The markets are ending their worst decade ever with a bang up year, as the S&P 500 is poised to return, on a total return basis, 25%. Unfortunately, this is not enough to offset 2008; the major market averages remain down about 25% from their peak, as well as down from their level at the start of the decade.
The Federal Reserve’s injection of massive amounts of liquidity help engineer the markets’ stunning turn around in 2009. This pulled us back from the abyss of more major financial institution collapses and the most severe credit crisis since the 1930s. Time Magazine did not make a mistake when it named Fed chief Ben Bernanke as person of the year.
Let’s Sum It Up
The stock market could gain some 10% in 2010. Why is this possible? Investors are growing frustrated with hordes of money market and short term investments earning next to 0%. Fixed income has given them quite a ride in 2009; rates now are quite low and offer little further upside to offset their risk if interest rates rise. There are clear signs that the economy is improving, offering upside to companies’ earnings estimates.
>From a contrarian perspective that fact that Main Street has not embraced 2009’s rally is a bullish factor; markets generally don’t get overheated until the little guy goes all in and starts spouting stock tips.
Stocks in 2009: Who Would’ve Thunk You’d Make 25%
In retrospect, few thought the equity markets would return 25% in 2009. Fears of the worst financial crisis since the 1930s, residential real estate prices down by nearly a third, and unemployment soaring past 10%, the highest in nearly 30 years, made keeping your money in stocks, to say nothing of forecasting a double digit gain, well nigh impossible.
Indeed, the naysayers were well on their way to victory, as by March the S&P 500 hit a 12 year low, with the Dow dropping to close to 6500. However, the stimulus of Federal Funds interest rates at just 0% to 0.25%, February’s enactment of the $787 billion stimulus spending bill, and early reports that major banks’ operations had turned profitable caused stock markets to turn up. The initial disbelief and cynicism gave way to a grudging acknowledgement that the near 65% bounce off the March bottom by the end of 2009 was a classic case of the stock market acting as a precursor of better times ahead.
The distrust of the market is reflected in 2009’s cash flow figures for mutual funds. Nearly $20 was invested in bond funds for every $1 put into stock funds. This lopsided statistic is rare as generally stock funds garner more of investors’ cash. If fund investors get interested in stocks, this bull will have a longer life.
Bonds: On a Risk Reward Basis, Hard to Beat
At the start of 2009, “junk” bonds yielded close to 20% over comparable maturity Treasuries, while investment grade bonds sported spreads of nearly 7% over Treasuries. Bond investors who took advantage of those values earned handsome returns: Investment grade bond funds returned nearly 20%, while high yield funds scored profits of 50% or more; for example, Fidelity’s Capital & Income Fund, focusing on distressed debt, racked up a 70% total return.
If you can get equity like returns with less than equity like risk, that’s a superior combination. Bonds are less risky because their pay offs have priority over stocks’. Of course, with bonds having done so well in 2009, investors should not expect such stellar returns in 2010. Given that spreads of private sector bonds over Treasuries are still historically wide, bond investors may still expect a good year, although rising interest rates are a threat.
Did the Dollar’s Fall Cause Stocks/Commodities To Rise?
As markets rebounded from their 12 year lows the US Dollar fell, sliding 17% from early March. This begs the question, was the historic rise in commodities and stocks reflecting fundamental economic strength or merely a speculative flight from our currency? If the latter and the US Dollar is due for a rebound, investors should be cautious in embracing stocks and commodities in 2010.
No question, part of the run up does represent a shift out of the Dollar. That’s one reason to not expect 2010 to match 2009’s results. If interest rates rise in the United States, as a result of Federal Reserve tightening, an improving economy, or both, the Dollar will become more attractive. This will reduce the attractiveness of the “carry trade,” the practice of borrowing at very low rates in Dollars to make speculative bets in riskier assets.
Overseas Securities: The Best Game in Town Next Year?
