Economic Growth
Standard & Poor’s Investment Outlook sees 25% growth in operating earnings of financial stocks. It sees 5% growth in earnings per share in all other sectors. The Congressional Budget Office, a nonpartisan group, says that GDP will fall 2.9% for all of  2009. In view of that confusion, I am at a loss to predict overall growth in 2009. What I hope to do is establish positions in companies with significant and sustainable competitive advantages,  great management, and returns commensurate with those characteristics. In addition, I expect to establish positions with best-in-class mutual funds with great managers. Hopefully, growth in portfolios will follow with these investments and managers, if not in 2009, then in 2010 and beyond.

In our last investment outlook letter, we were cautious about US stock investments and bargains were hard to find. We saw the start of a correction in 2006, and what we got was a deep recession with 50% plus pullbacks in market indices, measured from October 2007. There are fairly priced companies now, but the timing I am leaving up to the timing service.

Job Growth
In 2008 2.5 million full-time jobs were “lost”, 1.9 million in the last four months of the year. The job loss in December was 524,000.  The unemployment rate climbed to 7.2% in December. When the percentage of workers who have dropped out of the labor force and/or are only working part-time is added in, the unemployment rate becomes 13.5%. The number of workers collecting unemployment is at a 26-year high. The workweek fell to 33.3 hours, the lowest since the statistic was started in 1964.

Job growth is tied to economic growth, which in turn is 70% consumer-driven. The consumer is now reducing debt and squirreling away savings for a rainy day. Government bailout money may add jobs, but it’s a stretch to believe it will recoup the kind of jobs that the 2.5 million job loss represents. This has the look of the worst recession since 1945 and I don’t see job growth in 2009.

In the meantime, these employment figures cast some doubt on whether there will be a robust recovery in the economy in 2009.

The Consumer
Most economists think the consumer will spend less in 2009 due to fear. The Consumer Conference Board confidence index decreased to 38 in December from 47.7 in November and 90.6 a year ago December 2007.

Consumer spending in November was $9.974 bil., down from $10.030 in October, but slightly ahead of the $9.949 bil. in December 2007. When you consider that the Consumer Price Index was 212.4 in November versus 210.2 a year ago, real consumer spending is flat to slightly down.

According to the Federal Reserve (http://www.federalreserve.gov consumer credit decreased at an annual rate of 3.75% in November 2008. Personal saving (disposable personal income less personal outlays) was $298 bil. in November vs. $252.3 bil. in October. However, disposable personal income (personal income less taxes) decreased by $11.8 bil. in November 2008  vs. an increase of $16.7 bil. in October. Personal income decreased by $20.7 bil. in November 2008.

According to Federal Reserve Board statistics, total household debt as a percentage of disposable personal income (personal income less taxes) has risen from 11.13% in Q1 1980 to 14.01% in Q3 2008. During 2006 it was an average of 14.31%, and in 2007 it was an average of 14.37%.  There seems to be a downward trend from the 2006-2007 period, possibly explained by homeowners losing their homes and having to rent.

Much has been made of the effect of decreased gasoline prices. Much has been said about income tax give-a-ways, I will call them.  None of it will turn the economy around if unemployment rates , consumer fear, and consumer savings rates remain high.

We wonder how the consumer can support the economy during a recession if personal incomes drop significantly due to unemployment.

Inflation
The Consumer Price Index for All Urban consumers increased .9% in April, before seasonal adjustment. That’s 3.5% higher than April 2005.  The consumer price index unadjusted was 201.5 this April compared with 194.6  a year ago, according to the Bureau of Labor Statistics.  Commodity price increases may be finding their way into manufactured product. We are all too familiar with the effect of crude oil and commodity prices.

One of the restraints on the effects of inflation is productivity. On May 4, 2006, the Bureau of Labor Statistics reported that productivity in the business sector during Q1 2006  grew faster than Q4 2005, 3.4% versus 3.2% as revised (seasonally adjusted annual rates). Productivity is one of the keys to neutralizing the effects of wage inflation.

