Predictions for 2010

Eric Linser, CFA | Jan. 25, 2010

It is the time of year when market pundits offer predictions for how the coming year will pan out. Such forecasts should always be taken with large grain of salt, given the dynamic nature of markets and the inherent unpredictability of the future. Moreover, successful investing requires flexibility, humility and openness to a range of possible outcomes. This mindset is particularly important in the present environment, given the enormous uncertainties investors face.

Among them:

• What are real underlying economic and market conditions, absent government life-support measures?

• What is the capacity for government debt expansion before bond markets revolt and demand much higher interest rates?

• How will the markets react when the Fed winds down its “quantitative easing” operations and moves off of its zero percent interest rate policy?

• Has the housing market really stabilized, or will there be another leg down, driven by higher mortgage rates and continued defaults and foreclosures?

Major uncertainties such as these make it difficult to assign a very high level of probability to any particular market forecast. Rather than have an entrenched point of view or set of expectations, it is preferable to think about the markets in terms of multiple potential scenarios; assess new information on a continuous basis; and adjust one’s investment posture accordingly. That said, we (humbly) offer the following predictions for 2010.

Stocks Have More Upside, Which Will Probably Be Realized Over The Next Several Months, But That Could Set Up A Selling Opportunity

The uptrend is arguably still intact, and there is not yet sufficient objective evidence to “fight the tape.” The stock market rarely tops out when:

• Market breadth and all the major indexes (domestic and foreign) are in gear on the upside; and

• Monetary policy remains extremely friendly.

Until bearish evidence accumulates, the bull market should be given the benefit of the doubt. We are reluctant to speculate as to how high the stock market could go, or how long it will keep rising. For the time being, we don’t see any significant signs (other than frothy investor sentiment) that the liquidity and momentum-driven recovery in stock prices won’t persist into the first half of 2010.

At some point during the course of the year, we anticipate a sharp stock market sell-off, which could meet the bear market threshold of at least a 20% peak-to-trough decline. In other words, we are inclined to expect that the cyclical bull market that started in March 2009 will expire in 2010. However, we are not entrenched in that view, and will take it one week and month at a time; it’s a risk that “bears” watching.

Our lack of comfort with the economic and stock market recovery is based on its artificial and unsustainable underpinnings. Multi-trillion dollar deficits, zero percent interest rates, subsidies, bailouts, Federal Reserve asset purchases—these extraordinary measures arrested last year’s deflationary spiral, and have succeeded in reflating asset prices, but where do we go from here? The scope of monetary and fiscal stimulus that was put in place in 2009 cannot be sustained. It remains to be seen how much of it is withdrawn, and what effect that will have on markets and the economy. Our sense is that markets will suffer when the government begins to withdraw stimulus, because underlying economic conditions remain fragile. Alternatively, if the government attempts to maintain the level of fiscal and monetary stimulus now in place, inflation fears will escalate and markets will be threatened by much higher levels of interest rates.

Earlier in the rally, investors were compensated adequately for bearing the above-average risks of the present environment, because stocks and bonds were attractively valued. Now, after the huge rallies that have occurred, valuations are no longer attractive in an absolute sense, only relative to abnormally low short-term interest rates.

What are some indicators to watch for signs that the bull is exhausted? On the technical front, we would expect to see deterioration in market breadth and a breakdown in relative strength in leadership groups like technology and emerging markets stocks. Investor sentiment, which moves in the direction of prices, has recently moved towards a bullish extreme, but there is room for positive sentiment, especially among individual investors, to increase further. The narrowing of credit spreads has been a very bullish indicator for the stock market, and spreads are currently near 52-week lows. We would expect rising credit spreads to serve as an early warning mechanism for weakening economic conditions, renewed stress in the banking system and debt markets, and a reduction in investor risk appetite (all of which would clearly be negative for stock prices). A rise in the 10-year Treasury yield above 4.25%, which would violate a key resistance level in yields (see chart below), would be a significant negative for housing and the stock market.

Global Equities Will Remain Highly Correlated

We expect the pattern of recent years to continue in 2010. Global stocks will tend to move in the same direction, and investors should not expect much diversification benefit (in terms of reducing downside risk) from investing in foreign stock exchange traded funds (ETFs). Returns on US stocks, after adjusting for currency movements, should not diverge significantly from the performance of foreign developed markets as measured by the broadly defined EAFE index. Given that the US dollar looks like it has bottomed relative to the euro and the yen, the S&P 500 has a good chance to outperform the EAFE index (in dollar terms) this year.

Emerging markets will remain a high-octane play on the global recovery and reflation theme. If the bull market continues in 2010 and stocks finish the year higher, emerging markets will likely have another year of outperformance relative to developed markets. Conversely, if bear market conditions return, emerging markets indexes will be vulnerable to deeper corrections. Emerging markets face heightened risks from protectionism, which is a growing threat given chronic unemployment in developed countries.

