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 confident from these levels. Conversely, the unrealized profits we had in our long Japan and short TBond positions two weeks ago have evaporated, providing 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...
2009 Forecast Revisited
Highlights of last year's forecast in italics
US Economy and Inflation 2009
"The economy will deteriorate significantly through the first quarter of the year. Come Q2, financial, housing, and auto manufacturing layoffs are likely to slow. Unfortunately, layoffs in retail as well as state and local government positions will accelerate…History suggests that unemployment will continue to rise to at least 8 1/2%...it could rise to 10%...Long term interest rates will rise, while persistent unemployment will prevent the Fed from raising short term rates…Money creation will translate directly into a weaker dollar and higher consumer prices…Consumer prices may show year over year declines through summer and big jumps at year end…Asset appreciation will lag in the absence of easy credit so don’t expect any mega bull markets in stock or home prices for many, many years...In reality...the 1st qtr of 2009 will [be] the most painful…The pace of decline will diminish after that, but the economy is likely to shrink through the summer." - We got the big picture right; higher unemployment and inflation than either the administration or most forecasters expected. A lot of what I didn’t get wrong was by omission rather than brilliance. I didn’t offer specifics on GDP which in fact swung so wildly quarter to quarter that the final number could hardly be considered representative for the year.
Commodities 2009
"Inflationary pressure will be concentrated in the necessities of life…gold mining companies are likely to be better bets than gold prices in 2009…oil prices…should rebound back to the $60/bbl area…gold is likely to see $765 sooner than $965. Long term…gold prices should double in the next few years.” - Aggressive action by the Bernanke Fed (flooding the known world with dollars) pushed prices of almost everything (commodities, foreign stocks & currencies) higher than was justified by the fundamentals when measured in US dollars. Gold prices retreated less than I expected before rallying. Mining stocks outperformed through the November peak but have since retreated much faster than the metals themselves. Oil prices rose from $35/bbl through my $60 target to around $75.
Housing 2009
"Housing is again affordable for anyone with a decent down payment, enough income, and good credit. Statistically, the median price in most areas will continue to fall…prices are likely to reach a temporary bottom in the first few months of the year then stabilize through summer. The previously immune, upper end which is still overpriced, will feel the most downward pressure. The best buys in some affordable areas may be right now…The surprise will come next winter when mortgage rates inch higher and prices adjust down again.” - I didn’t foresee how long the Fed would aggressively support the mortgage market, holding rates below 5% (rather than the 6% market rate we forecast). Home prices are likely to soften when the Fed ends the mortgage purchase program and this stimulus is gone (March 31).
Interest Rates and the Fed 2009
“A year from now, 10 yr TBond yields will be back above 4%…Foreign investors who enjoyed big gains on TBonds in 2008 will suffer losses in 2009...Inflation Protected Treasuries (TIPs) are the only bright spot for treasury investors…Mortgage rates may fall further early in the year as the Fed buys mortgage backed securities…High yield bonds are likely to be the best performers…AAA mortgage backed bonds, high grade corporates, and municipals should offer solid if not stellar returns while TBond investors are likely to loose money in 2009…Long term interest rates will rise, while persistent unemployment will prevent the Fed from raising short term rates...This sets the stage for a weaker dollar and renewed inflation at year's end." - 10yr TBonds briefly hit 4% mid year and ended at 3.83%, leaving investors with a net loss on the year. High yield bonds returned over 50% and TIPS produced double digit returns when CPI jumped back up to 2.7%. High quality corporate bonds provided solid gains while conventional TBonds produced losses. Some aspects of our forecast could have been a lot better, but we nailed the bond market.
The Stock Market 2009
"It is reasonable to expect some very good days and weeks in the near future...closing the year above 1000 on the S&P is likely...The biggest risk is that money will shift out of both TBonds and stocks into corporate bonds…The market could rally to S&P 1100...[but} a rally of that magnitude increases...a minor risk of a major correction...opening the possibility of a drop in the index to S&P 650.” - We had to wait a few months longer then expected for those “very good days and weeks”. The countertrend rally to S&P 1115 that I thought would precede a stock market plunge came after the market touched S&P 677 in March, not before. My stock market timing may have been flawed, but my target levels were on the money (S&P 650-1100). We stuck to the strategy of buying stocks at the low end of that range and lightened up at the high end. What our stock market timing lacked, our bond timing more than made up for. By year end, both our Diversified and Fixed Income strategies produced market-beating results.
