2.04.10 - Annual Forecast (February Style)

With the close of January, already we are well into what is shaping up to be another fascinating year.  As an economist by training (and forever in training), arranging and organizing the pieces of our constantly adjusting economic puzzle is my favorite part of what we do.  Throughout the year we send our thoughts about the most pertinent pieces that are influencing the markets at that moment.  With our annual forecast, I attempt to lay out the entire picture as concisely* and completely as I can.  But before we get too deep into it, I need to apologize because these days the markets seem to move faster than I can publish this newsletter.  Most of this edition was drafted in the middle of January when the market was making new recent highs.  By the time I pared it down to its current length and put the finishing touches on all the segments, January ended and the world had changed.  Pieces of our forecast are already being realized, while others look less likely.  For better or worse, I will leave them unchanged.  If you are using these forecasts to help plot your investment strategy please remember a few key points.

First, my forecasts of gains or losses in any market were relative to where those markets ended 2009.  For example, the decline in the S&P 500 and the rally in the dollar during the last week of January allowed us to already take some profits.  We maintain some positions that will profit from those trends, but they are smaller because I am less confiden from these levels.  Conversely, the unrealized profits we had in our long Japan and short TBond positions two weeks ago have evaporated, provided an opportunity to initiate or add to those positions.

Second, this newsletter was christened, “The 70% Solution” for a very good reason.  I am just plain wrong 20-40% of the time.  Maintaining this awareness is crucial to our investment decision making process.  We do not “bet the farm” on any of my forecasts.  We will however, overweight or underweight our positions based on the probability that I am correct.  Because the majority of my forecasts seem to work out, our portfolios generally have stellar long term market-beating track records.  I suppose it’s just human nature, but it is much easier to follow my more conventional forecasts than some of the wacky, contrary calls I make.  Be warned:  I’ve been at this for a long time; the wackier the forecast, the better our results have been. So let's get started!

We've had quite a roller coaster the past couple years.  It goes without saying that 2009 was certainly more fun than 2008!  But despite a spectacular recovery in the last nine months of the year, US stocks turned in their worst calendar decade of performance ever.  Unemployment rose to its highest levels since the 1980s, while GDP suffered its largest quarterly decline since the Great Depression.  Now as we enter a new decade, both the US economy and corporate America are again growing (in striking contrast to a year ago).  Though an economy and profits built on bailouts of large banks, GSEs (Fannie Mae and Freddie Mac), municipalities, as well as the (union owned) automakers like GM and Chrysler may not sit well with most of the citizenry, the short term alternative would have been much worse.  Many people want to know where all that bailout money went.  Despite appearances to the contrary, in the end the money went right where it was needed to stop the freefall. 

This is not to suggest that fashioning a tourniquet stops the pain.  With nearly 1 in 5 Americans in the labor force currently "underemployed" (seasonal workers, forced part-time, workers employed below their skill level), these have been trying times for many.  It seems unbelievable then that unlike every other recession, after-tax disposable personal income actually rose steadily on average throughout the course of this disaster.  The combination of reduced tax payments, municipal bailouts, cost of living adjustments (increases) for government employees and retirees, extended unemployment benefits, and subsidized COBRA health insurance payments more than offset the declines in wages and salaries.  Not only did after-tax incomes rise, but living costs fell for millions of homeowners who successfully refinanced at lower rates.  Add to all that the increased purchasing power of tens of thousands of homeowners facing foreclosure, but living mortgage and rent-free in the interim.  Some gained and some lost, but on average, after-tax income rose.  If this is true, why hasn't the economy fully recovered yet?  As I explained in last year's forecast, the recession can continue if the stimulus expenditures are offset by an increased savings rate.  Instead of continuing to consume as before, the private sector is now focusing on cleaning up their balance sheets through debt reduction.

Famed economist Milton Friedman (whose writings inspired my own love of economics) explained it better decades ago with his “permanent income hypothesis”.  Friedman demonstrated that consumers base their spending on long term income expectations rather than their current income.  After-tax personal income did grow in 2009, but confidence in the future evaporated.  Shrinking retirement accounts and home prices, anticipation of higher taxes, and inflation all returned us to a nation of savers.  Unemployment benefits may keep food on the table this week, but unlike a paycheck, one can’t count on temporary benefits to pay the bills for the next 5 years.  This recession wasn’t about falling income.  Instead it was a wake up call about how we have mortgaged our collective future.