We are in the thick of earnings season and so far, the reaction of most stock prices has been disappointing relative to the great numbers most companies have been reporting.  This may be another way of saying that a great deal of improvement in the economy was priced in with the gains investors experienced in 2009, at least in the short run. 

In general, I subscribe to the baseline view that while the economy may do great in 2010, stock market returns may be average.  What could cause the stock market to exceed this expectation?  In my opinion, the single greatest source of upside would be the employment outlook.  Right now, sentiment remains very negative, adhering to the notion that this recovery will be of the jobless variety.   Another alternative might be a sustained improvement in productivity, leading to a permanent step up in corporate profitability, beyond that which might be explained by inventory rebuilds, human or otherwise.  While not as politically desirable, it is a vision worth exploring.  Historically speaking, downturns have almost always given birth to technology transitions, perhaps because the costs of change are slight relative to the pressures of doing nothing.       

Last week, the markets took a five percent hit as several political concerns rose to the forefront of investors’ minds.  Democrats will tell you that the swoon started when Brown won Kennedy’s senate seat and plans for nationalized health care died, while Republicans might blame it on the proposed new banking regulations.  Those of both persuasions might lay the blame on Bernanke’s prospects for reappointment.  As always, there are many explanations to go around.

Personally, I think Brown’s election was a positive for the markets and that some of the banking regulations make a lot of sense, even though they won’t, of course, prevent the next downturn.  Politics have rarely played a significant role for me on the list of stock market risks simply because the government is such a well oiled bureaucracy, cable of much talk but little change.  Brown’s improbable win represents a fascinating case study in the perseverance of bureaucracy.  If you want to have faith in government, that’s a type you can take to the bank!

As for Bernanke?   I’m so tired of the debates, I’ve kept CNBC on mute for most of the past two days.  While I’d never want his job, I’m certainly glad he had it over the past two years.  I’m with Buffet.  I’d keep him.