2010 Forecast
Summary:
Strong economic growth that the US experienced at the end of 2009 should continue into early 2010. Government stimulus will add to inventory rebuilding, the ongoing benefit of low interest rates, and growth in exports currently bolstered by the recently weak US Dollar. This will be accompanied by an improving employment outlook and somewhat reduced inflation as residential rents plunge and the US Dollar begins a countertrend rally.
Later in the year, interest rate increases, a slowdown in the pace of stimulus spending, and the continued deleveraging of the consumer will temper the expansion. Slower (but still positive) growth will be accompanied by an inflationary uptick as the Dollar turns back down.
The prospect of higher interest rates will limit the Dollar's decline and put a ceiling on stock prices, while the actual increase in rates will end the rebound in home prices. Prices of both homes and stocks should end 2010 not very far from where they ended 2009.
The US Economy 2010
It’s hard to believe that less than a year ago markets around the world were in complete panic. A few months later, mountains of money printed by the Fed and distributed by the Obama team radically improved the short term economic outlook. Early last year, we suffered the largest quarterly drop in GDP on record, and the data supported those who expected deflation. Contrast that with the final quarter of the year when GDP is estimated to have grown by nearly 5% and CPI has risen to an annual rate of 2.7%. It’s reasonable to assume growth will continue as we enter 2010, even though the millions of currently unemployed are asking “what recovery?” and the core problem of excessive debt remains.
Even a couple months ago it was hard to envision 4% nominal (including inflation) US growth in 2010. Now that looks like a minimum and growth could be closer to 5% if the Chinese don’t slow their economy too much. The private sector has stabilized, and the temporary addition of a million census workers will combine with the infrastructure portion of the stimulus package to keep the economic expansion rolling into summer. Non-financial businesses are in an excellent position to exploit any opportunities (or increase dividends and buybacks) with a record 10% of assets hoarded in cash equivalents. These factors should temporarily overcome the drag from rising interest rates, cautious consumers, and deleveraging banks. The expansion of global trade and a recovering US economy will increase transaction demand for the dollar, raising its value. This will interrupt the upward trend in import and commodity prices, allowing falling residential rents to temporarily bring CPI back down. Inventories are being rebuilt and companies who survived 2007-2009 face less competition going forward. This is evidenced by the first quarterly drop in business bankruptcies since early 2006 (3rd qtr ‘09). Expiration of Bush tax cuts in 2011 may even pull some income forward into 2010 and home construction has bottomed, removing another negative factor. This will all translate into jobs. The underemployment rate (currently over 17%) should improve considerably while the headline unemployment rate should dip below 9%. The bottom line is that “real” growth in the first half could approach 4% while CPI temporarily slips back below 2%.
Low interest rates combined with a huge shift from consumer to government borrowing have drastically reduced the current interest expense of the total (public & private) debt, providing a big short term boost. The markets are betting heavily on the Fed’s vow to keep interest rates “extraordinarily low”. Historically, any Fed Funds rate below 2% is extraordinarily low. This allows for a considerably larger rise in rates than the market expects. They have also indicated they will end the mortgage purchase program in March, setting the stage for higher mortgage rates and a serious slowdown in home sales later in the year. At some point the Fed must address the long term inflation risks that extraordinarily low interest rates and massive government spending will inevitably bring. Intense political pressure precludes overt Fed tightening in either the next couple of months or the 2012 election year. Any serious tightening must be completed in the window between Aug 2010 and February 2012. Although official rates are unchanged, the Fed has already withdrawn a considerable portion of monetary stimulus. Less accommodative monetary policy will coincide with rising tax collections and reduced fiscal stimulus in the last half of the year. Relentless borrowing by the treasury (to fund record deficits and extend the average maturity of the debt) is already putting upward pressure on long term rates. Short term rate increases will follow later in the year. New restrictions on banks are likely to exasperate these trends. The addition of higher rates and less stimulus spending will add to the drag from deleveraging consumers and banks to slow the economy in the second half. Real growth will drop below 2% while CPI will inch back up toward 3% by year end.
Right now things are getting better, but economic growth will be impaired for years to come by continued deleveraging and a larger government sector. Unlike every other post WWII recovery, this one is not, and will not be, led by the US consumer. Consumers are cleaning up their acts. For the first time in decades, consumer credit is plunging and the savings rate is rising. Economic gains in 2010 do not prevent slipping back into recession in 2011. We must recognize that some of the recent economic improvement is purely statistical. High unemployment and reduced consumption are not signs of an expanding economy but statistically they improve GDP by reducing imports and keeping inventories high. Going forward, we will suffer a series of mild recessions and enjoy only modest recoveries for years to come. This means we face persistently higher inflation, lower growth, and higher levels of unemployment than we have come to regard as normal.