The popular view a year ago was that the United States had more problems, including sinking real estate, skyrocketing unemployment, and capital challenged banks, than the rest of the planet. Investors feared the effect of our ultra easy money policies and the highest Federal budget deficits since World War II. Money flowed out of this country into both overseas stocks and bonds. Indeed, some of the most robust returns in 2009 with just a few weeks to go come from such markets as Brazil (+77.9%), India (+73.3%), and China (+71%).
While there are always a few overseas bourses that outperform ours, expect better relative performance stateside in 2010. Not all is better economically overseas, underscored by the Dubai World’s default on its debt and ratings agency downgrades of Greece’s sovereign debt. Meanwhile, clear signs of US economic strength, starting with a positive figure for Q3’s GDP and continuing with November jobs report, reporting the biggest improvement in US unemployment statistics in three years, may well direct more money to our shores. It’ll also bolster the Dollar.
Treasuries: Is All the Bearishness Justified?
Treasury debt has been a consistent and resilient performer over the last decade. Treasuries were virtually the only asset class to make investors money in the disastrous financial markets of 2008; they’ve only declined once in the last decade, as they are poised to finish up 2009 in the red.
Given their very consistent performance, nil credit risk, low volatility, and coming off a down year, we think they deserve an important spot in investors’ portfolios. First, with everyone expecting interest rates to rise, from a contrarian’s perspective you might be skeptical, which would benefit Treasuries. Second, even if rates rise as the economy improves, economic betterment is expected to be slow and muted, so its adverse affect on Treasuries is likely to very gradual. Inflationary expectations, another negative for Treasuries, appear well contained, according to the Federal Reserve.
Treasuries will be the clear winner should the economy “double dip”, meaning decline again, as they are free from credit concerns. So, offering strong protection should the economy weaken and relatively small risk if the economy strengthens, Treasuries should occupy a key role in most portfolios in 2010.
The Case for Stocks in 2010: The Least of Many Evils
While there are certainly many risks for stocks in 2010, including greater than normal valuations, uncertainties as to whether profits will live up to expectations, and concerns over the economy, investors must ask: If not equities then what? Bonds and cash are the other two major asset classes.
Both bonds and cash look much less attractive than they did a year ago. Cash’s return is close to zero; as confidence improves investors are likely to grow dissatisfied and impatient making next to nothing if other financial problems fail to surface.
Corporate and municipal bonds were extremely attractive a year ago, as nearly record spreads over Treasuries prevailed. Today, following double digit returns in 2009, they just don’t offer the value and are likely to attract fewer Dollars. Bonds could lose fans quickly if interest rates back up suddenly and bond funds suffer losses.
Stocks may attract a lot of interest in 2010 when investors starting making careful comparisons of their choices.
More Mergers and Acquisitions as Confidence Returns
The pace of corporate transactions has turned up. The latest example is Exxon’s bid to buy domestic natural gas producer XTO. Certainly, more merger and acquisition activity will prove a boon to the market: It validates market valuations, increases concentration in particular industries, and generates excitement and speculation as to future acquisition targets.
With borrowing rates still low and the stock prices of potential acquirers coming off their lows, look for more merger activity in 2010. Of course, whether any particular merger proves successful over the long term is more uncertain, as the history of growth through buying market share and other companies is quite mixed.
Are There Any Undiscovered Sectors?
We prefer stocks sectors that have lagged, offer solid fundamentals, and sport good dividends. If the Dollar gains strength and money flows back into this country, sectors that are primarily domestic may outpace multinationals.
Healthcare fits the bill. Trading at 20 year valuation lows relative to the overall market, investors have steered clear. Fears over healthcare reform, weak research and development pipelines, and new regulatory hurdles have depressed it. However, whether we like it or not medical expenses will continue to grow faster than the overall economy. Concerns over the nature of healthcare reform are already baked into stock prices; the downside risk should the worst case develop may be less than the upside should any final legislation prove less onerous. Many issues pay above average dividends.
Electric utilities have also been overlooked in 2009’s run up. Trading at the lowest valuations since 2003, investors lament their limited overseas exposure, profits limited by regulators, and demand constrained by the recession. However, in many cases their dividend yields exceed their bond yields, thus offering utilities the opportunity to save money by issuing more bonds to finance stock buy backs. If the go overseas trend reverses in 2010, expect solid performance from the sector.
