Identifying Short and Long Term Trends for 2010 - Part I
(December 30, 2009)
Dear Subscribers and Readers,
My business partner, Rex, and myself would like to take this opportunity to thank everyone of you for staying with us and staying the course despite the stock market panic in early March! We also want to wish all of you a great New Year's – I expect 2010 to be a “transition year” (more on this later) but I also expect a much smoother year – at least for the global equity market. I would also like to say “thank you” to our regular guest commentator, Mr. Rick Konrad of Value Discipline for his absolutely invaluable contributions to our main site, as well as to posters rffrydr and nodoodahs for their immense contributions and active participation our discussion forum. Please keep these new ideas flowing as we head into 2010, and as we attempt to navigate what will be an interesting transition period for the stock market and global economy over the next few years. Rex and I looking to serving you all in 2010 and beyond! Similar to last year (please see our December 28, 2008 commentary “Identifying Short and Long Term Trends for 2009 – Part I” and our January 4, 2009 commentary “Identifying Short and Long Term Trends for 2009 – Part II”), this commentary will be the first in our two-part commentaries where we will outline our investment and economic thoughts for 2010 and beyond. The second part of our two-part commentaries will be in your mailbox next weekend. For this commentary, I would like to summarize the performance of the U.S. stock market in 2009 and how I believe the U.S. stock market will perform in 2010 and beyond. Without further ado, let us now dive right in.
After declining 36.85% last year on a total return basis (its worst-performing calendar year since 1931 – utilizing data going back to the 1820s), the S&P 500 is up 27.71% YTD. All ten economic sectors within the S&P 500 were up on a YTD basis. Out of the ten economic sectors, the S&P 500 information technology index performed the best YTD (+61.0%), followed by Materials (+46.9%) and Consumer Discretionary (+40.7%). The worst-performing sectors were Telecommunications (+3.7%), Utilities (+8.4%), Energy (+12.2%), and Consumer Staples (+12.6%). On a more granular level, the best-performing industries within the S&P 500 YTD are Real Estate Management & Development (+219.44%), Internet & Catalog Retail (+199.75%), and Automobiles (+195.70%). Meanwhile, the worst-performing industries were Construction Materials (-23.04%), Commercial Banks (-10.70%), Thrifts & Mortgage Finance (-9.68%), Biotechnology (-7.64%), and Diversified Consumer Services (-7.24%),
The severe stock market decline in 1931 was preceded by the Bank of England leaving the gold standard, resulting in a general drain on gold reserves in both the US and other major countries. As a result, the Federal Reserve was forced to raise the discount rate from 1.5% to 3.5% in a sinking global economy in order to stem the gold outflows. This confluence of events set off a severe banking crisis and a crash in the U.S. stock market. While bank failures across the country averaged 100 a month during 1930, it rose to a monthly average of 320 from September 1931 to February 1932. The Dow Industrials and the S&P 500, meanwhile, both declined approximately 30% during September 1931 – its worst monthly decline in history as the country crashed into the Great Depression. In early March 2009, many investors were getting similarly apocalyptic. Expectations for the nationalization of Citigroup and Bank of American were in full swing – fueled by scare tactics of the mainstream media and doom-and-gloom bloggers who professed to be experts on the U.S. financial sector and who were equally apocalyptic on the long-term potential of the U.S. economy. At the time, we stated that the argument for nationalization for Citigroup or Bank of America was non-sensical from a fundamental, political, and sentiment standpoint. In our March 8, 2009 commentary, we stated:
With the latest decision by the US Treasury and other investors to convert their Citigroup preferred holdings into common equity, the issue of more dilution for Citigroup is off the table, for now (note that the above stress test utilizes December 31, 2008 data and thus does not include Citigroup's just-announced preferred swap for common equity). Subscribers should also note that the US Treasury has “ring-fenced” in more than $300 billion of Citigroup's assets, or as much as 22% of their most risky loans and securities. Similarly, the estimated capital shortfall at Bank of America is not inevitable either. As of December 31, 2008, Bank of America was still holding a significant chunk of restricted stock on China Construction Bank - which is not officially counted as tangible equity on its balance sheet. Combined with a significant portion of super senior MBS that the firm has written down but will most likely be paid over time, Bank of America is probably understating its common equity by around $8 to $9 billion. In addition, there are also other assets that Bank of America could sell, such as a $3 billion stake in First Republican Bank. Finally, even if the government decides Bank of America needs a capital infusion, Morningstar estimates that it would result in only a 12% dilution for shareholders, while Goldman Sachs estimates a 19% dilution. In other words, I do not believe we are anywhere close to bank nationalization. And with the most attractive valuations in over 25 years, the oversold condition in the stock market, the numerous positive divergences that we discussed in the last two weeks, and investors starting to take advantage of valuations in riskier asset classes, I believe we are now in the midst of the greatest buying opportunity of our generation. Moreover, many institutional investors (such as pension funds) are now seriously underweight their target equity allocation, and will most probably rebalance back into equities (from mostly fixed income) over the next few months. For now, we would maintain our 125% long position in our DJIA Timing System.
