Outlook 2009

After a rocky start, stocks will finish the year in the black as investors anticipate a better economy.

By Andrew Tanzer, Senior Associate Editor

From Kiplinger's Personal Finance magazine, January 2009

Few investors will mourn the passing of 2008. In this annus horribilis, virtually every asset class crashed simultaneously. From the stock market's peak in October 2007, Americans suffered an epic destruction of wealth in excess of $10 trillion. And that's just at home. The U.S. financial crisis, triggered by the bursting of a colossal real estate and credit bubble, fueled a global panic and now an economic slump. John Makin, an economist at the American Enterprise Institute, calculates that $25 trillion of global wealth has vanished in this cycle.

Meanwhile, the U.S. economy has slid into a nasty recession. Kiplinger's thinks unemployment will surge to 9% in 2009. Deutsche Bank forecasts the weakest global growth since 1982, with the U.S., European and Japanese economies all shrinking in 2009.

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Clearly 2009 will be a dreadful year for the economy, but what about for the stock market? Perhaps not quite as bad, for the simple reason that stock prices already reflect a severe recession. From the market's 2007 top through December 1, 2008, Standard & Poor's 500-stock index plummeted almost 48%, a collapse that is up there with the most ferocious post-World War II bear markets.

David Wyss, S&P's chief economist, estimates that operating earnings of S&P 500 companies will decline 4% in 2009, following a 20% drop in 2008. Stocks are likely to trend downward and remain volatile at least through the first quarter of the year, as investors fixate on the rapidly deteriorating earnings picture and the shaky financial system.

Still, after a rocky start, the U.S. stock market could gain 5% to 8% for the year. How can that happen in light of all the gloomy economic news? Stocks typically begin to rebound three to six months before the start of an economic recovery, often when the news is still dismal. Kiplinger's expects the economy to shrink for at least the first two quarters of 2009, followed by tepid growth the rest of the year.

If President Obama and the new Congress enact massive public-works projects and take other steps to stimulate the economy, the recession could end a bit sooner and the recovery could be somewhat stronger. As a result, corporate profits should start to recuperate in 2010, and the stock market, looking ahead, could begin a sustained recovery in the second or third quarter of 2009. Wyss projects earnings growth of more than 10% in 2010.

Many segments of the bond market may be more attractive than stocks in 2009. Dysfunctional credit markets have created distortions and alluring values in a number of bond classes, says Brian McMahon, chief investment officer of Thornburg Investment Management. "It's the greatest liquidation sale in history in bonds," he says.

Slow growth ahead

The U.S. could be in for years of sluggish economic growth because it will take years to flush out the system. Among the main drags on the economy in 2009 (and beyond) is the savage deleveraging of the U.S. financial system and household balance sheets. Deleveraging -- paying down debts -- is an ugly word for an ugly, painful and strongly deflationary process.

The nation didn't reach this point overnight. U.S. indebtedness has risen relentlessly for 25 years, and the rate of increase went parabolic this decade, inflated by the mother of all credit bubbles. Wall Street firms, banks, insurers and hedge funds leveraged up with reckless abandon, and now the country's financial arteries are clogged with the sludge of bad debts.

As banks purge debts and repair their devastated balance sheets, they must curb lending, which will be painful for businesses and consumers. Goldman Sachs, which estimates that a half-million workers in the overgrown financial sector will be laid off in 2009, notes that 30% of S&P 500 profits in recent years came from financial companies. That's twice the historical norm. Says Jeremy Grantham, a founder and director of GMO, a Boston money-management firm: "We have had a bloated financial industry feeding off the real economy."

As on Wall Street, U.S. households are like credit junkies. Americans have borrowed and consumed well beyond the growth in real income for many years, a trend reflected in the dramatic widening in our current-account trade deficit, which has quintupled this decade, and our burgeoning foreign debt. Wyss notes that the ratio of household debt to after-tax income has jumped this decade from 100% to an unsustainable 139%.

So overextended consumers will go on a crash diet in 2009 and beyond as they service and curb debt and boost savings. They'll have little choice. Credit will be less readily available and pricier. More frugal, less indebted consumers are ultimately healthy for the economy, but decreased spending will crimp growth in the near term and suppress economic recovery.

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