Interest Rates
The Federal Funds rate is essentially zero, the lowest it has ever been. Thirty-year fixed mortgage rates are around 5%. Bankrate.com national overnight average is 5.13% as of Friday, January 9, 2009. The rate on the 10-year Treasury note is 2.44% as of Friday, January 9, 2009. Six month CD rates are about 1.58%. One-year Treasury bills pay .41%. Corporate bonds Aaa are paying 5.03% according to the Federal Reserve Statistics released on Friday, January 9, 2009. The big question is whether mortgage rates can go lower.

Longer-term, the question will be how can the US Government run up $2 trillion in debt in the next two years and during that timeframe hope to sell the notes and bonds to the world economies, which at the moment do not have a lot of spare cash themselves, except for China. As of October 1, 2008, China’s central bank announced that its reserves were $987 bil., the largest in the world and growing by $18 bil. each month. It has been estimated that China currently holds about $700 bil. in US debt obligations. Will China buy all of the US $2 trillion bonds and notes Congress and the President cause to be issued in the next two years? I don’t think so! And which other countries have surplus reserves? OPEC and other Asian countries, like Japan?

The issue of stable interest rates will come up a year or two from now when and if inflation shows up, the Federal Reserve raises rates to combat inflation, and foreigners demand higher yields from the less than AAA rated US debt obligations.

The stock market typically does not act very well when rates are rising, but that’s not going to be a concern in 2009.

Money Supply
There is an old saying: “Just as the party gets going, the Fed takes away the punch bowl.”  The opposite is true now. The Fed is not only providing the punch bowl, they are opening the door to the refreshment warehouse. The M1 measure of money supply was $1.605 trillion for the week ended December 29th whereas a year ago it was $1.262 trillion. The M2 measure of money supply is $8.123 trillion for the week ended December 29th whereas a year ago it was $7.461 trillion.

History shows that, over time, when money growth increases, the economy increases. The question is can the Federal Reserve prevent inflation from getting a griphold in the economy. Did they react in time to prevent this recession? I don’t think so! But this is a 2010 and beyond problem, I believe.

Look for the punch bowl to be slowly eased away towards the end of  2009 or beginning of 2010, is my guess.

Earnings
The S&P 500 earnings estimates vary. I think $50 to $60 is a reasonable range. Standard & Poor’s estimate is $60. Goldman Sach’s is $55, which they consider a low-ball number; however, they use a 20 PE to forecast a 1100 close on the S&P 500 by the end of 2009. Put a historical 13.3 PE which is typical during troughs since the 1950s and you get an S&P 500 trading range of 665 to 798. On November 20, 2008, the S&P 500 hit 752. Put a bear-market crash type PE of 10 to that, and you get  an S&P 500 trading range of between 500 to 600, a possible new low from which a strong rally would begin. Put a long-term historic PE of 14.84 to it (1871-2001) and you get a more reasonable trading range of 750 to 890. The S&P 500 finished at 909 on Friday, January 9, 2009.

Foreign company earnings growth has slowed significantly, but China, Asia ex-China, Canada, and Latin America, particularly Brazil, may continue to outpace the rest of the world. Even though China’s growth will come down to 6-7% range, I think China is still a land of opportunity. We hope so. We’re invested.

Since the US is less than 45% of world GDP, diversification off shore still makes sense. The percentage allocation and countries are the only questions.

Energy
Oil closed at $40.83 per barrel on Friday January 9, 2009. This compares with a closing high of $145.78 per barrel on July 14, 2009, and a closing high of $95.98 on December 31, 2007. When oil trades down into the $40, and maybe even down to $35 per barrel, investing in the energy sector is a real gamble that the OPEC supply tightenings and demand recovery will push oil prices back up into the $50 to $60 range. I believe that’s in the range of Saudi Arabia’s cost of production.

It used to be that a weak dollar sent oil prices up. In December oil prices came down as the dollar index came down. There was a temporary spike up to $48 and change on January 5, 2009 when Israel attached Gaza. That didn’t last long. The dollar has strengthened from $80.88 to $82.71 while oil prices have plummeted.

According to the IEA Oil Market Report (http://www.omrpublic.iea.org ), global oil demand is expected to shrink to 86.3 million barrels per day while global oil supply will be about 86.5 million barrels per day. Approximately 22% of production is light sweet crude, which everyone wants for clean gasoline. The rest is heavy, sulfur rich crude, more expensive to process, and is typically used for other purposes.

