Jan 5, 2010

2010-Goodbye to the Naughties

2010-Goodbye to the Naughties

January 4th, 2010

“If you could kick the person in the pants responsible for most of your trouble, you wouldn't sit for a month.”—Teddy Roosevelt

2010 percentage performance for the major indices
Based on last Friday’s official settlement...

INDU: 18.8%
SPX: 23.5%
COMPQ: 43.9%

I hope you had a wonderful holiday season. Ours was terrific, although I’m not sure having three kids home for 18 days is exactly my wife’s definition of a vacation. Thank goodness for sports camps!

After ten years of what can be viewed as a lost decade (think jobs, stock markets, GDP, housing, etc), someone finally coined a name for the decade that makes sense-The Naughties. What were some of the biggest events of the decade? How about two recessions, two burst bubbles, a near collapse in the financial markets, hanging chads, rolling blackouts, a war, social networking, a democratic takeover of Washington, bird and swine flu, reality TV, The Sopranos, blogging, privatized gains/socialized losses,
Tiger Woods, texting (and in Tiger’s case, sexting), steroids in baseball, and the iPod? By far the biggest event will remain September 11, 2001 when 3000 of our fellow citizens were cut down by terrorists. It certainly hasn’t been a boring decade.

Well, goodbye and good riddance to the Naughties, hello….Teens.

This week I’ll be departing a bit from the weekly norm to review my predictions for 2009 and discuss 2010.

Review of 2009 Predictions

In the January 4, 2009 note (http://weeklymarketnotes.blogspot.com) I laid out 12 predictions for 2009. Some turned out to be a bit weak, but nonetheless I am reviewing each of them below. You can go to the website to review them in their entirety.

1. Stock Market-I was looking for a range bound market for 2009, this was obviously incorrect. I had the first two breaks of the year correct, was accurate with adding to equities under 750 and going net long (the S&P bottomed at 666), but never got bullish enough as the market never looked back after hitting that low in March. I still think the market will resemble that of the 1970’s over the next couple of years, marked by powerful rallies and powerful declines. For now: wrong

2. Economy-I said the economy will be weak all year, but it will improve slightly. After posting negative GDP from Q308 until Q209, we had a slightly positive Q309, up 2.3%. Correct

3. Corporate Earnings-I missed here also, but need to add a disclaimer. I never anticipated that the accounting rules for financial services companies would change from mark-to-market to mark-to-imagination. This change resulted in a major surge in corporate earnings versus consensus, but will provide a challenge in 2010 in the guise of tougher comps during the back half of the year. I’m calling this a tie due to the accounting change.

4. Sports Predictions-
I hit two of the three on the screws. I picked the Lakers to win the NBA and the Angels to lose in the ALCS, both of which were correct. My miss was on USC, which for once wasn’t ripped off by the BCS. Correct

5. Inflation-I discussed inflation as a potential issue in 2010 and 2011, but stated that “for 2009 inflation will remain tame.” Correct

6. Dollar-I was very bearish on the dollar, especially after it had a big run in the back half of 2008. I suggested gold as a hedge against the declining dollar. For the year the dollar was down double digits (see chart below), while gold rose 26%. Correct

7. Commercial Real Estate-
I said that CRE loans would be the bane of regional banks, and this is starting to take hold. The process has been slower than I would have anticipated, almost like watching a slow speed car crash. However, the number of banks being taken over by the FDIC continues to rise, and commercial lending is increasingly becoming the cause of these disasters. Correct

8. Obamanomics-I said that Congress would agree to the massive spending being pushed by the incoming Administration, but not without adding billions in pork. Predicting Congress would vote to spend money was too easy, I’m not taking a “correct” on this one.

9. Credit-I said that credit, as measured by Libor and the TED Spread, would improve over the year, giving us a shot at recovery in 2010. The chart below is a 5 year view of the TED Spread, which has certainly moved back to historically “normal” levels. Correct

10. Housing-I said we would see a bottoming process lasting 3-5 years, the jury is still out on this one.

11. More Credit-I recommended moving away from treasuries and high grade corporate to high yield paper. High yield returned 58%, investment grade 19%, and 30 year treasuries had the worst year in history, declining 24%. The chart below shows the yield increase (which corresponds to a price decrease) of the 10 year treasury. Correct

12. Oil-I said oil would rise for the year, but was thinking $60, not $80. Given my inability to capitalize all year long on the rise in oil, wrong! The chart below is the 5-year chart on the WTI.

Net-net I was 7 right, 2 wrong, 1 tie and 2 no scores, a bit better than 2008, although I think my economic and market calls for 2008 were much better, much more difficult, and more significant. The final score: 75% accurate versus last year’s 65%.

2010 Outlook
This is the part where I get to throw some darts, open myself up to a significant amount of ridicule, and be wrong once again. After the past two years the market should act much more along the “normal” lines, although this might make forecasting a bit more difficult as there aren’t as many obvious, yet to be discovered issues as the prior two years. Believe it or not, when you can identify big outlier events, whether positive or negative, it makes forecasting much easier. I feel that 2010 won’t have the significant number of outliers as 2008 or 2009.

