2009 in Review & 2010 in Preview: Bailouts Have Costs

Good Afternoon: I will briefly dispense with a review the opening two days of trading in 2010 before reviewing my predictions for 2009. I will then take a stab at what 2010 might look like, though I have less conviction this year than I had with forecasts in the 2007-2009 period.

The new decade began with a bang Monday, as a cold snap and a weakish dollar pushed higher the prices for oil, natural gas, and other commodities. With the energy and materials sectors leading the way, many other names came along for the ride, especially once a strong ISM manufacturing report was released thirty minutes into the session. Even Treasurys managed to lift a bit, and most of the major averages closed with gains of between 1.5% and 2%.

Tuesday’s action was much less noteworthy, and the flattish closes in most asset classes reflected it. Likewise, the economic data was a bit of a mixed bag, with factory orders coming in stronger than had been expected and pending homes sales coming in shy of estimates. Stocks traded in a narrow range (down 0.5% to unchanged) before settling mixed. Treasurys enjoyed a modest bid that saw yields fall between 3 and 7 basis points, while the dollar and commodities were basically unchanged.

2009, however, saw little of the tranquility the capital markets enjoyed yesterday. The opening three months saw a harrowing slide in equity prices that left the major averages with the worst bear market losses since the Great Depression. Though it was hard to know at the time, the major low was already in when the Bernanke Fed announced an aggressive program of Quantitative Easing in mid March. Previously shriveled risk appetites grew ravenous in response, and investors spent the rest of the year snapping up junk bonds, bank loans, orphaned credit contraptions, and equities of every size in almost every locale on earth.

But while describing 2009 in an overly simplistic paragraph is easy, investing last year was quite a bit more difficult. Many market participants felt the alternating pangs of both stupidity and genius during the year, but low prices and the Fed’s money printing schemes enabled risk assets to take flight. The major equity indexes and many credit instruments saw gains of 60% or more in the ensuing nine months) that left safety-seeking investors in the dust. Savers earned next to nothing on their balances, and Treasury investors suffered the worst negative returns in decades.

Being the first to exit the Great Recession, China — and its famous appetite for natural resources — helped commodities climb up off the mat. The Fed’s monetary exertions and a dollar that was weak for most of the year also did their part in lifting back up the components of the CRB index. As for my favorite CRB constituent, gold once again shined. The tailwind of money printing did more than just fill the sails of precious metals and risk appetites, though. That the Fed would try to move the monetary equivalent of heaven and earth to combat the financial crisis was the underlying thesis behind many of the predictions I made last year. Here are last year’s prognostications, as well as a review of them (in parenthesis).

2009 Outlook:

U.S. Economy: Recession deepens in the first half and then tries to stabilize. A recovery worthy of the name doesn’t arrive until 2010. (Decent forecast, though I underestimated the strength the economy would show in the latter half of ’09)

Stocks: Trade in a wide range. Upper end for S&P is 1000 to 1100, while there is a better than 50/50 chance we see the November 2008 low of 741 taken out in 2009. Prefer low-debt, high dividend paying stocks. (pretty good call, since S&P did indeed set a new low and high for year was less than 3% above high end of forecast)

Bonds: Avoid Treasurys and look for high quality elsewhere. Candidates are senior bank loans, select Municipal Revenue bonds, GNMAs, certain investment grade corporates, and TIPS with real yields above 3%. True credit analysis — finally — makes a comeback! (a lucky guess)

Dollar: Should weaken, but it could go anywhere. It might even rally if rest of globe stays weak or sees increased geopolitical conflict. (The greenback did trade both above and below the 2008 close, finishing down just enough to vindicate this wishy-washy prediction)

Commodities & Precious Metals: Long term positive, but a mixed bag in ’09. Prefer agricultural commodities to energy and prefer precious metals over base metals. Most commodity production is capital intensive (a negative), but most governments seem bent on shredding their currencies (a positive). Small to mid-size precious metals mining stocks may be the best way to play this sector, but volatility is the only guarantee for commodities in 2009. (wrong about agriculture outperforming energy and copper did outperform gold, but the yellow metal did advance for a ninth consecutive year. Fortunately, the huge outperformance by small to mid-size precious metals mining stocks more than rescued this call)

U.S. Housing Market: Will stay weak most of the year. Case/Shiller index to fall another 10% to 20%, but Fed efforts to lower mortgage rates will eventually help. (Right for only the first half of the year, and didn’t anticipate just how much lower mortgage rates and first time buyer subsidies would help)

The Fed: All in — short rates already essentially at zero, so next trick for Bernanke and Co. is to peg long term rates by buying mortgages and perhaps long dated Treasurys. (Helicopter Ben lived up to his name to help this one come true)

Volatility: With us all year. Highs are in for VIX, though, and it should range between 25/30 & 55/60 in ’09. (Good call on the high — 57.36 — but overestimated the actual low of 19.25)