The Federal Reserve’s injection of massive amounts of liquidity help engineer the markets’ stunning turn around in 2009. This pulled us back from the abyss of more major financial institution collapses and the most severe credit crisis since the 1930s. Time Magazine did not make a mistake when it named Fed chief Ben Bernanke as person of the year.
Let’s Sum It Up
The stock market could gain some 10% in 2010. Why is this possible? Investors are growing frustrated with hordes of money market and short term investments earning next to 0%. Fixed income has given them quite a ride in 2009; rates now are quite low and offer little further upside to offset their risk if interest rates rise. There are clear signs that the economy is improving, offering upside to companies’ earnings estimates.
>From a contrarian perspective that fact that Main Street has not embraced 2009’s rally is a bullish factor; markets generally don’t get overheated until the little guy goes all in and starts spouting stock tips.
Stocks in 2009: Who Would’ve Thunk You’d Make 25%
In retrospect, few thought the equity markets would return 25% in 2009. Fears of the worst financial crisis since the 1930s, residential real estate prices down by nearly a third, and unemployment soaring past 10%, the highest in nearly 30 years, made keeping your money in stocks, to say nothing of forecasting a double digit gain, well nigh impossible.
Indeed, the naysayers were well on their way to victory, as by March the S&P 500 hit a 12 year low, with the Dow dropping to close to 6500. However, the stimulus of Federal Funds interest rates at just 0% to 0.25%, February’s enactment of the $787 billion stimulus spending bill, and early reports that major banks’ operations had turned profitable caused stock markets to turn up. The initial disbelief and cynicism gave way to a grudging acknowledgement that the near 65% bounce off the March bottom by the end of 2009 was a classic case of the stock market acting as a precursor of better times ahead.
The distrust of the market is reflected in 2009’s cash flow figures for mutual funds. Nearly $20 was invested in bond funds for every $1 put into stock funds. This lopsided statistic is rare as generally stock funds garner more of investors’ cash. If fund investors get interested in stocks, this bull will have a longer life.
Bonds: On a Risk Reward Basis, Hard to Beat
At the start of 2009, “junk” bonds yielded close to 20% over comparable maturity Treasuries, while investment grade bonds sported spreads of nearly 7% over Treasuries. Bond investors who took advantage of those values earned handsome returns: Investment grade bond funds returned nearly 20%, while high yield funds scored profits of 50% or more; for example, Fidelity’s Capital & Income Fund, focusing on distressed debt, racked up a 70% total return.
If you can get equity like returns with less than equity like risk, that’s a superior combination. Bonds are less risky because their pay offs have priority over stocks’. Of course, with bonds having done so well in 2009, investors should not expect such stellar returns in 2010. Given that spreads of private sector bonds over Treasuries are still historically wide, bond investors may still expect a good year, although rising interest rates are a threat.
Did the Dollar’s Fall Cause Stocks/Commodities To Rise?
As markets rebounded from their 12 year lows the US Dollar fell, sliding 17% from early March. This begs the question, was the historic rise in commodities and stocks reflecting fundamental economic strength or merely a speculative flight from our currency? If the latter and the US Dollar is due for a rebound, investors should be cautious in embracing stocks and commodities in 2010.
No question, part of the run up does represent a shift out of the Dollar. That’s one reason to not expect 2010 to match 2009’s results. If interest rates rise in the United States, as a result of Federal Reserve tightening, an improving economy, or both, the Dollar will become more attractive. This will reduce the attractiveness of the “carry trade,” the practice of borrowing at very low rates in Dollars to make speculative bets in riskier assets.
Overseas Securities: The Best Game in Town Next Year?
The popular view a year ago was that the United States had more problems, including sinking real estate, skyrocketing unemployment, and capital challenged banks, than the rest of the planet. Investors feared the effect of our ultra easy money policies and the highest Federal budget deficits since World War II. Money flowed out of this country into both overseas stocks and bonds. Indeed, some of the most robust returns in 2009 with just a few weeks to go come from such markets as Brazil (+77.9%), India (+73.3%), and China (+71%).
