Outlook 2009
After a rocky start, stocks will finish the year in the black as investors anticipate a better economy.
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.
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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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Some numbers to illustrate the dynamic: In 2007, consumption accounted for an economically unhealthy 70% of gross domestic product. Some economists, such as Keith Hembre, of First American Funds, think the ratio needs to revert over a period of years to the historical norm of 66% through a multiyear adjustment. That implies a contraction in consumer demand of about $600 billion annually.
Let's not count on any help in 2009 from the housing market, which kicked off the financial debacle. Home prices are down more than 20% from their peak in mid 2006, according to the Case-Shiller index, which tracks prices in 20 large cities, but we think they'll fall at least 10% more, on average, before possibly bottoming in 2010.
The imbalances are too great to expect a more-benign outcome. Foreclosures and delinquencies are surging. Excess inventories are enormous. Home prices are still high by historical standards relative to household incomes and rents. Rising unemployment puts the squeeze on homeowners. Some economists project that by the end of 2009, a frightening 40% of U.S. homeowners with mortgages will owe lenders more than their homes are worth. It's hard to imagine a sturdy recovery and a turnaround in banking and the economy before housing stabilizes.
As bleak as the economy looks now, there are some hopeful signs. The collapse of energy prices is like a massive tax cut for U.S. consumers (for every penny that gasoline prices decrease, purchasing power increases by $1.4 billion). Declines in the price of oil and many other commodities are taming inflationary pressure, which should help keep interest rates low.
The Treasury's financial rescue package should begin to bear fruit in 2009. Once the banks get back on their feet and start lending again, the beneficial effects of the Federal Reserve Board's dramatic interest-rate reductions (to 1% on the central bank's key overnight lending rate) should start to ripple through the economy.
The China factor
We'll see government stimulus packages here and abroad. In early November, China, which is now as important to global economic growth as the U.S., announced a massive, $586-billion spending program to invigorate domestic demand. China's situation is the mirror image of the U.S. predicament: It has excess savings, huge foreign-exchange reserves and a strong fiscal position. And the Chinese have the muscle to pump up spending to counter an economic downturn.
As U.S. consumers retreat and rebuild their balance sheets, the emerging markets, with their rising middle classes, will pick up the slack over the medium and long term. U.S. export growth will weaken in 2009 (in part because of the surprisingly robust dollar), but import growth will weaken more dramatically.
So how should you invest in dour 2009? As always, that depends on circumstances such as age, wealth, risk tolerance and time horizon. If you're within a few years of a particular goal -- say, the year you face your child's first college-tuition payment -- don't even consider investing that money in stocks.
If you're in your twenties or thirties, this is an excellent time to start investing for retirement. You cannot predict the bottom. But low stock prices are wonderful for the long-term, buy-and-hold investor, and by several historical measures, such as dividend yield (about 3.4%), cash on the sidelines ($3.7 trillion in money-market funds) and price-earnings ratios, the market seems reasonably valued today. (Market forecaster Steve Leuthold says that at the October 27 low, the S&P 500 was in the bottom 15% of its valuation history over the past 52 years.)
GMO's Grantham -- often called a perma-bear because he was down on stocks for so long -- now reckons that U.S. stocks are attractive for the first time in two decades. Grantham, who ten years ago projected the past decade's disastrous market returns with uncanny accuracy, thinks U.S. stocks should return an annualized 6% plus inflation over the next seven years. That would put the market on track to approach its long-term return of 10% annualized. "The U.S. is decently cheap," says Grantham. "Super-high-quality U.S. blue chips are now very cheap." He projects even higher returns for foreign stocks.
Grantham is bullish in the long term, but he cautions that bear markets typically overshoot fair value on the downside. So be sure you can stomach another drop of 10% to 20% before you take the plunge for the long term. Grantham suggests filtering money into the market over a year or two.
Panic-selling has created some great opportunities in stocks, but no one knows when investors will regain their appetite for taking risks -- one of the keys to a sustained advance. "They don't ring a bell at the bottom," says John Buckingham, manager of Al Frank Fund. "The best time to buy is when everything looks awful."
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A shopping list
So if you're young and socking away savings for retirement, or if you're older, brave and want to purchase stocks and funds before evidence of an economic recovery is visible, here are some stock and fund ideas.
Two kinds of companies that tend to hold up well in a recession are those involved in health care and those that produce or sell consumer necessities. Companies in both sectors typically generate a lot of cash flow and maintain strong balance sheets. That means they don't need to tap unfriendly credit markets for financing.
David Chalupnik, head of equities for First American Funds, values the earnings consistency and steady growth of Abbott Laboratories (symbol ABT) and Medtronic (MDT). Abbott's growth actually appears to be accelerating, says Chalupnik, and Medtronic's management is cutting costs and running its business more tightly.
Turner Funds' Bob Turner, who specializes in fast-growing companies, is bullish on Gilead Sciences (GILD), a biotechnology firm that he calls "the next Big Pharma company." Gilead made its name in HIV treatments, but Turner also sees opportunity in Gilead's drugs for treating hepatitis B and hypertension.
Chris Baggini, who manages an Aberdeen fund that owns stocks and sells some shares short (a bet on falling prices), also figures that health care is relatively immune to recession. He favors CVS Caremark (CVS), which, after its merger with Caremark, is now part drug retailer and part private-benefits manager. Baggini likes CVS's acquisition of Longs Drugs, noting that CVS has a long history of acquiring and improving drugstore chains' operations, as it did with Eckerd.
