5 Predictions and 4 Possible Surprises for the New Year

Includes: DIA, QQQ, SPY
by: Sean Hannon

Having just reviewed my 2009 predictions, I now look ahead to 2010. My hope for the year is that the economic recovery takes hold, markets remain steady, and a sense of normality returns after what has been a very confusing and hectic period. However, as we have all become accustomed to expect the unexpected and wait for the next domino to fall, this is nothing but hope.

For this article I will outline five predictions for the year ahead as well as four potential surprises that could debunk my theses. Doing so will allow the reader to consider both angles of the argument- a practice we should all adhere to as investors. As always, as my views change I will update subscribers through the weekly newsletter, bonus articles, and these weekly commentaries. Even when we are adamant about future events, we must remain flexible and be prepared to alter our opinions when new information emerges.

My five key predictions are as follows:

  1. Profitability and GDP to skyrocket - Business cycles tend to follow a boom and bust pattern. When companies are optimistic about the future, they expand, hire employees, and increase inventory to handle expected future demand. If that demand never materializes, employees are shed, inventories liquidated, and businesses falter. Entering the "Great Recession," we did not have this typical pattern. Following the dot-com bust, companies began to manage their businesses better and avoid the excesses of the past. Since the recession has led to enormous job loss and inventory destocking, we now find ourselves with lean corporate structures and limited new products on hand. The result is that any increase in consumption will flow straight to a company's bottom line and lead to a huge upswing in production. With easy year-over-year comparisons for the first half of 2010, we could see a surge in corporate profitability and GDP that trumps what even the most optimistic forecasters expect.
  2. The Federal Reserve (Fed) stays in the market - Recent bond purchase programs are expected to end early in 2010. I expect the Fed to do an about-face and remain in the market. As the major incremental buyer of Treasuries, if the Fed steps away from the market as deficits are rising, the increase in interest rates would thwart an economic recovery. Instead, purchases will be maintained and the yield curve will flatten.
  3. Markets Fairly Valued - Last year my fair value target called for a sharp decline in the S&P 500. This year, at 1,150, my estimate calls for stability. Please remember this is a fair value estimate (a level at which we are being compensated for taking risk) and not a price target. Although this number is not much higher than the current price of 1,126, for the first time since 2004 I feel the market is providing a buying opportunity to start the year. A replay of 2004, when markets gradually moved higher, seems fair, but a repeat of 2009's 25% return is unlikely.
  4. Search for income - With markets fairly valued and bond yields unattractive, the theme for 2010 will be a search for income. With bond yields low and cash paying virtually nothing, investors will have to search far and wide. Expect high-dividend payers such as utilities to be among the year's best performers.
  5. Return of the meltdown -2009 was light on many of the hedge fund/financial meltdowns we experienced during the height of the credit crisis. As nearly every entity was too big to fail, the Fed and Treasury happily bailed out anyone needing help. Now with the dash out of TARP and large public backlash over Wall Street compensation, the next time trouble arises, the politicians will be less willing to help. I continue to believe many banks are not properly reserved and a flattening of the yield curve could crimp current profits. From there all that is needed is a surprise market move and we will face a quick test of who is truly too big to fail.

Although I'm confident in these predictions, I always present a counterargument. These four surprises, which I consider unlikely, could derail my predictions:

  • The New Normal - This theory states that the U.S. is adjusting to a slower growth future. If correct, the increase in consumption that will turbo-boost GDP will not occur as companies have reduced staff and inventory to levels that are in line with the new demand.
  • Dollar Collapse - A collapsing currency will force the Fed from the bond markets, increase the likelihood of interest rates rising, and force investors to hunt for capital appreciation over current income. In this scenario commodities and emerging market equities will flourish while utilities and bonds languish.
  • Bear Market Rally - A group of investors still believe the current rally is simply a countermove in a long bear market. If so, at some point the stock market will begin sliding again and any rational strategy will be mute as fear dominates and prices cascade lower.
  • Spike in Volatility - Volatility has been retreating for nearly a year and signs point to lower levels ahead. With this backdrop, businesses can invest and markets can grow. However, the outcome of the massive fiscal and monetary stimulus has not been felt yet and upcoming elections could alter the political landscape. This increases the potential for a surpassingly volatile market.

Summarizing all these ideas, I believe 2010 will be a positive year for investors. Whereas 2009 required a keen ability to flip from one idea to the next, in 2010 investors must be able to spot big trends and have the patience to trade with them. Neither total gains nor price swings from high to low will be as fantastic as what has been seen in recent years, but a nice, boring year of reasonable returns is expected. As we shift from a growth-driven market to one more focused on reasonable return and current income, both stock picking success and active risk management will be needed to thrive in 2010.