The world has become a riskier place in the past 30 days. Fears of China overheating and the potential sovereign debt default in Greece have created a growth scare in the marketplace. In the U.S., unemployment unexpectedly rose in January and consumer confidence fell in February. The S&P 500® index (the market) corrected 8.13% from its January 19 high to February 8, before recovering modestly over the next few weeks.*¹ Volatility (as measured by the CBOE VIX index) spiked 36% between January 11 and February 11 before retreating to lower levels.†¹ In a world where information and capital move at the speed of light, it is becoming increasingly difficult to separate a presage of things to come from the emotional knee-jerk reaction from hypersensitive investors.

That said, overreactions by investors create investment opportunities, provided the market direction is based on emotions and not the beginning of a more ominous fundamental trend. Before making allocation changes, let’s try to separate the hysteria from the fundamentals.

United States

Within the context of history, the past month’s mini-correction would seem nothing out of the ordinary. Historically, market sell-offs of 5% are common; they have tended to happen on average five times per year since 1960.² But it is also important to take a deeper look at what is happening underneath the recent headlines.

Concerns over the January spike in unemployment claims and the February decline in consumer confidence appear overblown and the prospects for a wider deterioration in the economy do not appear supported by other data, in my view. To differentiate a temporary correction from something more foreboding, we should ask ourselves what do we know and is there enough information to make a decision?

The four drivers of the U.S. economy are government spending, corporate spending, overseas demand and consumer spending.

Government spending is rising. Government spending is likely to continue to increase especially in a mid-term election year. In a rare bipartisan vote, the Senate passed a $15 billion jobs bill and is planning additional measures to stimulate hiring.

Business capital expenditures are rising. Business spending is highly correlated to GDP and profits, with about a one-quarter lag. In the fourth quarter of 2009, the S&P 500 non-financials companies reported revenue growth of 8.3% and EPS growth of 11.7% versus the third quarter. This is more than double the sequential quarter-over-quarter revenue growth from the second to third quarters.³ Manufacturing surveys appear to indicate that capital spending may continue.

J.P.Morgan writes, “Various industry surveys point to an increase in capital spending plans… The various Fed banks’ regional manufacturing surveys suggest that the trend in equipment spending strengthened beyond year-end. With five of the Fed’s regional surveys for January in hand, the average reading for capital spending plans (six months ahead) has increased from sharp declines through the second quarter of 2009 to a reading of 11.1 in the fourth quarter and 20.4 in January.”⁴ Also, core capital goods shipments, a key source data for estimating equipment spending, clearly accelerated during the fourth quarter.

Exports are rising. Real exports of goods and services rose 18.1% in the fourth quarter, versus an increase of 17.8% in the third.⁵ The V-shaped recovery in Asia has increased the demand for U.S. goods. A strengthening dollar should not adversely affect sales, except in the materials sector. Growing demand translates to top-line revenue growth. Overseas profit margins are higher than domestic margins for U.S. companies, allowing U.S. companies to absorb a stronger currency within their cost structures and remain profitable.

Consumer spending is likely to increase. The last and obviously most important key driver for the U.S. economy is the consumer. It takes two things for consumers to spend, the will and the means. Leading indicators for job growth suggest hiring is just around the corner. Layoff announcements over the past three months are down 72% year-over-year, according to the recruiting firm Challenger, Gray & Christmas, Inc. The employment components of the ISM manufacturing and non-manufacturing surveys are at their highest levels since August 2006 and August 2008, respectively. Temporary employment, often a precursor to full-time jobs, has grown by 247,000 in the past four months. Even online advertised job vacancies increased by 750,000 in the past three months, according to the Conference Board.⁶ Despite the high probability of job growth, the unemployment rate will likely increase because the unemployment rate is based on a survey. In this survey, participants are asked if they are currently working, and if not, are they looking. People who aren’t looking for jobs are not considered part of the work force and are excluded from the unemployment rate until they begin looking again. As more jobs become available and more people begin looking, the unemployment rate tends to rise before it declines. Lower unemployment and an increase in hours worked should provide the means for an increase in consumer spending. But do they have the will?

