NEW NORMAL | We enter 2010 with far greater optimism than that of 2008 or 2009, although not without its challenges, we look forward to the year ahead. As we peruse endless analysts 2010 forecasts it seems there is an equal amount of uncertainty and optimism. This leads us to the conclusion that there remains a wide range of economic possibility for 2010. If 2008 was the year of financial meltdown and 2009 the year of quantitative easing via government intervention, then 2010 appears to be the year of “exit strategies”. What we do know in the new normal we find ourselves in, it will be a lower returning world, diminished growth, deleveraging, increased government spending and potentially higher taxes. The stimulus starts to drop sharply in the latter half of the year, hopefully not a second before the employment picture improves. Savings rates should continue to climb as households work to reduce their reliance on debt. Economic growth remains sluggish but several indicators have improved since last month and most likely shall improve throughout 2010. Economic indicators have now risen for six consecutive months. We expect to see a broad rebound in Merger&Acquisition activity in 2010, which should help provide a boost to the markets in the vacancy left by stimulus programs. Unfortunately, the euphoria of government intervention is coming to a close and will come at a cost, namely to the tax payer. In an attempt to reduce the deficit to a manageable number, congress will likely allow the Bush tax cuts to expire and potentially add to it with some form of large tax increase. This tax hike is likely to equate to 4% of GDP and will provide a headwind to recovery coupled with the governments exit strategy. Economic Advisor to the Obama Administration, Christina Romer, has extensive work providing that tax decreases have a 3X’s positive effect on GDP, which we believe to be a negative correlation in a scenario of rising taxes.
A pivotal question for 2010 seems to be “When will the Fed raise rates?” Currently, the two most powerful influences on driving Fed policy are unemployment and elections. We don’t feel that the Fed will consider raising rates until unemployment drops into the 8-9% range. Job growth should turn positive by late Q1 or early Q2. With unemployment likely to remain high through the first half of the year we believe we may see a small rate hike by year end. Inflation should continue to be a non-issue through 2011. When 2010 comes to a conclusion we most likely look back and see all economic indicators improve, although not at a rate we had all hoped.
REAL ESTATE | Credit markets continue to thaw at a snail’s pace. The majority of all new loans for single-family homes in the U.S. were made with federal assistance, either through Fannie Mae(implied guarantee), Freddie Mac, or through the FHA. As of the third quarter, 23% of all homes with a mortgage throughout the U.S. were worth less than the balance of the mortgage. The housing market is likely to get weaker due to the great amount of excess housing inventory, the ultimate nemesis of real estate pricing. Additionally, there's a large number of defaults still to come due to mortgage-rate resets this year and the first-time home buyer tax credit set to expire in June. Home sales have tailed-off and recently hit a 9 month low. It is possible we may see another 10% decline in housing prices before we truly see a sustainable real estate bottom to recover from. After real estate has bottomed out, prices will likely mirror inflation, or in future years, deflation as they have historically.
The commercial real estate market remains one of the last boogie men in the closet. As discussed earlier, excess capacity and big refinancing requirements in coming years will continue to plague the commercial market namely hotels, malls, warehouses and office buildings. Moody's/REAL Commercial Property Price Index was down 44% last October from its October 2007 peak. Retailers closed 8,300 stores last year, more than the previous peak of 6,900 in 2001. Commercial real estate tends to be less leveraged but if refinancing isn't available, it may not make much difference how leveraged it is. Also, unlike the residential market, distressed commercial real estate owners definitely will not have the political sympathy and bailout prospects.
STOCK MARKET | After a strong rebound in the stock market, stock valuations find themselves back in a high range and don’t lend themselves well for long-term returns, without some correction. Our world, and certainly the US, is moving through a massive debt bubble unraveling, which takes time. To expect the violent straight up market move to continue would be counter intuitive to historical patterns. We believe we started to see cracks in the rally in early November which has begun to accelerate as of late. 2010 looks to be a better trading environment with increased volatility, which bodes well for active management vs. a traditional Buy&Hold approach.
With this said, stocks should outperform cash, gold and treasuries. Through fundamental analysis we believe the market may take a breather, with a sell-off into mid 2010. The stock market looks to be range bound with an aggressive upside target of 1225-1250 and a downside target of 950. If we had our feet put to the fire I would say that the S&P500 will ultimately yield returns in the range of low double digits for 2010. The stock market in 2009-2010 may very well mimic that of 2003-2004, as referenced in the chart to below. In 2003 the market experienced a strong rally into mid 2004. Starting in mid January 2004, S&P 500 lost momentum and spent the next several months consolidating volatility without making any progress. The Fed currently has rates at 0-.25% and equity markets typically peak when rates are low, so moving in desperation away from low rates into substantially overpriced equities more often than not, ends badly.
