A Second Quarter Surprise?

All my hopes and expectations, looking for an explanation
Have I found my destination? I just can't take no more
-Iron Maiden

Typically, we look forward to a new year and all it may bring. However, considering the markets and the economy, it feels as though many investors are already writing off 2009 as a lost cause.

The first obstacle in the way of recovery - improving the lack of confidence among market participants - is proving to be much more difficult to navigate than in prior recessions. The government support programs (mostly four-letter configurations) are designed to encourage investors to invest and consumers to consume. Eventually, confidence will return, but zero percent Treasury yields and the dismal holiday season are solid evidence that we are still traveling into the tunnel as opposed to coming out.

Everyone, it seems, is of this same opinion to varying degrees. Some investors, for example, only want Treasury risk, while others are happy with corporate risk - though with significantly increased restrictions.

However, by setting the lowest of expectations we increase the probability of an upside surprise. Thinking back to school days, there were plenty of students happy with "B" grades because at some point in their academic development, they became convinced a "B" represented their best expectations. Today, we seem to be hoping for a "D+" in 2009.

These undercut expectations could actually lead to a significant boost in confidence among market participants, allowing a base for growth to build during the year and increasing our expectations for 2010.

For example, later this week we will get December's change in nonfarm payroll figures which are expected to come in at minus 500,000 - meaning half a million people lost their jobs last month. Should that figure come in significantly lower at, say, 200,000, the markets would react strongly, taking this as a message that perhaps things aren't as bad as we believe. Of course, there will be 200,000 people who feel differently.

A more likely scenario is for a "lessening of negative news" to occur perhaps in the second quarter. It's quite possible to experience strong and sustained rallies in the second quarter should we experience less negativity than expected. But this will only happen if the economy can consistently perform better than expectations over an extended period of time.

Though I believe the economy will not recover to solid three-plus percent quarterly growth rates until at least mid 2010, it is certainly possible for the equity and bond markets to show great strength before then. All we have to do is exceed expectations and in 2009 it feels like the deck is stacked in our favor.