Just 11 trading days into the year including the two consecutive positive closes to end the week, the S&P 500 has droppped 5.8%. The good news is that despite eroding faster than time (the year is 4.3% over), we aren't likely to continue to drop at this pace. Unfortunately, though, it appears that the respite from late November to early January has ended. The following table highlights the recent changes and puts them in the context of the post-Q3 2008 change in the environment from recession of uncertain nature to full-blown crisis:
While it's way too early to form very conclusive views at this point, it sure appears that the trends in place indeed remain. What should we expect from the rest of this year? When (or even) will the erosion in the prices of most assets except for Treasuries stop? Will the dollar continue to at least hang in there? Will the supply of Treasuries overwhelm demand?
I have shared my views on most of these subjects on the pages of Seeking Alpha, but I will review my overall expectations. More importantly, I want to try to convey what I anticipate the year to look like in terms of overall magnitude and timing.
I remain bearish long-term on stocks, which have now declined for 5 consecutive quarters. Simply stated, the deck is stacked against equities: plunging earnings as sales contract and margins fall, inability for many indebted companies to restructure their balance sheets, forced liquidations by holders and better risk-reward in the bond market. I am most negative on larger-cap names, which may be contrary to traditional thinking about the behavior of stocks in an economic contraction. The most egregious balance sheets in both size and in quality reside in the S&P 500. I actually think that smaller companies with strong balance sheets will be able to better manage the challenges. I have personally reduced my exposure to names that I viewed as somewhat risky (you can see my holdings disclosure). I have a Conservative Growth/Balanced Model Portfolio that is invested exclusively in names that I believe can hold up best in this environment. That portfolio is positioned at its minimum permissible equity exposure of 45%.
While the market certainly could fall as much as last year (37%) and might do so during the year, I will be surprised if it falls to that extent. Even if it does, the loss of wealth will be significantly lower given the smaller base now. We should get a rally at some point this year, though I expect it will come from extremely oversold levels. With that said, I don't expect any single quarter to come close to the carnage of Q4 but rather a more traditional death by 1000 cuts. My base case for stocks is that they decline about 15-20% this year (S&P 500 of about 720-765). This level should serve as a multiple of about 12X-13X S&P 500 earnings I expect now for 2010. I expect an interim low in late March to mid-April, a positive Q2, a low in late Q3/early Q4 (call it 625-675) and maybe a positive Q4 overall. I believe that the biggest story in stocks this year will be the large losses in some of the largest names, like GE, T, WMT, and the large banks. Unlike Q4, where stock-pickers had very little chance, I expect that we will at least have a shot this year despite the negative overall tone. 20-30% of stocks in the Russell 3000 could actually rise this year despite the overall pressure on the broad market.
I spent the first 13 years of my professional life as a bond trader and then portfolio manager. I was very glad to switch to equities, but, for the first time since then, I sure wish I was better plugged into that part of the market, which is really almost exclusively institutional. For savvy investors and traders, corporate and esoteric mortgage debt should continue to offer incredible opportunities. I believe that short-term Treasury rates will remain low for all this year and beyond, but one can have a healthy debate about the back-end of the curve. While it appears that the recent plunge is somewhat ahead of itself, I believe that as the economy remains weak this year, folks will see that rates aren't as insane as they might appear. I expect mortgages to continue to offer good risk-adjusted returns, while corporates should outperform. Spreads should stay elevated, but they probably won't widen en masse. We could see, though defaults and downgrades, both of which will negatively impact the overall returns for corporate bonds. I am positioned very underweight in my model portfolio due to my expectations that long rates might rise somewhat and we might see a partial reversal of the improvement in spreads during Q1, but I look to redeploy that cash later this quarter.
While I haven't historically prognosticated in this area, I do have a strong view regarding gold. As I described initially and then more recently, gold has benefitted from a mistaken assumption that the dollar's value will be eroded and/or that we will suffer from inflation. I believe that as bad as things are here, they are just as bad to worse around the rest of the world. Many of the factors that have exacerbated demand for raw materials have reversed, and falling asset prices and economic demand both bode poorly for commodities in general but gold in particular due to its elevated valuation compared to other metals. I believe that the dollar should do well this year as Europe reduces its interest rate differential and the rest of the world's economic growth slows as dramatically as I expect ours to contract (negative full year GDP).
No matter what, this year should prove to be very interesting. Most investors, including me, have very little experience investing in economic environments like this one. This isn't the typical business cycle correction but rather an entirely different phenomenon of wealth destruction as all aspects of the global society change perceptions about borrowing. Old rules won't work, especially ones related to valuation. I have tried to address this issue in my recent commentary. Those who do best this year will be the ones open to the notion that a different game requires a different plan. I expect to see lots of dust and fury, but not as big a change in overall valuations as may be perceived given the gravity of the situation. The market has actually discounted a lot of bad already. In this type of environment, one should probably be willing to trade more rather than less and permit the volatility to work in one's favor.