At the beginning of each year, we like to run through the key components of the market in order to try and get a feel for what to expect in the New Year. We’re not so much trying to look into a crystal ball and make a bunch of predictions as we are attempting to identify where we are in the big-picture cycle. In short, if we know where we are and can identify where we could be going, the hope is that we might be better prepared for the inevitable roadblocks that tend to crop up along the course of any journey.
So, since we’ve got an awful lot of ground to cover, let’s get right to it.
The first key thing to recognize about 2010 is that we remain in the midst of a secular bear market. By now, I’m sure you’ve seen the statistics regarding the stock market’s “lost decade” where the S&P lost -24.12% for the ten-year period ending 12/31/09. But the numbers for the average investor may be much worse than that. According to our internal calculations, the Lipper Large Cap Growth Index (a proxy for the average large cap growth mutual fund) is down -35.76% since the beginning of the new millennium.
The reason we bring up these disappointing statistics again is to remind everyone that we believe stocks remain in a secular bear market (defined as an extended period of negative returns) that is now 10 years old. And unfortunately, if we use history as a guide, the current cycle could last a while longer yet as the last secular bear spanned the period from 1965 – 1982.
Thus, the second key thing to understand about the upcoming year is that the current run for the roses is likely to end or, at the very least, slow down. In other words, the easy money from this move has already been made. In addition, we believe we are likely to see more volatility and more risk than we’ve witnessed over the past nine months.
However, we are NOT saying that the current rally is over. On the contrary, we believe there is more upside ahead. As we have mentioned a time or twenty, we believe we are seeing a “mini bull” within the context of a secular bear. And based on history, this type of market advance usually lasts a year or two (640 days to be exact).
The bulls also have the “breadth surge buy signals” going for them. As we reviewed throughout the past year, the market is usually higher 12 months after we see a significant surge in breadth. And for the record, the latest breadth surge signal occurred in September.
Yet, given the extent of the current run, we believe that the bears are very likely to reassert themselves at some point during 2010. Thus, we believe it makes sense to go into the New Year looking for trouble and ready to play defense if needed.
Now let’s turn to what we believe will be the key drivers for 2010: the economy, the state of interest rates, corporate earnings, valuations, and the risks to the system.
Given the question marks that exist regarding the state of the economy, we believe the stock market will continue to take its cues from the economic data in 2010, especially during the first half of the year. Good data should lead to (but doesn’t guarantee) higher stock prices. We’ll get to the exceptions to this concept in a minute, but from a big-picture standpoint, economic reports that come in better than expected should continue to embolden the bulls.
We would expect to see the economy continue to improve in the early going, but then begin to stagnate as the year wears on as the headwinds begin to take their toll. For example, we need to recognize that the economic stimulus that was applied in order to pull the economy out of its death spiral will expire, and that given the country’s growing concern about the massive deficits being run up, we’re not so sure Congress will be able to toss around another trillion dollars in 2010.
Some of the headwinds blowing in the face of economic growth include higher taxes that are scheduled to kick in during 2010, rising interest rates, an anti-business mentality among Congressional leaders, and a generational change in consumer behavior.
Reviewing briefly; higher taxes for businesses mean less incentive to grow a business, hire employees, and spend. Higher interest rates increase the cost of borrowing, which, of course, impacts profits. The fear of what Congress might do to businesses is also not constructive in terms of job growth.
Then there is the change in behavior among consumers. Remember, the consumer represents two-thirds of the country’s GDP. Therefore, given the wealth destruction that has hit John Q. Public’s 401(k) and his home, as well as the uncertain job market, we expect the consumer to remain in a cautious mode for much of the year – if not for many more years to come.
The old Wall Street saw, “Don’t fight the Fed” is intended to remind investors that stocks don’t perform well in a rising interest rate environment. In the case of 2010, while we don’t think we will see the Fed raising rates, we do feel that investors will have to deal with rising rates.
Although the FOMC may not actually hike rates, this is not to say that the Fed and market interest rates won’t become a stumbling block for our heroes in horns. Over the past two weeks, we have seen two separate announcements out of the Fed introducing programs designed to withdraw liquidity from the banking system. And given the massive amount of monetary assistance the Fed provided during the crisis, Bernanke and Co. doesn’t need to raise rates in order to become antagonistic to the stock market.
Don’t forget that the Fed in general and Bernanke in particular, have taken a lot of heat for allowing the housing bubble to get out of hand. Regardless of the fact that pricking bubbles has never been part of the Fed’s job description, the Fed’s so-called exit strategy is becoming a political and economic hot potato.
