The Zarnowitz Rule¹ states that the magnitude of an economic recovery is mostly a function of the magnitude of the previous recession. In other words, the rule states that “like a rubber band, the further an economy stretches to the downside the greater the snap-back to the upside”.

While economists might debate this outlook given the current sovereign debt burdens, the Zarnowitz Rule has, so far, been accurate in forecasting the direction in the global equity markets.

This month’s commentary will outline what investors can expect over the next 12 to 36 months if the global equity markets continue down the path experienced in previous market cycles. As always, the past performance of the markets being no guarantee of the future.

Where do equity markets go from here?

As one might expect, the largest percentage gains in the equity markets have tended to occur in the first year after the markets bottom. Generally speaking, the magnitude of the gain seems to be a function of the percentage decline.

As of March 19, the percentage declines from the most recent market highs and subsequent rallies in major global equity markets are shown in the table below.

* Source: Bloomberg LP. Calculations based on the index highs and lows dated 10/9/07 and 3/9/09, respectively, for S&P 500; 10/31/07 and 3/9/09, respectively, for MSCI Europe; 10/11/07 and 3/10/09, respectively, for Nikkei; and 10/29/07 and 10/27/08, respectively, for MSCI Emerging Markets.

Yet, history has shown exceptions to this rule. In the early ’90s, global equity returns were disappointing largely due to the lack of an earnings recovery. In the late ’90s, global equity returns disappointed because of inflated valuations, primarily in the technology sector. Currently, however, global equity valuations look supportive of higher prices, trading at 14 times 2010 consensus estimates, and earnings estimates have continued to improve.²

If the first year of a recovery has tended to provide the most significant gains, what can be expected in subsequent years? Based on data since 1980, an analysis by Citi Global Markets offers several insights about the nature of global equity performance one to three years into a recovery.³ According to Citi, global equities have tended to trade 10-20% higher 12 to 36 months after the global equity markets bottom. In the first year, the equity markets were driven by multiple expansion in an environment of low interest rates and weak corporate earnings. In the subsequent years, strong corporate earnings, rising interest rates and multiple contraction tended to drive the equity markets.

The shift in drivers generally led to a shift in market leadership from high beta sectors to low beta sectors. Citi defines high and low beta sectors as the sectors with the best and worst performance in the bear market and subsequent recovery. These sectors can change in each cycle. In this cycle, the high beta sectors have been financials, materials, and industrials. The low beta sectors have been consumer staples, health care, and telcos. Citi’s analysis indicates high beta stock outperformance has tended to peak nine months after the bear market ends and to fade within 12 months. The performance of high and low beta sectors in the current cycle looks very similar to previous cycles, as high beta sectors stopped outperforming in the fourth quarter of 2009. I believe investors should strongly consider reducing the beta in their equity portfolio despite the likelihood of the global equity markets trending higher.

In contrast to high beta sectors, cyclical sectors, which can include high or low beta stocks and growth or value stocks, have historically demonstrated a more sustainable performance trend. Cyclical sectors’ (industrials, consumer discretionary, materials, energy, IT) relative outperformance of the defensive sectors (consumer staples, utilities, telcos, health care) has tended to last longer, about 20 months after a market low, according to Citi’s research. Cyclicals’ outperformance generally ended concurrently with a rise in interest rates, as cyclical stocks tend to perform poorly in a rising rate environment.

Reduce “duration” in equity portfolios

In previous market cycles since 1980, the Fed funds rate stayed low during the first 12 months, as it is now, and began to move higher 18 to 24 months into the recovery. Therefore, history suggests a Fed rate hike by the FOMC between the third quarter of 2010 and the first quarter of 2011. If interest rates rise as they have in previous cycles, Citi estimates the trailing P/E on global equities will tend to fall by 20-30% over the next two years.

Given this scenario, financial advisors and investors may have sought to reduce interest rate risk in fixed income portfolios by reducing duration. But what can investors do about interest-rate sensitivity in equity portfolios?

Duration usually refers to a bond price’s sensitivity to changes in interest rates, which relates to its coupon rate and maturity date. Shorter maturity bonds are less sensitive to changes in interest rates than longer maturity issues. Higher coupon bonds are less sensitive to changes in interest rates than lower coupon bonds. Zero-coupon bonds would be the most volatile fixed income security relative to changes in interest rates.

