundamentals, the long-term connection will continue and the risk of a significant stock market pull back is real.  Investors should consult with their financial advisor and revisit their asset allocation.  Making small and steady adjustments is the best way to gain exposure or make adjustments as needed.  Investors that choose to be all invested in the market or all out of the market generally take too much risk and live short investment lives.

As we head into the end of the year, investors will continue to bid up prices for stocks.  The new year, at some point, will bring an opportunity for the market to re-evaluate the relationship between prices and fundamentals and the loose relationship will, at some point, normalize.  The question then will be, "Have corporate and economic fundamentals gained enough to justify the higher market prices?"

In the short run, the market is a voting mechanism where the next voter (or trader) can push the market up or down depending on the direction and size of the trade.  In the long run, the stock market is a measuring tool that reflects the profitability, predictability and growth prospects of the underlying company as represented by the share price.

Technical analysis tends to measure the emotions of the next marginal trade and attempts to identify direction and magnitude without regard for company profitability, predictability and growth.  Fundamental analysts tend to believe that the technical movements of a market are emotional driven, inherently volatile and ultimately simple random noise.

In the last two years, it is hard to argue that the short-term technical movements in stocks were simply driven by the emotions of the marginal trader.  Similarly, it is difficult to argue that changes in company profitability could change as quickly as the market has seemed to believe that it has.

While day-to-day “noise” in the stock market is impossible to predict, the long-term fundamentals can’t account for the rapid changes we have seen in the stock market averages.  One technical indicator that is helpful for fundamental analysts is the market’s 200-day moving average.

The 200-day moving average is a long-term trend view of the direction of the overall stock market.  It measures the average market price over the last 200 trading days.  The reason people use the 200-day moving average is simply because a large number of technical analysts use it, that it begins to have merit.

The 200-day moving average is best used as an indicator of times when the market has trended to either an abnormally high level or an abnormally low level.  For example, on November 20, 2008 the S&P 500 was trading more than 32% below its 200 day moving average. 

As the market digested what had happened in the economy and the marketplace this would have been an attractive time to begin accumulating stock market positions.  Historically the market has rarely traded more than 30% below it’s 200-day moving average—twice during the 1930’s and once during the 1970’s.

Conversely, the stock market has rarely traded more than 20% above the 200-day moving average.  The reason for the bias is that the market is generally more orderly on the way up than it is on the way down.  At one point in the early 1980’s the market did trade higher than 120% of the 200-day moving average—however, it was quickly reigned in.

Today, the stock market (as measured by the S&P 500) is trading 19% above its 200-day moving average—a range we have rarely seen.  For those of you who like to pick tops and bottoms, perhaps this is interesting.

For those of us who manage investment risk, this is clearly a time where the market should pause and evaluate the fundamentals.

One of the key challenges to a market rally in the face of poor economic data is that investment managers are evaluated based on relative performance rather than absolute performance.  This causes a crowding effect that magnifies, in the short term, any market move of significance as investors “chase” the prevailing market direction.

While Wall Street economists and strategists continue to try to predict market tops and market bottoms, investors who follow such advice tend to suffer consequences in high risk and low real dollar performance. 

Wall Street economists and TV pundits make a name for themselves by being the first to forecast unpredictable market events like tops and bottoms.  In doing this they are forced to evaluate incomplete data and pick a point in time without good basis or conclusive reasoning. 

The risk for them is low because when they are wrong, as anyone who has followed the advice knows, they can then identify the new data that was previously unknown and a new thesis will make sense.  If they are mysteriously correct, they will broadcast their “correctness” for the duration of their career as the one professional that saw “it” before anyone else.

For investors, this type of investing game is dangerous with real dollar consequences.  Investors that pick market bottoms and market tops are difficult to find because they disappear so quickly.  These types of investors take the most amount of risk for the least amount of risk adjusted return—the odds are not with them.

For example, throughout 2008, month after month, economists were calling the bottom in the stock market and encouraging investors to buy more stocks.  They gave several reasons that were well thought out and suggested that we had seen the worst. 

By September, investors that had listened to this advice had tried and failed several times with the thought that this time they should be right.  As investors added to stock positions, the losses grew and by the end of the year most bottom-picking investors decided they weren’t very good at picking market bottoms.

An investor who attempts to pick market bottoms or market tops inevitably takes more risk in a portfolio than one who follows a defined trend over time in a methodical, well-founded discipline.  In other words, those who saw the market decline begin to define itself in late 2007 would have determined to reduce stock exposure until a clearly defined uptrend had established itself. 

