Scenarios for 2009: Straight Lines, Double Dips, Moonshots, EKGs

Nothing is ever a lock in the world of capital markets, and nothing ever happens the way it feels like it should, so let's think about some scenarios for 2009. None of them are pure plays, so to speak, and people will likely find something appealing/unappealing in more than one. They are, however, ways to mull some directions things could go from here.

To explain my motivation in a different way, I generally think it's important to have in the back of your head what you're expecting, what you're worried may happen, and what you think is impossible. In my own case, I then try to insulate myself to varying degrees from the latter two scenarios, while positioning for the former.

1) The Straight Line Lower

This one is the favorite of uber-bears and logicians and the Schiff-ian sorts, and it works out pretty much as described: The economy and markets sink deeper into depression as it becomes obvious to all sentient sorts (and most semi-sentients) how egregious credit market excesses have been. We see massive wipe-outs in retail, commercial real estate, tech (yes), insurance, etc., plus a give-up on GM later in the year. Bears are on TV non-stop, and at least one bear gets a column in a major magazine/newspaper/webthingie, assuming any sort of media industry still exists 12 months from now.

In terms of key bits and pieces of the financial machinery, the dollar tumbles, gold soars, Russia collapses, and global markets tank, with worldwide trade tumbling by something like what happened during the Great Depression, on the order of 30% or more. There are no signs of inflation, what with deflation everywhere we look. We maybe get out of the year without a new war though, and the Colorado snow pack looks decent, so we have that going for us.

Dow: 5,000. Nasdaq: 900. S&P 500: 500 Oil: $25 Gold: $1700

2) The Non-Boring Flat Line

No-one is talking about this, so it's at least worth throwing into the mix: The market races higher early in the year as Obama-nomics looks real and fun, and then tanks mid-year as the economy refuses to get off the floor despite lots of happy-talk, a few new bridges across things, and some state bailouts. Later in the year markets pick up again as strategists counsel patience, and chatter begins about a first-half 2010 recovery. We end the year essentially flat.

Turning to the financial bits, the dollar surprises by only falling 10% against the major currencies; gold strengthens and then falls off a little; trade is crummy, but there are strong spots. There are a few surprises, like some sovereign wipeouts – Spain? Italy? Australia? other? -- but essentially flat-lining the year is a big surprise to all concerned.

Dow: 8400 Nasdaq: 1500 S&P 500: 900 Oil: $60 Gold $1000

3) The Double Dip

In this scenario we mess with the 2008 lows early in the year as worries increase that this is Great Depression 2.0. And then, however, expectations mount that something good has to come out of all this stimulus stuff -- damn the bears, look at the credit spreads and the 30-year mortgage rates! We hit mid-year confounding the critics with a 30% gain in the major indices, perhaps even a few pro-Ben Bernanke magazine cover stories, like "How Ben Did It!"

Things turn south, however, in the second half, perhaps on renewed signs of U.S. weakness, perhaps on some outlier events, but the upshot being the same, that global trade is not going to come back anytime soon at levels that justify prices at then-current levels. Markets start saw-toothing lower, a process that accelerates into the end of the year, leaving us lower than where we started.

Turning to the bits and pieces, the dollar weakens a little in the first half, but surprises everyone by strengthening again in the second half, as dollar gets squeezed on renewed fears of Great Depression 2.0. Gold falls early in the year, and then surges in the second half, ending the year considerably higher. The long bond ends the year closer to 5%.

Dow: 7500 Nasdaq: 1330 S&P 500: 765 Oil: $50 Gold $1200

4) The Moonshot: Nouriel Who?

The markets, to a chorus of carping all year long, climb a wall of worry. Consumers spend a little, businesses buy a little, and the Fed bails a lot, and the result is a surprisingly strong economy-like thing. Investors can hardly believe their good fortune in having repealed financial gravity, so they celebrate by taking stocks higher at every provocation through the year, despite some sharp falls here and there. Wells Capital's Jim Paulsen is the hero of bulls everywhere, and "Nouriel Who?" pictures are on NYSE traders' end-of-year celebratory t-shirts.

Is it pure froth all the way? No, of course not. There will be some sharp declines here and there. There will also be plenty of bankruptcies to keep bear-ish sorts from feeling entirely left out, and those will be viewed, in moralizing fashion, as just the sort of thing the Schumpeterian/Austrian economist/doctor ordered (even if they aren't). There will also be a sharp increase in inflation, but that will be shrugged off as "the price you pay" and something that the Fed can manage by "mopping up" all the liquidity it introduced. The year will close in this surreal fashion, albeit with bears pointing to myriad signs that the market is propped up solely by government deficits, and that Treasury yields are climbing and this game can only go on so long …

Turning to the numbers, the markets soar in the U.S., if less so elsewhere; gold starts the year strong and then weakens; oil strengthens; the long bond yield climbs sharply; and global trade, while weak, is non-zero.

Dow: 12,000 Nasdaq: 2100 S&P 500: 1210 Oil: $90 Gold $700

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And where am I in all of this? Probably closest to some variant of the double-dip. And what scenario am I most worried about from a portfolio standpoint? Much less the Straight Line than the Moonshot. The latter, given my views of the long-run credit cycle and its implications, is the thing I need to protect myself against.

Feel free to add your own scenarios/caveats/etc. in comments, as my musings here are neither comprehensive nor especially detailed.

