Still, there are many reasons to be optimistic about the markets in 2010, although no one expects repeat performance of 2009.  Most of the stimulus money is still not spent, corporate earnings continue to surprise on the upside, inflation and interest rates are low, and apparently unemployment rate has peaked.   Regular corrections are quite normal during the upward movement, and I don’t think this market is going to be different in this regard.

Nevertheless, the markets reacted in decidedly negative fashion to these benign reports and good earnings.  We saw a drop of about 8% from the 15 month market high reached just two weeks ago.  Skeptics are ready to point out that such a negative reaction to positive developments indicates that good news are already reflected in stock prices and that more trouble lies ahead.  Indeed, back in March 2009 the news were overwhelmingly negative, and yet that marked the beginning of the rapid market rise.  On the other hand, a correction such as we are experiencing is normal and is to be expected on a regular basis and especially after a huge rally we had last year.  In fact, since March 2009 there were three corrections already of the similar magnitude and the market kept marching higher after each one.

Who is right this time?  You know that no one can possibly answer this question.  In my view, we have reached a point where easy money has already been made on the way down and on the way up.  Any “dartboard portfolio” lost money in 2008 and made money in 2009.  I think that at present, stocks are reasonably valued and the skill of stock selection will once again become important going forward.

There are some global developments that definitely merit watching.  Financial crisis in Dubai, downgrade of Japanese bonds rating, and high debt obligations of Greece are troubling.  You are probably familiar with the acronym BRIC, which refers to fast-growing developing economies of Brazil, Russia, India and China.  Now we have another acronym: PIIGS.  This one stands for Portugal, Italy, Ireland, Greece, and Spain — countries in European Union that have high debt loads and face a possibility of default that would strain the whole Euro zone.  I even heard views that the euro as a currency may cease to exist within the next five years.  If indeed any of the PIIGS of the world comes even close to a default, you can be quite sure that this will not do wonders for any of the world stock markets.

We do have a lot of uncertainty at this point but this is nothing new.  In my view, a sensible investor must keep a well diversified portfolio of high quality stocks and be always positioned to take advantage of positive market moves.  This has worked extremely well for me last year.  In addition to that, caution and certain downside protection would also be warranted.

We’re nowhere near a market top now, but it pays to remember the signs in advance, like: (1) A general market euphoria, with talk of a “new investment era,” in which major corrections are a thing of the past, with the business cycle being softened or repealed. (2) Books like Dow 36,000 will replace the perennial “beware the coming crash” books on best-seller lists; and (3) market gurus will praise the virtues of “buy-and-hold,” while mocking the futility of “market timing.”

Right now, after a major crash, I can’t find anyone who will defend buy-and-hold.  Newsletter rating guru Mark Hulbert made a study of this phenomenon back in 1996 and found that investors disparage buy-and-hold when buy-and-hold would serve them best (as in the 1990s). Then, they become disciples of buy-and-hold at market peaks, when they should unload their big winners.

Ken Fisher echoed those findings in his 2007 book, The Only Three Questions That Count, saying (on page 277) that “at a bull market peak, there is endless advice saying you should never turn bearish and you should never ‘time the market,’ and that people who do are destined to miss the big returns of bull markets.  In 2000, this advice was rampant. The financial services industry marketed heavily that any professional who turned bearish was a quack or a charlatan.”

My sentiment about last quarter of 2009 remains very similar to that of a couple previous quarters.  The economy continues to exhibit more and more signs of clear recovery, in GDP growth, improving housing market, stabilizing unemployment, strong corporate earnings, low interest rates, and even consumer sentiment.   The sentiment of market advisors, however, remains decidedly guarded since the gains occurred much quicker than anybody could have anticipated.  Many believe that this is still a bear market rally.  Indeed, can the market really go higher having already risen so much and so fast since March?  The short answer is — yes, it can.  It was unimaginable to think that it could drop even further from the levels of one year ago – and yet it did.

I am sure you realize that I am not actually making a prediction here; I never do.  The future is unknown and my guess is as good as yours.  There is a very good possibility, however, that the market will continue its climb of the wall of worry.

Before closing, we’d like to leave our readers with two views of the market—the inside view and the outside view—and let each reader decide which is the more relevant framework for investing. The inside view says that the market can’t go up because our current circumstances are too perilous and uncertain. The laundry list of worries has been well chronicled by the media: a still-fragile financial system, a likely sub-par economic recovery, yawning budget and trade deficits, a vulnerable dollar, threats from both inflationary and deflationary forces, high and still-rising unemployment, continuing wars in Iraq and Afghanistan, nuclear saber-rattling by Iran, massive funding requirements for Social Security, Medicare and Medicaid, the burden of health care reform and a probable rise in tax rates. Yada, Yada! It’s a wonder any of us can get ourselves out of bed in the morning.

The outside view says, yes, we’ve got plenty of things to worry about, but that’s been true throughout history. Worries, concerns and problems are always an unavoidable part of the investment landscape, just as they are an unavoidable part of life. The outside view asks us to look past the current situation at the bigger picture. Over the longterm, stocks have been great wealth builders. This has been especially true after they have suffered extended periods of poor performance, such as the 10-year period we have just witnessed. To be more specific, according to data compiled by Jeremy Siegel at the University of Pennsylvania, stocks have provided average annual real returns (after inflation) of 6.66% for all 10-year periods going back to 1871. There have been fourteen 10-year periods, including the current one, where stock returns were negative. In every one of the previous 13 instances, the subsequent 10-year returns have averaged 10% real, about 50% better than the long-term average, and more than twice the return of bonds.

With funds currently flowing out of domestic equity mutual funds and pouring into bond funds, investors are being overwhelmingly influenced by the inside view. We think they are making a big mistake.

The government also revised job loss amounts for the previous months downward.  If this trend continues, there is a very good chance that we will see job creation as soon as the end of this year or in January.

More details in this CNN Money article.

From a contrarian perspective, this is great news.  This means that investors stayed skeptical all the way up during the current rally and chose to either sit on their cash or funnel it to “safe” bond funds (with interest rates near zero, I don’t think bond funds will be safe for long).

The wall of worry is still alive and well.

It looks like this won’t be a jobless recovery.

- Q3 GDP grew at 3.5%, so now the recession is finally officially over.
- Retail sales were better than expected.
- Auto manufactures, such as Ford, Nissan, Toyota reported (relatively) good results with sales higher than a year ago. Ford reported $1.8B profit. Apparently, it is still possible to make money in the auto business.
- Job cuts by employers are moderating, and unemployment claims are falling. In fact, more employers are planning to add jobs than ones planning to eliminate them.
- The housing market continues its recovery. Pending home sales rose by 6.1% and are now at its highest level in three years.
- Earnings reports continue upward trend of the last two quarters. Fully 80% of companies beat earnings estimates, which is a record.

Note that consumer spending and unemployment have been thorns in this recovery for quite some time. As you can see, now we are getting more and more positive news for both.

The market, in its infinite wisdom, decided to greet these news with a sell-off earlier this week, and continued high volatility later. One could argue that a consolidation is due after a rally we had, or this could be a case of “buy on rumor, sell on news”. In any event, markets can be quite irrational in the short term, but in the long term, it is the fundamentals and earnings that matter.

We have already seen other signs of recovery in industrial production and housing, but not yet in employment.  So this development is very significant.