“…...I should note that the cemetery for seers has a huge section set aside for macro forecasters. We have in fact made few macro forecasts at Berkshire,and we have seldom seen others make them with sustained success.”

Economic Growth

Prediction: Economic growth in the US in 2010 will be anemic, in the 2.5% to 3.5% range. Growth in China will continue in the 8% to 9% range.

Discussion: In the December 21st issue of Barron’s, 12 chief investment strategists for the major firms gave their predictions for GDP growth in 2010. They ranged from a low of 2.3% to a two highs of 4%. Blackrock, the largest firm, came in at 3.25%.  The Congressional Budget Office, a nonpartisan group, predicts that GDP will rise 2.9% in 2010 and 4.0% in 2011.  Their predictions were made in August 2009. Since then conditions have improved a little, I believe. Half of the chief investment officers in the Barron’s article think rates will remain low as will inflation in 2010.

One reason growth could be constrained is the weak consumer and housing sectors… 15 million unemployed workers with no money to spend, five million vacant apartments meaning no expansion in major building, and a housing sector running at below capacity.

Another reason could be a government miscalculation. Tobias Levkovich, one of the twelve, thinks the government has too much to manage perfectly. There’s a risk it could make a major screwup in monetary, tax or trade policy. Shame on you, Tobias, for thinking our government could make a mistake!! 

Another reason for believing that US growth will be anemic is the continuing anemic lending and extension of credit. Banks are going to be saddled with more unperforming loans, some of which probably have not yet been acknowledged but may have to be in 2010. If the bad loan problem causes banks to have to focus on raising more capital and improving the balance sheets, they could be constrained from making the significant lending needed to jump-start the US economy.

The historical average GDP growth during the first four quarters of a recovery is 5%, according to David Wyss, Chief Economist with Standard & Poors. In addition, the rate of growth was even greater if the recession was especially severe and long, such as the one we just went through. In order for the US to achieve the average, the next three quarters will have to be terrific. The third quarter 2009 GDP growth was only 2.2%, the first quarter to have positive GDP growth. Wyss’s most optimistic forecast is for 4.7% GDP growth, for period July 1, 2009 through June 30, 2010.

Manufacturing is supplying positive news. In December the Institute of Supply Management’s purchasing manager’s index rose to 55.9 (a number greater than 50 suggests expansion in manufacturing). The manufacturing index of new orders rose to its highest reading of 65.5 in five years, a 5.2 increase from November and the sixth month of expansion. The manufacturing hiring index showed manufacturers were hiring back workers. Similar increases in manufacturing activity are being experienced in England, France, Germany, China, India, Italy, and So. Korea.

Rising metal prices is supplying positive news. The price of rhodium, used in catalytic converters, has risen 60% since October to $2,360 a troy ounce (rhodium is not traded on any exchange). Iron ore and coal prices have risen because of demand from China.  Diesel demand (and prices) have risen because of Asian demand, US truck fleets, farmer’s machinery needs, and for increased railroad traffic. Base metals such as copper, platinum and palladium have been on a tear.

Job Growth

Prediction: Job growth will be very anemic, if there is any job growth at all, in 2010.

Discussion: While nonfarm payrolls decreased only 11,000 in November, initial weekly jobless claims are still in the 450,000 range. For there to be serious job growth we would think the initial weekly jobless claims has to come down significantly.     The weekly jobless claims have been trending down, but not fast enough.

Job growth is the key to economic growth in 2010. Job growth is tied to economic growth, which in turn is 70% consumer-driven. The consumer is continuing a trend started in 2008 of reducing debt and squirreling away savings for a rainy day. We don’t see significant demand contributing to job growth.

The Congressional Budget Office is predicting an average unemployment rate of 10.2 for all of 2010. The Blue Chip Economic Indicators is a publication based on survey of the leading economists in the US. They think the unemployement will average 9.9 for all of 2010. Either way, they are not that far apart and neither one spells a robust recovery in 2010.

It’s a stretch to believe the $787 billion TARP program will help recoup the kind of jobs that the 2.5 million job loss so far represents. This has been the worst recession since 1945. We don’t foresee any more significant government intervention in 2010 to create jobs.

The Consumer

Prediction: The US consumer will repeat the behavior of 2009, reducing debt, saving money, and watching consumption very closely.

Discussion: Working against a strong 2010 recovery are these facts. The US consumer has too much debt, still. Banks have tightened their lending standards. There is no equity loan “ATM” for consumers to tap for big purchases. Art work, antiques, and second home purchases will suffer. Consumer net worth is still low due to lack of a housing recovery. Disposable income is lower because of higher unemployment, wage cuts, and continuing layoffs. After a 25-year spending spree, the consumer is saving. Personal savings as a percentage of disposable personal income was about 4.7%, up from a negative saving rate in certain periods prior to 2009.  However, despite the negatives, we believe the consumer trends of 2009….slightly increased spending, debt reduction, and saving…. will continue in 2010.