Credit Spreads: Will be volatile but credit spreads offer the best value (the Graham & Dodd kind) among all asset classes. As deleveraging ebbs and as new money is earmarked for distressed assets, those with a talent for credit analysis (e.g. credit-oriented hedge funds and mutual funds) should have a banner year in 2009. (This one came true, but I underestimated just how much credit spreads would tighten and unwisely sold some positions too early)

Inflation: CPI is not a worry in 2009, but could be a large one in 2010 or beyond. Currency devaluation attempts by various governments will make inflation a relative battle (i.e. standard of living differentials among nations) in ’09. (CPI was in fact not a worry in 2009, though inflation — via commodities and many financial assets — did surface)

So, if the actions taken by the Fed last year proved to be such a tonic for the markets, will our central bank play a similarly important role in 2010? Yes, but perhaps not in the way most investors think. For at least the first quarter this year, the Fed will keep the funds rate pinned near the zero barrier and will continue to buy mortgage paper as part of its QE program. Commonly accepted wisdom then has Bernanke and company start the process of gradually unwinding their Quantitative Easing moves and then take the funds rate higher in baby steps during the second half of the year. Most Wall Street strategists think the markets will be able to shake off this theoretically gradual rise in interest rates because GDP will be striding without crutches and earnings will be growing at a gallop. For most stock market seers, earnings growth trumps all other factors.

It could all play out that way — IF this were a normal recovery from a normal recession. This time it’s different. We are still recovering from one of the largest credit bubbles in history, and the asset rallies in 2009 happened almost solely because a vast amount of unserviceable debt around the world was moved from private sector balance sheets onto public sector balance sheets. Central banks and taxpayers in the U.S. , U.K. , and Europe have been able to fill the credit breach created by the collapse of Lehman Brothers and the resulting breakdown of the shadow banking system in 2008. The bailouts have thus far “worked” by preventing the vaporization of the global financial system. Asset returns during the final nine months of 2009 were essentially a celebration that a catastrophe had been avoided, but the bill for this party will come due in 2010 and beyond. Rising taxes will be one cost, but the odds of a funding crisis (a run on the dollar, much higher long term interest rates, or both) will grow shorter with each passing day in 2010. As such, here are some guesses about what might happen this year:

2010 Outlook:

U.S. Economy: Fed will keep short rates near zero, so recovery continues early in year. Risk of GDP slipping back toward zero increases as year progresses, but any “double dip” recession may be a 2011 story — when higher tax rates take effect. Even if the U.S. economy displays surprising strength in the first half of ’10, the resulting increase in long term interest rates should forestall that growth later this year.

Stocks: Trade in a wide but uneasy range. Upper end for S&P should be 1200 to 1300, while lower end should be 950 to 850. Stock picking (alpha) will be more important to returns than getting the market trend right (beta). I still prefer low-debt, high dividend paying stocks (e.g. Big Pharma), as well as companies with rising cash flows that give managements financial flexibility (with some exceptions, higher quality names do not appear to trade at high premiums to lower quality companies). I also like having exposure to what Nassim Taleb calls “positive black swans. Some of the best of these “spec plays” could be in small mining stocks (still decimated after ’08 rout), or in smaller biotechs with attractive pipelines (e.g. drug candidates beyond phase 2 — preferably beyond phase 3). Corrections of 5% to 10% can hit at any time (even in January), but either higher interest rates or higher tax rates on incomes (and capital gains!) loom as potential downside catalysts after spring. My own plan is to use rallies to take profits and/or establish hedges.

Bonds: Very tough environment in 2010 and bonds deserve a minimal asset allocation for now. At these levels, Treasury investors need either geopolitical turmoil or a relapse in the economy. Since either of these outcomes will only add to the massive issuance needs of the U.S. and others in the G-8, use rallies to shorten duration and look for high quality among corporates, senior bank loans, and municipal bonds issued by well funded locales. True credit analysis will continue to be of value, since nimble active management should outperform lumbering mutual funds.

Dollar: Should weaken, but it could see intermittent rallies due to sovereign debit concerns (think: Europe), or increased geopolitical conflict (think: Iran ). Better than 50/50 chance the U.S. Dollar Index sets a new, all-time low in 2010. Favorite G-8 currency is the Canadian loon and favorite emerging market currency is Brazilian real, but the REAL question is how long can the imbalances of the dollar-centric, global fiat currency regime last?

Commodities & Precious Metals: I am still long term friendly towards commodities as a store of value, but components of the CRB index should be volatile in ’10. Energy and base metals might outperform early in year, but agricultural commodities should outperform as the year progresses. Gold will be volatile, but I think the barbarous relic will set another all time high this year. Responsible central banking (i.e. rising real interest rates) and fiscal discipline by sovereign governments represent the biggest long term threats to commodities, while “anti-speculation” legislation is a nearer term risk. The potential headwinds created by either monetary or fiscal discipline, however, are much less likely to materialize than the potential tailwind of currency volatility.

U.S. Housing Market: Subsidies, a Fed on hold for now, and various private capital solutions for upside-down borrowers will help U.S. housing during the first half of the year. Housing will flatten out or even suffer a relapse later this year as these tailwinds subside and long term interest rates start to rise.