Concern over consumers’ willingness to spend may explain the market’s negative response to the decline in consumer confidence from 56.5 in January to 45 in February.⁷ Although the index is seasonally adjusted, I believe the decline was exaggerated due to blizzard conditions across most of the country. I found myself a little testy after digging out of two 20-plus-inch snow falls. Flights were cancelled, roads were closed, people were trapped indoors. Of course consumer sentiment declined when some workers couldn’t show up for work to be paid, consumers on tight budgets had to pay higher utility bills, and those trying to find jobs couldn’t even get out of their driveways.

The point is: the economy is expanding, jobs are coming, and consumer spending is likely to improve enough to generate sufficient earnings for companies to meet or beat expectations over the next two to three quarters. Under that scenario, consumer sentiment is likely to improve along with economic growth.

Although poor weather conditions in January and February are likely to distort economic data for the early months of 2010, I believe data is likely to reflect economic growth momentum once the inclement weather passes. The market seemed to ignore these positive data points over the past month:⁸ New home starts up 21.1%, new permits up 16.9%, the Conference Board’s index of leading economic indicators up 8.9%, semiconductors book-to-bill ratio up, mortgage delinquencies declined, U.S. small company optimism index up, the New York Fed purchasing managers index up from 15.9 in January to 24.9 in February, the Philly Fed business activity index was up, having increased six out of the past seven months.

That said, over the long-term I expect economic growth to remain below trend (less than 3.3% GDP growth) over the next two to four years because of the burden of excessive government debt, lingering high unemployment, and tight credit conditions. However, below-trend economic growth does not mean below-trend equity returns. In context, the summation of current economic data does not warrant a major market correction, in my opinion.

Looking at the key drivers of the equity market, I don’t believe earnings or valuations will get in the way of the market moving higher. High profit margins and top-line revenue growth should allow corporations to meet or beat consensus estimates. Bottoms-up consensus earnings estimates for 2010 are $78, a 32% increase, according to Bloomberg.

Valuations appear supportive of higher levels given the 18.77 times trailing price to earnings multiple and the 14.17 times forward P/E multiple.¹ Price multiples tend to reflect expectations. Expectations are hardly euphoric. Furthermore, in the past when consumer confidence was below 60, the equity market traded higher one year later 89% of the time with an average return of 18.8% (measured over the period February 1967 through June 2008).⁹ Keep in mind past performance is no guarantee of future results.

The implied risk premium is above average but it could move higher, which would be a temporary negative for the equity market. The potential sovereign debt default in Greece and potential contagion within the European Union (EU) will likely influence the U.S. debt and equity market through a higher risk premium. A higher risk premium priced into the debt and equity markets means higher interest rates and lower equity prices as price multiples contract.

Inflation doesn’t appear to be a problem considering the slack in manufacturing and labor. From December to January, the headline and core consumer price indexes declined 2.7% to 2.6% and 1.8% to 1.6%, respectively.¹ Five and 10-year inflation expectations seem well contained. Ten-year treasury rates are within 10 basis points of where they traded 30 and 60 days ago.¹ Although I am concerned about the prospects of rising rates, I believe there is little evidence to warrant higher rates causing a major sell-off in the equity market.

However, technically the market correction looks incomplete. Low volume and a decline in the number of NYSE stocks trading above their 200-day moving averages suggest more weakness could unfold over the months ahead.¹ The fact that the S&P 500 index broke below its 50-day moving average provides further evidence the bulls are not in charge and a near-term top may be in place.¹ Furthermore, it is not unusual for the market to correct 20-25% in mid-election years, which has historically been the case since 1930.¹⁰ In my view, investors with cash on hand may want to wait before adding to cyclical positions until the S&P 500 breaks above the 1115 resistance level. Without a break above 1115, market technicians believe the market is vulnerable down to the 1020-1029 level, which would be a great entry point if the market stabilizes above that level, in my opinion.

While technical indicators suggest the market correction is incomplete, economic data and key market drivers seem supportive of higher levels. This would suggest buying on pullbacks instead of selling on strength. Investors may want to add to positions on market weakness if the S&P 500 holds at 1020 (if it gets that low) or 1056, or on market strength if the index breaks above 1115 and 1154, in my opinion. Market rallies off these lower levels are likely to be led by smallcap companies and cyclical stocks in the technology, industrials, and consumer discretionary sectors. As long as interest rates are stable, I believe these asset classes are likely to outperform. However, the opposite may be true if interest rates rise, with technology stocks the possible exception. Earnings growth in the tech sector may be able to overcome higher interest rates. I wouldn’t be in any hurry to underweight this sector.

