The course of markets is never smooth. After the blows of 2008, we entered 2009 with trepidation. Markets held, fell, rallied and are in a current state of nervous equilibrium. It seems as if we have held on by the skin of our teeth. So what sense do we make of this, and what now?

In the first few months of the year, government took center stage. Wall Street, accustomed to ignoring the beltway, took in every word and misstatement by a young government finding its feet in the debris of the outgoing administration. New initiatives poured forth: stress tests for financial institutions, a Term Asset- Backed Securities Loan Facility (TALF) to induce investors to buy consumer loans, a Private Public Partnership (PPP) to purchase the infamous toxic assets, an extension of the TARP, a Treasury buy-back program, a GM revival plan, talks of currency depreciation and a change in FASB accounting rules. The markets digested the news as best they could but took comfort in fundamentals. And this is where the picture encourages us.

Economy: the news has been grim. Housing starts, industrial production and capacity utilization have all recorded lower levels of activity. What makes this recession different is a) it is global, b) it is balance sheet-driven and c) it started in the financial industry. The global nature of the recession means that one country cannot pull out the others. What we need, and G20 consensus gives us some comfort, is coordinated policy to not make things worse. This seems easy, but governments are always one populist step away from protectionism, tariffs and currency manipulation. So far so good. Nor can consumers anywhere come to the rescue. They are too indebted, and with home values falling, it is illogical to expect a snap-back. Western financial institutions, mostly in the U.S., have unrealized losses of another $1 trillion, on top of the $1.5 trillion already acknowledged. This means that loan volume, the precursor to a normal recovery, will be slow to build.

The concerns relating to retail sales and unemployment remain. More bad news will come. But recent statistics have been mildly better than expected. Inflation remains low, indeed was negative for March, and companies are cautiously rebuilding inventories after a severe depletion late last year. Surveys of purchasing managers and manufacturers have improved. Recovery will be slow and painful, but perhaps the worst is over and a return to positive growth may occur by the third quarter of 2009.

Credit and Bond Markets: during the first quarter of 2009, interest rates remained historically low with short term rates as low as 40bp and 10-Year Treasury notes, the rate from which mortgages and corporate bonds price, trading firmly in the 2.5% to 3.0% range. The Fed signaled its determination to keep rates low by announcing a Treasury note purchase plan. This helped market confidence in the short term, but is a palliative only. For where interest rates are headed, we must look at banks, new issuance and inflation.

First, banks: no one knows the level of bad loans but the International Monetary Fund (IMF) recently updated its forecast that the cumulative total could reach $4.1 trillion, up from its estimate six months ago of $1 trillion. While we await the stress test results, there is little doubt that banks are in awful shape. Why? One-off trading gains and a re-write of the mark-to-market rules flattered first quarter profits. The cost of funding is close to zero so it is not surprising that banks found a way to make profits. One commentator likened it to airlines making money if the cost of jet fuel were free. It's not hard. Banks will depend heavily on government-sponsored programs, and this means, second, that government borrowing and issuance will remain high. In early May alone, we will see refunding needs of over $300bn. For perspective, global IPOs totaled less than $1.9bn and Investment Grade bond issuances have struggled to raise a net $36bn this year. So crowding ensues. And, third, if government debt creates artificial stimuli and crowding, inflation cannot be far behind. This may take a while to play out, for the normal inflation indicators such as U.S. Treasury's Inflation-Protected Securities (TIPS), commodities and currencies are unclear. But we remain vigilant.

Equities: the domestic stock market fell in almost a straight line from February to early March. But it quickly rallied and we saw six weeks of improvement to gain almost all of those losses back. The market remains cautious, particularly toward the financial sector, but has taken heart that the worst for the global economy may be over. Some of the indicators are:

• Volatility: the VIX index, also known as the Street's fear gauge, trades at one third of the level it approached in October. This suggests investors are taking on more risk and are more prepared to ride out volatility.
  
• Fewer Sellers: hedge funds are no longer the force they were. Most of their forced selling was completed in the early part of the year. Share buybacks, which reached a cumulative total of $2.2 trillion or 20% of stock market capitalization between 2002 and 2008, have all but disappeared. This was always a meager support to the market and their absence creates a more solid foundation for recovery.
  
• Earnings: for the S&P 500 companies for the first quarter, earnings came in at 35% below the level of last year's first quarter, their seventh consecutive quarterly decline. But the number of downgrades has improved and share prices generally have fallen far more than earnings. It seems as if the market has priced in much bad news.
  
• Valuations: they are necessarily predicated on past experience and can send mixed signals. However, the positive yield gap on equities compared to 10-Year Treasuries and forward price earnings ratios are in the high single digits. In an environment of current low, real interest rates, that suggests value.

In overseas markets, China looks promising. It will likely be the only one of the world's largest ten economies to show positive growth in 2009. Most estimates are for 8% GDP growth. China's fiscal expansion is targeted, domestic and infrastructure- focused. Companies selling into China are likely to see good years ahead.

Overall our investment strategy concentrates on companies with strong balance sheets, healthy dividend cover, visible order books and earnings and strong management. It is simple but not simplistic. We do not time. Where we strive to succeed is through long-term investing, knowing our companies and examining and preparing for the downside risk. We feel we can take heart from the current signs.