By Joseph G. Carson, Sharmin Mossovar-Rahmani, James Paulsen, Robert Doll, Richard B. Hoey
For the vast majority of investors, 2008 is a year they would like to put firmly behind them. But the year ahead is likely to be no less challenging, as a worldwide recession, and a still unsteady financial structure present critical decisions to the new Administration and Congress. As we have pointed out in the past, conventional investment "wisdom" no longer applies. The rules have changed.
To help broaden the perspective of potential scenarios, we sampled the opinions of some of the leading investment firms, economists and market observers. Below is their take on the year ahead.
Economic Backdrop and Policy Strategies for Sustainable Growth
Consensus forecasts for the US economy are universally bleak. So says Joseph G. Carson, Global Economic Research at Alliance Bernstein. Most analysts expect GDP to drop by at least 4% to 5% in the fourth quarter of 2008, followed by additional declines of about 2% to 4% in the first half of 2009. Yet despite the grim forecasts for the first half of '09, there remains a wide range of potential outcomes for 2009 because the second half of the year is harder to predict.
Compared to some past recessions, the economy today has the benefit of massive monetary stimulus and the promise of massive fiscal stimulus in 2009 from Barack Obama, according Carson. Media reports suggest that Obama's economic team is considering a stimulus plan estimated at about 3.5% of GDP, or at the upper end of packages that have been enacted in the past.
"The historical record on combined monetary and fiscal stimulus packages is encouraging-evidence suggests that, given time, the strategy works," says Carson. Of course, the downturn will still be painful and could ultimately inflict as much damage as the recessions of the mid-70s and early 1980s, which lasted 16 months and triggered peak-to-trough declines of between 2.5% to 3% in real GDP. According to Carson, the velocity of a downturn does not diminish the velocity of a rebound. "Thus, we believe that the economy has the potential for a much stronger rebound in the second half than consensus estimates suggest, as long as policymakers stick to their promises to prevent a collapse of the auto industry and deliver the impetus for economic growth."
Financial Markets Outlook
The U.S. is in the thick of the toughest market environment since the Great Depression. That's how Sharmin Mossovar-Rahmani, Chief Investment Strategist, Goldman Sachs Private Wealth Management, sees investors' current challenge.
Here's how she sums up what investors have recently experienced. "The violent unraveling of stock prices alone in the last few months has been nothing short of stunning." Major indexes have lost upwards of 50% from their peaks, with daily swings of 5% to the upside and downside becoming an unsettling norm. The S&P 500, for example, plunged from 1576.1 on October 11, 2007, to a low of 741.0 on November 21, 2008, a decline of 53%.
Mossovar-Rahmani adds, "the financial market meltdown, a global economic stall, and sheer panic have fueled a staggering and rapid destruction of equity wealth that has spared virtually no asset class, geographical region, or investment style." No, says the Goldman expert, we're not out of the woods yet. The combination of a credit crisis, ongoing de-leveraging in the financial system, and further declines in home prices should continue to take a steep toll on global economic growth in the coming year.
But equity markets tend to be forward looking, and thus tend to bottom well before the economy does. "By that guide," she observes, "the US equity market should have either marked its low in the fourth quarter of 2008 or be very close to doing so in the first quarter of 2009." Although it might seem counterintuitive against the current backdrop, Goldman recommends that clients consider adding US equity market exposure to their portfolios. Valuations have fallen to attractive levels, creating a compelling risk/reward entry point. Although stocks may weaken further in the short term, Goldman suggests using such weakness to gradually increase exposure, as equities are priced to deliver attractive expected returns to the long-term investor.
"We Find US Equities Compelling"
Although continued fund redemptions and the prospect of a deeper global recession are likely to weigh on stocks in the near term, there are several reasons why US equities are compelling, notes Sharmin Mossovar-Rahmani. First, valuations are attractive: Second, the current earnings yield exceeds the real long-term bond yield by about 7.9 percentage points, a level not seen since the early 1980s.
Earnings growth will continue to struggle in 2009. S&P 500 reported earnings have already fallen by around 50% since mid-2007. Importantly, equities have historically bottomed even while earnings are still contracting, she observes.
Given the extent of earnings erosion already seen in 2008, Goldman estimates that operating earnings will be flat to slightly down for 2009. As market participants begin to discount an earnings trough in 2009, they will increasingly shift their focus toward a profit recovery over the subsequent quarters. This should benefit equity prices as investors apply a higher trend multiple to more normalized trend earnings, says the Goldman Investment Strategist.
Given the extent of price dislocation across nearly every sector in the market, broadly attractive valuations, and the uncertainty of selecting which sector will lead the market out of this downturn, we believe broad exposure to the US market as a whole via the S&P 500 is the best implementation of our equity view, observes Sharmin Mossovar-Rahmani.
There are, however, some sectors that merit special attention. The first is infrastructure, an area the Obama Administration has repeatedly mentioned as a key focal point for government stimulus. Industries leveraged to domestic infrastructure spending, such as civil engineering, metals, cement, and materials companies, should hold up well in the coming months.
