The Market Is Due for a Correction

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2009 was a banner year for stock returns, but will 2010 be the same? According to Charles Schwab chief investment strategist Liz Ann Sonders, the answer is no. In other words, don't expect a repeat of last year's 100%-plus returns from the likes of Apple (Nasdaq: AAPL), Freeport-McMoRan (NYSE: FCX), or Intuitive Surgical (Nasdaq: ISRG). Instead, Sonders says, 2010 will feature several corrections like the one we witnessed last week, as well as more volatility.

"I'm actually probably a little more optimistic than the consensus about the economy, but I think the market has more things with which it's going to have to contend this year," Sonders said in an interview. "We're seeing the market faced with not only pre-existing problems, but also some new problems. I think we'll see more corrective phases like the one we seem to have gotten a signal of last week."

Indeed, she says she thinks we'll have the first relatively meaningful correction in the near term.

That could bode well for valuations. With a 65% gain in the S&P 500 from its low last year, Sonders says she thinks a lot of the easy money has been made. The first stage of the market rally, which we saw last year, was solely a function of valuation expansion, during which prices rose from Armageddon levels in March. For instance, the P/E ratios of Hewlett-Packard (NYSE: HPQ), J.Crew (NYSE: JCG), and Transocean (NYSE: RIG) have more than doubled since then. However, though the market is certainly not cheap anymore, Sonders says it's not overvalued, either. "At best, we're reasonably valued," she said. "So now you need the denominator -- the E [in P/E] -- to do the lifting. I think it probably will -- again, not without bouts of corrective phases, but I think earnings will be a pleasant surprise this year."

Though there has been some concern that earnings expectations have risen too high, Sonders says we're not there yet: "I'm still fairly confident that 2010 earnings are going to be at least as good as what is a pretty optimistic consensus right now." Sonders expects a 35% to 40% jump in earnings year-over-year for 2010. (She forecasts using a five-year normalized earnings stream, in which she averages operating and reporting earnings.)

More predictions for 2010 from Sonders

• We won't see the usual push into equities from retail investors this year. While permanent scarring from past declines is part of the reason, a renewed focus on absolute return versus relative return is another factor. Sonders also says individual investors have many options through which they can gain exposure to asset classes. With so many varieties of funds and ETFs available, investors have access to all sorts of alternatives, whether it's commodities, currencies, or emerging markets.

• Treasuries are not a great long-term investment right now, although that doesn't mean we won't see trading opportunities. In the long term, Sonders says she thinks Treasury bonds will underperform equities. "Your yield on a 10-year is only your ultimate return if you hold that Treasury the whole 10 years," Sonders says. "If investors are looking for yield, they might have better success on the equity side, in higher-yielding dividend stocks."

• We're going to see more countries than just China reign in excess stimulus, as they watch their growth rates accelerate.

• Large caps will rule. For there to be a sustainable period of small-cap outperformance, Sonders says we need to see true traction in the U.S. economy. Her list of constraining factors includes the fact that most small caps are not global in nature, they don’t have as much access to the capital markets for raising money, and they're credit-constrained in terms of hiring. "But," she says, "I think we could get to a transition where small becomes compelling again once we start to see the credit environment loosen up -- and if we eliminate some of these huge uncertainties that I think are facing small companies, like taxes and health-care costs."

• The individual investor is still extremely risk-averse. Sonders says she thinks individual investors are more focused on risk than ever before, and that she doesn't think that attitude will change anytime soon.

• However, Sonders says she doesn't see major bubbles on the horizon now (though she does warn that investors should keep their eye on emerging markets).

The economy
In the past, very sharp recoveries tended to follow very deep recessions. But this time, Sonders anticipates the recovery will be tempered by pressure on the private sector. Specifically, Sonders says she doesn't think the U.S. consumer represents anywhere near typical strength -- even with pent-up demand -- in this recovery.

However, she anticipates more strength than what is expected in exports, inventory replenishment, and business capital spending, and predicts that these factors will provide a bigger pop to GDP, at least over the next several quarters, than what is baked into the numbers right now.

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