Looking Ahead to 2010

History suggests that the stock market leadership of this year is likely to give way to a new crop of outperformers in 2010. There is no doubt that the energy, materials, industrial machinery and equipment, and transportation sectors, which have been the leaders since the March lows, will continue to do well next year, as revenues begin to accelerate and profit margins increase, leading to well above average earnings gains. That said, investors need to recognize that the strong performance of these groups since the market lows has already discounted some of that expected profit performance over the next year or two.

Our Exit Strategy

Since March of this year all the stock markets of the world have been in a new bull trend. Even after a gain of 60% from its capitulation low of 666 on the S&P 500, U.S. equities are still reasonably valued and right in the “sweet spot,” the period of strongest appreciation in any bull market. Indeed, history shows that during the first nine to twelve months of a new bull market, the broad market indexes typically achieve from one-half to two-thirds of their ultimate gain over the cycle. The reasons for this are really quite straightforward. Monetary policy has become extremely stimulative, and at the same time, households and businesses are both paying back their borrowings. There is little in the way of private sector demand for credit. Accordingly, the resulting surplus liquidity needs to find a home, and financial assets are always the logical first stop. The second factor is that after a lag of a year or so from the time monetary policy becomes stimulative, the economy bottoms out, and the outlook for economic recovery and ultimately expansion, becomes more clear. This is now happening on a global scale. Indeed, the economies of Europe, Asia and Latin America are already ahead of the U.S. in terms of recovery. This fact is not lost on those of us who have concentrated our equity investments on multinational U.S. corporations as the most efficient way to participate in economic growth abroad, particularly in the major emerging economies. The “sweet spot” is also fueled by massive short covering and the participation of relatively sophisticated day traders.

Doubters And Skeptics, Go Ye Forth And Multiply

At its annual Partners Dinner the late Leon Levy, Senior Partner of Oppenheimer & Company, always welcomed those newly admitted with the words, "You don't know how lucky you are to become an owner of a business in which the higher the price of the product, the more people want to buy it."  We recall those words every day as we encounter the trauma among wealthy investors, whose real estate and stock portfolios have plunged by an aggregate of $14 trillion over the past two years.  That loss has been unparalleled in human history.  This has been a "Rich Man's Recession and Bear Market" unlike all previous post-war contractions.  Of course, a 10% unemployment rate (15% if one counts the discouraged and the underemployed) has exacted considerable pain on the middle class in America.  This is reflected in a jump in the personal savings rate from virtually zero up to a current range of 5%-6% and is likely headed higher as people struggle to whittle down their debt while enduring a torrent of residential mortgage foreclosures. 

A memo to my friend, Larry Kudlow

On your terrific nightly show, THE KUDLOW REPORT, which I have the privilege of appearing on from time to time, you present regularly a wide array of investment experts who offer advice to your viewers which, in my opinion, is often counterproductive.  Of the approximately 7000 publicly traded companies in the U.S. only a small fraction, less than 5%, are interesting investments at any point in time.  Yet if one listens to all the experts over a month or so, nearly all industries get a recommendation.  Of course, much of the show's dialogue is framed as a debate between opposing points of view, one bullish, the other bearish.  By itself, this is an excellent format, but my critique is based on the fact that most of your guests state their views (a) with only a very short-term, trading-oriented perspective, which in this volatile environment often runs a high risk of whipsawing the viewers, and (b) these experts demonstrate insufficient respect for market-based indicators, which I think you and I agree are far more important in interpreting the present and predicting the future than the opinions of "experts" based on essentially static analysis.  Those pundits who recommend specific investment actions according to analyses that do not give proper weight to such market-based indicators as currency exchange rates, commodity prices, interest rates, etc., are doing your viewers a disservice.  Indeed, all market-based indicators are PRICES, the prices that real people pay in real transactions in the real world.  They occur in real time and are never retroactively revised.