While Wall Street will always encourage an investor to trade to earn a commission, truly disciplined investors will not take the risk of picking market tops or market bottoms.  After all, timing a market move is a risk that in the long run doesn’t compensate an investor very well.

In the later stages of a down market cycle, the market will tend to overshoot on the upside, just as it tended to overshoot on the downside. The challenge is that while there is a sign of recovery, much of the data hasn’t confirmed it and market participants will experience a bull market life cycle in a short-term window.

Those that are early predictors of market recovery will be the first in and will bid up the market causing mid-stage adopters to join in the market and buy the market higher. Volumes will tend to be reduced because market participants will have decided to either get out because it is too painful or to hold on because it is too painful. The low volumes combined with a large number of market participants now wanting to get into the market will cause a short-term over-bought condition in the market that can last for several months and can be significant in percentage terms.

The more important challenge for market participants occurs as the data coming from critical measures of economic activity continue to be inconclusive or “lumpy”. Some data may show improvement while other data will show further declines—in fact, some data my look great one month and terrible the next. While the market will predict the recovery six to nine months in advance—the market has seemingly predicted twelve of the last three recoveries. In other words, the market as a short-term forecaster is not particularly accurate.

The mixture of positive data with patches of negative data and large sets of neutral data make for a volatile market. The combination of market participants wanting to get back into the market, low relative market volumes and mixed signals from the economic data confirms and exaggerates market volatility.

For example, if the market believes that the economy is recovering quickly, the market may increase by a significant percent in a continuous set of daily gains. However, this is not necessarily an indication that the economy has recovered and the market is at risk of giving back those gains if new data does not confirm the recovery.

While strong recoveries sometimes follow deep recessions; historically, recoveries following financial crises have been slower and more painful recoveries. As history would suggest, we are now working through a significant financial crisis which would indicate that the recovery would be slow and painful with data that is lumpy and inconclusive.

A normal market response to this financial crisis recovery with inconclusive data would tend to be unusually volatile in the short-term and less profitable in the long-term. If this is indeed the case, the market will likely offer a less-volatile, abnormally profitable investment opportunity at some point in the future—but not today.

If, for example, in September 1929, with the Dow around 350, you look backward 17.6 years, the market experienced incredible prosperity.  On the other hand, if you look from September 1929 forward 17.6 years, the markets and economies of the world experienced intense uncertainty and the Dow fell until sometime around May of 1947.

In May 1947, the war was over, the Dow was around 170 and investors made money in nearly anything they bought until January 1965.  In January 1965, with the Dow around 900, the market and the economy struggled.  Nearly anything an investor bought experienced extreme volatility and ultimately not much gain.  With the economy languishing, political leaders passed stimulus packages, re-ordered taxes, created jobs programs and spent billions of dollars in order to stimulate the economy—all without success until July 1982.

In July of 1982, President Regan’s tax reduction and spending limitation policies had taken effect and new life was given to business enterprise and capitalism.  In fact, from 1982 through the end of the century, nearly anything an investor bought went up in value—that is until sometime around February 2000.

From early 2000 to today, the market has crashed, recovered and crashed again.  Nearly anything an investor has bought has struggled to increase in value and in most cases has decreased in value.  If the 17.6 year cycle theory is accurate, this could perhaps continue to be the case until 2017—wow, could this possibly be true?

Economic theorists have long taught the difference between a long-term secular economic cycle and a short-term cyclical economic cycle.  Whether the long-term cycle is exactly 17.6 years or not probably doesn’t matter very much.  The key for investors is in determining how best to invest and manage the challenges of different economic environments.

Investors should maintain perspective on the markets and their long-term investing goals.  Markets will go up and markets will go down.  We can count on the markets creating the most pain possible for the largest number of people.  Successful investors are long-term investors focused on objectives rather than short-term profits.  The volatility of market swings are more comfortable for investors with well founded long-term objectives.

In the short-run, the 17.6 year cycle is probably as good a forecast as any.

With history as a guide, there are several reasons why the government has not been successful in managing operations of a private business enterprise (see "Why Government Can't Run a Business, John Steele Gordon, WSJ, May 20, 2009). 

