As we reach the midway point of 2010, the economic and geopolitical environment remains characterized by persistent uncertainty. However, while many questions remain unanswered, some things have become abundantly clear. The cyclical bull market that commenced in March 2009 has clearly transitioned into a new phase. The nearly unabated push higher off the market bottom came to a halt earlier this year; in its place is a market that’s been characterized not by robust returns in risk assets but by a notable resurgence in volatility. 

U.S. Environment: Economic Recovery Intact

Reminding us again that the economy and capital markets around the globe are interminably interconnected, U.S. investors find themselves caught in a tug-of-war between conflicting forces. The generally positive cyclical economic story that took shape in the United States starting last spring has been a positive influence on market fundamentals, as economic growth has supported corporate earnings growth and nurtured improving confidence among investors.

Despite an improving economy, the Federal Reserve appears positioned to keep interest rates low for a longer period than previously anticipated; many economists are now suggesting that the Fed could stay on hold into 2011. Low core inflation at the consumer level (currently at a 40-year low of 0.9 percent), sub-par job creation (particularly in the private sector), and the overall fragility of the global recovery all point toward the Fed maintaining a loose monetary policy stance. Absent other mitigating circumstances, a growing economy, improving corporate earnings, and low interest rates are generally positives for stocks. While some recent indicators have disappointed, the current economic environment in the United States remains positive. 

European Crisis: Far From Resolved

The counterbalance to the guardedly positive outlook for the U.S. economy is the stubbornly troublesome situation in Europe. What first emerged as a more localized issue in Greece, whose economy represents only about 2 percent of the aggregate output of the Euro zone, has morphed into a crisis of much greater scale that’s not only spilled outside its borders but has stoked speculation that the viability of the Euro zone’s single currency union could be in doubt. Spain, Portugal, Italy, Ireland, Hungary, and the United Kingdom are also being subjected to various degrees of scrutiny for their fiscal policies and debt levels.

The succession of proposals to deal with the Greek debt crisis was merely geared toward creating a window of opportunity for its government to address its unsustainable deficit spending. We believe that the greater long-term issues that vex the many debt-laden developed economies are far from resolved. The immediacy of the crisis continues to ebb and flow, but perhaps the toughest decisions facing the debt-laden economies in Europe remain largely unaddressed: against sometimes fierce internal opposition from their citizens, can governments make the massive cuts needed to bring their governmental spending down to the point that their pace of debt accumulation is at least manageable? Moreover, such austerity measures will inevitably lead to a potentially severe recession in the affected countries, creating the potential for a vicious negative feedback loop. In the end, there are no easy answers and none that come without painful adjustments to the parties involved. 

What Will Garner Investor Focus?

The savage cyclical bear market that ended in March 2009 is unquestionably still fresh in the minds of investors. The most recent correction rattled nerves again, a poignant reminder of numerous sources of uncertainty that cloud the global outlook. While underlying economic and capital market fundamentals ultimately drive market returns over longer periods of time, the day-to-day gyrations of security prices tend to be driven to a greater degree by different influences. Investors — and the investment markets that collectively represent those investors — are constantly assimilating data ranging from the micro to the macro in an effort to establish, question, reestablish, reaffirm, or redirect expectations. Periods of relative calm and perceived clarity tend to contribute to lower volatility. Uncertainty, whether related to the strength and direction of the economy, geopolitical risks, meaningful changes in regulatory or tax policy, or a myriad of other factors, virtually always results in greater volatility that may challenge the patience of investors.

To a large degree, evidence of a cyclical recovery in the U.S. economy had been convincingly positive over much of the last year. In recent weeks, that data has become more mixed, opening the door of doubt on the trajectory of growth in the latter half of the year. Meanwhile, the sovereign debt crisis that continues to unfold in Europe threatens to spread well beyond Greece and the other troubled Mediterranean economies. Throw the figurative logs of rising geopolitical tensions in both the Korean peninsula and the Middle East on the allegorical global fire, and the investor anxiety that has bubbled up in recent months is understandable.

Which factors will be the focal point for investors? Those change virtually daily, and often with little warning. Basing one’s investment strategy on an attempt to predict the forces that will drive market direction over short periods of time is a gamble at best. There is far too much “noise” in the market to make investment decisions based on the daily flow of information. 

Strike a Careful Balance

To successfully navigate market choppiness, investors must strike a careful, calculated balance. We believe that investors should acknowledge and understand the developments that can drive short-term market fluctuations, but balance them with the broad fundamental themes that are likely to be more meaningful over the long term, including the investor’s overall financial condition (i.e., balance sheet). In our opinion, the development of a holistic financial plan that contemplates not only investment assets, but all other aspects of an investor’s financial well being, is the basis from which investment planning must be completed. The implementation of this plan should be governed by a well-devised investment policy that affords sufficient flexibility to react to market trends while providing appropriate boundaries to act as guard rails to decision-making when emotions are high.

As with many things in life, balance in investment decision-making is crucial. Having a strategic plan — and making decisions within the context of that plan — is a great start.