The Consumer Conference Board confidence index rose again in December 2009 to  52.9, up from 50.6 in November 2009.  For comparison, in December 2008, the index was 47.7  and in  December 2007 it was 90.6. The index is based on a sample of 5000 households. The December 09 rise is a little deceiving though. Consumers are pessimistic about their personal income and short-term prospects. They also are pessimistic about current-day business conditions.  However, they are optimistic about long-term business conditions.

Most economists think the consumer will spend less in 2010. We have a different view, considering the upward trend in 2009.  We think the consumer will spend a little more in 2010. Personal consumption spending in November 2009 was $10.610 billion, up from $10.564.6 billion in October 2009.  Personal income was 12,199 billion in November 2009, up 49.7 billion from October 2009. By way of comparison, personal income in Q4 2008 was 12.233 billion while personal consumption spending in Q3 2008 was 10.130 billion.

 When you consider that the Consumer Price Index was 212.4 in November versus 210.2 a year ago, about a 1% increase, real consumer spending is up about 3.7% year-over-year from Q4 2008 to November 2009.

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 the high of 13.91% in Q1 2008. Since Q1 2008, the ratio has declined in each quarter except Q3 2008. In Q3 2009 the ratio was 12.85, just over a full percentage point from the beginning of 2008.  It hadn’t been that low since Q2 of 2001.
 
We still question how the consumer can significantly increase spending to support a robust economy if unemployment is still as high as it is.

Inflation

Prediction: Inflation will remain relatively low in 2010, probably in a range of 2.5% to 3.0%

Discussion: The Consumer Price Index for All Urban consumers was 216.3 at the end of November, representing a 1.84% increase year-over-year,  according to the Bureau of Labor Statistics. The Producer Price Index for November was 177.4, up 2.78% year-over-year. The Congressional Budget Office sees the CPI up 1.5% in 2010.  The Blue Chip Economic Indicator publication predicts 1.9% increase in the CPI. The Federal Reserve Open Market Committee believes inflation is not a risk for all of 2010 and into 2011.

We believe that $100 oil is possible in 2010, but the intermediate target would be the $85 area. We also believe food prices are going to spike a little.  We are all too familiar with the effect of crude oil and commodity prices. Accordingly, we think inflation will be a little hotter than the forecasts above.

One of the restraints on the effects of inflation is productivity. We have not considered the effect of productivity on inflation.  Productivity is one of the keys to neutralizing the effects of wage inflation. We believe that businesses will be increasing technology spending and that could keep the CPI below 3.0% in 2010.

Another restraint on inflation in 2010 is the predicted anemic job growth. Without a strong consumer bidding up prices, inflation will remain relatively low, we believe.

Interest Rates

Prediction: Interest rates will rise due to market conditions and the Federal Reserve could be forced to raise rates before November.

Discussion: The Federal Funds rate is essentially zero, the lowest it has ever been, kept there by Chairman Ben Bernanke.   The rate on the 10-year Treasury note was 3.84% at December 31, 2009.  The 30-year US long-term bond was 4.63 % on December 31, 2009.  Bankrate.com national 30-year fixed rate mortgage overnight average is 5.33% as of year-end. One-year Treasury bills pay 0.45%, not much changed from last years 0.41%.  The trend of US rates is up in 2010.

The same question we had last year is how can the US Government continue to run up  deficits. The White House announced that it sees another $9.0 trillion in national debt. This debt must be financed by issuance of more US notes and bonds, in each of the next 10 years, and during that timeframe the world economies will have to step up, and at the moment not only do they not have a lot of spare cash themselves, they are running deficits also. The trend of world interest rates is up also.

China has been making noises all year about the US budget deficits. It has been estimated that China currently holds over $1 trillion in US debt obligations. Will China buy all of the next US $1 trillion round of bond and note issues in 2010? Congress and the President seem to think so. I have doubts that China can afford to.  And which other countries have surplus reserves?

The Federal Reserve could use higher interest rates as a tool to help bust asset bubbles should they appear. At the moment there is no danger of an asset bubble. It is not expected that the Federal Reserve will raise the Fed funds rate until sometime in the fall of 2010. However, around March 2010, the Federal Reserve will cease purchases of mortgages. William Gross of PIMCO estimates that the 10-Yr Treasury Note interest rate will spike up 30 to 40 basis points over a six month period,  probably by September. If that occurs, the rate would be about 4.25% by fall….not high enough to derail housing we believe.

