Alamo Asset Advisors Outlook February 2010

First is whether or not Chairman Bernanke will be the person to lead the Federal Reserve in 2010. After the Bernanke appointment is settled we will shift our attention to how American politics will shape up. With the Republicans still at a minority, but now having the ability to utilize the filibuster as a motivating tool, their cooperation or lack of cooperation will change the pace and breadth of President Obama’s agenda. The three headed dragon President Obama will attempt to slay in 2010 is; Health Care, Jobs, and Banks. What appears to be the quickest area to obtain results are the banks, so we are currently hearing a lot of political rhetoric directed at the banking system.

With mid-term elections approaching, the need to create jobs will receive more and more attention as both parties understand that the American public will vote based on emotion, and employment is a very emotional issue. The fascinating fact that tends to get lost is how intertwined the investing world has become with the political world. Just a few short years ago when we spoke to investors about geo-political risk we spoke of governments such as Japan. Now we find ourselves considering the geo-political risk that is presented by the government of the United States. While we do not consider the stability of the US government at risk with regards to its existence, we strongly consider the actions of the government and the effect of those actions on a multitude of fronts, including trade policy, monetary policy and defense spending, as well as new areas of government intervention such as helping home and auto buyers with tax credits.

The real issues facing us in 2010 and 2011 are: How does the government unwind its involvement in the day to day economic habits of the American public? How is the Fed going to shrink its balance sheet back to normal size? What is the regulatory environment going to look like in the banking and financial industries?

Trivia - The oldest known receipt for goods and services is
a receipt for the purchase of an alcoholic beverage.

When thinking back on 2008 and 2009 two quotes come to mind; “What doesn’t kill us makes us stronger” and, “Those who cannot remember the past are doomed to repeat it.”

The most profound lesson learned is that we are all connected. Just a few short years ago those on Wall Street could often be heard saying something like, "If the U.S. catches a cold, the whole world catches the flu." I believe we now know, if any major economy catches a cold, we all get sick.

Balance sheet strength matters. Just ask those companies that needed to borrow short term money and could not, how their day to day operations were affected.

We will have other crises. Keep your tolerance for risk at the forefront of your investment decisions.

Investors, while they may not think explicitly in terms of tactical and timing issues, will try to discern tactical allocations: which stocks to own and which sectors of the market will respond to external factors as well as timing issues; when to get into certain sectors and when to get out. Most exercises in timing the market fail.

While some like to focus on lagging indicators such as unemployment, I prefer to look at leading indicators such as the cost of money, the shape of the yield curve, the direction of credit spreads, the inventory cycle, and monetary and fiscal policy. All of these indicators have continued to point to further improvement for the economy in 2010. In fact, we may well have an economy that surprises the economic consensus with its strength.

That's not to say that there aren't risks. A big concern is that the consumer is in no condition to return as the driver of our economy. After all, consumers no longer have the income or home equity to spend, and the banks aren't lending. While that's a valid concern, I think it's one for 2011, not 2010. Because the inventory cycle should have enough momentum to carry the economy for the next four quarters or so, perhaps to a growth rate as high as 5% or more.

Monetary policy is expected to remain highly simulative in 2010 even if the economy recovers. The Fed has a dual mandate of full employment and price stability. It is clear that its main concern right now is unemployment and not inflation. According to the Taylor Rule (one of the mathematical formulas used by the Fed to help determine at what
level it should set its target interest rate), the federal funds rate should not be where it is now, at 0.13%, but rather -5.83% given a jobless rate of 10%. A negative rate isn't possible, of course, which is why the Fed has injected a trillion dollars of reserves into the banking system. This is called quantitative easing (or printing money) and is designed to make up for the fact that the Fed's "conventional" ammunition isn't working (i.e., short-term interest rates). So, the question, in terms of monetary policy, is what unemployment rate will lead the Fed to raise the funds rate? By utilizing their own methods of calculation, it would take a decline in the jobless rate from 10% to 6% to warrant any hike in interest rates. I think that's a long ways off, which is why I think that it's unlikely that the Fed will do any tightening in 2010.

The technicals are still OK. Not great but not terrible either. We still see a pattern of higher highs and higher lows in the major stock market indexes (which, after all is the definition of a bull market), but we do have some negative divergences from small caps, market breadth, and financials (i.e., they made a lower high while the S&P 500® Index made a higher high). Not the end of the world, but clearly a sign that the bull market is getting tired.

Sentiment is also still OK. Not great, but also not terrible. Sentiment surveys, such as the American Association of Individual Investors AAII Sentiment Survey, and Investor Company Institute (ICI) mutual fund sales continue to show a sentiment pendulum that has swung from a pessimistic extreme to the middle, but not (yet) all the way to an optimistic extreme.

All in all, the weight of the evidence from where I am sitting demonstrates that the economic recovery is progressing and may well turn out stronger than many investors expect, that the Fed will not risk an early exit from its policy, and that technically the bull market in stocks is intact but getting more and more mature. So, I see more opportunities than risk over the intermediate term.

Over the longer term, however, there are a number of questions that loom on the horizon.
For one, when will the Fed exit? Will Congress continue to run deficits, and what impact will that have on interest rates, the dollar, and the price of gold?

First, temporary employment hiring is rising at the fastest rate ever, 28.7% on a three-month annualized this is one of the key leading indicators for the U.S. job market. Second, overtime and total hours worked in manufacturing are rising. In the past, that's been the first sign that the labor market is starting to improve. Third, initial unemployment claims are falling. There's always a natural creation and destruction of jobs in the economy. We're seeing movement in both: improvement in new jobs and job destruction receding.

I see many parts of the world that look like the U.S. did in the early 1900s. Brazil is the world’s 5th most populous nation. Less than 7% of Brazil’s population is over 65, with total population growth around 1% per year. Indonesia is the world’s 4th most populous nation with less than 6% of its population over 65 and a growth rate of about 1.2% per year. India has a population growth about 1.5% per year and fewer than 5% are over the age of 65. Yes, overwhelming poverty, horrible education systems, and horrible welfare systems hold these countries back, but they are getting more educated, smarter in the ways of the world, more stable politically, and more diversified economically.

I recently spoke with a friend who is intricately involved with the banking system in Brazil and according to him, their technology is “light years” ahead of the technology in the American banking system. I see growth in these countries akin to that of America throughout the 20th century. The advantage these countries have over the America of the 1900s is technology. While I can’t predict what will happen in any given year, I feel very confident is predicting that these countries and others will drive the growth of profitability across the globe for years to come.