Coal tar sands in Canada hold roughly the equivalent of the Saudi oil fields, but production has been cut. Solar, wind, and other energy alternatives are not cost-effective while oil prices are low.

The energy problem is not going away anytime soon. Energy investments will once again make sense when the economy and demand picks up.

US Current Account Deficit
The US current-account deficit, the broadest measure of US international trade, decreased to $174.1 billion (a preliminary figure) in Q3 2008, versus 180.9 billion in Q2 2008, according to the Bureau of Economic Analysis (www.bea.gov). In other words,
the US is buying more from the world than it is selling to the world by about 174 billion a quarter. As a share of GDP, that’s 4.8%. It should be no surprise. We have a greatly diminished manufacturing capability in the US.  Consumers buy foreign cars even as our US car makers are crying, begging for help. We buy clothing, toys and many other products from China while unemployment in the US ratches upwards and China gets richer and richer. How long can this go on?

Economists do not think this high rate is sustainable. Is this a problem? The current situation works fine as long as the world buys US Treasury notes, bonds, and bills and US securities or the dollar depreciates against the world’s currencies, or their currencies appreciate. However, if foreign countries decide not to recycle the dollars back into US debt instruments, that would cause US interest rates to rise in order to entice foreigners into buying our debt and, if rates continued to rise, a recession in the housing market and other sectors of the economy would occur.

In a papers entitled "How long can the unsustainable U.S. current account deficit be sustained" written by Bertaut, Damin, and Thomas,  the authors concluded as follows and I quote: “All told, it seems likely it would take more than a decade for U.S. indebtedness to reach any limits of global investor’s willingness to extend financing.” The full 67 page report can be accessed online at: (http://www.federalreserve.gov/pubs/ifdp/2008/935/ifdp935.pdf

In March 2005 Korea said it was thinking about cutting back on US debt purchases because it didn’t like the depreciation of the value of those notes and bills due to the declining dollar. The 10-yr Treasury note yield went from 4.20% to 4.6% in a couple of days, which tells us what might happen or worse if the world suddenly stops buying our debt.  The stock market dipped as well as the market price of the notes.

So for now, all other considerations aside, bond investors do not have to worry about rising interest rates driven solely by foreign buyers reluctance to finance our continuing foreign buying spree and extravagance.

US Current Account(Budget) Debt
It was Will Rogers, the great humorist, who said, “Alexander Hamilton started the Treasury with nothing, and that’s the closest our country has been to being even.” Every city, town and state has to balance their budgets. The federal government prints money to balance its budget, which is no real balance at all. There used to be a provision that for every appropriation, there had to be a offsetting revenue-raiser. Not any more.   There is little or not control.

The amount borrowed by the “General Fund” in the US government’s budget through January 9, 2009 was $10.6 trillion (it changes every second). The surpluses in the Social Security Trust and other Government Trust Funds (Medicare, highway, etc.) total 7.1 trillion. Total debt held by the public totals $5.9 trillion, according to the website http//zfacts.com. It appears that the Social Security Trust surplus is not counted in reducing the $5.9 trillion in public debt. At least that’s accounted for separately in this paragraph. That’s a 53  year high, measured against the GDP, or anything, for that matter. Now, your government wants to add $775 billion to the debt.

Research by James Investment Research, Inc. of government stimulus spending starting with 1940 to the present suggests it takes $7.14 of government spending to have the same economic impact as $1 of private sector spending. Yet, the current bailout plan as it stands would put more dollars into the hands of consumers. True,  there is some allocation to infrastructure. The last time a bailout was tried in the form of a tax rebate, consumers paid off debts or put the rebate into a savings account. As a result the US government is $300 billion more in debt with nothing to show for it.

The question every investor should have is, is the market going down in response to the bailout proposal (read “added debt and eventual increase in taxes to pay for it”) or is it going down for other reasons? It’s a good question and I wish I knew the answer.


Stock Market, Long-Term
We think the market will track the economy and S&P earnings growth. Earnings are the bottom-line driver of stock prices. There will be cycles of irrational exuberance followed by irrational despair. That’s why we have a cycle timing service, to warn us when things are getting out of hand.

