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Top Ten Predictions for 2009

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January 2, 2009

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As we enter 2009, you will see some familiar themes to this list (housing and banking under pressure, asset prices falling, commodity prices rising). Nevertheless, I am considerably more bullish now than I have been in years past. The correction of 2008 has been caused by two factors, one of which I believe investors should view as temporary and one as permanent. The first, and temporary, factor is a decline in valuations due to a decline in earnings power as a result of the current economic downturn. Although it does not seem like it, eventually the economy will improve and this factor will reverse itself. The more permanent shift (call it a decline in risk appetite if you want) is that investors are now willing to pay less for the same amount of earnings and thus P/Es have dropped. While things may change, investors should view this as a permanent condition. In my opinion, in consideration of these two factors, the equity markets are roughly fairly valued, depending on how deep the current recession will be. However, we might expect markets to overshoot which means there probably is some more correcting to do. 2009 should mark the final capitulation as more investors are forced to throw in the towel.

Credit crises tend to be a bit like brush fires, burning hot and hard for a short period. This credit crisis, like others that have preceded it, will, like the brush fire, eventually burn out. And I do believe that government intervention will eventually push asset prices back up (perhaps at the expense of low inflation). So, while I don't have much expectations for great positive returns in 2009, I am not extremely pessimistic. As Peter Lynch says, it never pays to be a pessimist unless you are "a short seller or a poet looking for a wife". Since I am neither, I remain open minded for a rebound in asset prices.

That being said, the market that will and must rebound first in my opinion is the debt market. Spreads on corporate bonds and "private label" mortgages are at barely to be believed wide levels. There are numerous companies trading with very substantial equity valuations and corporate debt that yields in the 15-20% range. While recovery values have certainly gone down, many company's debt issues are already trading at recovery values, giving the investor any upside virtually for free. Either the equity market or the debt market has to be wrong-either the debt is a terrific buy or the equity market is incredibly over optimistic (or the equity is just an out of the money option trading at a very high premium). I am open to both explanations but I lean toward the former. At times, as a real money investor, the values in the debt market are such that I actually question whether I should bother with the equity market at all any more. It may be instructive that in the Benjamin Graham era, it was usually contemplated that investors would have 40-50% of their assets in debt. Given most investor allocations and the need for income going forward, I would recommend 2009 as an excellent year to increase debt allocations. You may have heard of a "stock picker's market". Well, 2009 will be the year of the "debt picker's market".

So, here goes for the fearless 2009 predictions:

1. Housing Market Continues to Fall; Coastal Markets Will Be Hard Hit

I hate to say it again for another year but housing prices look set to decline again. While conforming mortgages are available and the lower end of the market may not suffer as much, rising unemployment, weak incomes and vastly overpriced markets mean that prices have to continue to fall. And the market dynamics are atrocious with rising foreclosures and a complete lack of buying interest. I predict another 10%+ drop in housing prices as measured by the Case-Schiller index in 2009. The drop will be especially acute in the high-priced coastal areas where lack of income growth and asset weakness will hit these overpriced markets. As many jumbo portfolio lenders lend heavily in these markets, expect jumbo rates to continue to be elevated and the stocks of portfolio lenders to take a hit. The good news is that if prices fall in 2009 and again in 2010, I think prices may increase in 2011 and thereafter.

Investment Thesis: Do not jump into the property markets. Reduce mortgage debt.

2. Corporate Bonds and Private Label RMBS Outperform Other Markets

As noted above, the prices of corporate bonds are at hard to be believed levels. Many bonds of companies with substantial equity valuations trade at or below recovery value, implying that there is no value in the rest of the capital structure and no belief that steps could be taken to repay the bond at par. You can even find companies who have more cash on their balance sheet than debt outstanding-and their bonds still trade at double digit yields! The sweet spot appears to be with BBB/BB corporate bonds.

Most private label mortgage bonds trade at "IO" or "interest only" levels, meaning no value is assigned to a return of a single dollar of principal. Their value is purely a function of how many more interest payments will be received. There may not be terrific upside given where the housing market has been and seems to be going, but if all you are counting on is a couple of interest payment, there is not much downside either. If there are no values here for the intelligent, informed investor, then we are all in some very serious trouble.

I favor 3-6 year risk to mitigate potential interest rate issues.

Investment Thesis: Go long intermediate term corporate and/or private label mortgage debt.

3. US Equities are Flat to Slightly Down

As noted above, the 2008 correction has brought equity valuations back from the extremes of overvaluation to a market with moderate undervaluation in energy, materials, industrial and technology stocks and moderate overvaluation in consumer, retail and financial issues. However, given that the financial sector remains impaired, housing wealth is disappearing and consumer balance sheets have still not been fixed, I think we have a real risk of correcting to the downside. The drumbeat of terrible economic news could drag the S&P down to the 600-650 level at some point during the year. However, I predict that, if it does get down there, there will be a significant pullback and that the major US indices will get back to roughly where they are now.

