While
most professional investors realize that forecasting an unknowable future
is mostly folly, at this time of year, the media is full of investment predictions
for the New Year because everybody wants them. We are happily providing our
predictions, not just because we want to satisfy the desire for them, but
because the exercise of reading, thinking and writing about our outlook for
the future can actually be extremely useful.
In making predictions we must think about possibilities: not only
why a particular market may go up, but also why it may go down. We
must think not only of possible scenarios, but also what risks there
may be to those scenarios. Especially provocative predictions may
seem to border on silliness, but they too can serve a useful function
in stretching our thinking and forcing us to consider even seemingly
unlikely scenarios. As we were all reminded this past year, anything
can indeed happen.
We also benefit from the outlooks of portfolio managers with whom
we are invested or considering for investment. Examining their outlook
can provide valuable insight about how they think about, and potentially
construct portfolios. The accuracy of their forecast isn’t
the object of the exercise; it is attaining a better understanding
of their investment philosophy and process.
Even though, with varying degrees of conviction, we have our own
market views and forecasts, we believe in the wisdom contained in
this famous quote from Oliver Wendell Holmes: “Prophesy as
much as you like, but always hedge.” In other words, while
we may tilt our portfolios towards those market segments that we
believe offer the best combination of reward and risk, “hedging” those
opinions by building balanced, diversified portfolios remains the
prudent way to invest.
All that said, it’s time for our own outlook. Our somewhat
different approach, however, is to identify a few market opinions
that might qualify as “surprises” to the current year-end
market consensus. We are not trying to be radical in predicting a
long shot event. Instead, we are trying to identify those situations
where most participants appear to be leaning one way, and go against
the grain. In our experience, when most investors are leaning one
way, the market has a tendency to go in the opposite direction.
Before we introduce our list for 2009, let’s quickly take
a look back at our 2008 list.
Review of our Potential Surprises for 2008
The Economy and Corporate Earnings Will Do Worse Than Many Expect
At the end of 2007, the consensus expectation for 2008 year-over-year
operating earnings growth was +15%. We thought those estimates were
too high. As we mentioned last year:
“Principally, we still don’t see any signs that the
residential real estate market is stabilizing ... match that with
rising unemployment, deteriorating consumer confidence, high energy
costs, a credit crunch, and record consumer debt levels, and it is
difficult to imagine that consumers will be able to sustain spending
at the same levels they have in recent years.”
Needless to say that was on target as earnings growth in 2008 is
now expected to decline by approximately 25% (based on actual data
through September and estimated fourth quarter earnings).
The Dollar Will Get Stronger
We expected that the U.S. dollar would be stronger against a broad
basket of currencies in 2008 primarily due to negative sentiment
and attractive valuations. The positive trend in the current account
balance also pointed to a stronger dollar.
Helped by those factors as well as the “flight to quality” trade
from global investors, the U.S. Dollar Index was up roughly 6% in
2008. This gain came despite dollar weakness at the end of the year
(the dollar had been up over 11%), and the dollar’s worst year
against the Japanese yen in two decades.
U.S. Stocks Will Outperform International Stocks
Again, due to valuation and sentiment factors, along with our expectation
that the U.S. dollar could be stronger in 2008, another potential “surprise” we
saw was that U.S. stocks would do better than international stocks.
This was another hit as the S&P finished 2008 down 37%, while
the Morgan Stanley All-Country World Index (ACWI), minus the U.S.,
lost 45% and the Morgan Stanley Emerging Market Index was lower by
53%.
The Stock Market Will Perform Better Than People Expect
Our fourth prediction, however, was a significantly different story.
The year started poorly and most months during 2008 prices went
backwards, not forwards. The year ended up ranking among the worst
in U.S. market history.
Our expectation that stocks might do better was built on a few factors.
Heading into 2008, sentiment, for instance, was quite negative. While
we thought the economy would be softer than people expected, and
that credit conditions would remain difficult, we simply did not
think losses would cut as deeply and as painfully as they did. We
were wrong. We also expected that while the economy would remain
weak, the market would begin to recover well before the economy.
While that is still our expectation, it simply did not happen in
2008.
Potential Surprises for 2009
1. Earnings Growth Will Be Better Than Expected
In the closing weeks of 2008, analysts continued to slash their estimates
for 2009 corporate earnings. As of this writing, consensus reported
earnings expectations for the S&P 500 in 2009 are around $42,
while operating earnings (defined as reported earnings minus “extraordinary” one-time
items) are expected to be approximately $82. These numbers are 20%-
30% lower than the respective consensus of $59 and $104 just a few
months ago.
