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Market Outlook for 2010: These 3 Economic Forces Will Determine Market Direction

While predicting market and sector performance for the coming year is difficult to the point of futility, identifying the types of forces and events is not, and is far more useful. As long as we’re focused in the right directions, we’ll see what’s coming before much of the market. That’s usually good enough to make profitable trades and investments.

S&P 500 Daily AVA FX Chart     05 DEC 31 H

Can global equities and other risk assets continue to climb in 2010? The balance of forces for and against them remains the same.

Forces in favor of continued rally include:

 

  1. Continued low interest rates. Even if much of the developed world sticks to mid 2010 as the deadline for beginning rate increases, these will likely be small and cautious moves unless growth in jobs and spending or inflation is really heating up, which few expect to happen. This helps demand for stocks as it supports earnings by keeping credit costs down, and also leaves yield-seeking capital few alternatives.

 

  1. Moral Hazard Weakened: Risk taking investors can take a certain comfort in knowing that the global policy makers will not allow  the financial system to collapse, at least if they can at all avoid it. So far, they’ve managed, regardless of the future bill to their taxpayers. Thus insolvent banks can indeed be seen as rational stock buys if they are too big to fail. Ditto overpriced stocks and the high yielding bonds of major EZ countries, at least for now.

 

Forces in favor of a pullback

They are numerous. Most can be summarized as variations on the following basic idea:

  1. Massive and growing debt levels that may not be sustainable:

a)       On every level, from international banks and central banks to individual homeowners. So far, accepted Keynesian theory as handed down by Bernanke and other central bank heads has been to print money, bail out any large lender, and keep the national and international financial system and real estate market on life support until it can sustain itself.

b)        Fine if it self-sustaining growth or at least stability in jobs, spending, and earnings occurs before governments don’t exhaust the supply of buyers for their debt, at least at affordable rates. If they do, then bond rates rise, mortgage rates rise, debt defaults rise, banks or the global credit system gets shakier.  No one really seems clear on how long the game can go on how many bullets governments have left, or how creative they can be in devise ways to keep things going until genuine recovery kick in.

c)       We know it’s like a game of dominos. The more debt per player, the higher stacked and less stable that domino becomes, and the more vulnerable it is to even minor tremors. The more players in debt or dependent on steady repayments from the others, the closer the dominos are packed, and thus more vulnerable they are to even a distant, single collapse that sets of a chain of falling institutions (and governments?) that rapidly spreads to all. Or at least to enough so that confidence in the credit system fails and causes a credit seizure, which is almost the same result.  Consider:

  • Australia’s latest GDP report, though not dramatic in its nominal results, showed seeds of deep trouble. It revealed that most of the growth, the best in the developed world, as the result of government spending, not self sustaining growth. Australia has many advantages over most of the developed world, including relative proximity to China and a relatively healthy banking system. If Keynesian spending has not yet worked for them, what does that say about the chances for the UK, EZ, and the US?

 

  • There is strong reason to believe that US housing sales will drop off once the $8K credit for first time buyers expires, as purchases were not increased but merely pushed forward, suggesting an equal or worse drop off in home sales once the credit is finished.

 

  • The prices on longer term US bonds are already dropping as demand has been fading, thus driving up yields, the same yields on which mortgage rates are set. Most homeowners with mortgages in the US have either zero or negative equity in their homes as prices have fallen in the past year. However, With millions of adjustable rate  mortgages due for reset in 2010 and 2011, that could mean soaring defaults and foreclosures if rates become too high as falling or stagnant incomes render homeowners incapable or unwilling to continue paying on homes in which they’ve zero or negative equity. Should home prices truly begin to rise, that may push off such a fate

 

  • Hint: The crisis began with trouble in the banking and credit sector, and perceived improvements or at least survival of these sparked the ongoing March 2009 rally.  Because growth in jobs and consumer spending seem to be the missing components of a recovery that allows the financial and housing markets to recover on their own, watch for news about anything that impacts these.
Conclusion:

 

We don’t know what will happen. We can, however, make a good stab at what key events to watch for given the above key forces that are likely to drive markets in 2010.

Watch for any news that

  • Suggests continued or added borrowing or stimulus beyond that which is currently planned.
  • Points to growing default rates in any major sector of the US or global economy
  • Raises the risk of major sovereign debt downgrade of default
  • Suggests that growth was due mostly to government stimulus rather than self sustaining growth

 

Our bias: we remain impressed by global policy makers’ ability and creativity in keeping the Keynesian public spending fest going. We are skeptical that it can continue unless self sustaining growth kicks in soon.

Disclosure: No Positions