Saturday, 3 January 2009

Themes and Predictions for 2009

Firstly lets have a look at predictions I made at the beginning of last year.

  • The All Ords will not do as well in 2008 as it did in 2007.
  • The Nikkei will do better.
  • The Hang Seng will do worse.
  • Shanghai will do worse.
  • The US indices will put in negative returns.

Obviously the prediction for the Nikkei turned out to be way of base, down -11% in 2007 followed by a -42% decline in 2008. All other predictions were right, but to be fair one really can't claim a great degree of accuracy by saying the XAO would do worse in 2008 than 2007 given the -43% decline in the XAO in 2008 compared to a rise of 14% in 2007. However I will take credit for the call on the US given that Wall Street overwhelmingly saw the S&P500 rising in 2008.

So what will 2009 bring? Before making predictions for next year, lets take a look at some of the themes that will, in my opinion will be dominate in 2009.

Deflation to persist
Deflation reared its head in 2008 as predicted. However even in the midst of the biggest deflationary unwind since the great depression economists and market pundits continue to talk about inflation. With the Fed at 0% and seemingly printing money hand over fist it might seem like a fair call. However, notions of inflation are premature.

Few seem to remember that Japan embarked on one the biggest monetary expansions in history during 'the lost decade' and inflation was nowhere to be seen. Consensus seems to be that the treasury market is the last remaining bubble and they might be right. However, consider that the last time 10 year US treasuries went below 3% they stayed there for 24 years. That is worth thinking about in comparison to all the chatter you currently hear about buying property now because interest rates won't stay this low for very long.

While the RBA was flapping on about inflation I was talking about the RBA cutting rates to 3.0%. Now that the RBA has cut 3 full percentage points from the official cash rate in the second half of 2008, I'm probably on the high side, don't be surprised to see the RBA cash rate with a 2 handle on it. The futures markets have priced in 2.5% by mid 2009, that sounds about right to me, with the caveat that there is risk to the downside.

China will NOT save us
The myth that Australia is somehow insulated from the global recession because it digs up rocks and sends them to the fast growing Chinese economy will be completely shattered if it hasn't been already. Economists are forecasting the Chinese economy to slow to a growth rate of around 7 - 8% in 2009, I find that far too optimistic giving the growing signs of a sharp slowdown in the Chinese economy.

The myth of decoupling has been replaced by the reality of recoupling. The Chinese manufacturing sector has contracted for five straight months, not a good sign for an economy that relies on manufacturing for more than 40% of its output.

How will a Chinese economy growing at 2 - 4% affect commodity prices and the Australian economy? That is the question that investors should be asking rather than clinging to the hope that China will plow through at an 8% run rate in the face of a global recession.

US 2nd Half Recovery that will not be
Remember the second half recovery of 2008 that never was? Well the consensus view of economists and market pundits are predicting another second half rebound in the US economy in 2009. For the record, I believe most economists should be viewed as a source of light entertainment rather than any credible source of information. Thus the consensus can be almost always ignored but it is not enough to be a contrarian just for the sake of it.

The consensus view is that the monetary measures undertaken by the Treasury and the Fed combined with the pending fiscal stimulus will help the US economy climb out of the doldrums. It was also the consensus view if you recall, that the fiscal stimulus of rebate checks would get the economy back on track last year. It was also the consensus view at that time that the US economy was not in recession although it had been for 6 months.

The stimulus will take a long time to get off the ground and will have the effect of cushioning the recession rather than restoring growth. Unemployment in the US will continue to rise toward 9% during 2009 as the economy weakens further under pressure from a financial system on life support, a weakening global outlook and the continuing retrenchment of consumer spending.

One economist that has been worth listening to is Martin Feldstein. He was in front of the Fed in mid 2007 telling them that they were going to be cutting interest rates and was well ahead of the pack on the recession call.

Click on the image below for his latest interview on CNBC in which he expresses the view that we will be lucky if the US economy is turning up by this time in 2010.

Martin Feldstein
Martin Feldstein

US Earnings weaker than most expect
With just one quarter to go, S&P500 Operating Earnings forecasts for FY08 are expected to come in at about $66. I expect it will closer to $64as the fourth quarter will be weaker than expected, however a couple of dollars is of little importance. What is more prescient is the outlook for 2009.