The Fed & Interest Rates 2010
The Bernanke Fed is being bludgeoned by Congress and the public for bailing out the banks; but without those imperfect actions, a deflationary collapse a year ago was a genuine threat. This would have brought much larger losses in jobs, stock prices, and home foreclosures, even if it would have shortened the eventual malaise by a few years. While there is much to criticize in the bailout specifics, it’s hard to imagine anyone doing a better job in managing the crisis than the Bernanke Fed did (despite serious failures like bailing out bank bond holders).
While the economic challenges have moderated, the political challenges grow daily. They are epitomized in Bernanke's recent comments denying the critical role of the Greenspan Fed in creating the bubble. If the Fed chairman truly believes that Fed action did not encourage and facilitate the bubble, we may be on our way back to the stagflationary seventies. Fortunately, the Fed is already reducing monetary stimulus, indicating that those comments were political posturing rather than being oblivious to the inflation risks. Even with these recent Fed moves, the unsustainable policies of the past year will reduce growth and raise inflation over the next decade. This will only be aggravated by additional government spending in 2010.
To be more specific, the Fed has only supplied enough additional credit to offset the continuing contraction of bank credit during the last six months. Money supply, which soared in late 2008 and early 2009, has flat-lined in the last six months. The bulk of Fed-supplied credit has gone directly into the home mortgage market. Fannie Mae, Freddie Mac and FHA have purchased over 80% of all new home mortgages in 2009. Banks and other mortgage issuers were mere conduits. These mortgages were securitized and the Federal Reserve has bought 85% of the securities. In the absence that support, the housing market would have completely collapsed, dragging the economy back into recession. The Fed is scheduled to end this program in March.
Other central banks around the world flooded their economies with money in 2009 as well. Already the Australian Central Bank and the Bank of China are shifting toward modest tightening, and India is threatening the same. This central bank trend will accelerate throughout the year. These actions do not bode well for the world’s stock markets.
There is more than enough blame for the bubble to go around. Just as Bernanke has denied the integral Fed contributions, Congress and the Obama Administration are doing everything possible to shift blame in other directions. Since it would be political suicide to blame suffering consumers, Wall Street and the Fed are the obvious targets. In this highly politicized environment, the Fed is treading on thin ice. First they must postpone any overt rate hikes until it is too late to affect this year’s election. Then it is crucial that they complete any rate hikes before the 2012 campaign is in full swing. Rates hikes will continue until early 2012 unless the economy double dips first. The overnight fed funds rate could easily hit 1½% by year end and be above 2% by March 2011. Historically speaking, a 2% funds rate is still "extraordinarily low". Even without Fed action, a record supply of TBonds is pushing up long term rates. This is happening despite the accumulation of almost a trillion and a half dollars of mortgages by the Fed. When the Fed stops buying mortgages in March, the upward pressure on rates will intensify. There is a legitimate disagreement about how fast interest rates will rise, but they are not going down.
Rising rates are disastrous for bonds and bond funds. Investors who in the past decade suffered two blood baths in the stock market and a third in the real estate market are beginning to suffer setbacks in the bond and commodity markets where they fled for safety. Last year, holders of corporate bonds, municipal bonds, and TIPS enjoyed substantial capital gains in addition to their interest payments as individual investors fled the US stock market. Only holders of conventional TBonds suffered. TBonds will continue to be the biggest losers in 2010, but other bond holders will have to endure capital losses, consuming part or all of their interest payments. Bond prices can only go down. Last year, owners of high yield bonds (like us) were the biggest winners. The total gains on these securities were substantially larger than the stock market. This year, high yield are the only category of long term bonds that are likely to provide interest payments large enough to more than offset their falling market value. The only hope for TBonds this year is the unpleasant and unlikely possibility that a recession arrives even before 2011.
Last year, ultra-conservative investors could have avoided the disaster in TBonds (as we predicted) by investing in TIPS (inflation protected treasuries). In 2010, TIPS offer no such protection. Any increase in CPI above the current 2.7% levels is likely to be minimal this year and more than offset by the fact that TIPS pay about 2% less interest than conventional bonds. The 2010 risk in TIPS is aggravated further by the fact that they are the cheapest way (in terms of this year's deficit) to extend the maturity of the federal debt. Therefore, the Treasury is likely to increase the supply of TIPS even faster than the rest of the TBond supply, increasing the downward price pressure.
