The markets' sweet spot sours

Most markets saw in February with solid gains, but so far2010 has been heavy going. The S&P 500 slid by 3.7% in January, its worstmonth since March 2009. The FTSE 100 lost 4%. We've had the biggest correctionglobally since the rally began, says John Authers in the Financial Times.

Bad news is no longer shrugged off, while good newsdoesn't invariably provide a fillip. One problem is that markets had alreadypriced in a strong earnings and economic recovery. The S&P's cyclicallyadjusted p/e, for instance, is 25% above its historic average. The fact thatsurprisingly strong fourth-quarter earnings have been greeted withprofit-taking suggests that the massive rally since March "bought and paid for"strong fourth-quarter earnings, says Michael Santoli in Barron's.

But it also seems that investors are starting to take acloser look at supposedly good numbers. Even the unexpectedly high 5.7%annualised rate of GDP growth in the fourth quarter couldn't give the markets akick last week. The problem? The inventory cycle, which tells us nothing aboutthe strength of underlying demand, accounted for 3.6% of the figure. Andunderlying demand remains poor, says David Rosenberg of Gluskin Sheff. Domesticdemand growth actually slowed to an annual rate of 1.7% in the fourth quarterfrom the summer's 2.3%, despite all the stimulus. With consumers and banksdeleveraging, don't expect a strong rebound anytime soon.

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Rather than celebrate the recovery, investors arerealising that growth looks set to be sub-par for a long time, says Neal Sossof Credit Suisse. Fear of tightening is another key theme. The market is like aperson having to "relearn a task after a major illness", says Peter Dixon ofCommerzbank. Markets will have to "learn to do without the huge amount ofsupport from governments and central banks", as recent jitters over China alsoillustrate. Sovereign risk is a new worry for 2010.

The bottom line? In 2009, investors had it both ways,says The Economist. Good news meant recovery, while bad news meant interestrates would stay low and liquidity ample. This year, either the recovery willdisappoint or the stimulus will be withdrawn. The 'sweet spot' markets enjoyedin 2009 now looks over.