The End Is Near!   (That is the year, not the bear market)

OUR OUTLOOK FOR 2009

Notwithstanding Washington’s actions to resuscitate the economy, in our judgment, not enough has been done to deal with the most critical problem facing the economy, namely, the real estate mess.  Banks may be using federal funds to shore up their balance sheets but unless and until lending to the housing market resumes in earnest, house prices can be expected to continue  falling, the public’s wealth confidence as well as jeopardizing thousands of businesses dependent on that market.

As we approach year’s end, stocks may stage a mini-rebound as investors become dissatisfied with the current nominal-to-zero returns on cash and cash equivalents.  Logic seems to dictate that investors may turn to debt and equity instruments, seeking returns which are starting to appear persuasive.

As we approach the new year readers might find it instructive to re-read our prediction for 2008 published on January 4, 2008, entitled “What Cannot Be Cured Must Be Endured.”

THE DECEMBER EFFECT

With only a few trading days remaining in 2008 about the best we can say is, “Thank God it’s over.”  If we’ve learned anything from history, post-election markets have been worse under Republicans while new incoming Democrats fared better in the post-election period.  During the past twelve decades, there have been 10 post election bull market rallies, and the 2 bear market post election exceptions were: the Crash of 1929 and 1969.  Unfortunately, we suspect that this anomaly seems destined to repeat itself in 2009.  Since January’s market has usually been foreshadowed in what is commonly known as “the last two trading week of December phenomenon,” which holds that so goes the last 2 weeks of the year, so go the year ahead.  Based on this allegory, the statistics do not bode well for 2009.  And, absent an unparalleled rally in the last days of the trading year, 2008 will go down as a bear market year.

For the full year 2008, the Dow Jones Industrial Average is apt to post a nearly 36% drop, having started the year at 13,261.82 (It closed Friday at 8515.15). Based our on Risk Premium Model, there is no immediate relief in sight.  As for 2009, our Risk Premium Model points toward a continuation of the bear market, with February and March being especially “high- risk” months, as audited earnings are released and the heightened Hedge Fund redemptions caused by poor performance and moves to diversify investment vehicles.

Risk Premiums For The Dow Indices 

The Risk indicators for the week ended December 26, 2008 follow:

§  The Industrial Risk Premium increased to 9.74% versus 9.66% in the prior week

§   Over the same period the Transportation Risk Premium increased to 7.94% from 7.58%

§   Finally, the Utility Risk Premium increased to 9.13% from 9.01%

(Graphs are below)

THE FIRST TWO QUARTERS: A SLIPPERY SLOPE

We have difficulty endorsing a bullish outlook for the first and second quarters of 2009 since it is difficult to envision a meaningful market rally while the Big Three U.S. automakers remain at death’s door and with the strong possibility of a failure of related industries. As companies release year-end 2008 results, including 2009 earnings’ guidance figures, we anticipate that 2008 corporate performances will fall short even of consistently revised negative expectations.  A meaningful rebound in the first half of the year ahead is extremely doubtful.  In fact, we envision a scenario in which many companies will look to 2010 as a turnaround year after experiencing sluggish second-half improvements in 2009 which would be consistent with historic economic and  market behavior.  However, forecasts at the outset of the year will bear closer monitoring than ever, given the extreme uncertainty of the times.

THE CHILLING IMPLICATIONS OF AN AUTO INDUSTRY BANKRUPTCY  

The Obama administration will need to deal with an array of thorny economic issues, ranging from an effective plan to revive the depressed housing market (however unpleasant that might be) to the herculean challenge of salvaging the auto industry.  In much the same way aiding the financial services’ sectors was imperative, so was bailing out the U.S. car makers.  While there have been calls in some quarters for the U.S. car manufacturers to file for bankruptcy,  we feel that because of the immediate crippling effects this would have on the U.S. economy it is a risk not worth taking.

PS: On a personal basis, apart from being at a competitive cost disadvantage, the U.S. produces cars which are simply ugly.  Perhaps one of the lacking elements is a heightened sense of style. Why should I pay a premium for a box with four wheels manufactured domestically when I can buy the same unsightly four wheel box for less money from a foreign automaker?

SO WHAT’S AN INVESTOR TO DO?  (The easy answer is pray)

It’s time for investors to seriously do their homework, narrowing the field of stocks and bonds they would like to purchase as securities reach exceptional bargain-basement prices and a market rebound appears to be at hand. Our advice is to start with super high-quality companies. Go for the base hit, not a home run unless you have a very high-risk tolerance.  Focus on companies with conservative balance sheets zeroing in on assets – especially liquidity relative to stock price – and financial flexibility on the capital side of the ledger.  Next take a careful look at business position, focusing on market share, global presence if any and consumer desirability.

VALUATION STANDARDS

Once you are satisfied with a company’s qualitative prospects, the next step in the process is to examine relative valuation benchmarks, for example, P/E multiples (10X or lower), dividend yields (4.5% or higher) and earnings yields.  With the stock market so severely depressed over the past 18 months, stocks (including certain preferred stocks) and corporate bonds are starting to look cheap in absolute terms.  That is not to say securities might not get cheaper, but in view of the fact that cash and U.S. Treasury instruments are now offering near zero returns, equities are certainly worth considering.  Options are also worth looking at since they can serve a key role in enhancing returns if the strategies are carefully undertaken.

DON’T OVERLOOK CORPORATE BONDS

It seems to us that insofar as corporate bonds are concerned, investors have been “throwing the baby out with the bathwater.”  Investors should seek out disparities between stock and bond values for the same corporation since the right approach may provide some interesting profit potential.  The time has come to read prospectuses again (and indentures for the brave of heart) because yields are high in absolute terms.  And if and when the bond market improves (i.e. liquidity), corporations may find this venue an attractive way to lower their debt costs. This could be a windfall for holders of certain debt obligations.  As always, caveat emptor.  Investing in non run-of-the mill corporate bonds can be a hazardous strategy and we strongly advise investors familiarize themselves with their redemption features.  Unlike stocks these instruments can have complex provisions.

RATING AGENCIES: READING BETWEEN THE COMMAS

While it may seem obvious, the actions of rating agencies can have a powerful and untimely influence on fixed-income securities.  We strongly advise that investors not only become familiar with the rating but “carefully read” the rating rationale.  Oftentimes the credit rating and accompanying text may be incongruous.  This should be a red flag.  Very often rating opinions reflect factors which may precipitate a change in rating direction, either up or down.  Thus, rating explanations can hold insights beyond those expressed by the mere letter rating. n

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