Municipal Bonds are a horse of a different color. Defaults would be the current norm if it weren’t for the likelihood of federal bailouts and the issuance of US Treasury guaranteed (taxable) Build America Bonds. The balance sheets of most state and local governments are reminiscent of the balance sheets of over-indebted consumers. The inability of these governments to print money means that without help, many (including California) would fail. Imminent bailouts in this class do not preclude a fair share of angst in the meantime. Ratings downgrades could decimate the market value of municipal bonds for years, even if the bonds eventually pay off. Ultimately, it is unlikely the Obama administration or Congress will permit a major municipal default. The time to buy municipals is in the middle of a threatened default crisis (as always, when blood is running in the streets.)
Our own fixed income strategy in 2010 will capitalize on the limited opportunity in high yield (aka junk) corporate bonds at least through summer. They too will decline in value, but the losses should not exceed half of the 8-10% interest rate they currently pay. Defaults, the bane of high yield investors, appear much less likely than normal now that the economy is on the mend. Most of the worst credits were wiped out by the recession last year. We continue to own the Fidelity High Yield Bond Fund (SPHIX) in both our Diversified and Fixed Income portfolios. This fund produced mammoth returns for us in 2009. We plan to intermittently hedge those high yield positions with ETFs (exchange traded funds) that move opposite the TBond market. We also hold a large position in the Fidelity Floating Rate High Yield Fund (FFRHX). This fund invests in bank loans and benefits from rising interest rates (unlike the high yield bond fund). Like the high yield bond fund, FFRHX will benefit from the decreased default risk consistent with this point in the economic cycle. It also offers the added attraction of higher interest payments if rates rise.
We must not forget that the rise in interest rates is restrained by current changes in consumer and investor behavior. Born again savers are still buying bond funds, limiting their price decline, at the same time that reduced demand for consumer credit is offsetting much of the increase in government borrowing. The result is that an inevitable rise in interest rates, although significant, will be less than some analysts expect. 10yr TBonds that ended 2009 at 3.83% are likely to end 2010 between 4.75% and 5%. Conforming mortgage rates are likely to get a similar increase to about 6%, while jumbo mortgage rates (which are already high) will only rise about half that amount.
Inflation 2010
Contrary to popular belief (as I have pointed out for decades), inflation rises when economic growth slows. It doesn’t matter whether the economic slowdown is when we enter a recession, or simply the result of bottlenecks following a period of rapid growth. Inflation generally rises when the economy slows and falls when growth accelerates. The economic disaster in 2009 was accompanied by a 2.7% rise in annual prices as measured by the CPI. The economy is improving as we enter 2010, so the rise in consumer prices should diminish somewhat. The same factors that push inflation up when the economy slows, hold inflation down when economic growth accelerates. A number of these factors indicate a brief respite from what is now a rising inflation trend. First, the appreciating dollar is holding down commodity and other import prices. Second, the slowdown in US consumption (which is still a huge portion of global consumption) is juxtaposed with excess global capacity to produce consumer goods. Third, residential rents (the biggest component in the CPI) are falling in response to record vacancies. Finally, labor productivity is high, as producers remain in a tightfisted mood holding costs down even as production rises.
Later in the year, the importance of these factors will diminish. At some point rents will bottom. The oversold condition of the dollar will be alleviated and the currency appreciation will end. Rising global demand and positive employment trends will put upward pressure on commodity prices even as producers step up hiring and increase production. Inflation pressures should begin to reappear toward the end of the year and continue into 2011. Ultimately, the huge increase in government spending will severely reduce productivity. Even higher interest rates, which the Fed uses to reduce long term inflation risks, will increase business costs and contribute to inflation in the short term. Those who argue that remaining excess capacity and high unemployment precludes inflation have forgotten the lessons of the 1970s. It has been almost two years since the economy entered recession. A great deal of the “excess capacity” has become economically obsolete. Every month that passes increases obsolescence in a world of rapid technological change.
Corporate America is also rebuilding profit margins by limiting output to levels they can market without discounting. This is most clearly evident in the auto industry which has drastically cut output and discounts. Unless interrupted by a major slowdown in China (or worse, the bursting of the Chinese real estate bubble), global economic recovery will continue to exert upward commodity demand. After the dollar peaks and rents bottom, commodity and other import prices will push inflation higher. Anticipation of that demand pushed commodity prices ahead of the economic realities in 2009. After an early 2010 correction, they are likely to rise again in response to the lagged effect of 2008/2009 multinational fiscal and monetary stimulus. However, the rise in prices is limited by the deflationary impact of ongoing deleveraging by households & banks. The battle between these conflicting forces will continue for years. In 2010 I expect consumer price inflation in the 2 ½ to 3% range.