From a political standpoint, I mentioned that the argument for a nationalization was a non-starter as such a decision would be a PR disaster for foreign investors (i.e. the Singapore and Middle Eastern sovereign wealth funds) who had injected much-needed funds into these two banks through both preferred and common equity. Such a move would discourage foreign investment for years to come. In addition, it makes no sense for the U.S. Treasury to nationalize them given that it had promised to “ring-fenced” in more than $300 billion of Citigroup's and $100 billion of Bank of America's assets just weeks earlier. From a sentiment (and from an investor's standpoint), a nationalization would also be a disaster, as this will further confirmed investors' fears that assets or companies could be expropriated by the U.S. government at will. Note that such fears were rampant after Freddie Mac and Fannie Mae were put into conservatorship without warning – fears that spiraled into a further decline in risky assets and which ultimately led to a “global bank run” that triggered the bankruptcy of Lehman just a week later.
While such fears were definitely justified during the dark days of September and October of last year, the chances of a global financial system collapse were significantly less by the time March 2009 came around. The Federal Reserve, the U.S. Treasury, and all the world's major central banks were – by that time – getting on top of the situation by helping to “back stop” all the world's major financial systems and cross-guaranteeing all the major currencies. More importantly, the political will to do more to back stop the system was still there – not just in the U.S. but across the world as well (including the Euro Zone, China, Japan, and the U.K.). In Part I of our outlook last year, I stated that each of us could take our own lessons from the Great Crash of 2008. While we all understand deep down that investing in stocks is a risky endeavor, many of us underestimate our propensity to stick to our disciplined investment plan when the going gets tough. As John Pierpont Morgan says of the stock market many years ago: “It will fluctuate.”
It has always been most important to learn and understand our own psychological makeup and how it affects our investment or trading decisions over the years, especially during tough times. What type of person are you when it comes to the market? Does your psychological make-up allow you to take short-term but significant losses in the hope of long-term and outsized investment gains? More importantly, are you an independent thinker or merely a follower? During the tough September to October 2008 period, as well as March 2009, I have received many emails from subscribers asking for advice or guidance – from the disciplined 25 year-old who shifted some of his bond holdings to stock index funds in his 401(k) plan during the decline to the retiree who was speculating on the stock market with leverage and trading financial ETFs with two times leverage. More often than not, it is the 25-year-old with the disciplined asset allocation and a long-term plan who will prosper in the long run. In order to succeed in investing, you need to understand your own risk tolerance, have a long-term plan, and have the right expectations for your investment strategies. This will not only ensure that you will not sell your stocks at the worst possible time, but that you will not be taken out by large losses. More importantly, assuming you have a proper asset allocation to begin with, you will be able to utilize any decline as an opportunity to put more of your investments into equities to take advantage of the great companies that are selling at large discounts to their historical valuations.
I also asked our subscribers to is to read or re-read Peter Lynch's “One Up on Wall Street.” Not only does the book tell you some common sense ways to beat the S&P 500 and professional money managers through individual stock picking, it also discusses if you should invest in equities or buy individual stocks in the first place. Again quoting the same passage I quoted last year:
Before you think about buying stocks, you ought to have made some basic decisions about the market, about how much you trust corporate America, about whether you need to invest in stocks and what you expect to get out of them, about whether you are a short- or long-term investor, and about how you will react to a sudden, unexpected, and severe drops in price. It's best to define your objectives and clarify your attitudes (do I really think stocks are riskier than bonds?) beforehand, because if you are undecided and lack conviction, then you are a potential market victim, who abandons all hope and reason at the worst moment and sells out at a loss. It is personal preparation, as much as knowledge and research, that distinguishes the successful stockpicker from the chronic loser. Ultimately, it is not the stock market nor even the companies themselves that determine an investor's fate. It is the investor.
For those that sold out during October 2008 or March 2009, it is probably best to reevaluate one's risk tolerance and determine whether investing in stocks (and if so, how much) is the right thing for you to do in the first place. If not, one will always play victim to the stock market – whether it's selling out at the bottom or buying at the top. To succeed as an investor, one must use the market cycle's to one's advantage – or at the very least, be able to simply stick to a disciplined buy-and-hold plan.