We think that these forecasts, especially for reported earnings,
are probably too low. We believe that low interest rates along with
aggressive and massive stimulus from the government are going to
make a difference. A variety of government programs, including the
TARP (Troubled Assets Relief Program) and the upcoming American Recovery
and Reinvestment Plan proposal from President-elect Obama, could
help the housing market and the over-all economy stabilize much sooner
than most expect. In that case, corporate profits could easily beat
the downtrodden consensus forecasts over the course of the year.
There is something else to keep in mind regarding earning expectations.
Wall Street analysts (who form the consensus expectations) have the
same tendencies as most economists and investors; they typically
expect the foreseeable future to be like the recent past. But markets
tend to exhibit strong cyclical tendencies over time. In other words,
the consensus usually misses the inflection points in the economy
and markets.
Lastly, the current recession is already a year old (and for corporate
earnings the recession is even more mature having started in the
third quarter of 2007). Since the Depression, recessions have averaged
a bit under one year in length and the two longest (1973-75 and 1981-2)
were each 16 months. So it is likely that this recession is closer
to its end than its beginning. In fact, depending on how one looks
at the earnings data, we may have seen the worst of the earnings
recession in the third quarter of 2008.
2. The Global Stock Markets Will Have Above-Average Returns
Would this really be a “surprise” given that many prominent
voices already seem to be calling for a significant rebound? That’s
a fair question, but the reality is that the sentiment and actual
asset allocations of both individual and institutional investors
suggest that most remain hunkered down, still quite concerned about
the market’s prospects.
The potential reasons for a good year in 2009 are many. The prevailing
negative sentiment just alluded to is one reason and the aforementioned
possibility that earnings growth could be much better than expected
next year is another. Valuations, which are powerful drivers of longer-term
returns (though admittedly not necessarily great short-term market
indicators) are at their most attractive levels in decades (depending
on which valuation metrics one looks at). The Federal Reserve has
stated it will keep interest rates low for quite a while which is
a positive backdrop for stocks and there is a lot of cash (pent-up
demand) on the sidelines.
Technically, the market is very “oversold.” The term
oversold refers to a market that has come under extreme selling pressure,
pushing prices down more steeply and more quickly than warranted
by the underlying fundamental conditions. What it may also mean is
that the selling pressure has been exhausted.
The market just finished one of its worst years of performance in
the last 100. It should be noted that, as shown in the table below,
in the prior ten worst years of performance for the Dow Jones Industrials,
the Dow rose the following year 8 out of 10 times, with an average
gain of 25%.
| The Worst 10 Years in Dow
History |
|
|
|
| |
|
Percentage |
| |
Percentage |
Change |
| Year |
Change |
Following Year |
| 1931 |
-53% |
-23% |
| 1907 |
-38% |
47% |
| 1930 |
-34% |
-53% |
| 1920 |
-33% |
13% |
| 1937 |
-33% |
28% |
| 1914 |
-31% |
82% |
| 1974 |
-28% |
38% |
| 1903 |
-24% |
42% |
| 1932 |
-23% |
67% |
| 1917 |
-22% |
11% |
| Average |
|
25% |
|
|
|
| 2008 |
-32% |
? |
| Source: The Bespoke Investment Group |
If one takes out the Great Depression years of 1930, 31, 33 and
37 (we think the only real parallel between the current environment
and the 1930s is the level of market volatility; in economic terms
the current environment doesn’t even come close), then all
six of the remaining years on the ten-worst list reported gains in
the following year with an average return of 38%.
We’re not necessarily calling for a 25% gain in 2009 (though
we recognize the possibility). The point, however, is that deeply
oversold markets do tend to produce sharp rallies in the following
years.
3. Larger Companies Will Do Better Than Smaller Companies
Another potential surprise for 2009 is that larger companies will
do better than smaller companies. This would qualify as a surprise
because in the early stages of an economic recovery and stock market
rebound, smaller companies typically outperform larger companies.
The idea is that smaller companies’ performance tends to
be more cyclical and thus driven by the economic cycle. Larger
companies meanwhile, given their more diversified products and
services, tend to exhibit smoother earnings streams. Companies
with less earnings volatility tend to be considered “higher
quality.”
However, it isn’t a given that large companies must lag in
market rallies and lead during slumps. Last year was a good example
of that as large caps did not display consistent leadership despite
significant economic and market weakness. Returns for small- and
large-cap stocks were fairly similar across both growth and value.
The key reason large caps may do better than small caps is their
relative valuations. Historically, small companies tend to trade
at a slight discount (lower P/Es) to the valuations on larger companies,
but are now priced at large premiums. Based off work from Leuthold
Weeden Institutional Research, using five year normalized earnings,
small caps were recently selling at 22% above their normal relationship
to large caps. This is particularly unusual because when the market
is recovering off recession or bear market lows, small caps are typically
at their most attractive valuations.
