The S&P 500 Index broke to a new bear market low on Friday as the U.S. government took a 36% equity stake in Citigroup, and an updated GDP report showed the U.S. economy contracted at a stunning 6.2% annual rate in the fourth quarter of 2009. The decline on Friday was the ninth in ten days, and the month's 11% loss marked the worst February since 1933. More worrying, the losses occurred during an important week for the Obama Administration, which included the President's first address to a joint session of Congress, and the unveiling of his first budget. It seems that few investors are tuned in to the high approval ratings of the new president.
We have been cautiously optimistic that November 20, 2009 marked a short term low for the market. Although we feared the hangover from years of a debt-induced spending binge would ultimately take stock prices lower, we were mindful of the fact that some of the biggest rallies in history occurred within the context of secular bear markets. On the bright side, signs have emerged during the recent retest of November lows that the market remains in a bottoming process. For example, much fewer stocks are breaking to new lows compared to the November decline, and declining volume to advancing volume is much improved relative to the extreme levels seen last fall, indicating a lack of panic selling. The better relative performances of the NASDAQ, as well as growth stocks and emerging markets, are consistent with historical tendencies around past market bottoms.
However, the current political environment and the health of banks around the globe create substantial risks that equity prices decline further. While we all knew the Obama Administration would bring sweeping change, the anti-growth provisions of the 2010 budget are breathtaking, considering this is the worst recession since the Great Depression. Examples: raising dividend and capital gains tax rates to 20% from 15%; reducing the mortgage interest deduction at a time when housing prices are collapsing; introducing a cap and trade system for carbon emissions which will raise energy prices for consumers; and increasing marginal tax rates on incomes over $250,000.
We continue to advise clients to maintain a defensive posture until the market exhibits more definitive signs of improvement. Our current recommended portfolio includes just 30% in equities, with the balance in high quality fixed income securities and alternative investments such as gold and managed futures. Investors with higher allocations to equity should look to reduce exposure should the markets continue to break down in the days ahead.
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