Progress is Our Most Important Product

In the wake of a 26% rally in the S&P 500, the strongest four weeks since 1933, which has taken the index up to its downward trending 100-day moving average line, the overriding question remains:  Was it merely a bear market rally with all the attendant vulnerabilities to follow, or have investors witnessed the beginning of a sustainable bull market in equities?  My bottom line is that the fundamentals are moving in the right direction, but they are not yet strong enough to sustain a bull market, especially in view of the severity and after effects of the worst credit crunch and global recession in modern history.  However, I do believe that a durable double bottom occurred on November 21st and March 9th marking the lows for this bear market.  A great many risks remain, but many "second derivative" metrics are turning less negative.

The Square Root of Recovery

Unfortunately, no one rings a bell to announce the inflection points in either the economy or the stock market.  In our work, in order to get an early jump, we track a number of early-cycle, market-based indicators including various agricultural commodities, several base metals, the Australian Dollar, the Baltic Dry Freight Index, the yield on the 2-Year Treasury Note, etc., etc.  Although each of these experiences significant fluctuations on both an intra-day and a weekly basis, all of them have been in unmistakable uptrends since late last Fall.  In addition, Ed Hyman’s ISI firm surveys a broad mix of companies each week to see how they view their businesses.  These surveys are starting to show a tiny improvement, albeit from very depressed levels.  Also, the four week moving average of unemployment claims has turned lower, several Regional Federal Reserve bank business surveys have improved in January, December sales of existing homes rose 6.5% on a month-to-month basis, reflecting lower prices as well as improved availability of financing.  These signals should not be ignored.

A Fool and His Money are Soon Parted

Recently, a lady friend told us about an acquaintance of hers who had lost everything in the Bernard Madoff scandal.  I replied that it was astounding to me that anyone would invest all of his financial assets with only one manager, particularly one who refused to discuss his methodology, and who acted also as stockbroker, fund administrator, and custodian.  The lady replied, "What's a custodian?"  Therein lies the root of the problem.  Many people who have accumulated wealth in fields other than finance and who now require management of their financial assets rarely have sufficient understanding of either the vocabulary of Wall Street or the workings of the investment management business.  About a decade ago, we were given a summary explanation of Madoff's strategy by one of his investors, and we quickly concluded it would be impossible for this method to produce consistently positive returns regardless of prevailing financial market conditions.  For so many investors to have accepted it on faith seemed incomprehensible.

The End of the Beginning

·        Despite a strong rally last week, October was one of the worst months in history for the S&P 500, which declined (16.8%).  The (32.8%) year-to-date decline in the Index includes reinvested dividends. The MSCI EAFE Index is down (43.5%) for the year-to-date, and most Emerging Market indexes are down more than 50%, including China, which is off 67%.

·        Although politicians maybe reluctant to use the “R” word, there is no doubt the U.S. is in a steep recession.  Real GDP in the fourth quarter is likely to contract at a 5% annual rate or worse.  The current period is experiencing the steepest fall in economic activity, as the credit crunch is in full force.  Most banks have belatedly tightened their lending standards.

The Best Values Coincide With The Greatest Panic

The public at large seems to have recently discovered what professional investors have known for some time, namely that as a result of the credit crisis and resulting deleveraging process, the global economy is now in a serious recession, with falling asset prices, rising unemployment, declining consumer and investment spending and a drop in world trade.  As a result, stock prices everywhere are in a free fall, as both panic selling and forced liquidation have encountered a buyers’ strike on the part of those investors still flush with cash reserves.  Stock prices are well into the overshoot phase of the bear market, as irrational fears of a deflationary spiral are in control of investors’ emotions.

The Owl Of Minerva

"The Owl Of Minerva Spreads Its Wings Only With The Falling Of The Dusk" -Hegel

With apologies to those who have been kind enough to read my previous memos, I offer the following, a good deal of which is repetitious but with greater conviction.

The U.S. economy is in recession. Unlike all previous post-war recessions, which have been caused by a tightening of monetary policy to combat inflation, the current recession has developed because of the bursting of a massive credit bubble. Although this started in the subprime mortgage market, it has spread, to one degree or another, into other mortgage categories, as well as to auto loans and credit card loans, where delinquencies and write-offs are now rising. Along the way, the banks have been forced to write down nearly $500 billion of securitized loans and other assets, and have tightened lending standards as they aggressively raise new equity capital.