Historical returns have been 10.3% since 1929, but that could be reduced to a 7% to 8% range in the coming years, as some of the brokerage houses have forecasted.

Currently, businesses seem to be fairly valued, maybe even a little undervalued. We think a small pull back is coming to provide better pricing. The bear market which started in October 2007 is looking old. The median bull market since 1900 has lasted about 27 months, according to Leuthold Weeden Research. However, in recent years, a bull market has tended to last 2 ½ to 3 ½ years, according to State Street Global Markets, a Boston brokerage firm.

We think the 18 year bull market from 1982 to 2000 could be followed by an 18 year secular bear market, with intervening rallies...lower highs and lower lows. Buy-and-hold will be replaced by buy-and-watch.

Active portfolio management will be essential to success during the coming years.

Stock Market, for 2009
According to Sam Stovall, Chief Investment Strategist for Standard & Poors, a lot depends on whether November 20, 2008 was the bottom of the bear market. Certainly, in the 16 bear markets since 1929, the more than 50% decline qualifies as a severe one, the third worst they say. Assuming that November 20 was the bottom, Stovall says that the average recovery in the first 40 days is 33% which would mean 1000 on the S&P 500. The index hasn’t reached 1000 yet. The next step is a 7% to a 13% retracement which would take the S&P 500 to either 930 or 870. The S&P 500 finished at 890 on Friday, January 9, 2009, not very far from 870. 

According to DOW Theory which says there are three waves down in a bear market, the first one being mild, the second one being violent (oh, have we had that), and the third one being mild. From there, a new bull market is supposed to start. Bull markets start typically three to six months ahead of when the recession ends. That is a big question this year because of the severity of this particular recession. The bears say that the recession will not end until well into 2010. If that were to happen, the conventional wisdom that the end of the recession will be midyear will turn out to be wrong.

CBO Director Robert Sunshine has said that this is no run-of-the mill recession. It will be long and deep (paraphrasing his quote).

Stock Market, Technical Indicators
Fibonacci retracements have proven quite reliable historically, and they work for most markets. On a monthly timeframe, the S&P 500 gave up over 100% of the gains since the October 2002 low, closing at 752 on November 20, 2008, but intraday, it reached 741.02 for a 103.7% retracement or decline, call what you want. It would appear that there have been only two waves down, and Dow Theory says that there is normally three waves down. So I have provided a weekly timeframe from the November 20, 2008 low to the January 6, 2009 high with retracement levels. The intraday low on Monday, January 12, 2009 was 864,  a 38.2% retracement within two points. The question is…how much lower?

On a monthly timeframe, the Russell 2000 gave up 91.27% of the gains since the October 2002 low.  On an intraday basis, it reached 371.30 for a 91.2% retracement or decline, call what you want. It would appear that there have been only two waves down, and Dow Theory says that there is normally three waves down. So I have provided a weekly timeframe from the November 21, 2008 low to the January 6, 2009 high with retracement levels. The intraday low on Monday, January 12, 2009 was 466.75,  within $4.17 of a perfect 38.2% retracement. The question is….how much lower?

These indicators are not really giving any specific direction as of January 9, 2009.

Stock Market, Sentiment Indicators
As of January 9, 2009,  the American Association of Individual Investors Index percentage of bulls was 48.7%, the percentage of bears was 35.1%, and the percentage of neutrals was 16.2%. Since a high percentage of bulls to bears is a contrary indicator, the market may be approaching a temporary resistance level. However, a 48.7% of bulls is not particularly high.  

The Chicago Board of Exchange’s VIX or volatility index finished the week ended January 9, 2009 at 42.82.  From September 2, 2008 until January 9, 2009, the VIX ranged from 21.43% to 80.86% on November 20, 2008 (the low of the market indices).  A VIX over 25 indicates fear, investors paying premiums for puts, a contrary indicator, and a possible buying point. A VIX at 10.00 indicates complacency, investors paying less than normal prices for puts, and possible selling point.  (The VIX is derived from two month of prices of all quoted at-the-money and out-of-the-money S&P 500 Index puts and calls.)  

I believe we are at the middle of a retracement up of the second wave down from October to November 20,  as of this writing January 9, 2009, and after the completion of the retracement up, and the third wave down, the market may make some progress during the remainder of 2009 because sentiment may improve more than it has already.  