In the case of equities, investors interested in reducing “duration,” or interest rate risk, would focus on the stock’s dividend yield. Investors should consider reducing “duration” in their equity portfolio by increasing exposure to higher dividend-paying stocks to the degree they believe interest rates will move higher. If the probability is 40% or 60%, then investors should have 40% or 60% of their portfolio in higher dividend-paying stocks, in my opinion.

Investors unsure of the direction of interest rates should consider the following: the average 10-year Treasury spread over core inflation over the past 30 years has been 340 basis points.⁴ Consensus estimates for 2010 core inflation is 2.00%, according to Bloomberg. This would suggest a 5.40% 10-year Treasury rate once interest rate spreads normalize.

Spread between 10-Year Treasury Yield and Core Inflation (1979-2009)

Source: Bloomberg LP

Despite data that suggests inflationary pressures are tame, the supply/demand outlook for government bonds is quite troublesome in my opinion. As mentioned in previous commentaries, the FOMC will end the purchase of government mortgage-backed securities at the end of March. Last year, the FOMC purchased approximately 90% of the new supply issued by the federal government. New issuance of government bonds is expected to be substantially higher this year. If the demand for government bonds doesn’t increase from other sources, interest rates will likely rise. Furthermore China, the largest owner of U.S. government bonds, has been reducing its allocation over the past year.

U.S. outlook

March turned out to be an historic month in the U.S. It marked the one-year anniversary of the bear market bottom, the passage of the health care bill, and a 10% rise in the S&P 500 index in the five weeks since February 8, 2010, a move which falls in the top 2% of five-week gains since 1957.⁵ In the past, when the market has generated top quintile five-week performance, the market moved higher 72% of the time over the next six months with an average return of 5.1%.⁵ Keep in mind past performance is no guarantee of future results.

In my view, investors should give the global recovery the benefit of the doubt and continue to overweight the cyclical sectors of the market. If interest rates stay lower for longer, I believe the cyclical sectors are likely to outperform. This would include overweighting small-cap stocks. Corporate profit growth, consumer loan delinquencies, high yield credit spreads, equity market volatility and bank lending standards continue to favor small caps, in my opinion.

However, the cyclical trade — and it is a trade in my opinion — has an expiration date. When interest rates rise these sectors are likely to underperform as mentioned previously. In other words, investors that move defensively too soon into higher dividend-paying stocks are likely to underperform until interest rates begin to rise. Of course, each investor’s relative allocations across cyclical and defensive sectors depend on an individual’s time horizon and risk tolerance.

Economic momentum continues to build with data showing improvement in manufacturing, employment, and retail sales. The household jobs survey reveals after 12 months of declines that civilian employment has improved in the last two months, amounting to a gain of 850,000 workers.

On a technical basis, the S&P 500 index broke through two resistance levels (1115 and 1153) last month in convincing fashion. This would suggest continued strength in the market, with the index perhaps breaking above 1200.

Europe outlook

Greece was able to sell $6.8 billion in 10-year government bonds on March 4, which investors believed reduced the risk of default. Austerity measures were announced to reduce deficits in Greece, Italy, Ireland and Spain to help buttress confidence in the fixed income markets. Partially offsetting the improvement in investor confidence was Fitch’s downgrade of Portugal’s sovereign debt rating to AA-.

The region expects Greece to finance its deficits and roll over its debt in the capital markets. If a liquidity crunch occurs, the European Union (EU) would deliver a financial package as a last resort and not at a discounted rate. Greece wasn’t happy with EU support and threatens to go to the International Monetary Fund (IMF). Greece going outside the “family” would indicate that the EU cannot keep its house in order and will likely raise fears of other potential financing problems with other “Club Med” countries. The near-term reaction would likely be a weaker currency. The immediate risk of default may be limited for now, but Europe’s sovereign debt problems are hardly over.

The debt overhang is likely to produce sluggish growth in the region relative to the U.S. The widening growth differential between European and U.S. economic growth is likely to weaken the Euro/dollar exchange rate.

Despite the EU’s debt problems, I believe continued global growth, a weaker Euro/dollar exchange rate, and supportive valuations should drive European equity markets higher at some point this year, but probably not in the near term. Another 10% correction would make the European equity markets a more attractive entry point, in my opinion.

