Newsletters 2009 Newsletters Outlook for 2010
Monday, 14 December 2009 21:12
The stock market rally resumed in November with the Dow Jones Industrial Average, S&P 500 Composite and NASDAQ Composite rising by 6.51%, 5.74% and 4.86% respectively. These important market barometers are now up 17.87%, 21.30% and 35.99% respectively through November. The composite of all Osher equities under management is up 25.66% for the same year-to-date period.
As we rapidly approach year-end, it is once again time for analysts and prognosticators to dust off their crystal balls and look forward to what 2010 might hold for the markets and investors. We cannot remember a time when the range of opinions differed so widely. Herein, we will share the issues and concerns that are shaping our expectations as we approach 2010 and offer our preliminary outlook for what the market may have in store in the coming year.
First, at the risk of jinxing our year-to-date good fortune, we are compelled to bask a little in the glow of what has turned out to be a very good year for Osher Van de Voorde clients. In our January “Outlook for 2009” newsletter, during the middle of the credit crisis and a period of widespread pessimism, we predicted 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” and “by mid-year, the market will begin to look toward more normalized economic performance at the end of 2009 and into 2010”. Our prognostication for a “year-end target of 1150 for the S&P 500” now seems quite prescient. The market has managed to follow the script we laid out last January and our decision to stay the course through perhaps the worst stock market crisis since the Great Depression has been rewarded.
Again, back in January, we were willing to stick our necks out and predicted that “an ultimate target of 1300 to 1400 seems very reasonable looking out to 2010”. Since we are finding more obstacles that the markets must overcome if 2010 is to turn out as we currently expect, we think these price targets are overly bullish for 2010 and should be considered beyond the coming year into 2011 and 2012. Here are our primary areas of present concern:
1. Deficits and taxes: The Obama administration and Pelosi-Reid Congress are fixated on policies that will grow the role of government and increase our already massive deficits to dangerously unacceptable levels. The trillion dollar deficits created by spiraling Social Security and Medicare entitlements, wasteful stimulus programs and government bailouts will only be exacerbated if health care reform’s “public option” is passed. Furthermore, the looming expiration of the Bush tax cuts will be compounded by the tax increases inherent with any potential “public option” or “cap and trade” bill.
2. The dollar: While much of the weakening of the dollar since the mid-March crisis crescendo can be attributed to the unwinding of the “flight to safety” trade that resulted from the market panic, we have been recently reminded by the rhetoric of Chinese diplomats and oil sheiks alike that there are limits to our creditor nations’ propensity to own dollars as U.S. policy drives the greenback lower. The sharp rise in the price of gold indicates that many investors are increasingly alarmed by the potential for U.S. policy mistakes and are insuring themselves against that possibility. Currency disputes increase the propensity for protectionism and policy mistakes that could cripple global trade, the greatest current source of economic growth for the U.S.
3. The U.S. consumer: Increased regulation and tighter underwriting at banks has made it very difficult for many consumers to take advantage of historically low interest rates. With losses in commercial real estate expected to rocket in the coming years, banks may continue to hoard cash and restrict lending to only the most creditworthy of borrowers. With approximately one out of every four homes worth less than the underlying home mortgage and unemployment still at 10%, the consumer will not be the engine of growth as in past recoveries. The looming threat of higher taxes will add insult to injury.
4. Iran: As our involvement in Iraq unwinds and a new commitment to Afghanistan emerges, there seems to be an uncomfortable silence with regard to our strategy to thwart Iran from becoming a nuclear threat. Diplomacy has failed thus far and military intervention by Israel seems almost inevitable. As with other exogenous events, this concern is less structural in nature than the above three and would likely result in a short-term correction. That said, war in Iran would almost certainly lead to a spike in the price of oil that could further impede the U.S. consumer.
The first three issues listed above taken together add up to an over-arching concern that the weight of growing deficits, higher taxes, a falling dollar and a weakened U.S. consumer leave the U.S. economy unable to reach “escape velocity”, a self-sustainable rate of growth that can be maintained as government intervention is removed. Thankfully, the centrist voter message delivered both in New Jersey and Virginia last month seems to have become a rallying platform for indepen-dent voters across the nation (see the full page ad taken out by www.rethinkreformaction.com in the Wall Street Journal on December 9th). Obama’s popularity and political capital are declining, making it increasingly more likely that the most liberal of his policies will not pass muster. Indeed, the continued strength in the stock market may just be sniffing out a defeat of the “public option,” “cap and trade” that may be dead on arrival and compromise on the Bush tax cuts that maintains the advantaged rates on dividends and capital gains. Outright defeat of, or centrist compromise, on these punitive and ill-timed policy initiatives would increase the likelihood for the consumer and U.S. economy to get back on a self-sustaining track.
