Friday, January 2, 2009

Themes for 2009 - Part 5 (Equity Outlook)

It is official. 2008 was the worst year for the Dow Jones Industrial Average since the depths of the Great Depression. For the S&P 500 you have to go back to 1957 to find a worse year. The breathtaking daily declines of 6 and 8% made front page news around the world. Government interventions made the subsequent short-covering rallies even more violent. If there is one word I used more than any other, it was "wow!"

At times I would get that chill down my spine. The one you get when you realize you're living through history. That people 100 years from now would be writing entire books about what happened at that very moment. Every grueling tick of the stock market served as further confirmation that my worst fears were coming to pass. And that by extension, society as I knew it was about to change dramatically. But by their very nature, the chills are a signal of a fear of the unknown. To what extent will the events of 2008 affect those of the next decades? Nobody knows exactly. But we know they will.

As I wrote in the Macro Outlook, the psychology of investors, consumers and producers alike has been damaged irreparably. People will not go back to speculating on condos. They won't go back to buying new boats to impress their friends. And they will no longer accept mere representations of something real as the original. Instead, we will start seeing people go out of their way to categorically reject anything they view to be associated with the aforementioned. Golf club memberships will plummet. Gluttonous vacations in the tropics will become a rarity. Images of women walking out of shopping malls with 14 bags of new shoes will exist only in our memories. Taking it's place will be an increased emphasis on time with family and close friends. On health and well-being. On home cooked meals.

So what does this have to do with the equity markets? Well, for starters, there has been a noticeable trend of producers, retailers and policy makers to categorize this progression of behaviour toward saving as "irrational." As if it is only temporary. Soon to be revived by some other outside influence as it was so many times before. But it's not coming back. Not only because it can't, but because most people really don't want it to. As a result, the aforementioned parties are baffled at this sudden change in consumer behaviour. They have not adjusted proactively and are very slow in reacting - if they have reacted at all. Even those that have, seem to be making the wrong decisions. Take GMAC's new policy to reduce the acceptable credit rating to qualify for 0% car loans. Or a multitude of retailers offering 2 for 1 deals on their products. People don't want 2. They want 1. And they want it at a discount. The end result is for them to buy none - and wait.

This is going to have disastrous consequences for corporate earnings, which, believe it or not, are still expected to rise substantially in 2009 by most "analysts." It is my expectation that at some point in the coming year there will be a sudden realization. That zero percent interest rates are doing nothing to entice people to spend more. That no price will fetch a buyer for certain goods or services. And that the trillions of dollars in derivative contracts sitting off the balance sheets of major financial companies are not ever again going to be priced based on what their quantitative model says is "normal."

I am expecting a wave of nationalization in the financials, bankruptcy in the retail space, and massive retrenching of expenditures and expansion plans for nearly everything else. Stocks could fall another 50% or more from current levels in order to accurately reflect this new reality. And even at that point they have the potential to become so universally detested that they are sold down to absurdly low levels. Whether this happens in 2009 or 2010 is unknowable. But I don't see the markets gaining much upward traction given the social headwinds I described.

Since mid-November, I have been tracking (and trying to take advantage of) a fairly weak "Santa Rally." I talked about this in previous articles "Looking for Relative Strength" and "Time for a Santa Rally?." I am seeing some early signs of exhaustion in some indicators that I follow that may be hinting that the rally is already nearing it's end. Of course, none of this excludes the possibility of stocks moving higher, or even substantially so. It just makes it increasingly more unlikely. Consider the following charts:

Click on any chart to see an enlarged version.

This chart is of the volatility index. Previously this year, the index hit highs nobody even thought were possible. But it has now worked off enough of it's "overbought" condition to warrant a bounce higher (suggesting stocks will fall). There is a confluence of support around it's 200 day moving average and previous spike highs from mini-panics in January and March.

Next up is a chart of the 10 day moving average for the Advance/Decline ratio. This measures the amount of stocks rising on any given day vs. those falling. Typically, when the recent average of this ratio rises to a certain level, it signals an extreme in optimism. It is far past that level as of the close on Wednesday.

Similar to the last chart, this one indicates a potential extreme in optimism. This is a chart of the put/call ratio. It monitors the amount of total put options traded compared to the total amount of call options traded each day. The blue line is a 10 day moving average of that ratio. Previous major market tops have been marked by visits to this same level (the all-time high in Oct '07 and the recovery high in May '08).

Again, this does not mean the rally must be over. These conditions could go on to reach even higher extremes in the coming weeks (perhaps another round of Obamamania?). There are legitimate arguments to be made for the S&P to return all the way back to the "point of recognition," which I believe started back in early October on a gap down below 1075. But the indicators I am watching are saying that this is unlikely. I'm sure there are other indicators that could argue for higher prices. There always are.

I am expecting 2009 to see a continuation of the global stock market correlation. Unless you happened to be invested in Ghanian, Tunisian or Ecuadorian stocks, you probably didn't make out very well in 2008. There will be some exceptions again in '09, but large declines will likely be the rule. Certain problem areas could even see shocking declines, market closures and other drastic measures taken by foolish government officials. I'm specifically looking at Russia, China, Pakistan, the UAE, and some eastern European countries. I am more optimistic on Latin America over the long term, but even they might not escape a similar fate.

In my Mid-Year Review I made specific mention of Russia's stock market, which had enjoyed 6400% gains since the Ruble Crisis of '98. It has since experienced a gut-wrenching 78% decline, wrought with market closures and other interventions. The recovery since October has been especially weak in Russia. The economy is reeling from low oil prices, and what was once thought to be the "Putin Miracle" has exposed itself to be nothing more than a miracle of high oil prices. There are deep undercurrents of social unrest afoot, and this market could still go much lower.

A similar situation is unfolding in China, where it wasn't high oil prices that had driven the economy, but rather a manufacturing sector that exported cheap consumables to the US and Europe. Consumers cannot afford these items that are typically discretionary in nature, and even if they could, they don't care to purchase cheap representations of a real product - they want the real thing. Many had thought that China would be able to make a smooth transition to a domestic consumption economy, thus avoiding any serious economic consequences of an American recession. I always thought that to be a rather pie eyed assumption. Here is a country that makes millions of trinkets that Chinese society has zero practical use for. And not only that, but they don't have the infrastructure for a consumerist society. If the Chinese were going to start consuming more, it is something that would occur over decades, not months.

Demographically, China is a ticking time-bomb. They have millions more men than women (a nasty side-effect of the One Child Policy). And now those same millions are being thrown out on the street as their factories close. Jobless, unmarried men are not typically a jolly bunch, and I could see them kicking up a bit of a fuss.

Some analysts are going out on a limb and predicting a "massive" slowdown to 5% growth this year. Again, I think that is way too optimistic. I see actual economic contraction in 2009, and perhaps a 20-30% total contraction of the economy in the next few years. China could be the epicentre of this global unwind by the time all is said and done. Naturally, that's not something that even the 73% decline has priced in, and China could see a US Great Depression-style 90% decline. Another 60% down from these levels. Whether that proves to be the buying opportunity of the century, as was the 1932 bottom in the Dow, remains to be seen.

I could elaborate further on other markets, but the pattern is clear. Social and economic problems are abound, and they need to run their natural course before buying opportunities present themselves. I will be monitoring events closely. When I see the appropriate extremes in pessimism, I will try not to hesitate to act boldly. As difficult as that may seem at the time.

I'll be back with a summary of my Themes for 2009 early next week. Have a great weekend!


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Anonymous said...
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steven said...

Interesting comment. Appreciated.

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