In response to those who say that now is a table-pounding buying opportunity in the equity markets, please see above about where debt market valuations are. Even if you are the most died in the wool equity bull, price recovery will have to happen first in the debt markets and, therefore, every investor should be exposed at least somewhat to that market. If the recovery is tepid, then debt could improve substantially and equity might go nowhere (this is, in fact, what I predict). If there is a terrific rebound, the returns in the debt market will be sufficiently high that you will not have lost out too much on the resulting bounce in equity prices.

Investment Thesis: Do not go long equities until more pain has been felt (600-650 target for S&P). Consider playing for a bounce if indices drop 20-25%.

4. International Equity Markets Underperform

International markets have always ebbed and flowed with the flow of capital around the globe. With the flow of capital moribund, I don't see a recovery for international equity markets in 2009. It also appears that the European banking sector is in terrible shape which will cap recovery in that region. Asian economies will continue to feel the effects of slowing exports.

Investment Thesis: Stay away from emerging market shares.

5. Continued Trouble in Banking Sector

So far, problems in the financial sector have been weighted toward "writedowns" and "loan loss provisioning", e.g. non-cash related charges to loan books. However, beginning in 2009, the real, cash credit losses are going to begin to hit and that is going to exacerbate the problems in the banking sector and cause a further cash crunch. For many institutions, these cash losses may be enough to tip them over the edge. I expect at least one financial institution that received TARP funds will have to go back for more. The political fallout from that will be significant.

Investment Thesis: Be very cautious of equity risk in the banking sector. Expect more political interventions in banking.

6. Commodities Move Sideways-Oil and Precious Metals Rise

Commodity prices will end the year largely unchanged on demand weakness roughly counterbalanced by supply reductions. I expect industrial and base metals to continue to be weak, agriculture to be flat and energy to rise. The supply and demand fundamentals in the oil markets actually look favorable as I expect supply cuts (from OPEC and geological factors) to outweigh demand destructions. I expect precious metals prices to remain strong on political uncertainty and problems in the financial sector.

Investment Thesis: Go long oil and precious metals. Other commodities will be laggards.

7. Treasuries Unsuitable for Investment

The advantages of being an individual investor can be considerable and nowhere should that be more apparent than what is going on in the Treasury market. Presumably institutional investors need to buy Treasuries because of the lack of suitable alternatives for vast amounts of money. The individual investor need not be so concerned. Treasuries prices will go up, down or sideways in 2009 depending on various unpredictable moves of government and huge institutional investors and every individual investor should just completely steer clear of this market. What is clear is that at current levels, US Treasuries do not provide a real, economic return to real money investors. The only reason to be in the Treasury market now is to buy and sell to a greater fool for more, which as history has proven, is an extremely risky and dangerous proposition. Your cash investments will yield significantly more in FDIC insured CDs, FDIC insured bank debt, Fannie/Freddie debt or defeased municipal bonds and achieve the exact same effect of having a government backed investment. Why would you use $10,000 to buy a Treasury bill yielding 0.01% when you could get an insured CD for 3%+? The only thing the Treasury market does provide you is access to longer term instruments. But if lending out money and receiving a fixed payment of 2.6% a year for 30 years and then your principal back in 30 years sounds like an attractive investment to you, please contact me as I have a wonderful bridge in Brooklyn you might also be interested in.

Investment Thesis: Stay away from Treasuries. Cash like investments should be in bank deposits, insured CDs, FDIC insured bank debt or deceased municipals.

8. Canadian Dollar, Australian Dollar, Mexican Peso Outperform-European Currencies Weakest

The currency market was turned upside down this year by the volatility and the market deleveraging. Given the current and expected US budget deficits and the low level of interest rates, it is amazing that anyone would prefer the US dollar to a currency like the Canadian dollar or Australian dollar where there are real, positive interest rates and little public sector debt. I expect some of these hard hit currencies to reverse their 2008 losses. European currencies look especially vulnerable to me.

Investment Thesis: Long Canadian Dollar, Aussie dollar, Mexican peso. Short Swiss franc, Euro.

9. Shortages Appear

One positive element of "capitalism" has been the constant availability of product as long as the buyer was willing to pay the asked for price. As governments are increasingly controlling the supply and demand in the markets, we should expect shortages to begin to appear as private actors will no longer be able or willing to respond to the current price mechanisms. The risks are especially acute in energy where the US is so dependent on foreign imports. Gasoline and food are the chokepoints where shortages might first appear (although we will probably also see some in retail items). If shortages appear in these vital commodities, expect significant political and social ramifications.

Investment Thesis: Play for a commodity bounce as soon as signs of shortages appear.

10. Return of US Political Instability

As the US economy has grown and prospered, we have enjoyed an unprecedented level of political stability. In the course of human history, that is actually more the exception than the norm. With the growing dissatisfaction of the middle class and an overly involved and heavy handed government, expect US political instability to make a return in 2009.

Investment Thesis: Invest in a solid bunker and some ammo :)

As always, have a great year, and happy investing!