Foreign Stock Markets
At a seminar on May 6, 2005,  a representative from Julius Baer Global mutual fund showed correlation between US stocks and foreign stocks to be approximately 90%, meaning that the 90%  of the performance of foreign stocks can be attributed to performance of US stocks (Standard & Poors says it is 81%). If US stocks fall $1.00, foreign stocks should fall by $ .90 cents. However, he gave other reasons to invest in foreign markets at that time.  Valuations were generally more reasonable. Opportunities for growth were greater back in 2005 and we believe certain foreign markets still offer better growth than the US in 2009. Foreign consumers do not have as much debt; therefore they have more sustainable consumption patterns.  On the other hand, there are economic, political and currency risks. The recession is worldwide and the foreign countries may not recover before us. Even so, the high correlation may rule out any delay in the foreign stock market recovery as the US market recovers.

Housing Market Bubble
The last time I wrote an investment outlook letter, it was in 2006. I don’t know when the 11 million plus inventory of unsold homes is going to come down to normal levels. I do know that my 2006 investment outlook letter warned about an overheaded real estate market. Accordingly, I believe there may be some interest in reading what I wrote a year before the crisis actually occurred.

Lately, there has been much debate about whether there is a housing bubble. Since 1929 the average annual increase in real estate has been 5.3%. Since 1968 the average annual increase has been 6.2%.  In 2004 the increase was above 10.0% in many areas versus around 5.0% in the 2000 to 2002 timeframe. Properties in coastal areas have risen at a greater rate than 10.0% recently. Prices in certain areas of the country have risen at higher rates. Prices are being driven by low interest rates, low down payments, loss of objectivity on the part of realtors, appraisers, and mortgage brokers, shortages of desirable land, high immigration rates, speculative activity, and lack of supply (of good homes and land). Household or personal incomes are not keeping pace, pushing affordability down.

In our view, anytime prices are rising faster than the historical average, there is the potential for a bubble. The present rates are not sustainable, irrespective of whether there is a bubble in a particular area of the US. A study of historic median house prices to median incomes will show the multiple is much higher than historic multiples. A study of rent to house prices will also show higher ratios.

Yale professor Robert Shiller believes there is a housing bubble, but he is not sure how to measure it or when it will end. He believes that excessive talk about and attention to the problem will be the catalyst. He believes it will end badly, whatever that means to individual sectors and areas of the country. Not everyone agrees with the bad ending.

Why should you care? Because a severe break in housing prices can cause a recession in the US and in turn possibly in foreign countries. Stock markets will follow downward.

For those of you thinking about a real estate purchase now, let us add this little postscript. Martha Stewart has sold her East Hampton NY place for $9 million in 2005 and has her Turkey Hill farmhouse in Westport CN listed for sale at $9 million. Her cost in 1972 was $80,750.

Building industry stocks have already anticipated a turnaround, but I think there will be better opportunities for an entry point later in the year.

Commodities
In a deflationary environment, commodities have not performed well. Yet, I believe that sometime in 2009, commodities should be a part of every portfolio. Oil and fertilizer prices, key expenses to the farmer, are going to come back. The ETF I use for grains will be the choice. Oil will come back as the economy comes back and, just as important, as the pleasure driver comes back to the roads. Gold is a protector against inflation and the decline in the dollar. Inflation and dollar declines are going to happen due to the tremendous amount of debt the Congress and President are going to approve, and 2009 may be the year of anticipation of their happening in 2010.

Gold is in a corrective phase as this is written, but I believe every investor should have some portion of their portfolio in gold, the ETF for gold, the most popular being GLD.

Valuations
At any one time, the market is either overvalued or undervalued. We believe it is never precisely fairly valued as so many commentators will say from time to time. When Robert J. Shiller published Irrational Exuberance in 2000, he thought the market was clearly overvalued. Today, he thinks it is fairly valued. High prices, relative to average, have been followed by lower prices, regardless of fundamental factors. In every market, reversion to the mean takes place.

