Third Quarter Outlook Points to More Turbulance But A Positive Outcome

Grand Street Advisors

Market Outlook

Third Quarter 2011

Where we are. Right to it. The US equity market is celebrating its third anniversary of the bull market kick started in early 2009. Top down and bottom up analysis of the economic recovery have been wildly bullish and wildly pessimistic, basically all over the map. This is no more evident in the scorecards for hedge funds over the last twenty four months, negative thirty percent to positive one hundred percent. These are supposed to be some of the best and brightest who put their money where their “black box trading models” are. Just evidence how difficult and challenging it has been in reading the economic tea leaves and investing appropriately.

From my perch analysts are looking at this earnings cycle from the wrong perspective. Many view the earnings momentum as about to peak. In my view, for this to occur, the US economy would need to revert back to the brink on recessionary levels. I just don’t see it. The US economy is growing below trend. Domestically, steps are being taken to stimulate growth with potential tax cuts being discussed in the hallowed halls of Congress as we speak. Thus far emerging market growth has been pulling the US along for the ride reflected in the explosive growth in exports and export related job growth. When the US economy regains its traction and we will, earnings and revenue growth should accelerate up markedly, unemployment should drop precipitously. The austerity measures being negotiated currently up on the hill will push the US back towards a balanced budget and trend rate growth.


I will have to be the first to state I’m wrong (as far as I know anyway) my projections for the market were incorrect. I’ve been far too conservative. Even with unemployment at 9% corporate earnings and productivity have defied gravity. Viewing an accommodative Fed policy for the next two years (due in no small part to the bulbous housing stock), strong export driven growth, lower corporate tax rates and even a modestly expanding job market coupled with pristine corporate balance sheets earnings and revenues should continue their upward trajectory dragging the S&P 500 along for the ride well through 1500 over the next six to twelve months.

Risks.

1. Forget about the 800 lb. gorilla in the room, let’s look at the 1200 lb. polar bear. He’s the one less dangerous looking, highly pet-able and cuddly that will rip my face off if I don’t have a 3” glass partition between us. He’s lurking out there. He’s playing coy in the form of the potential US debt default. Should our fearless leaders dig in their heels and fail to come to a deficit cutting, revenue increasing compromise a US debt default would most assuredly shred any and all portfolio making the Lehman Titanic look like a dingy.

2. The end of the Feds QE II asset purchase program allows natural market forces to identify and dictate where investors are willing to commit capital. If it turns out rates rise precipitously it may choke off any housing recovery.

3. Greece Part Deux. The ECB and Jean Trichet seem to not have learned anything these last few years. The ECB refuses to or is unable to get out in front of this potential financial collapse and/or exit of Greece from the EU.

It is not only Greece the markets fear, it is the potential contagion and bond vigilantes. If Greece fails, the thinking is then Portugal, if Portugal then Ireland/Italy and Spain etc... This would be the equivalent of Lehman squared. There would be nowhere to hide…again.

In the end we have to factor in probabilities. Ex-Lehman our esteemed academics may have run an experiment and re-hash “moral hazard” (hey it was catchy) and let either Greece or the US go thinking they have any collateral damage contained. However, they have experienced the Lehman catastrophe and found out first hand how interconnected the global financial system is no matter how many creative financial derivatives we concoct to “hedge” our risk. We can still see the carcasses in the rear view mirror, we know the claw marks would cut too deep and critically injure any recovery.

So, while we need to be aware of risks and always look for the unexpected, I believe the likelihood of any default to be extremely slim. Going forward I see uneven market gyrations, but ultimately ending with a strong rally to finish up the year and recommend an aggressive posturing to equities. We’ll continue to monitor the data and market. Should our opinion change and we need to alter our strategy I will be in contact immediately.



Thank you again for your patience and confident in these very challenging times.



Yours in pursuit of the Kwan!