The Fed: Stays “All In” by keeping short term rates on hold for most of 2010. Threats by the Fed to tighten monetary policy will be idle ones unless economic growth and job growth really surprise to the upside. Should the economy slip back, expect renewed Quantitative Easing. Mr. Bernanke seems willing to risk a funding crisis down the road in order to prevent a repeat of what he has said were policy errors by the Fed in the 1930’s (i.e. they tightened too soon)

Volatility: More subdued in 2010 than in past two years and should range between roughly 15/20 and 35/40 for the VIX. Geopolitical turmoil, or a disorderly fall in the U.S. dollar, are the biggest risks to the upper end of this range.

Credit Spreads: Credit spreads still offer value, but not nearly as much as at this time last year. Solid credit analysis will expose relative value opportunities, but at least some profits should be taken if spreads continue to compress. Volatility caused by higher long term interest rates or disorderly currency conditions could present better investment opportunities.

Inflation: CPI is not a worry during the early months of 2010, but it could become one later this year or in 2011 if the near zero fed funds rate overstays its welcome. Cost-push inflation (i.e. rising food and energy prices) is much more likely than demand-pull (i.e. rising wages) inflation.

If, as I’ve claimed, the Fed-induced, taxpayer-supported recovery we’ve seen is indeed different, and if, as I believe, some sort of funding problem faces the U.S. and many other developed nations at some point, then why do the above predictions lack the fire and brimstone attendant to a run on the dollar or much higher interest rates? The answer lies in the timing. Given the calendar constraints of a twelve month forecast, I think the most virulent aspects of paying the bill for all the bailouts may lie beyond 2010. I do think the Fed is well and truly trapped by circumstances largely of its own creation, but it may take time for market participants to appreciate this threat to wealth preservation.

A weaker dollar and higher interest rates should be a cost the capital markets find disruptive, but these eventualities might take time to develop or even be rationalized away as part of what some will call a “return to normalcy”.. And if the Bernanke Fed responds to rising longer term interest rates with more quantitative easing, the short term reaction could even be one of welcome, despite the obvious long term harm that will come from debt monetization. It is only when creditors, both foreign and domestic, start to balk by demanding much higher rates in order to compensate them for the risk of U.S. efforts to reflate that will cause the 2007-2009 bailout strategy to unravel. As Bill Fleckenstein has said, it will be up to the markets to “take away the Fed’s printing press”. Bill also thinks the first clues this process is under way will come when the dollar and Treasurys start sinking together in a concerted way. I think this process could take time to develop because most current investors have little experience with the harm sharply higher interest rates can wreak upon portfolios. After all, Treasurys have been in a secular bull market for almost three decades (from 1981 to 2008).

That taxes will rise on incomes, dividends, and capital gains is a given. They represent another cost of the 2007-2009 bailout experiment. It’s a bill most market participants expect to pay starting in 2011, since the Bush tax cuts lapse at the end of 2010. Whether investors have yet factored in just how large will be the supply of stock looking for a bid as a way of locking in a capital gains rate of 15% is unknowable. What I do know is that legislation to repeal the Bush tax cuts sooner than year end is a non zero probability that has not been factored in. And what, pray tell, will the market reaction be if Congress decides to make the tax hikes retroactive to January 1st of this year? Before you say, “it can’t happen”, just remember that this form of retroactivity DID happen during President Clinton’s first year in office (1993). It’s unlikely to happen, but the political backlash against Wall Street should not be underestimated.

Unfortunately, rising tax rates will not alone cure our fiscal ills. Spending cuts (or at least budget caps) will also need to be part of the solution, but the political will to impose costs in this way is sorely lacking in Washington . Ironically, the only thing resembling political will may come in the form of political pressure on the Fed to continue the quiet bailout of Quantitative Easing, an agenda that dovetails nicely with Chairman Bernanke’s previous speeches about what he believes were the Fed’s policy mistakes during the 1930’s that prolonged the Great Depression. PIMCO’s Bill Gross, among many others, expects the Fed to implement its so-called “exit strategies” as soon as March (see below). I don’t agree.

The thesis underlying most of the above predictions is that the Fed will keep the funds rate low and do little more than talk about exits. They, as well as elected officials from both parties, will keep trying to postpone the painful costs of the 2007-2009 bailouts. Kicking the can down the road is the one truly bipartisan policy in Washington , and it was Alan Greenspan’s M.O. during his entire tenure at the Fed. If I am wrong, and the FOMC does vote to begin reversing its QE purchases in March, then some of the pain I see coming sometime after this spring will instead arrive with this year’s thaw. Maybe I’m wrong about Mr. Bernanke, and maybe he’ll decide to do the right thing by grounding his fleet of money-dropping choppers. But to quote Jim Grant, “’Helicopter’ is who he is.”

— Jack McHugh

Investment Outlook: Let’s Get Fisical, by Bill Gross, PIMCO

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