1. Market
The market has roared off the bottom, the only surprise being there really wasn’t a significant correction during the bounce. What fueled this resurgence, and will it continue? The fuel was provided by the Fed, pushing massive liquidity into an economy which wasn’t or isn’t ready to absorb it. This excess capital has moved into the riskiest assets-equities, high yield bonds, and commodities, and should remain there until the economy starts absorbing the capital.

For 2010 I expect the market to continue its upward march through the first one-third of the year, with the possibility of a pull-back to consolidate 2009’s gains. A more significant stalling beyond that time frame is highly possible.

Prediction: look for the S&P500 to rise another 8-10% (north of 1200) before settling back in the back 2/3 of the year. Should the Fed be forced (they won’t do it voluntarily) to raise rates, the market could correct back towards fair value, which I peg at 975-1000 (15x $67).

2. Earnings
Earnings for the first quarter should be quite robust as the comps are very easy. Earnings comps should become much more difficult during Q2-Q4 as we anniversary the accounting shift in the financials (from mark-to-market over to mark-to-imagination). The banks are not yet lending and are still contending with write downs in spite of the fantasy accounting treatment of some loans on their books, so earnings growth for the market in the back half of the year may be difficult without a contribution from the financials.

Prediction: Look for strong first half earnings growth followed by weak second half growth, overall up 20% (consensus is for a 34% increase).

3. Economy
The economic numbers suggest we have passed the depths of the downturn, for now. I’d say we have a 20% chance of a double-dip recession in 2011. As far as the market is concerned, we may be in a new world where good economic news becomes bad news for the market as we inch ever closer to the Fed pulling back on its quantitative easing. The market is enjoying a giant carry trade being fueled by a weak dollar and a viewpoint that the Fed is afraid to pull back on its stimulus programs. Strong economic numbers may spook investors concerned about the Fed taking away the stimulus.

The ISM (see chart below) has been above 50 for the past five months, indicating manufacturing expansion. The tricky question will be whether this is sustainable without the stimulus.

Prediction: Watch for GDP to continue meandering and substandard growth rates through the year while employment stabilizes below 10%. David Rosenberg says that typically the first quarter of GDP growth post recession averages 7.3% versus Q309, which was 2.3%, 90% of which came from government stimulus.

4. Inflation
2010 is the year where my inflation concerns may arise. As I have stated, this won’t be a supply constraint or demand driven inflation, but instead due to currency weakness. Prediction: Watch inflation pick up in the back half of the year as the dollar wanes again. The caveat here will be if the Fed is forced to pull back on their stimulus as a result of better economic results and/or an increase in money velocity. Watch bank lending to get a handle on money velocity.

5. Real Estate
Mortgage rates and foreclosures will both be up in 2010. If 10-year treasury rates rise again, and mortgage rates don’t budge, we could actually witness mortgage rates lower than treasuries. Does this suggest that the American homebuyer is a better credit than the US government? Probably not. It would simply be a result of more aggressive MBS purchases by our boys in Washington.

Prediction: The residential housing market will ebb and flow in a bottoming process over the next 2-4 years, and I fully expect another drop in this market during 2010 (10%+).

6. 2010 Election
The Dems will lose seats in both chambers, that’s my call. The question is will they lose enough to balance out Washington and save us all from single party rule. Remember, I don’t really care who is in charge, I just prefer gridlock because I believe that no action from Washington is superior to any action.

Watch job growth because incumbents benefit from job growth, challengers from job weakness.

Prediction: I don’t think we will get significant job growth in 2010, therefore the Dems will lose seats, but won’t lose their majorities.

7. Oil
Here we go again. The fundamentals on oil are still very weak, and I am expecting a pullback from this $80 level. I know and understand that this is counter to my view that the dollar will be weak, and I have been living with that dichotomy for a while (not very profitably, by the way). Oil will be range bound in 2010, being pulled down by weaker fundamentals but pushed up by a weak dollar. If the dollar strengthens during the year, oil will take a significant tumble as both the fundamentals and the carry trade work against it.

Prediction: Fair value is probably $60-$65, a that number is as good a guess as any for the year.

8. The Fed
I’ve mentioned the Fed in a number of these predictions, and I feel they are one of the key variables in determining what occurs in 2010. Based upon Mr. Bernanke’s recent comments that low rates didn’t cause the housing bubble, I’d say the Fed chief won’t be in any hurry to raise rates. In fact, he is likely to lead us directly into another bubble, which politically is easier to swallow than another recession. The hope in Washington will be that everyone will be termed out by the time the next bubble bursts. This chairman would rather stoke inflation and devalue the dollar than manage through another recession. Don’t think that all the carping going on in the Senate about not reconfirming Mr. Bernanke is anything more than a warning to the chairman that should he raise rates too soon, his independence will be on the line in the form of increased Congressional and Treasury oversight.

