Summary: RCM’s outlook for 2010 remains positive, with some prospect for a year-end rally and the market up at the lower end of 5%-10%. Expectations of quantitative easing by the Fed, the election season and the earnings season may create some short-term volatility.

Looking at the macro data over recent months, the results have been very mixed. We have seen a very strong recovery in the marketplace, especially in September, when markets did extremely well. It continues to be a highly volatile market environment due to mixed macroeconomic data points; the market’s reaction has really been more about the expectations heading into those data points. During the summer, there was a significant downdraft in the equity market and most economic data points were disappointing relative to expectations—especially on the labor front, where there was a spike in initial unemployment claims that created a lot of angst and fear about a double-dip recession. On the flip side, September saw, relative to expectations, much better data points on the labor front, with initial unemployment claims coming in better than expected. If one looks at a smoothing-out of those initial unemployment claims over a four-week moving average, we have essentially gone nowhere for the last several months in terms of the labor market. It is not really improving, and it is not really getting worse. The market had a significant run-up of over 10% during the month of September, one of the best Septembers in history in terms of equity market returns.

So where do we go from here for the remainder of the year and into 2011? We have previously drawn on the analogy to 2004, which is an interesting one: Just as we had a significant market rally in 2003 off of a recessionary low, we had the same phenomenon in 2009. So entering into 2010, much like 2004, we had the issue of having to digest a significant move in the market with a lot more uncertainty about the pace or the slope of the recovery. 2004 was also an election year, just as 2010 is, and there is typically a lot of angst surrounding elections, which has an impact on the market. As a result, our expectations for 2010 were similar to what we saw in 2004, which was for a choppy market environment for the first six to nine months of the year, with some prospect for a year-end rally and the market up 5%-10% by year-end. This remains our best forecast for the market in 2010, although we are at the low end of that range right now.

Our market expectations for 2010 was tied to a belief in the need for a reset in growth expectations, particularly for 2011. We believe most of the reset has already occurred. Wall Street forecasts for 2011 GDP have been ratcheted down significantly over the last several months; the consensus is now close to 2%, which is also our forecast for 2011. I believe we are now at a point where 80%-90% of the necessary reset for 2011 is already behind us, which I think is good—and which certainly bodes well for 2011.

However, there are a few short-term potholes that can create some volatility over the next one or two months. The first of these is expectations of a second round of quantitative easing (QE2) by the Fed, which has been discounted in many markets—not just the equity market. We believe QE2 would be positive for equities to the extent that there is additional stimulus. We believe it would be positive for Treasuries in the sense of lower yields; the 10-year has now dropped below 2.4%. We also believe it would have positive implications for commodity prices in general; gold has also hit all time highs. The one asset class that has suffered a significant negative impact is the dollar, which has declined precipitously and has completely retraced the earlier strength seen this year; it is basically flat now for 2010. Our expectation at this point is that most of the QE2 has already been factored into market expectations. We may actually see some sort of “selling-on-the-news” reaction if we do not get significant quantitative easing at this point.

The other factor that could create some short-term volatility in the market is the election season. The market is discounting a Republican victory in the House, and the increasing likelihood of a Republican victory in the Senate. For political junkies, intrade.com updates the probabilities for election outcomes on a daily basis. As of late September 2010, it was showing a 73% probability that the Republicans would take the House, and about a 40% probability they would take the Senate. From a stock market standpoint, a Republican victory in Congress would not be a surprise, and therefore should not have a positive impact on equity market performance at this point.

The final factor that could create some short-term volatility in the market is that we are heading into earnings season. Our expectation is that it is going to be a bit of a mixed bag: In some cases, we believe stocks have run up too far and too fast, and we are likely to see some retrenchment.

So where does that get us is on a very short-term basis? We believe there could be some downside to the equity market given that a lot of good news, or perceived good news—whether it’s QE2 or a Republican victory in Congress—is already factored into prices, and mixed to disappointing earnings results in Q3 are not yet fully discounted in the market.

However, as opposed to earlier this year, we believe this presents an opportunity to get more aggressive with equity exposure because we have largely reset expectations for 2011, and much of the angst about 2011 is now behind us. Once we have worked through this short-term volatility, we expect to see a much better market environment late this year and into early next year.

Tax policy is the one wild card. There has been a lot of discussion about an extension of the Bush tax cuts. With a lame duck session of Congress, it is very difficult to tell at this point what is going to happen, and there are many outcomes that could impact the market in one way or the other. The Bush tax cuts could be extended for some period in their entirety, or they could all expire in 2011. Much of the market action in December and January will be dependent upon how the Bush tax cuts will play out. Our best guess is that there is likely to be a compromise in the lame duck session sometime between late November and the end of December that will temporarily extend the Bush tax cuts for everyone, which we believe would be a positive catalyst for the equity market.

In summary, we see very short-term volatility with perhaps a downward bias. However, over a 6-12 month timeframe, we see a much more optimistic outlook for equities.

Scott Migliori, CFA, is the chief investment officer of RCM U.S., an Allianz Global Investors company. He received his B.S. in accounting from the University of Southern California, his JD from the Boalt Hall School of Law at the University of California, Berkeley, and his M.B.A. from the Anderson School at the University of California, Los Angeles.

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