From an asset allocation stand point we look to be overweight in high quality Agriculture, Technology, Heathcare, and Energy. We will most likely remain under weight in most materials and commodities. There remains much uncertainty in the Euro Zone, as such we recommend avoiding exposure until we have more clarity. After leading the global market we are tempering our enthusiasm for Asian markets. Emerging markets remain attractive, although far less than at the outset of 2009, partly due to weakness in commodities. We will look to move to an overweight position in the second half of 2010 into Financials, as most toxic debt will be either shed or priced in. Financials have been penalized greatly because they were the origination of the market sell-off. With this said, financials remain about 15% behind the rest of the market but their underlying fundamentals are outperforming most industry sectors.
As distant as 2011/2012 seems, we may experience another downturn, the severity of which will be determined by the progress or lack thereof this year. A downturn may be prompted by high P/E's(15+) creating an uphill battle, rising interest rates and taxes, a commercial real estate market debacle, and the end of a stimulus euphoria. The stock market has never exited a Secular Bear Market with P/E's +15, one of the reasons why we continue to stress an active management philosophy over a tradition buy&hold approach.
FIXED INCOME MARKET | Castle is looking to reduce exposure to high yield bonds. Spreads have tightened and we don’t feel we will be compensated adequately to remain in an overweight position. During recessions and the 1-2 years that follow high yield bonds typically outperform equities. Last year was no different, junk bonds returned over 50%, much more than the 26.46% gain on the S&P 500 index. Default rates on junk bonds normally peak late in recessions or in the year after it ends. Currently default rates are at 10-12% and we’d expect them to fall off considerably later this year.
Turning to municipal bonds, the fundamental credit picture among state and local governments continues to generate negative headlines. However, the technical story remains positive as income tax rates will most likely be increasing, thus helping to support continued demand for municipals. Municipalities continue to take prudent action, including cutting expenses and raising taxes to balance their budgets. Treasuries will continue to be a safe haven in a troubled world and benefit from deflation. Highly liquid, Treasuries provide the best credits in the world. Treasury bonds greatly outperformed equities in the 1980s and 1990s in what was the longest and strongest stock bull market on record. Muni and Treasury yield ratios are most attractive in the 20-30 year maturity range.
GREENBACK & GOLD | Dumping on the dollar for gold was a predominant theme in 2009. The financial meltdown in 2008 herded investors to the dollar as the global safe haven, but in early 2009 that status faded as fears of financial collapse dissipated. The fed funds target rate at 0-0.25%, makes the greenback the preferred funding currency for the carry trade in which it is borrowed and then sold for other higher yielding currencies with rising interest rates. The falling dollar against those currencies enhances the profitability of those trades. Despite all the drawbacks, the dollar remains the world's reserve currency and safe haven, regardless of suggestions by the Chinese and others that the dollar should eventually be replaced by a global currency. This is an interesting item to note as Asian equities tend to suffer when the US Dollar rallies.
Gold performed well in 2009 and appropriately so, given the economic environment. Fear that unfettered spending by the U.S. government will lead to future inflation, as historically gold is used as an inflation hedge. Inflation won't rear its ugly head in the short-term, but long-term inflation expectations are beginning to creep up. Secondly, gold is also a hedge against uncertainty. Gold is deemed to be a store of value that retains its worth even in the presence of chaos, but its value can fall off a cliff when world events calm down. By now we've seen or heard ads about gold, “Mail us your unwanted gold jewelry cluttering your jewelry box to cash in on the gold rush!”. We tend to believe these are very simple indicators of an asset bubble in the making. Much like the recent Real Estate bubble or the Tech bubble in the late 90’s that preceded it. As Warren Buffet aptly stated “Be fearful when others are greedy and greedy when others are fearful”. Gold has been trading sideways since early November. We believe $1240/ounce was likely the short-term high and we may see a retracement through much of 2010.
ENERGY | Natural Gas seems to be one of the few commodities currently selling at a large discount vs. its perceived long-term value. Natural gas finds itself down more than -46% over the past year, due to historically high levels of supply. Inventories have swelled impart to; reduced manufacturing, newly discovered reserves, greater burning efficiency technology, and new mining technology. Demand should continue to increase as it remains one of the most efficient and cleanest burning fossil fuels and remember like all fossil fuels, it’s a finite resource. Ultimately we find ourselves in the midst of a “Perfect-Storm” long term buying opportunity. We maintain a positive bias with regard to oil at $70-75/barrel. As the economy continues to recover, inventory will be replenished and transit will pick-up on; planes, trains and ships. In addition, OPEC and Venezuela have painted themselves into a corner and need to rely heavily on squeezing every penny out of oil.
CLOSING | In sum, brace yourself for increased volatility and market dislocations that will most certainly breed investment opportunity. We recommend investors to be positioned to provide solid relative returns while continuing to focus on risk management. We believe this emphasis on risk management presents the opportunity to generate superior, long-term, risk-adjusted, compounded returns. Until next quarter.
Kyle P. Webber
Disclosure: Long: UNG, USO, GLD, UUP