By Ryan DeCaro, Associate Investment Strategist

October 21,2011

The current environment is clouded with intense fear over a global double dip recession. We hear about the problems in Greece, Ireland, Spain, etc. and fear that they will hurt U.S. based companies and in turn our economy. Moreover, we are forced to watch Congress quibble over ideologies, putting their beliefs over what is right for the country. We have witnessed debt crises in the United States and Europe, along with a credit downgrade for the United States. Bloated balance sheets have caused a number of large economies to push austerity measures and consumers have resorted to stuffing their mattresses to preserve whatever cash they have left. It has been a rollercoaster ride over the past six months and there are no definitive signs that these problems will be resolved anytime soon. Fortunately, corporations and individuals worldwide have been much more responsible than their governmental counterparts since the beginning of the recovery. On average, corporations are holding 10% of their balance sheet in cash, they have slimmed down their workforce, and have invested heavily in internal research and development to enhance their margins. Individuals have also done a tremendous job tightening their belts since 2007, resulting in the lowest levels of debt in five years. Key economic drivers have also shown a much brighter picture for the economy than being reported. Manufacturing data is positive, housing data has bottomed, and the employment picture is getting brighter. We are now in an environment where the Federal Reserve has basically stated that they will do whatever it takes to avoid a recession and leaders from France and Germany have pledged their support to aid countries like Greece and Spain out of their respective fiscal doldrums. Domestically, we have incredibly low interest rates that have driven demand for consumer and business loans higher. Banks are also beginning to see the light and are now becoming more receptive to lending to these entities, resulting in more economic activity. GDP is stronger than initially reported, although it is still quite lackluster. Corporations have also continued to report stronger than expected earnings, with last quarter being the ninth in a row that they have beat analyst estimates. Additionally, last quarter saw companies on average beat both top and bottom line estimates in addition to earnings per share estimates. After reviewing numerous earnings calls, it is clear that businesses are now cautious because the consumer is worried, but they feel that the outlook for the future is positive and earnings should continue to trend higher.

An important consideration holding back growth is uncertainty related to taxes. Businesses and individuals are not sure what their tax rates will look like beyond this year, so they are less willing to spend reserves. Once we gain some certainty regarding taxes for next year (and hopefully beyond) we may see a pickup in spending and an improvement to GDP.

Moving forward, a number of key leading indicators are pointing to a much stronger economy. Starting with the unemployment picture, forecasted job cuts continue to decline, job postings increase, and initial jobless claims have fallen. Automated Data Processing (ADP) reported last quarter that they anticipate a strengthening job market in the fourth quarter and into next year. CEO’s are announcing plans to hire and the government has reduced the level of cuts they started making last year.

Production has also witnessed relative strength over the past few months as both industrial production and capacity utilization are at their highest levels in years. Beyond the current rise, indicators are also pointing towards businesses ramping up production as inventories hit historic lows. The current inventory to sales ratio is a mere 1.2:1. Institute for Supply Management(ISM) data also shows that the economy is continuing to expand, with readings coming in above 50 on their scale. A number above 50 indicates a growing economy while a number below 50 is indicative of a shrinking economy.

The housing market has also showed signs of bottoming as housing starts and existing home sales are starting to increase. We still have inventory of existing homes that need to be sold before we can see a true housing recovery, but with interest rates at these low levels, it is conceivable to believe that we will begin to see the inventory sell off by the end of next year, which will lead to a rebound in new housing activity. Along these lines, building permits have also started to move higher again showing a renewed interest in housing starts. As consumers begin to see some of the governmental fiscal troubles subside, we believe that they will begin to take advantage of low interest rates and start buying real estate. The loosest credit standards since 2004 should help move this process along fairly quickly once consumer confidence returns.

One of the most important pieces of data available favoring a rebound in the economy is the level of pessimism currently in the economy. Consumer expectations are below those in March 2009, as continued coverage of the U.S. and European debt concerns have paralyzed the general public. With CNBC , CNN, and Fox News (to name a few) bombarding people with all this bad news, it is easy to see why they would be scared. The beginning of 2009 shows us exactly what high levels of pessimism amongst the general public leads to: superior market results. The last time consumer expectations were this low, the S&P saw a rebound of more than 75%.

The past six months are reminiscent of the slowdown that we had in 2010. Economic indicators were flat and problems in Europe were mounting. We saw the S&P 500 slip by more than 16% over a three month period of time only to rebound more than 22% to end the year. Back then, we were hearing the same stories about ineffective leadership, global debt problems, and a double dip recession. All that noise was washed away though as the markets started to rebound. Sir John Templeton said it best: "Rejecting technical analysis as a method for investing, you must be a fundamentalist to be really successful in the market.Invest at the point of maximum pessimism." We believe that time is now.