Does ripe fruit never fall?
2010 Outlook
Howard Marks, Oaktree Capital, has recently said, "Investors today may think they know what lies ahead, but they should at least acknowledge that risk is high, the range of possibilities is wider than it was ever thought to be, and there are a few that could be particularly unpleasant." Our outlook for 2010 in a word is: Caution.
Our thoughts will center on the global economy and the stock market, but we also want to make a political prediction since our economy is now deeply rooted in government policy.
The Economy
Many of you won't be surprised when we say the economy is not healthy, and in our opinion it will take years to improve. The two biggest issues we face are unemployment and debt (government, mortgage, credit card, and auto debt). The economy won't recover until the American worker is back earning a decent wage and paying down debt. Our Federal government is pulling out all the stops trying to prevent deflation, but we don't think they will be successful. So here are some of our thoughts regarding the economy:
High unemployment - the economy needs to produce about 100,000 jobs a month just to keep up with population growth, but we are still losing jobs every month. Even if the economy produced 250,000 jobs every month, it would take 8 years to get back to 5% unemployment. We may see a temporary improvement in the spring when the government hires for the census. Unemployment could come down if congress passes legislation aimed at job creation (i.e. immediate income tax cuts at the margin).
Consumer Comeback? - Since 70% or our economy is based on personal consumption, we have been looking to see how consumer spending is progressing. Here is where we get confused. The Bureau of Economic Analysis reports that consumer spending rose 1.1% in the third quarter of 2009. However, according to the Rockefeller Institute sales tax revenue declined by 8.9% during the same time period. Bottom line, the consumer is hurting. Contracting credit and high unemployment are forcing the consumer to cut back.
Credit Crisis II - What started this recession/depression back in 2007 was the "subprime" mortgage problem. For the most part, the subprime problem has been worked through, but we now face a three-headed monster in Alt-A/Option ARMs resets, commercial real estate loans coming due, and a huge number of homes saddled with negative equity. Most "experts" are predicting that we have hit bottom and we are on the upswing. Our own humble opinion is to look for continued declines in real estate prices over the next two years as deleveraging continues and interest rates rise.
Government Debt
Ernest Hemingway once said, "A man goes broke slowly, then all at once". This is precisely what is happening to central governments around the world. They have been going broke slowly and soon their debts will become unsustainable. Let us make a few observations:
Sovereign debt problems - There is serious trouble brewing in Greece, Spain, France, Ireland, England, and Japan. They all have debt problems. One or more of the above countries will either default on their debt payments or they will print more money to devalue their currency. Neither outcome is good. But don't be fooled, we have similar problems at home. Our debt is growing quickly and we will soon have trouble attracting buyers for our bonds. Interest rates will eventually go higher and higher.
State and Local governments bankrupt - If our Federal government doesn't bail out states like California, New York, New Jersey, and Arizona; they will be forced to take some drastic measures. Don't be surprised if states start to default on their debt obligations (municipal bonds). Tax revenues have collapsed and expenditures are rising-a toxic combination.
Stock Market
As we write this, the consensus 2010 forecast from economists is 4% GDP growth and a 36% increase in corporate earnings are being projected by strategists. Only 16% of economists have a negative outlook for 2010. So here we introduce you to Bob Farrell's investment rule #8: "When all forecasts and experts agree, something else is going to happen."
Experts say the stock market is forwarding looking and the price of the market reflects future conditions-not current conditions. However, eventually fundamentals rule the day. Right now the market is pricing in a massive economic recovery. We don't see a V-shaped recovery materializing, economic expansion will be slower than anticipated. The economy may really struggle once government stimulus ends.
The stock market will lose value in 2010 - OK, we are sticking our necks out on this one. The collective view from the biggest Wall St. banks is that the market will be 10% higher by the end of 2010, even after a 70% increase since March. Here we quote John Hussman, "when market conditions are characterized by unfavorable valuations, overbought conditions, overbullish sentiment, and upward yield pressures, the market's tendency is exactly that - to make continued marginal new highs for some period of time, followed by abrupt and often steep losses virtually out of nowhere" (emphasis ours). Our analysis has the market currently overvalued by 30% to 35% and thus our title to this commentary, "Does ripe fruit never fall?"
Politics
2010 is the off-year elections. Every member of the House of Representatives and 1/3 of the senators are up for reelection. Incumbents are reelected over 90% of the time, but we think this year is different. We have already seen prominent democrats retiring from their Senate seats, instead of running for reelection.
Republicans make big gains in both houses - Why? In off-year elections the party in power usually loses seats plus, it is our contention people vote their pocket book. With unemployment at 10%+, home values plummeting and wages declining, voters will be looking for change. The electorate sees politicians from both sides of the aisle spending us into oblivion and being self-serving. Americans are not stupid and won't stand for what's been going on in Washington.
We want to wish everyone a prosperous 2010. In many ways we hope we are wrong on our assessments, but things will get better as we address the crucial issues that confront us. If nothing else, we are a resilient people that can overcome any obstacle in our path. We continue to search for ways to achieve positive returns in any environment.
Geoff W. White, CFP
John S. Peart, MBA
Aaron C. Matheny, MS, BCE
John L. Olsen