Comments

[bearfund:]

Either of (2) and (3) seems plausible to me. But notice something; among all plausible trades, there's one constant: no matter what scenario one envisions, shorting the long bond (against gold) is a winning trade.

We've reached a point where yields are so low, and weakness so pronounced and widespread, that both sides of the barbell mean higher Treasury yields. A dramatic deepening will mean a supply explosion and real risk of default - the FTQ trade will mean selling, not buying, Treasuries. On the other hand, a recovery will allow the massive increases in the money supply to find their way into prices, and if nothing else those fat juicy yields on corporate paper and even stocks will be too attractive to justify sitting around getting 2.6%.

About the only way Treasury yields fall further is if the world collectively loses its mind (wouldn't be the first time, to be sure). Maybe multiple rounds of deep competitive devaluations could do it? Aliens showing up from Barsoom to buy up all the bonds? Congress suddenly refusing to allow more deficit spending? Just kidding on that last one, of course.

2008 Dec 30 04:19 AM

[prudentinve...:]

Very thoughtful. It would have been nice if you had given us your crystal ball guess about the percentage probabilities for each scenario. My guess, and only a guess is (1)5%, (2)40%, (3)30%, (4)25%.

Gold at $1700 seems too high for scenario (1) which is deflationary to the point that money would be better than gold (if that were not an oxymoron!).

Gold should be much higher than $700 and oil higher than $90 with scenario (4), which is highly inflationary.

Scenario (4) would also bring us back to a crisis just like the current one within a few years, as it would just reinstate an unsustainable economic model and simply push the current problems into the future.

2008 Dec 30 08:21 AM

[djk!:]

I know this is selfish but what I would like to see is my portfolio to recover to the point that my unrealized losses = my realized gains so I can get out even. That's all I want at this point. I'd be very happy.

2008 Dec 30 08:44 AM

[Jason Rines...:]

I have stated my position here often since March of 2008 and that is number 3. I believe that Washington will get some things right about job creation and infrastructure, mitigating the second leg down in 2010 and gaining momentum in 2011 & 2012.

Tax policy is a wild card at this point and I can only state what I wish would happen, cut all corporate taxes to 12% which would create a massive influx of foreign investment and signal to the globe we are finally cutting our bloated Federal government in the process.

2008 Dec 30 10:15 AM

[peterthepai...:]

cripes!...what to do? ...what to do?

how long have i got?....

they all look plausible from here...but No.1 looks the easiest to deal with...

get it over with and move on...finger down the throat...gotta vomit some time...when you're sick...

no.4 is what they're trying for...doncha think?

for me No.2 is goldilocks and feels about right...

i won't argue with No.3 though...nor be surprised by anything that happens next...

2008 Dec 30 11:17 AM

[morph366:]

Enjoyable article - but would be even more helpful to a non-US investor to have your view on the US dollar as well. If the US looks like it's emerging from the global recession first it could spark a major rally in the dollar which would help to alleviate some of the suffering that those who have piled into long term Treasuries with such meagre coupons

2008 Dec 30 11:59 AM

[Roger Knights:]

"I generally think it's important to have in the back of your head what you're expecting, what you're worried may happen, and what you think is impossible. In my own case, I then try to insulate myself to varying degrees from the latter two scenarios, while positioning for the former."

That's thinking like Taleb! (Who recommends minimizing exposure to downside catastrophes, while "exposing" oneself to possible positive longshots.( And I like the way the author thinks in terms of alternative scenarios--that's a great mind-expander.

2008 Dec 30 01:42 PM

[Roger Knights:]

Bearfund wrote: "But notice something; among all plausible trades, there's one constant: no matter what scenario one envisions, shorting the long bond (against gold) is a winning trade."

Agree.

2008 Dec 30 01:49 PM

[sr9web:]

"The Non-Boring Flat Line"

I'm expecting this.

2008 Dec 30 02:13 PM

[perceptions...:]

In the Short term, all things are possible, there can be eratic movements up & down, for any number of reasons.

That said, it is the longer term trend, where little attention is paid, which is of greatest concern.

The basic drivers of Economic growth, over the last 150 years or so, have been Oil & Population growth.

The tremendous RATE of POPULATION GROWTH has been the pre-eminent driver of DEMAND and the CHEAP, EASILY ACCESSIBLE & ABUNDANT SUPPLY of OIL, has ENABLED many things to be possible in THE MODERN ECONOMY.

Those BASIC ECONOMIC ASSUMPTIONS, Baby Boomers earning & spending capacity and the Oil production HAVE NOW PEAKED.

In addition to reasons such as greed & debt, THE DEMAND ECONOMY MUST NOW DECLINE, as the rate of population increase slows, following the passing of the Boomer & Oil era.

We can not simply have another Baby Boom, the planet can not sustain the current population, over time.

Unless there is a very well hidden replacement for Oil, the economic enabler is also on BIG MAC TIME and the economy has to slow oil consumption, to provide breathing space to look for its replacement and the long lead times required.

Debt, Deflation, Inflation, Interest Rates, Derivatives, TBills etc, all part of what is happening, but not what is driving events.

So, you tell me, WHAT IS GOING TO REPLACE THE BOOMER DEMAND & THE OIL SUPPLY that is sustainable, over time ?

2008 Dec 30 07:47 PM