The economy is primed for recovery, although the initial expansion will be more moderate than the strong rebound that characteristically follows deep recessions. The equity market rallied very strongly in 2009 in anticipation of this recovery. The economic expansion must become well entrenched and self reinforcing for the equity market to build on the 2009 gains, critically by producing recurring job gains. That event still lies ahead. However, we expect such gains in the near future.
The sexy story is still that the housing market will renew its decline as defaults, mortgage resets, and rising mortgage rates reverse the modest improvement we have seen to date. Nevertheless, we expect a rise in new construction activity of at least 30% and, possibly, as much as 50%, along with recovering home values that should set a peak on the rise in mortgage defaults. No government policy will help defaults as much as rising home values that give home owners a strong financial incentive to maintain monthly mortgage payments. Home prices have already increased for five months in a row. Our forecast for 2010 is based on the ongoing decline in housing inventories that is still underway. New home construction has increased almost 20% since the low in April 2009, while inventories have declined to the lowest levels since the 1970s, although our population is now about 50% larger. Without an increase in new home construction, housing shortages are likely in some cities before the year is out. Instead, it is far more likely that construction activity increases quite significantly.
The sheer size of the consumer sector ensures that households remain the key to any recovery. Consumer spending has been stronger than expected for the past several months, notably during the holiday shopping season. But until job growth resumes, ongoing gains in spending will not be assured. Job growth, reinforced by wage gains, provides the rise in personal income that is necessary to finance recurring increases in spending. Unemployment claims have declined significantly, which is an excellent start to the process. We still await job growth, but this should be evident within the next few months. The housing market is likely to be part of this job growth story. As the housing glut turns into scarcity, further gains in construction activity will contribute to job growth.
The scarcity in housing is mirrored by the decline in auto stocks. Sales in 2008 and much of 2009 were below the rate at which cars are being scrapped. Cash for clunkers was highly criticized as ineffectual, but it did rid the industry of excess inventory. And within months after the program ended, sales are higher, allowing the industry to increase production schedules.
The corporate sector retrenched very sharply in 2008 following the collapse of Lehman. Firms reacted very aggressively by cutting costs, unloading inventories, and building cash. In fact, business cut back on production (and employment) more than sales declined, so a significant rebound is necessary just to halt the record pace of inventory liquidation. The rise in final sales reinforces this need for increased production, which will also contribute to new hiring. Companies are also flush with cash, which provides the flexibility to finance capital investment or acquisitions. Indeed, strategic merger and acquisition activity has picked up very noticeably, after a period almost devoid of M&A deals. The cutbacks last year also set the stage of a strong revival in profits. Profit margins widened in each quarter of 2009, even in the first half of the year when GDP declined. As sales revive, profits will surge, which will support the economic expansion and provide a sound foundation for equities to advance in 2010.
The market’s valuation is still somewhat low, despite last year’s rally, suggesting that many investors remain fearful of equities. The equity market was priced for a depression when the turnaround started in March. Stocks rose almost 60% from the low point, but still have not recovered to the pre-Lehman level. The consensus estimate is almost $80 for S&P 500 operating earnings in 2010, which implies a price earnings multiple of less than 14, a low level for this stage of the business cycle. Normally, the price earnings ratio would be well above average before an economic recovery. If profits rise as growth resumes, there is plenty of room for stocks to continue advancing. Expect stocks to post another solid gain in 2010.
In contrast, the bond market will perform badly in 2010. Interest rates are still very low, reflecting the Fed’s aggressive efforts to stimulate growth. As the Fed succeeds in its mission of getting a recurring, self-reinforcing expansion under way, interest rates will normalize. Investment grade corporate bonds did very well in 2009, but that will not repeat in 2010. Treasury bonds are likely to suffer a second consecutive year of negative returns, with 10-year Treasury yields breaking above 4.5%. The flight to safety will fade as stocks do well. Similarly, investment grade bonds also trade at yields that are too low, but they will follow Treasuries downward.
Disclosure: "No Positions"