New Year, Same Economic Trends

Just 11 trading days into the year including the two consecutive positive closes to end the week, the S&P 500 has droppped 5.8%. The good news is that despite eroding faster than time (the year is 4.3% over), we aren't likely to continue to drop at this pace. Unfortunately, though, it appears that the respite from late November to early January has ended. The following table (click to enlarge) highlights the recent changes and puts them in the context of the post-Q3 2008 change in the environment from recession of uncertain nature to full-blown crisis:

While it's way too early to form very conclusive views at this point, it sure appears that the trends in place indeed remain. What should we expect from the rest of this year? When (or even) will the erosion in the prices of most assets except for Treasuries stop? Will the dollar continue to at least hang in there? Will the supply of Treasuries overwhelm demand?

I have shared my views on most of these subjects on the pages of Seeking Alpha, but I will review my overall expectations. More importantly, I want to try to convey what I anticipate the year to look like in terms of overall magnitude and timing.

Stocks

I remain bearish long-term on stocks, which have now declined for 5 consecutive quarters. Simply stated, the deck is stacked against equities: plunging earnings as sales contract and margins fall, inability of many indebted companies to restructure their balance sheets, forced liquidations by holders and better risk-reward in the bond market.

I am most negative on larger-cap names, which may be contrary to traditional thinking about the behavior of stocks in an economic contraction. The most egregious balance sheets in both size and in quality reside in the S&P 500. I actually think that smaller companies with strong balance sheets will be able to better manage the challenges. I have personally reduced my exposure to names that I viewed as somewhat risky (you can see my holdings disclosure). I have a Conservative Growth/Balanced Model Portfolio that is invested exclusively in names that I believe can hold up best in this environment. That portfolio is positioned at its minimum permissible equity exposure of 45%.

While the market certainly could fall as much as last year (37%) and might do so during the year, I will be surprised if it falls to that extent. Even if it does, the loss of wealth will be significantly lower given the smaller base now. We should get a rally at some point this year, though I expect it will come from extremely oversold levels.

With that said, I don't expect any single quarter to come close to the carnage of Q4 but rather a more traditional death by 1000 cuts. My base case for stocks is that they decline about 15-20% this year (S&P 500 of about 720-765). This level should serve as a multiple of about 12X-13X S&P 500 earnings I expect now for 2010. I expect an interim low in late March to mid-April, a positive Q2, a low in late Q3/early Q4 (call it 625-675) and maybe a positive Q4 overall. I believe that the biggest story in stocks this year will be the large losses in some of the largest names, like General Electric (GE), AT&T (T), Wal-Mart (WMT), and the large banks. Unlike Q4, where stock-pickers had very little chance, I expect that we will at least have a shot this year despite the negative overall tone. 20-30% of stocks in the Russell 3000 could actually rise this year despite the overall pressure on the broad market.

Bonds

I spent the first 13 years of my professional life as a bond trader and then portfolio manager. I was very glad to switch to equities, but, for the first time since then, I sure wish I was better plugged into that part of the market, which is really almost exclusively institutional.

For savvy investors and traders, corporate and esoteric mortgage debt should continue to offer incredible opportunities. I believe that short-term Treasury rates will remain low for all this year and beyond, but one can have a healthy debate about the back-end of the curve. While it appears that the recent plunge is somewhat ahead of itself, I believe that as the economy remains weak this year, folks will see that rates aren't as insane as they might appear. I expect mortgages to continue to offer good risk-adjusted returns, while corporates should outperform. Spreads should stay elevated, but they probably won't widen en masse.

We could see, though, defaults and downgrades, both of which will negatively impact the overall returns for corporate bonds. I am positioned very underweight in my model portfolio due to my expectations that long rates might rise somewhat and we might see a partial reversal of the improvement in spreads during Q1, but I look to redeploy that cash later this quarter.

Commodities/Currency

While I haven't historically prognosticated in this area, I do have a strong view regarding gold. As I described initially and then more recently, gold has benefitted from a mistaken assumption that the dollar's value will be eroded and/or that we will suffer from inflation. I believe that as bad as things are here, they are just as bad to worse around the rest of the world. Many of the factors that have exacerbated demand for raw materials have reversed, and falling asset prices and economic demand both bode poorly for commodities in general but gold in particular due to its elevated valuation compared to other metals. I believe that the dollar should do well this year as Europe reduces its interest rate differential and the rest of the world's economic growth slows as dramatically as I expect ours to contract (negative full year GDP).

No matter what, this year should prove to be very interesting. Most investors, including me, have very little experience investing in economic environments like this one.

This isn't the typical business cycle correction but rather an entirely different phenomenon of wealth destruction as all aspects of the global society change perceptions about borrowing. Old rules won't work, especially ones related to valuation. I have tried to address this issue in my recent commentary. Those who do best this year will be the ones open to the notion that a different game requires a different plan. I expect to see lots of dust and fury, but not as big a change in overall valuations as may be perceived given the gravity of the situation. The market has actually discounted a lot of bad already. In this type of environment, one should probably be willing to trade more rather than less and permit the volatility to work in one's favor.