According to Jeremy J. Seigel in Stocks for the Long Run 3rd edition,  the real return on stocks from 1802 to 2001 was 6.9%. Add inflation of 3 to 4% and you get a total return of somewhere north of 10%. Seigel argues that the price of an investment should equal the present value of the future stream of dividends, including buyback of shares from retained earnings. Whether you get a 10% return depends in part on the the price you pay for the investment and the dividends it pays. This bring us consideration of the price-earnings ratio or PE ratio.

According to Seigel, the historical PE ratio of “the market” from 1871 to 2001 has been 14.45. Divide that into the average value of “the market” and you get a figure called the earnings yield, 6.8%, which nearly matches the 6.9% real return, cited above. Seigel says that “the market” represents the entire market value of all stocks of all companies, both large, medium, and small in size. That makes comparisons difficult with individual indices such as the DOW, the S&P 500, the DJ Utilities, the NASDAQ, and the Russell 2000.

As of January 9, 2009, according to Barron’s,  the historical PE ratios for two of the three indices are higher than 14.45, (DOW 17.96, S&P 19.38, DOW utilities 11.30). Seigel argues that a stable economy, low trading costs, low inflation, and lower taxes justifies PE ratios in the low 20’s, for an earnings yield of between 4 and 5%.  The major indices are have earnings yields of over 5% as of January 9, 2009.

Using a forward PE ratio for the S&P 500 and earnings of $60, the current forward PE is 14.83 (890/60), very close the 130 year historical PE. This suggests the S&P 500 is reasonably valued.

For 200 years, the equity premium in the earnings yield of stocks over the rate of “safe” long-term government bonds has been about 3.5%. Since 1926, the equity premium has been about 5.0%. Seigel argues that the future equity premium should be between 2.0% and 3.0%. The earnings yields on the DOW, the DJ Utility average, the S&P 500 Index, and the S&P Industrial Index are all higher the 10-yr Treasury note yield of 2.39% plus 2.0% and the 30-yr Treasury bond yield of 3.06% plus 2.0%. Again, this suggests the market is reasonable valued.

Historical dividend yields have been in the area of 3.0%. Prior to 2004, dividends received by individual taxpayers were taxed at their marginal tax rate. Today, qualified dividends are taxed at a maximum rate of 15.0%. Dividend yields could conceivably be in the area of 2.4% and still be at the historical level. The dividend yield for the Dow and S&P 500 Index are presently 3.66% and 3.04% respectively. Companies aware of the desirability of paying dividends are increasing them, narrowing the gap between historical and present yields. This suggests the markets are at fair value.

Historically, the ratio between earnings growth and price to earnings (PEG ratio) has been 1.00. Put another way, over time, the percentage of earnings growth of a company should be the same as the percentage of the price-earnings of the stock. The S&P 500 forecasted earnings for 2009 ranges from $50 to $60 versus the historical $78.74 for 2007, an implied negative growth rate relative to 2007, and $45 for 2008, pending Q4 earnings reports. With a PE at 19.38 the PEG ratio of the S&P 500 is presently over 1.00

Bonds
I believe the outlook for bond investments is tricky and difficult to predict in the short-term. Long-term, the prices of Treasuries are clearly in a bubble because of fear. Other sectors, such as munis and corporates look enticing. My strategy would involve some hedging, such as TIPS against inflation, Vanguard GNMA for safety, a Loomis for further protection against a declining dollar, a short-term bond fund, and a temporary short bond fund. The TBT comes to mind.

Certain bond mutual funds are a good buy at this point, but one must be alert to the inflation threat, or simply, the disappearance of deflation.

REITS
REITS have historically performed well against other asset classes over the last five years, but that trend ended in 2008.

You would think low interest rates would be favorable,  as also a slowing economy could be. Yields on REITS are good, but the fundamentals are not in their favor. The  recession is increasing vacancy rates.  We will need to be patient with investments in this asset class.

Our overall focus is long-term, but we have short-term concerns about getting the correct entry point for investments.

Cash
We expect to vary cash positions depending on opportunities to invest and hedge.

We believe that healthy cash positions, hedge positions, foreign equities, energy, and defensive-type equities will serve us well in sustaining our outperformance of the indices during 2009.

We appreciate the trust and confidence you place in us to manage your wealth.

Source of the index information is the online website http://www.finance.yahoo.com/.