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Morning Matters:

The Glass Is Half Full
by Geoff Garbacz

Last Sunday there was an interesting article in The New York Times. The premise of the article was the risks to the market. Three risks were identified. They were earnings, valuation and policy risk.

The current selloff is being driven by policy risk. Policy risk in my humble opinion does not cause bear markets. It causes panics. In this case, the fears are unwarranted. Why? Simply those in control of policy for the U.S. changed last Tuesday. It was a subtle change but a change that will impact how President Obama governs.

Until last Tuesday, the Democrats could do whatever they wanted as long as they were united because they controlled 60 votes in the Senate. Then last Tuesday, Scott Brown beat Martha Coakley for the Massachusetts Senate seat. Brown is a Republican and he replaced the lion of the Senate, Ted Kennedy. Now the Democrats control 59 seats and cannot pass legislation without some support from the Republicans. No more closed door sessions and back room deals, Chicago style.

This is why on Wednesday night in the State of The Union President Obama offered up several potential game changers that the Democrats simply rarely stand behind like offshore drilling, nuclear power, tax cuts for small business and R&D credits. President Obama is telling the Republicans he and the Democrats want to play ball with the Republicans so he can get healthcare and financial reform passed.

The stock market did great under President Clinton because he had to work with the Republicans as they controlled the House and Senate. He ruled from the center. President Obama does not want to rule from the center but the Brown election forces him to rule from the center or he will be a one term President. Sooner than later investors will realize this change and stocks will find a level to rally.

The others risks are fairly anemic for the first half of the year. There will be some challenges to the second half of the year. Earnings that are being reported now are compared against Q4 of 2008. At that time, the world was amiss due to the financial crisis. Q1 2010 earnings will be reported in April. Like Q4 2009 earnings, the comps are very easy. Then Q2 2010 will be the first challenging quarter and these earnings will be reported in July. Really tough comps will start for Q3 and Q4 earnings.

The earnings growth for many stocks is very strong for 2010. As an example, Exxon (XOM) will earn $3.90 in 2009 and $5.80 for 2010. This represents growth of $1.90 or 48% growth. The P/E for 2009 is 16.66. If the same P/E continues for 2010 then the stock is worth $96.63 ($5.80 *16.6). Many stocks have similar scenarios for 2010.

The valuation risk is not a clear and present danger to the market. In our stock scorecard section, we have been reviewing the price targets of the stocks in the Dow Jones Industrial Average. So far, 15 names are below their price targets and two above. Why? Cash levels are at all time highs for companies. The hoarding of cash is being used to buy back shares and pay down debt levels. Why? There is no confidence that Washington is going to help business. Therefore, CEOs are hunkering down for the equivalent of a nuclear winter.

The problem with this thinking is that CEOs are always too cautious and miss the turn back up after a recession. These leaders are not adjusting to the change taking place in the political landscape. This is not the type of change that Obama and the Democrats like. Rather it is a change being mandated by the American population. Just look at recent elections in Virginia and New Jersey along with last Tuesday's stunner.

Markets may not reach valuation and earnings risk the second half of the year if we can get some top line growth. This growth refers to rising revenues. So far, the bulk of earnings growth has been delivered via failing cost of goods sold due to lower demand and cuts to the workforce. Productivity is tapped out and companies must being to hire and this will drive the top line growth.

We prefer to see the glass half full rather than half empty. If our perceptions of what is going to happen to policy risk is incorrect, then we will have to revisit the best case scenario. The bottom-line is the S&P 500 has a good chance to move back to the prior high on the S&P 500 by 2011. Next week we will explore why the prior high on the S&P 500 of 1550 looks doable.

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