Since the direction of interest rates is likely to determine market direction and asset class and sector outperformance, investors may want to hedge their positions with a barbell allocation.

Consider allocating 50% of the portfolio in growth stocks, overweighting small-caps and cyclical sectors such as technology, industrials, and consumer discretionary. The materials sector would usually fall into this category but the sector is typically negatively affected by a stronger dollar, which I believe will continue. The other 50% of the portfolio would be invested in larger companies in the non-cyclical sectors: consumer staples, health care, telecom, and utilities.

Another allocation strategy would be to use inflection points (support and resistance levels) to determine adjustments. Just as there are inflection points in the equity market that influence market direction, the same is true for interest rates. Two levels that are likely to influence the direction of 10-year treasury yields are 4.05% and 4.53%, in my analysis. Investors should consider reducing exposure in small-cap companies and the cyclical sectors if the yield on 10-year treasuries breaks above these two levels. Each of these levels are major resistance levels; if broken, they would suggest higher interest rates.

International Markets

Europe

Greece’s potential sovereign debt default is serious. Greece brings to focus the broader fiscal problems that exist in the southern European countries known simply as “PIIGS” (Portugal, Italy, Ireland, Greece, and Spain). The risk is that recent volatility could be a taste of things to come. Spain’s and Portugal’s projected structural budget deficits are viewed as unsustainable. The problem is that a bank funding crisis could develop as a result of a default which would have contagion effects in two important ways: the damage to banks’ equity capital and a general pullback from risk assets by nervous and distrusting investors.

Worst case, these two channels have the potential to push the global economy back into recession via an even more constrained banking sector and another negative shock to household wealth. BCA Research notes, “The U.K. and continental European banks are most vulnerable; they comprise 92% of total foreign bank exposure to public and private sector borrowers in Greece, Spain and Portugal.” Total European bank exposure to the three countries amounts to $1.323 trillion.¹¹

Most likely case, the cost of capital will increase across the EU, and negatively impact the recovery in the region at a time when economic data was already showing signs of slowing. Germany reported a decline in economic output in the fourth quarter of 2009. Imports, consumer spending, and capital investment all fell, dragging the economy to stagnation.

Since the 1970s, European equity markets have tended to generate negative returns (averaging 2-8%) over the six months after the first post-recession peaks in certain growth indicators, with slightly positive returns over the following year. These indicators include the OECD world indicator (which recently hit a 34-year high), the ECRI leading index (which just rolled over), the Ifo survey, and/or the ISM manufacturing index.¹²

Investors should consider underweighting this region, in my opinion, given the change in leading indicators and the potential long-term drag on economic growth from the PIIGS. Two likely outcomes would be a bailout from the IMF and/or a much weaker currency. Don’t be surprised to see the USD/Euro exchange rate at 1.24.

Japan

The Japanese economy would never be confused with the economies of China or India. This aging developed country is well past her prime. After years of countless reform packages passed by various coalitions, the ruling parties have been responsible for building a mountain of debt that will hinder growth for generations.

However, when investors buy Japan they are not buying the Japanese economy, they are buying into an equity market that is export driven; much in the way the S&P 500 is becoming. Investors are buying into an equity market that is leveraged to global growth where the risks in the domestic economy are priced into equities. Many stocks are priced below book value. Japanese banks seemed to have avoided the “toxic assets” that continue to plague U.S. and EU banks.

The TOPIX was the best performing developed equity market year-to-date as of February 25, 2010.‡ ¹ Two events could continue this outperformance, in my view. One, the problems in Europe make Japan look less bad. Global investors who are already underweight Japan may begin to increase their holdings in the country to avoid the potential risk of underperforming their peers. Secondly, analysts who cover the region are expecting the Bank of Japan (BOJ) to increase quantitative easing (QE) in an attempt to stimulate growth and offset the deflationary forces that are mounting. This change in monetary policy could be the catalyst that would garner greater attention from global investors and increase money flows into their equity market. If the currency continues to weaken and a QE policy is announced by the BOJ, I believe Japan will outperform other developed markets in 2010.