Gold Will Consolidate For A Few Months Before Starting Its Next Move To The Upside

Gold is ripe for a pullback after a 33% rally from July to early December. Our sense is that gold will settle into a trading range for a period of time, with the upside defined by the December high at $1,225 and downside risk limited to $1,000 to $1,050. The US dollar appears to have put in an intermediate-term bottom in early December. Pessimism towards the dollar became excessive, and debt problems in Europe reminded investors that the dollar is by no means the only troubled currency. If the euro remains under pressure for a period of time, gold will have a hard time making much upside progress, since the two markets have had a fairly high positive correlation. However, gold is in a strong secular bull market and may well decouple from the euro and resume its advance earlier than we expect. Over an intermediate-to longer-term horizon, we continue to be bullish on gold and precious metals. Driven by demand both from private investors and emerging market central banks, we expect gold to reach $1,500 at a minimum over the next two to three years, and it could potentially trade much higher if speculative dynamics really take hold.

Treasury Bonds Will Have Another Year Of Negative Returns

2009 was the worst year for long-term Treasury bonds in 40 years, as the yield rose from 2.69% to around 4.64%, punishing investors with a 21% loss. The only maturities of Treasury debt that didn’t lose money last year were under three years. We expect 2010 will be another disappointing year for investors in US Treasuries. There will likely be periodic counter-trend rallies in longer-term Treasuries, brought about by economic growth scares and stock market downdrafts, but large deficits now appear to be the norm, for the foreseeable future. The US ran a deficit of ~ $1.4 trillion in 2009, and now the Treasury needs to refinance $2 trillion worth of short-term debt in 2010, in addition to $1.5 trillion of new debt – a certain recipe for higher interest rates.

We think it will be hard to make money in 2010 in other areas of the bond market as well. 2009 was an extraordinary year for investors in riskier debt, because we began the year with historically cheap and compelling valuations. Then, the Fed threw a protective blanket over credit markets with quantitative easing, debt guarantees, and a commitment to a zero percent interest rate policy. As a result, riskier classes of debt had massive rallies in 2009.

However, the situation today is much different. Treasury yields are rising. The Fed is preparing to withdraw from its quantitative easing operations starting at the end of this quarter, and may soon signal a move away from zero percent interest rates. Credit spreads (corporate bond yields relative to Treasuries) have fallen back to levels seen during healthy economic times, offering little margin of safety. Investors face near-zero returns on money markets, but that is preferable to losing money, which is a very real possibility in many areas of the bond market.

A number of risks loom for the housing market in 2010, and the possibility of another significant (that is, 5% to 10%) drop in prices should not be discounted. In the past month, 30-year mortgage rates have jumped nearly a half percent. This move up in rates is already putting pressure on housing activity, as reflected in recent mortgage application data, and will also have a negative effect on home prices. Mortgage rates are likely to continue to rise in 2010 given the downward trend in Treasury bonds and the Fed’s intention to wind down its direct purchases of mortgage-backed securities, which totaled over $1 trillion last year.

Fragile conditions in the housing market remain a key risk for the economy, the banking system, and the stock market in 2010. Sales activity has been stronger in recent months and prices have firmed in most parts of the country, but recent positive trends in housing may turn out to be a temporary reprieve, created by government home purchase incentives and the spike down in mortgage rates that occurred last fall.

In addition to the risk of higher mortgage rates, the home price outlook remains clouded by an overhang of existing home inventory, which may get worse in 2010 as a result of foreclosures. Approximately 14% of homeowners are currently delinquent on their mortgages or in foreclosure. This is the highest level ever recorded by the Mortgage Bankers Association. Moreover, high levels of mortgage defaults and foreclosures may continue in 2010 as a result of:

• 15 million mortgages (23% of US home loans) being in a negative equity position; and

• Another wave of adjustable-rate mortgage resets.

It is a fair assumption that a large percentage of the loans that will reset this year are “under water,” because they were taken out towards the tail end of the housing bubble, when prices were most inflated. There is a high correlation between “under water” mortgages and default rates because borrowers have less incentive to make their payments if they are in a negative equity position. Interest rate resets threaten to aggravate the problem of defaults and foreclosures if the amount of the mortgage payment is increased, which is typically the case in a reset scenario.

Renewed weakness in home prices in 2010 would be a significant negative for the financial markets, because it would create new problems for the financial sector, and place addition stress on household balance sheets, which would in turn depress consumer confidence and spending.

Asset Class Returns in Review

Looking Ahead

What to do? Don’t swing for the fences, nor cower in fear. The key to successful investing is building out a well diversified portfolio that aligns to your goals and time frame. Read our article “Ingredients for Your Investment Pie, Slice by Slice” for our big picture themes for 2010. Getting the direction of trends right can be critical to the overall performance of your portfolio. You can help ensure that you are on track without having to do all the position-by-position heavy lifting with a portfolio review. Call or email us to discuss your goals and objectives so we can help determine the appropriate investment mix for you.

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