As a result of the 40% to 65% (depending on the index) gains we have seen off the lows, stocks have moved from (nearly) dirt-cheap levels three months ago to valuations that seem appropriate to mildly undervalued given the economic environment and the yields available in fixed income markets.

The economy is clearly beginning to recover, but the strength and durability of the rebound remains to be seen. After this initial bounce from government stimulus and pent-up demand runs its course, the economy may be vulnerable to a "rolling recession" type of environment as a result of private sector balance sheet rehabilitation, which will involve a multi-year process of higher savings and debt reduction.

Emerging markets stocks, which have delivered 15% per annum returns over the past five years (versus returns of minus 1.9% per annum for the S&P 500) are the most expensive of the major equity segments—relative to their history. Of the three broadest global equity segments—U.S. stocks, foreign developed markets stocks, and emerging markets stocks—emerging markets stocks are the only asset class whose price/book multiple is close to its historic average (see the following three charts). This seems appropriate when one considers the relative economic positions of emerging markets versus developed markets in the context of the past 15 years.

Bond Market Review

Long-term U.S. Treasury bonds were the top-performing asset class in 2008, but they have been the worst-performing investment in 2009. The 10-year Treasury bond yield has increased 170 basis points this year, and has jumped 120 basis points since March 18, when the Fed announced its intention to purchase Treasury bonds to hold down interest rates. It seems the "Bond Vigilantes" are back. This is a term used to describe Treasury bond investors who can enforce some discipline on a government that is potentially behaving very irresponsibly with respect to fiscal and monetary easing, and courting serious inflation risks.

A dramatic rebound in inflation expectations accounts for nearly all of the rise in nominal Treasury yields in 2009. In the past six months, the spread between the 10-year Treasury yield and the 10-year TIPS yield (which represents the market's expectation of the annual CPI inflation rate over the next 10 years), has jumped from under 50 basis points to nearly 200 basis points. Treasury investors are clearly becoming concerned about the $10 trillion in projected federal budget deficits over the next 10 years, and the ability of markets to absorb this supply. Hopefully, the recent jump in Treasury yields has delivered a warning shot to the government to restrain its spending excesses now that the financial crisis has largely been resolved.

Outside of conventional Treasuries, 2009 has been a rewarding year for investors in a number of fixed income categories, including corporates (especially high yield), emerging markets, municipals, and TIPs.

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