Japan outlook

Japan’s economic outlook is improving faster than the global economic outlook.

Morgan Stanley economists have recently increased the 2010 economic outlook from 0.4% to 1.8%. The TOPIX has been the best performing G3 equity market year-to-date as of March 24, 2010. Since 1983, periods of Japan’s outperformance have typically lasted for more than a year.⁶,^‡ Corporate earnings are likely to increase 75% this year, according to Morgan Stanley Research. In my view, the Japanese equity market should continue to benefit from further monetary easing from the Bank of Japan, increased consumer spending from payment of child allowance benefits in June, and increased capital flows from global investors reducing their underweight positions.

Emerging markets outlook

In the next 10 years, emerging market equities are likely to be what Japanese stocks were in the 1980s, and technology stocks were in the 1990s an opportunity to build substantial wealth. Although all booms eventually run their course, as was the case with Japanese and technology stocks, I believe emerging market equities are not currently in bubble territory. Over the next decade, the emerging markets are likely to deliver superior earnings growth and currency appreciation, in my view. The equity markets can be volatile but the overall direction should be higher.

After bottoming on February 8, the MSCI Emerging Market index has been basically flat for the year so far.² Investors appear to have accepted the anticipated series of rate hikes likely to unfold in the coming months as monetary policy moves away from “extremely” accommodating to just accommodating. The index is trading at 13.2 times 2010 estimated earnings, which is below the 10-year average of 15.3 and at a discount to developed markets’ multiple of 14.2 times earnings.²

Summary

This month’s commentary focused on the prospect of things not being different. Despite all the talk of the “new normal” and structural debt problems in the developed world, the global equity markets are reacting similarly to markets in previous market cycles. If equity markets maintain this course, global equities will likely continue to trade higher, albeit, at a much slower pace. Strong earnings growth will be somewhat offset by higher interest rates. The timing and magnitude of higher rates will likely determine the performance of high beta/low beta sectors and cyclical/defensive sectors.

What wasn’t discussed in this month’s commentary was the possibility that the magnitude of global stimulus has masked the underlying structural problems that exist in the developed world—too much debt, excess capacity that could limit corporate pricing power, and a wounded financial system that will likely limit access to credit. These concerns will be addressed in a future commentary.

Regardless, investors should consider reducing “duration,” or interest-rate sensitivity, in their equity portfolios by adding positions in higher dividend-paying stocks. Popularized in the 1990s, an investment strategy known as the Dogs of the Dow, which purchased the highest dividend-paying stocks on the Dow Jones Industrial Average every year, generated superior returns in the ’90s. However, the strategy hasn’t worked in a decade. Part of this underperformance has been due to the accommodative monetary conditions that have prevailed since 2002, in my opinion. Excess liquidity rewards risk taking and momentum investing. Currently the FOMC has made it clear by their actions that they are in the process of reducing excess liquidity in the marketplace. Don’t be surprised to see dividend strategies outperform and fundamentals driving stock prices in the future.

+++= 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.

Common stocks do not assure dividend payments. Dividends are paid only when declared by an issuer’s board of directors and the amount of any dividend may vary over time based on the business prospects of the company.

The opinions referenced above are those of Rick Golod as of the date of this report and are subject to change at any time due to changes in market or economic conditions and may not necessarily come to pass. These comments are not necessarily representative of the opinions and views of the firm as a whole. The comments should not be construed as recommendations, but as an illustration of broader themes. Past performance is no guarantee of future results. This material is for educational purposes only and does not contend to address the financial objectives, situation or specific needs of any individual investor. It is not a solicitation, or an offer to buy or sell any security or investment product.

^* 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 MSCI Europe Index measures the performance of the developed markets in Europe. The Nikkei Index is an average of 225 top-rated companies on the First Section (for large companies) of the Tokyo Stock Exchange. 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 indices are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

^‡ 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.

¹ An economics law named for Victor Zarnowitz, University of Chicago and National Bureau of Economic Research economist, widely considered an expert in business cycle and recession/recovery trends.

² Source: Morgan Stanley Smith Barney, March 2010

³ Source: Citigroup Global Markets, March 17, 2010

⁴ Calculations by Van Kampen Investments. Data from Bloomberg LP.

⁵ Source: JPMorgan, March 18, 2010

⁶ Source: Morgan Stanley Research, March 22, 2010