While admittedly this relative over-valuation of small caps has
persisted for the last few years, (and actually improved a bit last
year), small caps are still at some of their most unattractive valuations
relative to larger companies since the early 1980s.
4. Lower Quality Bonds Will Outperform Higher Quality Bonds
Typically, when higher quality stocks are outperforming lower quality
stocks, then higher quality bonds (like Treasury bonds) are generally
outperforming lower quality bonds (such as high-yield corporate
bonds). This year, however, could be the exception to that rule.
Again, it boils down to valuations. While the stock market may
have priced in a healthy recession, it could be said that the credit
or fixed-income markets have priced in a depression.
A way to examine valuations for the credit market is to simply look
at yield spreads. In the chart below, we compare the spread in yields
between high-yield bonds and U.S. Treasuries of similar maturity.
As one can clearly see on the chart, high-yield bonds now enjoy
a whopping 17% yield advantage over Treasuries (already coming down
from nearly 20% a month ago) compared to an average of just under
6% since 1996. Such a huge spread provides a considerable margin
of safety, and likely will provide a very attractive rate of return
for high-yield even if defaults rise significantly (which they likely
will) over the next year or so.
High-yield bonds are not the only attractive area in the fixed-income
markets. In fact, there is historic cheapness in many areas, as the
dysfunction and disarray in 2008 washed out many segments. Many active
managers are talking about how the buying conditions for a variety
of fixed income asset classes and sectors are the best that they
have been in many, many years, if not generations.
5. Inflation May Reappear
One reason why many fixed income segments look so appealing, however,
is that they are simply being compared to Treasury bonds. Due to
a combination of reasons including flight to quality, liquidity
preferences, and diminished concerns of inflation, yields on Treasuries
have been pushed down to their lowest levels in decades. These
low yield levels are not likely to persist, however. One reason
is simply because liquidity preferences tend to be shorter-term
considerations, but just as important, we think the markets are
currently underrating the prospects for inflation moving forward.
There are a couple of ways to look at how the market is assessing
the future prospects of inflation. One is to look at the over-all
level of interest rates for Treasury bonds. The current yield for
a 10-year Treasury is just over 2%. That’s really a remarkable
level. The long-term rate of inflation has been about 3% a year.
If that history is any indication of what inflation may be like moving
forward, that means investors would be accepting a negative real
(after inflation) return of -1%. Obviously investor inflation expectations
must be lower than the historical average, if not close to zero.
Another way to look at inflation expectations is something called
the “break-even inflation rate.” This is calculated by
comparing the yields on nominal (regular) Treasury bonds to yields
on inflation-linked Treasury bond (called TIPS, which is short for
Treasury Inflation Protected Securities) of similar maturities. Currently,
the break-even rate is under 0.25% for 10-year maturities. This basically
means that the expectation for inflation over the next 10 years is
only 0.25%! If an investor who must invest in Treasury bonds has
the option to choose between nominal and inflation-linked Treasuries,
actual inflation only has to be over 0.25%/year for TIPS to be a
better investment.
Given the expected economic contraction and retrenchment of the
U.S. consumer, then why would we expect inflation to be higher than
these expectations? In short, it’s due to the same reason we
think the markets could do better in the short-term – massive
liquidity coming into the marketplace from government programs and
actions.
In so many words, the Fed essentially reduced the short-term interest
rate under its control to zero and pledged to print an unlimited
amount of dollars, with the intention of stabilizing the economy
in the short term, while risking higher inflation in the longer term.
We are not debating the need for the stimulus, and in the short run,
it won’t likely be inflationary as it is simply hoping to help
arrest the decline in consumer spending. But a potentially much larger
inflationary problem looms when the consumer does stabilize and the
economy starts to get some traction. Will the Fed be quick enough
to remove the stimulus, or will there be too much wood on the fire
for too long, so to speak?
The Right Principles
Though many believe the most important element to successful investing
is having the most prescient outlook, that is not necessarily the
case. As Benjamin Graham, investing legend and author of the seminal
text “The Intelligent Investor” said in an interview
back in 1976: “I think we can do it [investing] successfully
with a few techniques and simple principles. The main point is
to have the right general principles and the character to stick
to them.”
The key element to remember about forecasts, ours included, is that
they are obviously far from infallible. While some may appear to
have called the recent market correctly, they surely have had their
misses in the past and they will have them in the future as well.
We’d like to believe, however, that we do have the right general
principles. In our view, the disciplined practice of diversifying
your money across asset classes remains the best recipe for long-term
investment success.
Wishing you a happy and more prosperous New Year.
Sincerely,