While there are always a few overseas bourses that outperform ours, expect better relative performance stateside in 2010. Not all is better economically overseas, underscored by the Dubai World’s default on its debt and ratings agency downgrades of Greece’s sovereign debt. Meanwhile, clear signs of US economic strength, starting with a positive figure for Q3’s GDP and continuing with November jobs report, reporting the biggest improvement in US unemployment statistics in three years, may well direct more money to our shores. It’ll also bolster the Dollar.
Treasuries: Is All the Bearishness Justified?
Treasury debt has been a consistent and resilient performer over the last decade. Treasuries were virtually the only asset class to make investors money in the disastrous financial markets of 2008; they’ve only declined once in the last decade, as they are poised to finish up 2009 in the red.
Given their very consistent performance, nil credit risk, low volatility, and coming off a down year, we think they deserve an important spot in investors’ portfolios. First, with everyone expecting interest rates to rise, from a contrarian’s perspective you might be skeptical, which would benefit Treasuries. Second, even if rates rise as the economy improves, economic betterment is expected to be slow and muted, so its adverse affect on Treasuries is likely to very gradual. Inflationary expectations, another negative for Treasuries, appear well contained, according to the Federal Reserve.
Treasuries will be the clear winner should the economy “double dip”, meaning decline again, as they are free from credit concerns. So, offering strong protection should the economy weaken and relatively small risk if the economy strengthens, Treasuries should occupy a key role in most portfolios in 2010.
The Case for Stocks in 2010: The Least of Many Evils
While there are certainly many risks for stocks in 2010, including greater than normal valuations, uncertainties as to whether profits will live up to expectations, and concerns over the economy, investors must ask: If not equities then what? Bonds and cash are the other two major asset classes.
Both bonds and cash look much less attractive than they did a year ago. Cash’s return is close to zero; as confidence improves investors are likely to grow dissatisfied and impatient making next to nothing if other financial problems fail to surface.
Corporate and municipal bonds were extremely attractive a year ago, as nearly record spreads over Treasuries prevailed. Today, following double digit returns in 2009, they just don’t offer the value and are likely to attract fewer Dollars. Bonds could lose fans quickly if interest rates back up suddenly and bond funds suffer losses.
Stocks may attract a lot of interest in 2010 when investors starting making careful comparisons of their choices.
More Mergers and Acquisitions as Confidence Returns
The pace of corporate transactions has turned up. The latest example is Exxon’s bid to buy domestic natural gas producer XTO. Certainly, more merger and acquisition activity will prove a boon to the market: It validates market valuations, increases concentration in particular industries, and generates excitement and speculation as to future acquisition targets.
With borrowing rates still low and the stock prices of potential acquirers coming off their lows, look for more merger activity in 2010. Of course, whether any particular merger proves successful over the long term is more uncertain, as the history of growth through buying market share and other companies is quite mixed.
Are There Any Undiscovered Sectors?
We prefer stocks sectors that have lagged, offer solid fundamentals, and sport good dividends. If the Dollar gains strength and money flows back into this country, sectors that are primarily domestic may outpace multinationals.
Healthcare fits the bill. Trading at 20 year valuation lows relative to the overall market, investors have steered clear. Fears over healthcare reform, weak research and development pipelines, and new regulatory hurdles have depressed it. However, whether we like it or not medical expenses will continue to grow faster than the overall economy. Concerns over the nature of healthcare reform are already baked into stock prices; the downside risk should the worst case develop may be less than the upside should any final legislation prove less onerous. Many issues pay above average dividends.
Electric utilities have also been overlooked in 2009’s run up. Trading at the lowest valuations since 2003, investors lament their limited overseas exposure, profits limited by regulators, and demand constrained by the recession. However, in many cases their dividend yields exceed their bond yields, thus offering utilities the opportunity to save money by issuing more bonds to finance stock buy backs. If the go overseas trend reverses in 2010, expect solid performance from the sector.