Commodities 2010
Early 2010 notwithstanding, higher commodity prices seem inevitable. Absent a second global collapse, demand from a growing global economy combined with governments monetizing massive deficits seem certain to push prices higher. Premature focus on Chinese commodity demand sent prices of energy, metals, and foodstuffs soaring in 2009. Much of that demand was speculative, which was why we took profits in our position in the gold mining sector last September (too early as usual). According to a survey of forecasts by Birinyi Associates, gold prices are expected to rise to $1213 and oil is expected to rise to $80/bbl this year. My long term bullish forecasts not withstanding, we are currently experiencing a short term correction in the energy and metals markets. Some commodity prices have already fallen to where I expect prices to end 2010 (Gold $1100 & Light Crude $75). Generally speaking, we will be buyers a few percent below these levels and sellers a few percent above. As long as the global recovery remains intact, platinum, silver, and palladium are likely to outperform gold. Similarly, agricultural prices on average are likely to fair better than gold or oil simply because there has been significantly less speculative interest in them during the past year. Like gold and oil, platinum, palladium, silver, and agriculture prices will all face the temporary headwind of a stronger dollar. Unlike the metals and energy, the vagaries of weather make specific agricultural price predictions way beyond my level of expertise.
Housing Market & Real Estate 2010
Post housing bubble (and bust), home prices are adjusting to the realities of available inventory, jobs and affordability. Conforming mortgage rates held artificially low by the GSEs and the Fed have kept affordability high for moderately priced homes. This has led to 5-10% rebound in prices from the 2009 lows. The prices of more expensive homes have continued to drift lower, but unlike a year ago, all ranges are selling, although sales volume is slipping as interest rates creep higher.
Like the overall economy, the housing market faces crosswinds. Great affordability for qualified buyers and an improving jobs outlook are juxtaposed against falling rents, ongoing foreclosures, and the prospect of rising mortgage rates. Those looking for big profits from current price levels won’t be getting any instant gratification. Conversely, those looking for another chance to pick up a house at the give away prices of six months ago have a better chance if they are just entering grammar school. Sideways price action seems most likely with substantial variation between states, cities, and neighborhoods as available supply adjusts to geographic employment shifts.
Right now may still be the best time for many to buy a house in the next few years. The first time buyer tax credit is still in place while the after tax costs of a 5% mortgage compares favorably with rent. Homebuyers should not be deterred by the very real risk of price declines in 2011. Only those with very strong financial statements will be able to take advantage of any dip, and higher rates will offset any drop in monthly payment due to a lower price. Significant additional near term appreciation is unlikely, but over the very long term, inflation will probably push prices higher. Homeowners who purchased or recently refinanced with 30yr mortgages between 4 3/8% and 5% will enjoy a relatively low cost of living. However, those who wish to purchase or refinance later in the year will face rates between 5.5% and 6%. Anyone with the income and credits scores to refinance now at 5% should act immediately. The increase in rates later in the year will radically reduce affordability and end the housing rebound.
Speculators beware: for the past ten years the money was made when you sold property into a rising market. For the next few years, the profit will be made when you cut a good deal on the purchase. Investment real estate, both commercial and larger residential properties, remain at an impasse. Almost nothing is turning over. Sellers are holding out for a price recovery that is nowhere on the horizon, while buyers are holding out for price drops that reflect the ongoing decline in rents. This may be the year when sellers finally focus on falling rents and drop the price to reasonable levels. In the meantime, tight financing makes deals impossible. Unlike conforming mortgages on primary residences, financing for other real estate is tight. This means buyers with lots of cash can make great deals if they find someone who needs to sell. This is where the big money will be made, but it will take lots of work.
Many publicly traded REITS (real estate investment trusts) have performed dramatically better than I expected in the last six months, but this is unlikely to continue. Their recent success is attributable to the ability to reduce costs by issuing bonds in the current hot market. Unlike the banks which need to reduce real estate loan exposure, property companies with otherwise solid balance sheets have found ready buyers of their debt in the bond market. The problem going forward is that falling rents are reducing yields on REITS to uncompetitive levels at the same time that rising bond yields are likely to provide stiff competition for investors.
