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January 4, 2009

Market Outlook 2009 - Thoughts of a Professional Investor - Macroeconomic Articles on

Many highly successful traders exercise their skills within a framework of fundamental analysis. Given that lesson, I like to take reflection time at the beginning of each year to establish macro themes around which I can trade. One year is a relatively short time with regard to macroeconomic themes. Scenarios typically develop over much longer periods, building as events unfold and psychology shifts. In addition, time unfolds within a trader's imagination at a much faster pace than in reality. In other words, one's fundamental analysis may be thorough and one's conclusions accurate, yet the scenarios envisioned may not come to fruition for quite a bit longer than anticipated. A trader must invoke patience and pay close attention to market signals, not only to trade at the right time but also to not trade at the wrong time.

Many of the expectations outlined below have been discussed in daily posts to my market blog.

Macroeconomic Backdrop
In 2008, the tremendous misallocations of resources built up due to excessive credit expansion during the housing bubble finally produced the long-expected panic and crisis. It is important to note that panic and crisis are not the same. Panics are emotional events... reactions to news that may or may not have any lasting effect on economic activity ... whereas crises deal with concrete restrictions on economic activity, whether it be lack of credit or a dearth of natural resources.

It is academic to try to pinpoint exactly when a crisis begins, but it is safe to say that by the time Bear Stearns collapsed in March, we were entrenched in our current crisis. The panic came in autumn (who would have guessed?) with the stock market meltdown. Crises tend to last anywhere from days to years after the manifestations of panic, depending on the scope of the preceding resource mismanagement. Given the current situation, it would be hard to imagine recovery occurring directly after the panic. In fact, 2009 is likely to be remembered for soaring unemployment, massive waves of bankruptcies, and scores of bank failures.

Just how big is the problem? Well, take a look at its foundation. From 1995 to 2000, unmitigated monetary expansion created a stock market bubble which sent the S&P 500 from 450 to 1550. The ensuing recession... and they always come when resources are misused... promised to be nasty. By 2002, the SPX had fallen back to 750. If healthy market forces had been allowed to do their work, the entire bubble would have been unwound, a few inefficient blue chips would have folded, and lots of smaller inefficient companies would have followed. To the chagrin of policy makers, prices of goods and services would have dropped (I like lower prices. Don't you?), resources would have returned to higher utility, and by now Americans would have been enjoying a productive (rather than speculative) economy along with a selection of bargain stocks with promising futures.

Instead, the Federal Reserve forced more credit down our throats and induced an even larger bubble. While the tech bubble's scope was measured in the hundreds of billions, the housing bubble dwarfed it. Tens of trillions of dollars were tossed around the globe in the forms of ill-advised loans and ill-advised derivatives on those loans. Yet despite its enormity, the housing bubble only managed to push the S&P 500 back to nominal highs. Why? Because it was all a fraud. Real wealth cannot be created simply by printing money. The housing boom was soaking up resources that would have been more efficiently used elsewhere or even left in the ground. Inefficient businesses thrived because they had access to capital at below-market price. We basically robbed our future resources simply for the guise of economic activity.

We are now entering a period of depression, in the classic economic sense, in which debt is detroyed, prices fall, and inefficient businesses... except those fraudulently supported by governments... fail. I do not believe that any government action can prevent this process from unfolding. Efforts by western central banks to force more credit creation will change nothing but the level of inflation economies suffer when expansion returns. Furthermore, reactionary antics by a new set of politicians are likely to deepen the coming depression through inefficient policies of regulation, taxation, and price controls.

With such a backdrop, it is highly unlikely the stock market has seen a low. I firmly believe the current rally out of November will fail sometime in the first quarter. I do not expect another panic, however. It seems more probable that the market suffers a slow erosion brought on by forced liquidation as unemployment rises and hope that government action will succeed slowly fades. I expect the stock market to end the year below the November 2008 low, but just how far below will depend on many factors, not the least of which is the extent of government interference.

Bonds and The Dollar
The quantity of money being created by the Fed in response to credit contraction will ensure that all other dollars in existence will be worth significantly less. However, in times of crisis people want safety, and the ultimate perception of safety still comes in the form of U.S. Treasuries which, by the way, are still sold for U.S. dollars. Add to this natural allure the fact that the Fed has explicitly stated its intention of depressing long rates, and one has the formula for a bond run and by extension, a dollar run. In conjunction with the deflationary forces of debt destruction and depressed economic activity, we now have the luxury of lower prices.

This luxury will not last. Market forces will eventually discipline the Fed through a combination of higher rates and inflation. The turning point will also mark a secular trend change for bonds, which have enjoyed a 27-year bull market. It is possible that the recent run carries the signature of the parabolic-style move that ends such long-term bulls. I suspect we will see the inflection during the course of 2009. With regard to the bond market's effect on stocks, the recent flood of money into bonds has likely stunted the extent of the stock market rebound out of November. Ironically, if bonds fall fast enough, the rise in rates could likewise stunt stock performance.

There is no doubt that the monetary expansion being executed by central banks will lead to a painful level of inflation in coming years. However, inflation typically coincides with credit expansion. In other words, current monetary policies are not having the desired effect, nor will they be efficacious until the global economy finds a footing. As implied above, I have serious doubts that such a turn will occur this year. It is therefore unlikely that commodities will cycle back into bull mode during 2009. It will be a trader's market, and any rallies should be shortable. Industrial commodities such as energy and non-precious metals should remain especially weak. However, I suspect gold will continue holding relative strength versus all other commodities in anticipation of the coming inflationary phase.

Wishing a healthy and prosperous New Year to all…

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