Disclosure: None

Comments

[Big K:]

Well, which is it? Stay out of the stock market because, as you started out saying, you are long-term bearish? Or be more willing to trade, as in your closing statement, because the bad news is already factored in? In the future, you should summarize your conclusion more concisely, as your article wanders a bit and ends up ambiguously.

I will make your conclusion for you. The data presented in the opening paragraph seem to say it all. We are in for more asset deflation in 2009. I agree, this is not merely a standard business cycle correction, but rather a generational spiral down of wealth destruction that will make a large percentage of the population a lot poorer. Only cash seems to hold its value these days leaving people who hold physical assets and equities stripped of wealth.

It's ironic that some folks call the dollar "fiat currency", because its value is not backed up by anything, and think the government can manipulate its value arbitrarily. It is obvious now, however, that those who believe this are wrong. Actually the dollar is the only thing that has consistent value, and instead, assets such as real estate, oil, metals, stocks, businesses, art, etc. have values which are arbitrary and can be dramatically reset relative to the dollar(usually to the negative) in a matter of a few trading days. Every now and then people forget this, and asset bubbles form. Cash is still king and always has been. Once every generation or so, people forget this law of economics (because its "different this time"), and have to be taught this lesson. Now, we are in school, and look to be held back for another year.

Jan 18 03:35 AM

[Alan Brochs...:]

Thanks for your comment and for sharing your views. Maybe I wasn't clear, but that is perhaps because I didn't define a single audience very well. To answer your question "which is it", it depends. On the one hand, I assume that many readers aren't traders, and I would propose that they underweight or avoid stocks and not get sucked into rallies this year. For most, though, which include either active traders or at least folks who are willing to adjust their exposures as market conditions change, I believe I was pretty clear in terms of overall positioning and when I think it makes sense to play against the main trend.

I had fantastic success at several points last year sticking to my original plan that I laid out in writing on Seeking Alpha. Plans are only maps, though, and one would be foolish to think that one's plan will prove to be fully correct. I shared my deviations and the rationales during the year, and clearly I made a terrible error stepping away from my forecast in May and sticking with the rally. I was still having a fantastic year in both trading and investing despite that miscue up until September, when I made my second and worse error of sucking it up while the market was trying to find a bottom rather than betting on the market getting crushed as I had originally expected. The investment portfolio that I manage ended the year down 10.5% after having been up 1% YTD as of the end of September. While that was solid relative performance given my mandate of stock exposure of 45-75% and bond exposure of 10-55%), I was very disappointed with the absolute return. Sadly, while I was 45% stocks (the minimum) at the beginning of the year, I spent most of the last 3 quarters closer to the high end of that range, reducing it back to 45% the first week of January. I made money trading as well, but, again, my errors were extremely costly.

I mention this because I believe that the point I was trying to make is that it is possible to succeed even in a challenging market if there is volatility, but it requires a disciplined plan of attack and a willingness to let volatility work for you. Forget about how I personally executed if you want and instead focus on what I wrote. People were often confused by my views at times - a huge bull in position but a megabear in sentiment. Personally, I prefer to be bullish to bearish, and that psychological challenge really hurt my decision-making process several times last year as I reacted incorrectly to technical oversold indicators (especially as we had what I thought were climactic types of events) despite my clear awareness that the times were indeed different.

Jan 18 05:42 AM

[Steve in Gr...:]

Dear Mr. Brochstein, Thanks for sharing your insights. You wrote:

“…As I described initially and then more recently, gold has benefitted from a mistaken assumption that the dollar's value will be eroded and/or that we will suffer from inflation. I believe that as bad as things are here, they are just as bad to worse around the rest of the world…”

Question: I agree that while the global economy is in recession (2009-2010), it makes sense to stay in USD cash. But isn’t it true that once the economies restart that inflation will start up in a big way, due to the huge increases in USD money supply? Doesn’t this mean we need to begin to transition our holdings out of USD-denominated assets (and maybe incur USD-denominated debts) and into assets such as precious metals, oil and other commodities during 2009 to be ready for the eventual recovery?

Jan 18 09:18 AM

[Alan Brochs...:]

Steve, thanks for your comments and your question. The simple answer is maybe, but I doubt it. The process of resizing the leverage within the global economy will take years. As the economy stabilizes, it will struggle to expand rapidly because private credit will continue to contract (individuals and companies will continue to repair their balance sheets by paying down debt and/or issuing equity for quite some time). The inflationistas seem to look only at one part of the picture, which is the expansion of government credit. I believe that we will see that slow - the governments around the world won't continue to mortgage their collective futures as the economies stabilize. More importantly, at least domestically, the soon-to-rise tax burden will serve as a huge barrier against growth. So, I doubt that the economies "restarting" will bring about inflation. Have you checked the Japanese inflation rate in the past decade or so?

Jan 18 10:13 AM

[prudentinve...:]

Alan,

Thanks again for an insightful article.

I agree with much of your prognosis, except that I feel your case for bonds and cash may not fully discount the massive increases in liquidity underway by the world's central banks.

Jan 19 08:15 PM