The second is homebuilding. These stocks, which at year-end 2008 had fallen 80% from their peak in 2006, have already discounted an onslaught of bad news. Moreover, some traditional measures of housing activity have reached previous trough levels, such as new and existing home sales. In addition, the government is taking explicit measures to lower mortgage rates and stem the tide of foreclosures, both of which should ultimately rekindle housing activity. As such, a bottoming of residential real estate in the second or third quarter of 2009 is quite possible, according to Sharmin Mossovar-Rahmani.
V-Shaped Stock Market Recovery
"We think the odds favor a rather sharp and significant rally in the stock market this year for two primary reasons. First we expect a V-shaped economic recovery and second, history suggests stock markets which fall hard and fast typically recover hard and fast," forecasts James Paulsen, Chief Investment Strategist, Wells Capital Management. Since 1900, the U.S. stock market has experienced six panics which resulted in price declines comparable to the contemporary panic (i.e., of at least 40 percent.)
History is on the side of a fast rebound. In five of the six major stock market panics since 1900 (the Great Depression being the only exception), the entire stock market collapse was regained within 18 months of the crisis low, comments Paulsen. Even though most seem to believe recovery from the contemporary stock market collapse will take years, unless this is the second coming of the Great Depression, history suggests a sharp and quick stock market recovery is more probable.
Investment Advice: "Stay Pollyannish"
Polly got destroyed in 2008, but we think those who stick with her will likely be rewarded in 2009, says Paulsen. Since "perceived risk" is so high today, "actual risk" is probably quite low. The real risk for 2009 is probably being overinvested in areas "perceived to be of low risk." Keep minimum exposure to cash with zero yields, recommends Paulsen who also doesn't see much reason to own Treasury bonds at record low yields or the U.S. dollar with a healthy safe-haven premium.
"Further downside risk seems quite limited," observes Paulsen. "Yes, the stock market could again revisit its November lows. But we doubt it will decline much further on any sustained basis." Even if it does take some time before recovery materializes, it will be worth the wait. "The upside for risk asset prices (stocks, credit bonds, and commodities) should be considerable once confidence begins to improve."
Twelve Predictions for 2009
The year 2008 turned out to be a year investors would like to forget, but instead will vividly remember, says Robert Doll, Vice Chairman, Black Rock. In the first half of the year, equity markets held together as the hope of global decoupling kept investors from panicking despite substantial deterioration in credit markets. "The seminal event appears to have been Lehman Brothers' bankruptcy declaration in September, which drove fear higher and confidence lower while causing a massive decline in economic activity in the United States and globally," comments Doll.
The new year begins with uncertainty high, expectations low and problems significant. It is with this backdrop that we venture forward with our predictions for 2009, says Doll.
- The US economy faces its first nominal GDP decline in 50 years.
- Global growth falls below 2% for the first time since 1991.
- Inflation falls close to zero in many developed countries, but widespread deflation is avoided.
- The US Treasury curve ends 2009 higher and steeper than where it began.
- Earnings fall by a double-digit percentage again in 2009, the first back-to-back drop since the 1930s.
- High yield, municipal and investment grade corporate bond spreads narrow in 2009.
- US stocks record a double-digit percentage gain in 2009.
- US stocks outperform European stocks while emerging markets outperform developed ones.
- Energy, healthcare and information technology outperform utilities, financials and materials.
- Stock market volatility remains elevated as periodic double-digit percentage rallies and declines occur.
- Oil and other commodities bottom and move higher by year-end as emerging market economies begin to recover.
- The US federal budget deficit soars past $1 trillion as the government continues to grow.
According to Doll, 2009 will see a slow, but noticeable, return to "risky" assets over "safe" assets. Increasingly attractive valuations, coupled with high degrees of skepticism supported by massive sideline cash, lead us to believe that equities will have a positive, albeit volatile, year, he adds.
Is a Depression Possible?
Many of the investment experts and economists we polled presented a very sobering view of economic conditions in the U.S. and worldwide over the coming months, some going so far as to not rule out the possibility of a very severe recession bordering on a depression. Obviously private investors, whose chief aim in these tough times is to preserve their wealth, are nervous to hear any talk of the infamous "D-Word."
One economist who has written gloomy forecasts for 2009 is Richard B. Hoey, Chief Economist, The Bank of New York Mellon. But in a recent report to clients. Hoey sets down very lucid reasons why a depression can be avoided.
"Fears that asset deflation and a serious financial crisis could trigger a depression have increased in recent months. We believe that we are experiencing a severe global recession but are confident that a depression can be avoided," says Hoey. The reason depression occurred in the 1930s, he points out was a misdiagnosis of the economic risks and a set of counterproductive policies which resulted from that misdiagnosis.
"Today, in contrast, we believe that the economic diagnosis and the policy response are correct. Fed Chairman Bernanke, an expert on the Great Depression, recognized the risks of debt deflation spreading and has been willing to be aggressive in fighting it, observes Hoey." On fiscal policy the Obama administration will adopt a large Keynesian fiscal stimulus. While this stimulus is not a cure-all, comments Hoey, it increases the likelihood of preventing a serious recession from deteriorating into a depression.
Still investors should expect a somewhat slower trend growth rate in the U.S. in the coming years due to decreased immigration, greater regulation and taxation and the secular exhaustion of the strong uptrend in the use of debt. "However, we strongly believe that a depression can be avoided," concludes Hoey.
