Will the U.S. economy continue to strengthen through 2010? Will hopes for another strong profit rebound be fulfilled? Will these improvements allow ongoing stock market gains? We are willing to predict that the answer to all three questions is “Yes”. Will normal economic growth patterns return and continue beyond the current year? That’s a little trickier.

GDP dynamics. In the 2009 fourth quarter, real GDP gained a healthy 5.9% on top of a 2.2% rebound in the third quarter. Unfortunately, more than half the fourth quarter gain came from inventory rebuilding rather than final sales, but this is probably not a negative. Inventories had been very low, and allowing them to increase can be interpreted as a vote of confidence in the near term future.

It is important to remember that the headline GDP percentage change numbers are measured quarter to quarter, not year over year. While it is gratifying to note that 2009’s fourth quarter was much better than the third, it is sobering to note that the year in total was down 2.4% and that the fourth quarter of 2009 was close to even with the depressed fourth quarter of 2008. For 2010, consensus forecasts call for Gdp growth of only 2.5-2.7% or so.

Why the sluggishness? The boom that preceded the bust was fueled by extraordinary levels of added debt by consumers. One effect of the spending spree was job creation; employment grew month after month, and unemployment fell to low levels. When the debt bubble burst, the unemployment rate increased more dramatically than was the case in other recessions, more than doubling from the end of 2006 to the end of 2009. This obviously put a crimp in consumer spending, a large majority of U.S. economic activity. High unemployment reduces spendable dollars for consumers in total, which reduces demand, which leads to lower output of goods and services, which leads to higher unemployment. The Federal government’s various pump-priming programs are helping some, but in past recessions the return to steady economic growth bubbled up through the private economy.

The unemployment rate remains near 10%, and the underemployment rate is worse. The large majority of consumers who have not suffered income loss have logically been worried about those statistics and have collectively trimmed their spending. Recessions end when consumers regain sufficient confidence to spend more enthusiastically. There is growing evidence that this is happening.

It is common for GDP growth to be above average for several post-recession quarters before settling into the normal range of historical growth rates. Yet this time forecasters believe that growth for the foreseeable future will be below the postwar average of 3.2%. (This average includes both periods of expansion and recession.) There are two primary reasons for this stance. First, breaking out of the vicious unemployment cycle will not be fast enough to restore normal growth. Unemployment may remain above-average for some time. Second, it is widely believed that the extreme Federal deficits will bring tax increases – always negative for economic growth.

Global comparisons. Despite all this, the dollar has recently strengthened against other currencies, and many predict this will continue. Government budget difficulties and impediments to growth are worse in most of Europe and in Japan. The fiscal problems facing first Greece, now Portugal, and potentially others are a threat to the Eurozone as a whole, making that currency less attractive. All these countries suffer worse cases of the same problems the U.S. faces. For most of them, near-term Gdp growth rates are predicted to be less than 2%, making the U.S. look relatively good.

The only area of faster growth is Asia (excluding Japan). China’s projected annual growth continues to be in the 8-10% range, India 8%, and smaller countries are following in their wakes. China is attempting to slow growth to forestall inflation, but these efforts are not likely to reduce the pace anywhere near the lower levels of the western world and Japan.

And stocks? You might expect these less-than-ebullient comments about economies to carry over to stocks. That is not the case. Despite caution on economic growth, we continue to expect decent gains in stock markets.

There is historical precedent for this view. Stock markets invariably begin recovery while the recession remains underway, and they usually extend that rebound as economic growth resumes at any pace. For example, after the recession of 1990-91 – also real estate induced – stocks posted dramatic gains early and then continued to do well despite the nasty hangover of defaulted real estate loans that persisted for several years.

Corporate earnings forecasts for 2010 initially called for substantial improvement, and through the first quarter estimates have increased. These gains are coming more from productivity improvement rather than increased sales (thus not helping unemployment much), but they are solid and are creating an upward push to stock prices. Most major companies outside the finance sector have healthy balance sheets and thus little or no dependence on outside financing.

Especially in sectors like industrial goods, technology, and consumer staples, global companies can enjoy better revenue growth as well because they sell into the faster-growing markets of Asia as well as Europe and North America. We can easily hypothesize stock prices extending their gains despite below-average growth in western economies.

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