James Nesci Senior Vice President Chief Wealth Management Officer		Alan D. Segars Vice President Investment Management Officer

During the latter three quarters of 2009, risky assets, such as developed and emerging market equities, commodities and high yield debt, rallied significantly. These so-called risk trades were facilitated by cheap borrowing costs, improved credit conditions, global economic recovery prospects, and improved investor sentiment. Risky assets have, however, performed rather poorly thus far this year. The S&P 500 Index, for instance, is about flat year-to-date. This lackluster performance begs the question as to whether the risk trade is over. Certainly one can point to isolated incidents, such as monetary tightening by Chinese authorities or debt challenges in Greece, which have contributed to stalled price momentum. We have, however, chosen to focus on variables which, over time, have provided a guide to the sustainability of the risk trade.

Two such variables are credit conditions and monetary policy. Simply put, when credit conditions are improving and monetary policy is loose, risky assets rise in price. In other words, risky asset performance should be inversely correlated with credit conditions and monetary policy. Historically, some of the strongest equity returns have occurred during periods of improving credit conditions and loose monetary policy. For example, the equity rallies following 1991 and 2001 were sustained in this fashion.

This inverse relationship between equity prices and credit/monetary conditions has held up during recent periods as well. When credit spreads narrow and the Fed funds rate is lowered, S&P returns rise and vice-versa. We correlated S&P 500 returns against investment grade corporate bond spreads (credit proxy) and Fed funds (monetary proxy) from 1Q2006 to 4Q2009. For the entire period, the model’s R-squared was over 50% and undoubtedly higher during the latter part of the period when S&P returns skyrocketed. Both variables were statistically significant with credit spreads being the more meaningful of the two. Given the importance of the credit spread variable, we developed a separate model to predict it using the ISM Non-Manufacturing Index and Capacity Utilization data. The rationale for selecting these variables was that strengthening economic conditions result in lower borrowing requirements, growing earnings, and higher corporate credit quality. We tested this relationship quarterly from 2001 to 2009, which resulted in an extremely satisfying R-squared of 81%.

So what does all this imply for the risk trade going forward? Based on trends in the ISM Non-Manufacturing Index and Capacity Utilization, we believe credit spreads will continue to narrow this year. Additionally, credit spreads typically narrow during periods of rising medium- and long-term interest rates, such as 10- and 30-year Treasury yields. Our forecast calls for these yields to increase. If that happens, bond investors would typically gravitate toward higher-yielding corporate versus Treasury securities to help counter the decline in bond prices. We also assume that monetary policy will be tightened a touch but not enough to wipe out the beneficial effect of narrowing spreads on the risk trade. So, although equity returns ballooned in 2009, we believe the risk trade can be sustained in more limited fashion through much of 2010. In terms of an S&P 500 price forecast, we prefer to focus on direction as opposed to magnitude. Suffice it to say, however, that this exercise confirms our 1,175 most probable price target mentioned in last month’s Monitor.