Emerging Markets

China’s central bank required local banks to set aside larger reserves for the second time in a month in an attempt to reduce lending, avert an asset bubble, and restrain inflationary pressures. Investor concern over China’s monetary tightening triggered a 9.22% sell-off in the emerging markets (represented by the MSCI Emerging Markets index) from the previous January 11 high, as of February 24, 2010. § ¹ Investors are clearly aware that policy accommodation in China is behind them. As a result, emerging markets’ price-to-earnings multiple contracted to 11.8 times and now trades 7.8% below its long-term forward P/E of 12.8 times. Consensus earning growth for 2010 is currently +28.4%.¹³

Inflation fears in China and the debt problems in southern Europe will likely move money out of risk assets, temporarily. Over the short term, emerging markets are probably range bound until inflation fears abate, which data should confirm by the summer. Investors should consider adding to positions on weakness given the strength in fiscal balance sheets, the high earnings power by corporations and valuations that appear attractive.

Summary

The world is a riskier place, which makes hedging cyclical positions prudent. Since a higher risk premium and/or higher cost of capital are likely to manifest themselves into higher interest rates, investors should watch the yield on 10-year treasuries carefully. Consider constructing a decision-making tree that predetermines allocation adjustments if the 10-year treasury yield rises above 4.05% and 4.53%.

Investors should consider overweighting the U.S. equity market relative to Europe and Japan because of GDP growth differentials. Large-cap growth stocks with high quality balance sheets, low debt levels, paying dividends tend to outperform when investors become more nervous and/ or risk adverse.

Emerging markets remain attractive despite their potential short-term weakness. Investors should consider adding to positions on pullbacks.

The growth disparity between the U.S., Europe, and Japan will likely translate to a stronger U.S. dollar. Dollar strength could have temporary adverse consequences on the price of gold, commodities, and energy because of potential margin calls to investors that shorted (sold) the dollar and went long (bought) gold, commodities, and energy.

The global recovery is still unfolding, albeit, with less investor confidence. Nevertheless, I believe the global expansion, earnings momentum, attractive valuations, and low investor expectations warrant overweighting equities over debt and cyclical stocks over positions that are more defensive.

+++= Overweight ---=Underweight

This allocation is shown for illustrative purposes only. Investors should consider their time frame and all of their personal savings and investments, in addition to their assets and risk tolerance level. Your financial professional can help you assess your individual situation before you make any allocation decisions.

All investing involves risk including the risk of loss. Diversification does not eliminate this risk. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging-market countries are greater than the risks generally associated with foreign investments. Small and mid cap stocks carry special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies.

^* The Standard and Poor’s 500® Index (S&P 500) is a broad-based index, the performance of which is based on the performance of 500 widely-held common stocks chosen for market size, liquidity and industry group representation. The indices shown in this article do not include any expenses, fees or sales charges, which would lower performance. The index is unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

^† The CBOE VIX index is a commonly cited measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

^‡ The TOPIX, or Tokyo Stock Price Index, measures the performance of all companies listed on the First Section (for large companies) of the Tokyo Stock Exchange. The indices shown in this article do not include any expenses, fees or sales charges, which would lower performance. The index is unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

^§ The MSCI Emerging Markets Index measures the performance of equity markets in the global emerging markets. The indices shown in this article do not include any expenses, fees or sales charges, which would lower performance. The index is unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

¹ Source: Bloomberg LP

² Source: Bank of America Merrill Lynch, February 12, 2010

³ Source: Bank of America Merrill Lynch, February 22, 2010

⁴ Source: J.P.Morgan, January 29, 2010

⁵ Source: Bureau of Economic Analysis, January 29, 2010

⁶ Source for layoff, ISM, temporary employment and help wanted ads data: J.P.Morgan, February 16, 2010

⁷ Source for consumer confidence data: Bloomberg LP

⁸ Source: Catalpa Capital Advisors, LLC, February 16, 2010, February 18, 2010, and February 22, 2010

⁹ Source: The Conference Board, Morgan Stanley Smith Barney Research

¹⁰ Source: Bank of America Merrill Lynch, February 22, 2010

¹¹ Source: BCA Research, February 11, 2010

¹² Source: Morgan Stanley Research, February 8, 2010

¹³ Source for P/E ratio and earnings growth data: Morgan Stanley Research, February 19, 2010