Similar to last year's Outlook, I want to recommend a book that is timeless and that is also relevant for the current times. One such work is “Keynes: The Return of the Master” by John Maynard Keynes' official biography Robert Skidelsky. The book traces the evolution of economies and critiques how the “Neoclassical School” of economics has hijacked the field and why it is no longer as relevant for the current times. In doing so, he also brings back and provides a straight-forward clarification of many of Keynes' ideas, such as those involving deficit spending, the gold standard, inflation, and general government intervention. Folks who have not read Skidelsky's biography on Keynes or Keynes' “General Theory” should definitely read this book – as one cannot truly understand Keynes economic philosophy and ideas through the mainstream media or bloggers who misrepresent his ideas.
On the same note, another book I would recommend is “The World Philosophers: The Lives, Times, and Ideas of the Great Economic Thinkers” by Robert L. Heilbroner. Now in its seventh revised edition, it was first published in 1953, and is the second-best selling economic text of all time (with over four million copies sold). The brilliance of the book lies in its straight-forward summaries of the various schools of economic thought from that of Adam Smith, Ricardo, to Marx, Keynes, and Schumpeter. The book also traces the evolution of modern economics through the lens of these various schools – and provides a critique of the flaws inherent in each one. This book provides a basis for understanding how modern economics has been shaped – and a good basis for policymakers and/or armchair economists on thinking how the U.S./global economic system could be reshaped post the 2008/early 2009 financial crisis.
Our 2010 Outlook for the U.S. Stock Market
Both our short-term and long-term outlook for the U.S. stock market have not changed. Over the next several weeks, we believe the U.S. stock market is still in “consolidation mode,” given the short-term overbought condition of the stock market (the Dow Industrials is more than 15% over its 200-day moving average), and given the general lack of upside breath and volume since mid-October (although as we should point out, the NYSE Common Stock Only Advance/Decline Line just made a new bull market high). From a sentiment standpoint, the U.S. stock market is also slightly overbought – the 10-day moving average of the equity put/call ratio currently stands at 0.61, while our proprietary sentiment indicators are also at near overbought levels (the VIX also closed below 20 for the first time since mid May 2008).
In the longer-run, however, there is no doubt that both retail and many institutional investors (such as defined benefit pension funds) remain hesitant on equities, especially U.S. equities. For example – despite experiencing one of the greatest rallies since early March – investors still yanked a net $1.9 billion of cash from equity mutual funds YTD (till the end of October). Meanwhile, bond mutual funds took in a net $253 billion (Bill Gross' PIMCO Total Return Fund has over $200 billion in AUM and is the largest mutual fund in the world). In other words, investors simply do not want to be owners of some of the greatest global businesses created since the dawn of the Industrial Revolution, despite record low interest rates, a stabilization of the global financial system, and the ongoing industrialization of emerging market countries such as China, India, and Brazil.
Over the course of the next 12 to 18 months, I expect investors to become more bullish on U.S. equities. On a technical basis (as we have illustrated many times before), there are no signs at all that the cyclical bull market that began on March 9, 2009 has topped out. All the classic signs of a top – such as rampant retail investor bullishness, a weakening in upside breadth (as exemplified by a weakening of the NYSE Common Stock Only A/D Line), extremely high valuations/corporate leverage, and a tightening Fed – are simply not there. Moreover, Lowry's proprietary Selling Pressure index just sank to a new rally low – suggesting that institutional investors are becoming more reluctant to sell their equity holdings en masse – and thus confirming the ongoing uptrend in the U.S. stock market.
On a valuation basis, the U.S. stock market is now fairly valued. For example, the price-to-book ratio of the S&P 500 stands at 2.5 – just slightly higher than the 32-year average of 2.4 (we've also mentioned that the book value of many companies in the S&P 500, such as Microsoft and Amgen, may be understated as R&D spending is treated as an expense and not capitalized on the balance sheet). In addition, the cyclically-adjusted P/E ratio of the S&P 500 (using today's price divided by the 10-year trailing EPS of the S&P 500), is currently at around 16, just slightly lower than the 80-year average of 16.7 (per Goldman Sachs). At the bottom in early March 2009, the cyclically-adjusted P/E ratio sank to just 9.9 – its lowest level since early 1985 (at the bottom of the 1982 bear market, it sank to just 6.2). The following chart courtesy of Goldman Sachs and Robert Shiller shows the progression of the cyclically adjusted S&P 500 P/E ratio from December 1927 to the present:
Given the strong support being provided by the world's major central banks, decent valuations, and strong demand/momentum in U.S. equities, I believe 2010 will again be an up year for U.S. stocks. Given the short-term overbought conditions of the stock market, as well as ongoing troubles within the European banking system (including the “marginal” countries of Spain, Ireland and Greece) and the U.S. commercial real estate market, I believe investors will continue to be cautious over the next three to six months. In addition, there's no doubt that Chinese residential real estate prices are now reaching bubble territory. Combined with the lack of visibility on the innovation front, 2010 will most likely be a transition year for the U.S. stock market. My sense is that stock market returns (as measured by the Dow Industrials and the S&P 500 will be relatively tepid in 2010 (at least compared to 2009). While I believe 2010 will be an up year, I don't believe the Dow Industrials will close 2010 at 12,000 or higher.
