Outlook for 2009 (1/09)

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Thursday, 15 January 2009 00:00 Written by James Van de Voorde

Chalk one up for the pessimists.  2008 proved to be the year when Grantham, Fleckstein, Roubini, Granville and Prechter all got it right.  We give the perma-bears their due kudos, but also remind readers what is oft said about stopped watches.  With such an awful year in the rear view mirror and with the hope that comes with each New Year, it is time to reflect on what went wrong with our outlook for 2008 and what we see ahead in 2009 and beyond.

With the exception of U.S Treasury securities and gold, every single asset class suffered material losses last year.  The Dow Jones Industrial Average, S&P 500 Composite and NASDAQ Composite fell by 33.84%, 38.49% and 40.54% respectively.  Indices for small to mid sized companies fared no better with the Russell 3000, Russell 2000, S&P SmallCap 600 and S&P MidCap 400 down by 38.7%, 34.8%, 31.99% and 37.28% respectively.  Foreign stocks as measured by the EAFE Index fell 41.04%, while emerging market stocks as measured by the MSCI Emerging Market Index declined 48.89%.  Corporate, municipal and high-yield bonds, REITs and commodities all too suffered broad-based declines last year.

While we recognized the clear and rising risk of recession at the outset of last year, we were convinced that the Federal Reserve had ample flexibility to do what was necessary to ward off a serious contraction.  Through the first quarter of 2008, the S&P 500 trended lower in a trading range collared by 1400 at the high end and 1270 at the low end, with the lows coinciding with the rescue of Bear Stearns.  The low of this range was only 8% below what we expected as the low end of a reasonable range for all of 2008.  During that span, GDP remained positive, earnings for Osher core holdings remained quite steady and the fruits of the government stimulus package (rebate checks) had yet to be felt.  Our forecast appeared to be on track.

The market peaked at 1425 in mid-May on optimism that recession would be averted and the U.S. economy would soon find its way to more normalized growth.  After all, GDP had remained positive even in the face of a very persistent rise in the price of oil.  But as Americans went on their way cashing and spending their stimulus checks, the price of oil entered a parabolic, bubble-phase that saw the price of West Texas intermediate crude spike from $100 to $147 per barrel between May and July.  Not coincidentally, the stock market took notice and an almost one-to-one correlation between rising oil and declining stocks ensued.  The S&P 500 swooned from its mid-May high of 1425 to a low of 1215 by July 15.  The S&P was now 12% below the low end of our forecasted range for the year. 

At that time, Goldman Sachs came out with its now infamous prediction that oil would reach $200 per barrel by the end of 2008.  Given the strong correlation between rising oil and falling stock prices, we grew seriously concerned about the potential for a “super spike” in oil and other commodity prices.  If oil were to remain at such elevated levels or (worse) rise to levels predicted by the likes of Goldman Sachs, we feared that the nascent, budding, stimulus-induced recovery would prove fleeting.  Despite Goldman’s claims to the contrary, our own research determined that oil prices had decoupled from the fundamentals of supply and demand and had entered a mania phase driven by hedge fund and index speculation.  We published “The Oil Bubble” newsletter report in July and cited compelling evidence why oil should trade at materially lower levels.  Further, we took decisive action and realized substantial gains by eliminating our exposure to energy stocks, materials stocks and gold and other commodity funds. 

With the immediate vindication of our theory and pricking of the oil bubble, we grew confident that a rapid drop in oil prices would lead to a virtuous cycle for the economy and the stock market.  GDP had been able to muster enough mojo to stay positive even as oil reached its mid July highs, so surely a precipitous drop in oil would be bullish.  As oil fell from $147 to $110 by the end of August, the S&P 500 rallied, yet only mildly, from 1215 to 1300.  We were confident that oil would continue its downward reversion to the mean and that this would ultimately boost consumer spending and the economy.  Furthermore, the S&P 500 had already suffered a 20% “correction” from its 2007 peak to its July 2008 low.   