Currently estimates for 2009 S&P500 Operating Earnings are approximately $82. That would be about 24% higher that 2008. However, as can be seen from the graph below, those estimates are coming down sharply. No-one in their right mind expects earnings of $80 next year, bearish analysts are looking for closer to $60 as a worse case scenario. My bet is S&P500 Operating Earnings will be closer to $50 with risks to the downside.

What started out as a financial crisis has now spread to the broader economy and that will show up in reduced earnings for non-financial companies. In addition financial companies will continue to post losses as writedowns persist and delinquencies on all types of loans ratchet up. In Australia, expect first half 2009 earnings to be weaker than expected and outlooks to get increasingly gloomier.

Bankruptcies to Ratchet up

25 US, FDIC insured banks went belly up in 2008 up sharply from the low levels of recent years. There will be more than 25 in 2009, that is almost a given. However the markets have become used to the FDIC announcements of failed banks on a Friday afternoon. What they haven't gotten used to is large scale bankruptcies in the retail sector. To be sure some retailers, went out of business in 2008, Linen & Things being one of the most high profile to go bust.

2009 will see many more retailers go out of business as consumer spending stays weak. Simply put, just as there are too many houses in the US and too many cars produced by an overcapacity in the auto industry, there are just too many retail stores to service a tapped out US consumer.

Home Prices Continue to Fall in 2009.
It would be remiss not to include a prognostication for the the market where many of the problems showed up first. Whilst sales of new and existing homes in the US break new records to the downside each month, there is still a huge amount of unsold inventroy on the market that will continue to pressure prices.

The chart above comes courtesy of the Contrary Investor and shows the number of vacant single-family homes relative to all single-family homes. Bascially such levels are unprecedented.

According to the Case-Shiller Home Price index, US home prices are down -23.4% from their peak. Regardless of the successful efforts by the Fed to lower mortgage rates, until that unsold inventory of homes starts to meaningfully decline, prices will continue falling.

There has been a continual chorus of bottom calling in home prices for at least 18 months and whilst they will eventually be right I doubt it will be until the end of this year at best.

In Australia, the government's attempts to shore up the property market with new home buyer grants is simply propping up prices that need to come down to restore a more equitable ratio between income and house prices.

It will be interesting to see what happens to home sales when the grants expire in June 2009. My bet is the government cannot stop an overdue correction in Australian home prices, but we should be prepared for the government to continue trying.

Changing Social mood
Social mood will increasingly darken, frugality is in and extravagance will be shunned. The optimism surrounding the borrow your way to prosperity environment of the last decade will seem ridiculous in retrospect.

Heightened Geopolitical Risk
Hardly a surprise, geopolitical unrest goes hand in hand with economic turmoil. I have no particular views on where things will get worse, just that they will get worse and there will be a few surprises.

Whilst none of the above themes seem terribly optimistic, one thing that is positive is that stock prices are now attractively valued. Not as dirt cheap as some pundits suggest but the cheapest they've been for a couple of decades.

Stock Market Forecasts:
Firstly, all forecasts should be taken with a grain of salt regardless of who makes them. Taking yourself and your predictions too seriously should be warning sign. Thus my investment decisions do not rely on these forecasts being met. I am also loathe to give a specific number but rather a range. Years in the broking industry taught me that price targets are meaningless and thus a target for the market is of little use.

Also of note is that market forecasters are overwhelmingly bullish on 2009. In a recent survey just 6% of forecasters believe the S&P500 will finish lower in 2009. It should be noted that last year the average forecast for 2008 for the S&P500 was around 1600.

In a year when the market fell -43% it is hardly risky to make the prediction that the following year will be better. As I've outlined in the last month or so, I believe the All Ords is yet to see its ultimate bottom in this cycle. I have no idea when the bottom will come but I believe it is still ahead of us in 2009. I think it is entirely possible that XAO will have a 2 handle sometime in 2009.

It will also be a year of huge volatility as 2008 was. I believe we will see at least a couple of false dawns as we saw in 2008, or more simply, strong rallies that ultimately fail. That said, I wouldn't be surprised if the market finished higher in 2009 but not much higher. I have a tentative range of about 10% either side of where the XAO finished 2008. So somewhere between 3300 and 4000 with wild swings well outside of that range during the year.