There was massive speculative interest that absorbed much of the foreclosure supply, which itself was limited by moratoriums and government pressure to renegotiate. A potentially large increase in inventory from foreclosures (about 6 million homes are in some stage of default or foreclosure) on option adjustable mortgages remains in front of us. Only a limited percentage will actually come to market, as the banks are in a renegotiating mood. Expensive homes have generally seen their prices continue to fall, but even this trend shows signs of nearing a bottom. The combination of low mortgage rates and low home prices made some spring 2009 purchases the buy of a lifetime for new homeowners. They got a lot of house for after tax payments lower than rent. They are unlikely to ever get the opportunity for lower monthly living costs, even if home prices dip again. Another price setback is possible, since about 25% of US homes have mortgages greater than their value, and millions of foreclosures are underway. These negative factors certainly limit the potential for any further appreciation in the next couple of years. High priced homes and investment real estate are still under pressure. So far most large real estate investors have refused to cut prices enough to attract buyers. That is likely to change as we move through yet another year of record vacancies and falling rents. If the current recovery gives way to recession in 2011, we may get the first real buying opportunity in investment property in a decade.
Foreign Markets & Currencies 2010
We turned bullish on the US dollar last fall. Our currency was bludgeoned for most of 2009, but is now recovering. The current value of the dollar makes US asset prices attractive, while making our exports competitive and imports expensive. This is improving our trade balance. Eventually, the dollar will appreciate to a level that erodes this advantage, but that is a 2011 story. Rising dollar demand comes from four primary sources. First, US economic activity is improving, abetted by 2/3rds of last year's stimulus package. Second, rising demand for our exports will require dollars to purchase them. Third, with or without Fed rate hikes, real interest rates are rising. The borrowing demands of a mammoth federal budget deficit are pushing nominal interest rates up, while the appreciating dollar will limit any near term rise in inflation. Finally, increased world trade (most of which is conducted in dollars) will generate a massive increase in demand for transaction purposes. The dollar is the place to be in 2010 (with the notable exceptions of China, who is already tightening credit, and India which is poised to do likewise).
An appreciating dollar has many implications. The first is that 25% of the outperformance of foreign stock markets last year came from dollar depreciation. An appreciating dollar reverses those metrics, setting the stage for the US stock market to be one of the better performers in 2010. If US stocks are, as I expect, going nowhere fast in 2010, this implies that most other stock markets will be in decline. The second implication is that the boost a weak dollar is providing to economic growth will diminish before we enter 2011. Finally it will subtract from rather than add to inflation, as it did in 2009, as long as it is going up.
I don’t pretend to be up on every market in the world. In general, I expect most European and emerging markets to underperform this year. The economic outlook for Europe is mixed at best with several member countries like Portugal, Italy, Iceland, Greece and Spain (aka PIIGS) trapped in recession by the Euro. Expectations for emerging market growth are high and dependent on Chinese expansion which is likely to disappoint now that the People's Bank is restricting credit. Two markets in particular stand out. The biggest stock market disappointment in 2010 is likely to be China, while the hottest major stock market is likely to be Japan.
The 2009 gains in the Chinese stock market priced in continued unsustainable rates of economic growth. Investors ignored the fact that much of what appeared to be growth in 2009 was unproductive financial and real estate speculation. Speculation fueled by the easy credit policies of the People's Bank of China. The PBOC has already moved to increase reserve requirements with the goal of reining in speculative lending and rising inflation. Tighter credit always impacts financial markets before it impacts the real economy. The stock market has already begun to correct. If these actions fail to stem speculation, it is clear that additional actions such as rate hikes will follow. A side effect of raising rates is upward pressure on the value of the currency. This will reduce Chinese exports and increase imports, further slowing economic growth. The PBOC is less concerned than last year that rate hikes will create excessive upward currency pressures, because US interest rates are also poised to rise further.
Hop over to Japan where we see an economy and stock market almost a polar opposite to China. After decades of deflation, the new ruling party is committed to trying to restore a little inflation. There are several factors that make investing in Japan attractive at the present time. First, the new government is stimulating the economy with monetary and fiscal policies. This represents a commitment to debasing their overvalued currency. Historically, debasing a strong currency has always resulted in pushing stock prices higher. (we saw this in the US stock market last year as well) Second, there is no risk of inflation in 2010 upsetting the government's plan. Third, expectations are low and stock prices are relatively depressed, offering the opportunity of an upside surprise. Fourth, the Japanese economy is more levered to global economic growth than any other major economy. A weaker Yen will generate disproportionate domestic gains during a global recovery. Finally, despite the highest major government debt to GDP ratio in the world, the cost of servicing that debt is extraordinarily low. Unlike other countries where long term interest rates are above 3% those rates are under 1 ½% in Japan. Furthermore, government debt (at and below 1.5%) is a much larger percentage of total debt than in other countries. The high percentage of government debt remains a drag on growth, but that drag has been fully (at least) priced in to the Japanese stock market. Conversely, with little to no near term risk of higher rates, Japan should be able to service almost triple the debt/GDP ratio of other countries. We began building a position in the Fidelity Japan fund (FJPNX) last year and have since expanded it. I fully expect a double digit decline in the value of the Yen and the Japanese stock market (measured in Yen) to appreciate at least double that amount.