Now factor in the fact that the Fed’s “quantitative easing” programs (the direct purchase of securities) are scheduled to end in the first quarter and it isn’t much of a stretch to see that the Fed will be commencing with its exit strategy very shortly.
While we’re on the topic of interest rates, the other thing to keep in mind is the Fed only controls the Fed Funds and Discount Rates. The world’s traders actually control the rest. And if you have a moment, take a peek at a chart of the yield of the 10-year T-Note. You will see that while the Fed has pledged to keep rates low for an “extended period,” market rates are already on the rise in response to improving economic data.
While we don’t expect to see rates spike to the upside, we do need to remember that rising rates have a negative impact on stock prices. Then when you mix in the more than $2 Trillion the Treasury needs to raise over the next 12 months, the idea of rising interest rates probably ought to be part of investors’ 2010 plans.
There is little doubt that earnings will continue to “improve” during the first quarter of 2010. The comparisons to the year-ago quarter remain akin to a child leaping over a bar placed directly on the ground. Thus, the expectations-versus-reality game played when comparing earnings to analyst forecasts ought to favor the bull camp for another quarter or so.
However, it has been quite clear that much of the gains seen in earnings lately have been driven by cost cutting. So, when you consider that costs can only be cut so far, at some point, we’ll need to answer the question: “Where’s the beef?
In English, we’re trying to say that investors will need to seen a “real” pickup in earnings at some point in 2010. And we’re not talking about “operating earnings” either. No, we’re saying that traders will want to see things like sales and/or revenues heading north if the bulls’ run for the roses is to be extended to any great degree.
As we wrote in our recent article Are Valuations Becoming a Problem? if you’re looking to start an argument about the stock market, bringing up the subject of market valuations will usually do the trick. You see, there are as many ways to look at valuations as there are ways to interpret the indicators.
It is important to understand that stock market valuation is more art than science due to the level of interpretation involved. But, after poring over numbers indicators, we will have to conclude that stock market valuations are becoming a bit stretched at the current time. Therefore, the bulls will need to see some earnings growth if they want to retain possession of the ball for the year.
Now that the bulls have enjoyed a record-breaking run in response to the funeral for the banking system having been called off on March 9th, even the most ardent bears will likely agree that risks are on the rise. So, in looking ahead, we think it is important to identify the risks that the bulls could face this year.
We see three big risks for stocks in the near-term: (1) The unwinding of the dollar-carry trade, (2) a spike in interest rates, and/or (3) a geopolitical incident.
While our list of risks probably don’t need much explanation, the dollar-carry trade does remain a mystery to a great many investors. So, let’s review the concept briefly. The problem isn’t so much the trade itself but rather the popularity of the trade. The idea of shorting the dollar and buying “risk assets” such as stocks, commodities, and emerging markets has become one of the biggest trades in recent memory. Thus, should something happen to cause this trade to “unwind,” the dollar would be bought and the risk assets would be sold – both in very large quantities.
Looking at interest rates, slowly rising rates are probably already priced into the market to a certain degree. Nobody expects to see rates stay at generational lows unless the economy does not improve. However, a move above say the 4.25% level on the10-year would likely be damaging to the bull case.
A review of both the historical cycles and the two markets that are most similar to what we’re seeing now (1974-76 and 2003-04) suggest that 2010 will be a mixed bag for stock investors. By looking at the traditional one-year cycles, the presidential cycles, and years that end in 00, it looks like things could be fairly bumpy throughout much of the year. But, when you compare the current cycle to what we saw in prior “mini bulls” that took place within the context of a secular bear, a better pattern emerges.
While all of this cycle stuff can be fun – especially when the market sticks to the historical script – it also is no way to manage money as this type of cycle analysis is merely computer-assisted guesswork. So, now that we’ve dispensed with our big, fat caveat, the good news is our roadmap for 2010 suggests that stocks will (1) be higher in the first 3-4 months of the year, (2) see a strong correction (which may or may not turn out to be a “mini bear” market) lasting about 4-5 months during the second and third quarter, and then (3) see a final rally into the end of the year.
So, what’s the best way to play the New Year? We’ll suggest that those who see the glass as half full stick with the bulls for a while but be ready to play defense when spring rolls around or whenever the risks become excessive.
The bottom line: We see a “buy-and-sell” type of market in 2010 with risks of a meaningful correction rising.
All the best,
David D. Moenning
Founder TopStockPortfolios.com
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