If the economy suddenly becomes robust, then the Fed may be forced to raise rates and pull back on their QE programs. This is the “good economic news is bad for the market” view. If the banks start lending again and money velocity increases, the Fed may be forced once again to pull back the reins. If inflation kicks up, the dollar becomes dramatically weaker, or treasury rates continue rising, the Fed may be forced to pull back.

My prediction is that the Fed will pull back on some programs (think MBS), yet will continue to hold rates well below that of the market, therefore spreads over Fed Funds will keep rising.

Prediction: Look for a single rate increase near the end of 2010.

9. Healthcare Reform
The train is out of the station, the horse is out of the barn, the mustard is on the sandwich, the beer is on the floor. This is a done deal. It will pass. It will be bad. It will cost 10x more than anyone admits. Rationing will occur. Taxes will go up. Quality of care will go down. Corporate costs will go up. Reimbursements rates will go down. Regulatory costs will explode. Illegal aliens will be covered.

Need I say more?

Prediction: It passes.

10. Kalifornia
This state is a mess that keeps getting worse. Until the state redistricts in a manner which isn’t skewed by partisan politics, the state will continue to be mired in red ink. California will only come back when the real estate market returns, and then only if the ridiculous FHA lending standards remain in place that allow a person with lower credit to take on more leverage than someone with higher credit when buying a house.

Can you say “Governor Whitman”? See my comment on employment above and the impact on elections.

Prediction: She’s in.

BTW-I still remember meeting with Ms. Whitman in the early EBay days and making the comment “so, you’re basically a swap-meet online?” She handled it gracefully and zinged me a year later when she was on the cover of Forbes after becoming a billionaire.

11. Bank Lending
Prediction: Bank lending will improve in 2010. I apologize for not having the appropriate chart in here to provide a relevant measurement, but will include one in one of the next couple of notes. In general bank balance sheets are still a mess, but many banks are maxed out on the amount of treasuries they own and are continuing to borrow to shore up their book. At some point they will begin lending to generate a return on their borrowed capital. An interesting data point from The Big Picture showed that 92% of the senior executives who “led” the big banks through the past few financial crises’ are still in place.

Banking is survival of the un-fittest at its finest.

12. Glass Steagall
I was against the repeal of this fine law that kept everyone doing their jobs, minimizing the risk in financial services. I’d love to say we are going to see this law come back, however, the big 5 financial firms pad too many pockets in DC to lose this one.

One more for the banks, one less for taxpayers. Again, privatizing the gains, socializing the losses.

Prediction: No repeal.

13. Treasuries

The rates on treasuries rose as much in 2009 as any year I can remember. The consensus is looking for a continued rise as issuance to cover the record deficits and anticipation of future inflation dominate the thoughts of investors. While I agree that rates will continue rising, I don’t feel it will be a straight line, and I question predictions of rate Armageddon being made in some shops.

Prediction: At roughly 3.85% for the 10 year Treasury today, look for the 10 year to end 2010 in the mid-high 4% range (4.5-4.9%).

14. Sports
OK, here is my early stab at picking some winners (and losers) in sports. I’m taking Alabama for the BCS championship. I’m picking the Lakers to repeat. I admit I have no idea in the NFL except to say that Sir Brett and the Vikings will NOT win. Tim Tebow will get drafted in the 3rd round, and eventually get a shot a playing QB in the NFL. My beloved Angels will miss the playoffs, finishing second to the Mariners in the West. The Trojans will struggle with another weak defense in 2010, but should finish 9-3 and play in the Holiday Bowl.

15. General Investing Philosophy
Whether in stocks, bonds, or other asset classes, 2009 was a year to focus on riskier investments. I expect the first portion (say first 1/3) of the year to again favor the riskier assets. From that point I anticipate a rotation towards higher quality across all assets. Consider high grade corporate bonds over high yield, defensive large caps over cyclical small caps, etc.

I wouldn’t get too cute on the timing, but instead would begin systematically rebalancing towards quality over the next few months.

Stocks don’t need a great economy to work, we’ve seen that repeatedly. The economy has many issues, and any missteps by the Fed could result in either catastrophic inflation or a double dip recession. The politicians understand the relationship between jobs and re-election, and are desperately trying to get the former moving before September, when most voters will have made up their minds.

Thanks to Byron Hector at Bloomberg and countless others for providing charts for this note and previous notes during the past year. You know people are truly your friends when they take time away from their busy days to help you with your non-paying writing hobby, which reminds me of my first quote of 2009: “Try to surround yourself with people who can give you a little happiness, because you can only pass through this life once, Jack. You don’t come back for an encore.” -Elvis Presley

I’m always open to suggestions, appreciate everyone’s great input and information from their various businesses, and even enjoy the weekly criticism.

Have a great week, and good luck in 2010.


“Behind the ostensible government sits enthroned an invisible government owing no allegiance and acknowledging no responsibility to the people.”—Teddy Roosevelt

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