The Stock Market 2010
The US and global economies suffered greatly in the past few years. But the recovery that began late last year is almost certain to continue through 2010. Our job is to decipher whether that growth will translate into additional market gains. To do that, we must correctly anticipate changes in both earnings and the price/earnings (P/E) multiple of the market. Although there are other factors at work, changes in the growth of credit, relative to the growth in the economy are usually followed by market movements in the same direction. Similarly, equity market changes are usually followed by changes in the economy six to nine months later. This is neither a coincidence, nor clairvoyance. Investment in the real economy (buildings, roads, factories and jobs) requires months of analysis, planning and negotiating. Last spring, the easy money policies of 2008 & early 2009 lifted stock prices by expanding P/E multiples, now they are lifting the economy and earnings.
An improving economy boosts corporate earnings. Higher earnings makes stocks more valuable, but in the absence of credit expansion, P/E multiples can contract, offsetting part or all of the earnings benefit. This is not a simple matter of whether the Fed raises or lowers rates. It is a matter of the Fed expanding credit even faster than the needs of a growing economy.
Since late summer, economic growth has accelerated while stock market gains have slowed. This is consistent with a dramatic reduction in money supply growth (I've oversimplified for the sake of brevity this late in the game. I will be happy to elaborate via email for interested readers). Economic growth is sucking up an ever larger percentage of available liquidity, so the P/E is shrinking. The rally can continue if earnings rise fast enough, but the bar has been raised. In the end, stock prices depend on both earnings and P/E multiples. Both are easy to measure, but challenging to predict.
but what the heck...
2010 gains in corporate earnings will be completely offset by a shrinkage of the price/earnings multiple.
Forecasters of S&P 500 earnings are generally divided into two groups. The first (bottom up) group adds up the individual earnings prospects of each of the 500 companies in the index. The second (top down) group analyzes the prospects of the overall economy, then calculates how much of that activity will be reflected in corporate profits. As a rule, the ‘bottom up' guys are usually the optimists and the 'top down' guys (like me) tend to be the pessimists. This year, the ‘top down’ guys are optimists while the ‘bottom up’ guys are really optimistic! Surveys of 'bottom up' analysts from major financial institutions project the S&P 500 will earn $78 in 2010, up roughly 30% from 2009. 'Top down' analysts estimate closer to $72.50, an increase of about 20%. According to a survey of forecasters from major institutions conducted by Birinyi Associates, the S&P is expected to end 2010 between 1120 and 1325. The average forecast is S&P 1222. The great irony is that you can find forecasts of S&P 1200 among those who are both bullish and bearish on the economy.
I share some of their optimism. Growth in the US and the world will accelerate this year. I also agree with the consensus view that US growth will accelerate in the first half of the year (boosted by government spending) and slow in the second half of the year (dragged down by reduced government spending and interest rate hikes). The rapid first half growth, combined with modest second half growth, should generate substantial earnings gains.
Where I differ is that I see many of the factors that drove earnings gains in 2009 disappearing or diminishing in 2010. 2009 earnings growth came from cost cuts, foreign earnings (falling dollar), fiscal stimulus, and interest rate cuts. In 2010, only fiscal stimulus is likely continue as a contributor. Rate cuts will be replaced with rate hikes, costs have been cut to the bone and will rise, and an appreciating dollar will reduce the earnings contributions of foreign divisions and subsidiaries. Therefore, 2010 earnings growth must come entirely from increased sales and price hikes. Improved sales and pricing are natural components of stimulus driven US economic growth and a currency driven increase in net exports. That will not, however, be enough to achieve earnings growth in excess of 20% without a hefty contribution from banks and other financial companies. The risk of disappointments from the financial sector is very real. Recent financial sector earnings have come from three sources. First, billions invested in Treasury Bills and Notes are being financed at 0% interest with money supplied by the Fed. Second, fees generated when banks sell (rather than hold) the mortgage loans they make to Fannie Mae and Freddie Mac. Third, the major source of profits comes from proprietary trading, which the regulators are pushing hard to reduce. Like non–financial companies, 2009 the profit sources will be diminished in 2010. Rising interest rates will impair the first two income streams leaving only trading profits, which are under regulatory assault.