Over the next two to three years, I continue to expect the Dow Industrials to trade in a range of 10,000 to 14,500. With the exception of various “Black Swan” events such as a major regional war or a major terrorist event, the March 9, 2009 low was the bear market low. At some point in 2012 to 2015, my research shows that the next era of Schumpeterian growth will finally arrive. The development and commercialization of such a technology (or technologies) will have a similar impact on U.S. economic growth as that of the development and/or spread of the U.S. canal system, the railroads, the telegraph, electricity, refrigeration, the automobile, radio, penicillin, the transistor, television, the personal computer, and the internet. Possible candidates include advances in fields such as biotechnology (customized therapies based on genetic sequencing, stem cell therapies for treatments of Alzheimer's, etc., various anti-aging therapies, etc.), nanomaterials (stronger and lighter materials such as carbon nanotubes, or better conductors, etc.), and alternative energy (more efficient solar panels that could put solar power at “grid parity,” commercialization of cellulosic ethanol and the discovery of second-generation biofuels that could put nuclear power to shame). This next wave of Schumpeterian growth will drive the next great bull market in U.S. stocks, venture capital, and private equity investments.
Our 2010 Outlook for the U.S. Economy
None of the technologies discussed above will allow the U.S. or the global economy above our 20-year historical average for a sustained period of time, but they will definitely allow the global economy to sustain a 3% to 5% growth rate at least for the next decade, or two. In the short-run, U.S. economic growth will still be dictated by the deleveraging of U.S. consumers' balance sheets, as well as pressure on the Obama administration to rein in the federal budget deficit. While U.S. real GDP growth in 4Q 2009 should be at 4% or over (due to the fiscal stimulus as well as inventory restocking), my guess is that U.S. real GDP growth in 2010 will be below-trend at 2% to 3%. Most likely, U.S. real GDP growth in 2010 will peak in the first half of the year, and decline gradually in the second half as the impact of the $787 billion fiscal stimulus plan starts to wear off.
I expect the U.S. unemployment rate to peak in the 10.3% to 10.8% range sometime over the next 12 months. The deleveraging phase is still in motion and should continue to hit the industries/sectors that have excess capacity or that have misallocated capital in the last few years – including many companies in the retail, lodging, and restaurants industries. Commercial real estate should also continue its deleveraging phase in 2010 – taking commercial real estate prices along with it. The graduation of the 2010 MBA and undergraduate class in the summer promises to increase the unemployment rate still further – as the number of unemployed and “yet looking” will no doubt increase at that time (similar to what happened last year). That said, many companies are starting to hire again. Another bright side is that many bright students in the natural sciences and engineering fields will choose to get their PhDs and stay in their fields, instead of heading to Wall Street. More monetary and talent research in the basic sciences and technology sectors will drive Schumpeterian growth yet further. However, neither this nor the fiscal stimulus plan would benefit the uneducated retail worker or mortgage broker who have been laid off over the last two years.
What is the Next Shoe to Drop?
While we have discussed incessantly the systemic risks that could emulate from the European banking/financial system, the U.S. commercial real estate market, and the disastrous state of U.S. state and municipal finances, folks should not forget about China. Note that both the Chinese stock market and the Chinese economy led the world out of its current slump early this year. As the Chinese economy's impact on global economic growth enlarges, we must be more vigilant than ever on tracking the Chinese economy.
As Chinese real estate prices reaches bubble territory, the Chinese government has been trying to cool it down to no avail. The major surprise in 2010 could be an unexpected tightening in Chinese monetary policy, as well as a much-reduced rate of capital/infrastructure spending. While this will no doubt have an impact on global equities, Chinese equities, and the Chinese economy, one asset class that could get hurt the most is commodities – as much of the rally in commodities over the last six years has been tied to the story of ever-increasing Chinese demand. If Chinese real estate prices bursts and spirals out of control, then this could emerge as a major source of systemic risk next year. For now, we will continue to monitor the situation in China. In Part II of our 2010 outlook, I will devote some space to the Chinese economy.
Until then – we wish you a great and happy New Year's and a prosperous 2010!
Henry To, CFA