Ron Rimkus, manager of BB&T Large Cap fund, is a big fan of Kraft Foods (KFT) and its chief executive, Irene Rosenfeld. "People still have to eat," he says. The maker of dozens of brands of packaged foods -- from Kraft macaroni and cheese to Oreo cookies -- benefits from crumbling commodity prices. Moreover, in early December, shares of this multinational giant served up a tasty 4.2% dividend yield.
As a retailer, Wal-Mart (WMT) isn't usually lumped into the same category as food and health-care companies. But the world's largest retailer certainly sells plenty of consumer necessities. Baggini thinks Wal-Mart will benefit as consumers trade down and search for the lowest retail prices. Indeed, Wal-Mart saw surprisingly strong sales growth in November, a disastrous month for nearly every other publicly traded retailer.
Tech on sale
The case for technology stocks is different. Companies are slashing capital expenditures, so tech manufacturers will feel some pain in the short term. But many of the most powerful players in the industry, with robust balance sheets and cash flows, are on sale. These outfits will survive, continue to invest in research and development, and thrive when the cycle turns.
Turner thinks that even during this recession, Google (GOOG) will generate earnings gains of 25% a year because of its expanding share of advertisement spending (Google is one of our top eight picks for the year; to see the rest of them, turn to page 32). He also likes Apple (AAPL), for its mastery of such electronic gadgets as iPods and iPhones, and Broadcom (BRCM), which designs the chips for the iPhone and many other popular devices.
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Stocks in economically sensitive industries, such as industrial equipment and commodities, have cratered because of recession fears. But therein lies a large opportunity, say veteran investors such as Don Hodges, of Hodges fund, and Jerry Jordan, of Jordan Opportunity fund. Many cyclical stocks, they say, already reflect the recession and then some, and they're selling at extraordinarily favorable prices.
Hodges, a crusty Texan, is buying Transocean (RIG), the world's largest operator of deep-sea drilling rigs, most of which are leased in long-term contracts. He also likes Boeing (BA) for its enormous backlog of orders for the new Dreamliner aircraft. In the small-company camp, he favors Commercial Metals (CMC), a steel-scrap business that in early November traded at five times earnings and at about 75% of book value per share (assets minus liabilities). It yields 5%.
Jordan also finds offshore deep-water drillers, such as Diamond Offshore Drilling (DO), too cheap to pass up. Diamond has no debt and has rig contracts signed for the next two years, says Jordan. He estimates that the company will earn $14 a share in 2010, up more than 20% from what analysts see Diamond making in 2009. Growth of that magnitude in a dreadful economy is bound to attract investors.
Overseas stocks
Foreign stock exchanges have been hammered even harder than stocks in the U.S. Through the end of October, says Leuthold, 43 stock markets around the globe suffered bigger declines than the drop in the S&P 500, which at its maximum point of stress plunged 44%. Sarah Ketterer, the bargain-hunting manager of Causeway International Value fund, is pounding the table for economically sensitive, high-quality companies in the capital-goods, industrial and engineering businesses. "I think this is a once-in-a-lifetime opportunity to own the very best companies worldwide in every industry," she says. "Investors don't want to own them at any price, which is about as interesting as it gets for a value investor."
Ketterer thinks she will reap big gains within a few years in German engineering giant Siemens (SI) and Japan's Fanuc (FANUF.PK), the world leader in robotics and factory-automation tools. Both stocks trade in the U.S. as American depositary receipts. And both trade for a bit more than book value, produce abundant cash flows and have strong balance sheets. "The first glimmer of economic recovery will be priced into these stocks very quickly," Ketterer predicts.
Jim Moffett, manager of UMB Scout International, prefers to hide out in health-care and consumer-staple stocks while most of the developed world remains mired in recession. Two of his health-care picks are Denmark's Novo Nordisk (NVO), the largest insulin producer, and Israeli generic-drug giant Teva Pharmaceutical Industries (TEVA). Two of his fund's core holdings are Switzerland's Nestlé (NSRGY.PK), the world's largest food company, and British American Tobacco (BTI).
If you're looking to increase the international-stock allocation in your fund portfolio, Causeway International Value (CIVVX) and UMB Scout International (UMBWX) are fine no-load choices. Over the long term, Asia should remain the highest-growth region in the world. One relatively tame way to invest in Asian emerging markets is through Matthews Asian Growth & Income (MACSX). Co-manager Andrew Foster says that many of the stocks he's buying yield 6% or more, a level he hasn't seen since the fund's inception in 1994. He's also buying bonds that yield 12% and more.
Back in the U.S., if you want to increase your exposure to health care, consider T. Rowe Price Health Sciences (PRHSX). Its manager, Kris Jenner, is a doctor by training. Two Kiplinger 25 funds that have a healthy respect for shareholders' capital and have excellent long-term results are Bruce Berkowitz's Fairholme (FAIRX) and Steve Romick's FPA Crescent (FPACX).
Finally, if you can't make up your mind whether to be bullish or bearish, consider Hussman Strategic Growth (HSGFX). A flexible mandate allows manager John Hussman to own the stocks and industries he likes while simultaneously short selling what scares him. Hussman, an economist by training, has shown a deft hand running this hedge-fund-like mutual fund since its inception in July 2000. Aside from a brief period in 2003, Hussman says, he finds the U.S. stock market undervalued for the first time in a decade. He believes stocks can return 8% to 10% compounded over the next ten years.
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Andrew Tanzer is an editorial consultant and investment writer. After working as a journalist for 25 years at magazines that included Forbes and Kiplinger’s Personal Finance, he served as a senior research analyst and investment writer at a leading New York-based financial advisor. Andrew currently writes for several large hedge and mutual funds, private wealth advisors, and a major bank. He earned a BA in East Asian Studies from Wesleyan University, an MS in Journalism from the Columbia Graduate School of Journalism, and holds both CFA and CFP® designations.
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