At the same time that 2009 income streams shrink, ongoing mortgage defaults, record drops in consumer credit, and corporations that don’t need loans because they are loaded with cash present ongoing obstacles to earnings growth. If that weren’t enough, the only proposals of the Obama administration supported by the public are the ones that tax and regulate the banks. In this environment, strong profit growth seems unlikely. In the unlikely event that bankers overcome these obstacles, strong profits and big paychecks will aggravate a growing public backlash that will need to be addressed.
Banks have a unique capacity to “manage” reported earnings by adjusting reserves for loan losses. The ability to postpone loan losses has been a key component of recent earnings gains. All banks have to do to lower earnings in 2010 is to write off questionable loans faster, or increase the amount they “reserve” for future loan losses. This would reduce 2010 earnings (but increase earnings in future years). In the past, regulators frowned on “earnings management”. In light of recent disasters, regulators will embrace “more conservative” accounting. This prospect will depress financial stocks. Without strong financial sector gains, it is difficult to justify S&P earnings above $70.
Ironically, nothing would be better for bank executives. Recently, pressure from the Obama administration and Congress has shifted compensation from cash to stock (diluting the holdings of other shareholders). Lower stock prices results in executives getting more “shares” at bonus time. Cramming loan losses into 2010 will set the stage for improved earnings in 2011 and beyond, leading to higher stock prices in the future, when bank executives are free to sell them. Is that a sweet deal or what??
Historically, stocks have traded, on average, at 16.5 times actual trailing earnings and 14 times the bottom up projections of future earnings. Using the current projection of 2010 earnings we arrive at a value of 1092 for the S&P 500 (14 x $78 = $1092). It would be reasonable to use even a slightly higher multiple because of the abnormally low interest rate environment we are in. Therefore, something in the 1100-1150 range makes sense. Now assume for a moment that as the quarters roll by and those earnings projections become actual numbers (trailing earnings), we see earnings reports pointing us toward my forecast of $70. This gives us a value of 1155 on the S&P (16.5 x $70 = $1155). By the time this occurs, I expect most interest rates to be close to normal and rising. Therefore, I am biased toward a slightly lower than normal P/E multiple. In 2008 I suggested that the market could drop as low as S&P 1100. Last year I forecast that we could rally to around S&P 1100.
Three factors lead me to expect below normal P/E ratios a year from now. First, I expect the economy to slow going into 2011, contrary to the consensus view of continued growth. This would make an anticipatory 2010 market decline more likely if my view proves correct as the year moves on. Second, our proprietary sentiment model continues to show that we entered the year with active investors and money managers universally bullish (consistent with the consensus forecasts), making a short term decline from current levels more likely than a short term rally. Finally, rising interest rates tend to be coincident with lower P/E multiples. After I adjust my S&P 1155 number for these factors, a 2010 year end target of S&P 1100 seems about right. That means buy and hold investors could end up with a 1% total return including dividends, and more bearish than anyone in the Birinyi survey. Guessing a precise level on a specific date is of course folly. At any moment in time, a reasonable market could easily be 5% above or below fair value. In the first few weeks of 2010, the market was at times 3% higher or lower than precisely where it ended 2009.
Opposing a universally bullish or bearish consensus has been a hallmark of the contrarian style I am known for. There are bearish forecasters who were not in that survey, but they are few in number. Although not as aggressively bearish as those outliers, I am certainly positioned contrary to consensus expectations of double digit market gains. Irrespective of how 2010 ends, I expect stocks to rally 3 - 8% (S&P 1148-1204) and decline 6-15% (S&P 947-1048) sometime during the year. Despite a decade of dramatically outperforming the most challenging market of most of our lifetimes, I still seem to be wrong about 20-40% of the time. Because of that, and my expectation of 6-7% annual stock market gains over the next decade, I temper my pessimism by keeping our diversified strategy 20-40% invested in US equities. The remaining balance is a mix of fixed income, cash, and a core position in Japan (mostly FJPNX), which I expect to do better than the US. The bond positions as well as the cash can be quickly liquidated to increase our stock market exposure when the market corrects.
I hope this analysis proves helpful and informative. It was a bit longer than I anticipated, but I must admit, I am blessed to love my job! And as my family and friends will confirm, I don't often shy away from talking about it. If you also can't get enough, please don't hesitate to contact our offices with questions and comments.
Clyde Kendzierski
Chief Investment Officer
*some may find my word choice here ambiguous