First, the government of the United States was created to be an inefficient management model.  The checks and balances of the branches of government were designed to create inefficiencies that would contribute to stability of government.  The theory, as our founding fathers posited, was that change would happen slowly and only by the voice of the people.  For example, as the government becomes involved in private enterprise, simple question of compensation and bonuses requires hearings in congress, long legislative sessions, approval of the executive branch and years of review through the judicial system.  Can you imagine Walmart making management hiring and compensation decisions by going through this process for each member of the management team?

Second, the government uses taxes rather than investor funds.  Because the government uses taxpayer money, they are not held to investor standards are required of the private business comunity.  For example, if Fannie Mae fails, the politicians can claim that tremendous public good was created by allowing people--who otherwise would not be able to afford homes--to afford a home.  A private enterprise that fails in the same way, would see its senior management team in handcuffs for failure to disclose financial status.

Third, the government is regulated by the government.  Outside of the partnership between the executive, legislative and judicial branches, the government is not regulated by anyone.  The government creates its own monopoly, after all, it is a governmental monopoly, and has the power to eliminate competition.  For example, a government entity, in competition wtih private enterprise, can simply lower prices by subsidy, without lowering costs, and provide real financial incentives for the government enterprise to be the only logical provider available. 

Ultimately, the government is run by politicians, not businessmen.  Businessmen are judged based on their performance in earning a profit for all stakeholders.  Politicians are judged based on their ability to please the constituencies that support them in the hope of re-election.  It is a rare occurance that these two objectives align.  Despite all of the recent political rhetoric, these two objective could not be further apart than they are right now.

I must say that I am somewhat surprised at the public support for government-managed companies and that the private sector has been unable to garner support for less government intervention.  Perhaps we, as a county, have a short memory.  It appears that we may have to learn this lesson...again.

Indeed we face difficult times. In fact, this morning, the unemployment rate was announced to be 9.4% with over 15 Million people out of work in the United States. The policy response has been to work towards a nationalized support of the banking industry, the auto industry, the transportation industry, the education industry and the healthcare industry immediately. And this is all being done in the name of supporting the crumbling economy.

As I hear the rhetoric, follow the market and watch the economic data, I am reminded of a quote that seems to fit this situation:

"A government that robs Peter to pay Paul, can always count on the support of Paul" -George Bernard Shaw

For those that can remember, during the early 80's, the Regan administration faced rising unemployment, soaring inflation, a difficult international climate and a severely handicapped financial industry. At that time, the policy response was to cut taxes and downsize government. In fact, deregulation was heralded as the solution to the problem. The administration believed that individuals, seeking their own self interest, could make better decisions than the government, seeking its best interest, could make for the people.

The results were amazing to watch. Businesses that were now taxed less and regulated less, found profitability in hiring additional people. Those new workers found ways to afford homes and cars in a lifestyle that was not available without the new job. Unemployment decreased rapidly and interest rates, which responded to the inflation by increasing, soon decreased to average long term levels. De-regulated industries found that competition created incentives and motivation that regulated behavior and offered new opportunity. The reduced size of government required less in the way of taxes, but, as history proved, tax revenue to the government increased, despite the much lower marginal tax rates. In a contrary economic theory, the Obama administration is planning to spend its way out of this recession.

History has shown that a government can't spend its way out of a recession, the country must produce its way out of a recession by employing all of its resources effectively and reducing the amount of waste that comes from additional taxation and additional spending or government incentive programs.

America is certainly a democracy and everyone has a vote. The fear is that "a governemt that robs Peter to pay Paul can always count on the support of Paul." If there are enough Paul's, the policy will continue until all of the Peter's are gone.

A market bottom is created when the largest number of investors are determined to leave the market and they attempt to leave the market all at the same time.  The rally that we have seen over the last two months is a rally that was sparked by the market participants discovering that the world really wasn’t coming to an end.  However, the rally is not a fair representation of the end of the economic problems that the world faces.

As is common in market folklore, the market tends to overshoot on the upside and on the downside.  What we have seen in the last nine weeks is a re-tracement from a market that clearly overshot on the downside—and now has perhaps overshot again on the upside.  The common question now is, “where do we go from here?”  

As market cycles complete, the markets settle down and volatility decreases.  The number of days when the market moves more than 2% in a day will decrease to a once a month, rather than the once a day move.  Analysis of the market will generally not be discussed in the local newspapers and will certainly not be the lead story on the local new stations.

This lack of attention given to the market will tend to give the markets some breathing room and time to heal from the craziness of the past two years.  Probably the best long-term and most calming series of events for the market would be a slow crawl sideways for an extended period of time.

Here’s hoping for a calmer stock market for the rest of 2009.