The just-released jobs report revealed a drop of only 11,000 nonfarm payrolls in November, ahead of the consensus expectation for a loss of 125,000 jobs and the best monthly showing since December of 2007. The question as to when the labor market might finally join the recovery may have finally been answered and is leading many economists to ratchet up their timing expectations for a rate hike from the Federal Reserve. The Fed Funds futures spiked after the report and now place a 68% probability that the target rate will be lifted to 0.5% by June and 90% odds that it will be raised to 1% by next December. A strengthened labor market or at least stronger than expected labor market is welcome news indeed and gives considerable pause to the economic “double dip” argument. Higher employment will increase consumer spending and provide the impetus needed to reach escape velocity. At the same time, improving employment trends will make it increasingly likely that the Fed will shorten it’s “extended period” of low rates, raising the risk that higher rates will upset the recovery now underway. We did not list the risk of rising rates as one of our primary concerns for 2010 because we believe the stock market would happily accept higher rates as a sign the economy is on a self-sustaining path. Given the recent testimony from Fed Chief Bernanke and minutes from the most recent Fed meeting, it is clear that the Federal Reserve does not intend to raise rates until it knows the economy can take it. Further, rates are at such an extraordinarily low level that, once the Fed starts raising them, it will be an “extended period” before they are high enough to curb growth.
If the recent labor report is more than a one-month blip and indicative of an economy on the right course toward escape velocity and the likes of the “public option” and “cap and trade” go down in defeat, the odds will surely rise for a virtuous cycle of self-sustaining economic growth, higher interest rates and increased confidence in the U.S. dollar. With the rise in the stock market closely linked with a decline in the dollar thus far in 2009, a stronger dollar-higher rates-stronger stock market scenario is not getting much attention and could be a welcome surprise for investors in 2010.
While the risks or issues outlined above do give us pause on what to expect in the stock market for the coming year, we remain convinced that stocks will outperform bonds for the foreseeable future. Consider the following excerpt taken from a recent report by Jensen Investment Management (we have long been fans of the Jensen Fund and have recommended it often to clients and friends with accounts that cannot be adequately diversified with individual stocks):
“During the past eight recessions (from 1953 to 2001), the average time for the S&P 500 Index to recover from its low point to its previous high was 1.9 years. This recovery time ranges from as little as 83 days to nearly six years.”
“If it takes five years from the date of the recent market bottom (March 9, 2009) for the market to regain its previous top (S&P 500 at 1565 on October 9, 2007), the annualized return would be 18.26%. Over a 10-year recovery period, the return would be 8.75%.”
“Further, even after a 56% increase from the bottom as of September 30, 2009, the annualized return would be 8.17% if it takes five years to regain the top and 4% if it takes ten years.”
There is an old saying that the stock market climbs a “wall of worry”. Warren Buffet’s spin on this saying is that investors “pay a high price for a cheery consensus”. If there were no material concerns to speak of and everyone loved stocks, chances are that this reality would already be fully priced into the market. There remain many concerns in today’s market, many doubters and much cash on the sidelines looking for higher returns – indeed the “wall of worry” is high and increases our confidence that stocks may surprise to the upside. And as evidenced by the data taken from Jensen, it should not be very difficult for stocks to outperform bonds over the coming years, especially when the Federal Reserve finally begins to raise rates.
In light of the risks present in the market place today, it is imperative to pay attention to quality, value and growth. The Osher Van de Voorde core equity portfolio is chock full of blue-chip companies with leading global franchises, fortress-like balance sheets, strong cash flow generation and the proven ability to increase earnings and raise dividends through varying political and economic cycles. Because these companies are so internationally diversified, they serve as a durable hedge against a potentially weaker dollar. Further, the growth of income inherent in their predictable records of dividend increases serves as a wonderful hedge against the potential for higher inflation.
Our base case scenario continues to call for a “new normal” where economic growth will be subdued below 3%, limited by the propensity for bigger government, increased regulation and higher taxes. Given extraordinary productivity, we still believe that corporate earnings can continue to experience a “V-shaped” recovery, even if overall GDP growth is subpar. Consensus earnings estimates for the S&P 500 are currently hovering at $75 for 2010 and we expect them to move closer to $80. A PE multiple of 15 on $80 implies a price target of 1,200 on the S&P 500 and a PE multiple of 16 gives us a target of 1,280 – an upside range of between 9% and 16% from the current level of approximately 1,100 on the S&P 500.
| Next > |
|---|