The market carnage that followed in the fall of 2008 was accurately predicted by the aforementioned perma-bears, but we did not recognize how deep the brewing weakness in financials ultimately was and simply did not see what was coming.  We had long avoided investing in the equity of Fannie Mae, Freddie Mac, Lehman Brothers and WAMU, but did not envision their outright failure.  We were smart enough to sell AIG and Citigroup shares at much higher prices, but would not have imagined them being bailed out by the U.S. government.  We were able to stay clear of Wachovia and Merrill Lynch, but it did not occur to us that these once mighty institutions would require shotgun mergers to avoid bankruptcy.

The subsequent credit freeze left the economy reeling and no doubt as to the existence of a sharp recession.  The financial world as we knew it had changed almost overnight and the Federal Reserve and U.S. Treasury scrambled to repair the tattered system and restore calm to the markets.  The S&P 500 bottomed on November 20, 2008 at 752 with an intraday low of 747, a remarkable 52% decline in barely over one year.  With a year-end close at 903.25, the S&P 500 was able to rally 21% from its low, ending the year with a 38.49% decline.  

We correctly predicted the oil bubble, but incorrectly assumed that oil’s demise would have a virtuous effect on the economy and the markets.  We avoided the vast majority of financial landmines, yet we did not envision a waterfall decline across all sectors in virtually every category of stock, regardless of fundamentals or quality.  While it is true that we may be guilty of erring on the side of the “glass half-full”, that is a trait that we will continue to bear (pardon the pun).  Stocks are unpredictable and may suffer bouts of irrationality in the short run, but remain very predictable in the long run. 

Despite countless corrections and recessions, Word War II, the Korean, Vietnam and Iraq Wars, political scandals such as Watergate and Clinton impeachment proceedings, the Kennedy assassination, major economic disruptions that marked the Great Depression, the oil embargo of the 1970s, hyper inflation of the early 1980s, the S&L Crisis of the early 1990s and the current credit crisis deflation scare, bubbles in technology stocks and real estate and the terrorist attacks on the World Trade Center, the stock market measured by the S&P 500 has enjoyed an average annualized return of 9.7% since 1927.  While the awful year that was 2008 was able to knock .7% off the S&P’s very long-term track record (from 10.4% to 9.7%), it is worth noting that $1,000 invested in 1927 would be worth just over $1,800,000 today!    While the perma-bears have their day in the sun, we’ll drink our half-full cup of optimism knowing that history and a proven discipline for long-term investing are very much on our side.                     

So, where does this leave us for 2009?  First, there are a number of positive undercurrents that point to an eventual economic recovery: falling swap spreads, LIBOR, TED spreads and mortgage rates, rising activity in commercial paper and yields in the safest of securities such as T-Bills, dramatically lower energy prices, enormous monetary stimulus, a more-than-committed Federal Reserve and an eventual stimulus package from the new Obama administration.  The current forecast for 2009 earnings for the S&P 500 is $71, only slightly higher than the $68 forecast yet to be completed for 2008.  At 903, the S&P 500 closed 2008 with a trailing PE of 13 and a forward PE of 12. 

While stocks historically trade at multiples in the high teens during such low interest rate environments, the current economic uncertainty warrants a more cautious stance and lower valuation expectations.  While we do not believe stocks will trade at an average high-teen multiple any time soon, we do think that an eventual market PE of 15 is reasonable.  A PE of 15 on $71 of annual earnings would produce an initial target of 1065 for the S&P 500, 18% higher than the 903 year-end close.

However, we continue to believe that the last quarter of 2008 and the first quarter of 2009 will prove to be recession trough quarters for the economy and for earnings.  At least by mid-year, the market will begin to look toward more normalized economic performance toward the end of 2009 and into 2010.  If we assume that 2010 S&P earnings can return to at least the $88 level achieved back in 2006, a PE multiple of 15 would produce a year-end 2010 target of 1320, 46% higher than the 903 year-end close.  Remember that “normalized” consensus earnings expectations were for $97 in 2008, so the expectation for $88 in 2010 does not seem like a stretch.  If investors were to gain more confidence in the recovery later this year and we apply even a slightly higher multiple, we could see even higher levels for the market.  For instance, a PE multiple of 16 on $88 would produce a year-end 2010 target of 1408 for the S&P, 56% higher than the 903 2008 year-end close.