In a speech to the American Economic Association’s annual meeting, Federal Reserve Chairman Ben Bernanke raised the possibility of raising the Fed funds rate if adequate regulatory reforms are not made or they prove insufficient to bust asset bubbles. Do we count that as the Fed’s third mandate, alongside maintaining stable prices and growing the economy? More likely this was just a Fed argument to buttress Bernanke’s contention that the recession was caused more by bad mortgage loans than by the Fed’s low interest policies. The accusation that the Fed was too lax on maintaining low interest rates for too long has been raging for some time, and Bernanke apparently felt obligated to counter it. Was this a political speech as some say? Nothing in the speech suggested the Fed was ready to raise rates in the immediate future.

There just doesn’t seem to be enough money in the world to finance US deficits. We believe market interest rates could rise by at least 1% by the end of 2010 which could force the Federal Reserve to follow with an increase in the Fed funds rate. The stock market and gold typically do not act very well when rates are rising without corresponding increases in worldwide rates.
 
Money Supply

Prediction: The money supply will contract during 2010.

Discussion:  The M1 measure of money supply was $1.683 trillion for the week ended December 14th whereas a year ago it was $1.607 trillion. The M2 measure of money supply was $8.405 trillion for the week ended December 14th whereas a year ago it was $8.104 trillion. The M3 measure of money supply is no longer tracked by the Federal Reserve but estimates place the amount around $4 trillion.

The growth rate of the all three measures of money supply have been declining since 2008 while the total money supply has been increasing; just not increasing as fast as pre-2008.  Corporate balance sheets are estimated to have about $9 trillion in cash and cash equivalents, a portion of which will finance technology and other low cost investments.

History shows that, over time, when the money supply increases, the economy and inflation increases. The question is… can the Federal Reserve prevent inflation and still allow ample money supplies to jump-start the economy?  Clearly the growth rate of the money supply is coming down, as shown on the chart at www.shadowstats.com. There is the possiblility that the growth rate could go negative in 2010.

Earnings

Prediction: The S&P 500 earnings will come in the range of $70 to $75 for 2010.

Discussion: The S&P 500 earnings estimates vary. . Standard & Poor’s estimate is $75.
The 12 chief investment strategists for the major brokerages and financial institutions average out at $75, but they range from $66 to $80. Goldman Sachs economists are anticipating a low growth US economy, higher exports, and higher unemployment. Those assumptions will push up corporate profits, they believe.

 Put a price/earnings ratio range of 15 to 17 (historical PE is 14.84) and you get a range of from $990 to $1,360. The question is… what will the end of 2010 S&P 500 look like?

We think that if revenues of the S&P 500 increase by approximately 8%, as some have predicted, and that results in a multiplier effect on profits of approximately 2-3 times, and the 2009 profits come in at about $60, then $70 to $75 makes sense.
 
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. We believe that China is still a land of opportunity and will be for the next decade.  Europe and Japan could continue to be slow growers, as their economies are mature, just like the US economy.

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

Energy

Prediction: Oil prices will rise to $82 after falling back to the mid $70s.
Discussion: February oil futures closed at 79.36 on December 31, 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. If we have a cold winter in 2010, it will have some impact for sure. We don’t see much oil pricing push coming from the US economy, but the world economies, especially Asia, will furnish upward pressure on prices.

 During 2009, the weak dollar helped to drive up oil prices. We think that trend will continue, with interruptions as the dollar temporarily rises due to better than expected economic reports.

According to the EIA US Energy Information Administration Oil Market Report, prices will rise to $82.  Global oil demand is expected to grow 1.1 million barrels per day (bbl/d) to 85.2 million bbl/d while the EIA says global oil production will be about 80.0 million bbl/d. The production number is about 5 million bbl/d short, so I don’t understand their forecast, but it is what it is, on paper. 
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 (Budget) Deficit

Prediction: Budget deficits and national debt will remain out of control. Debasement of US currency will be discussed more in public in the coming years but it will be too late to do anything.

Discussion: 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. 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 no control.

The amount borrowed by the “General Fund” in the US government’s budget through January 1, 2010 was $12.3 trillion (it changes every second). The surplus in the Government Trust Funds (Medicare, highway, etc.) total 4.2 trillion. Total debt held by the public totals $8.1 trillion, according to the website http//zfacts.com. That’s a 53  year high, measured against the GDP, or anything, for that matter. Now, your government wants to add $9 trillion to the debt over the next ten years. If there is another way to pay off this sum other than currency debasement, I would like to hear about it.

Stimulus programs (economists like to favor fiscal stimulus in recessions) don’t work. 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 US government and some business leaders and economists continue to endorse fiscal stimulus and mountains of debt with no end in sight.

The question every investor should have is, is the market going up in response to stimulus programs (read “added debt and eventual increase in taxes to pay for it”) or is it going up for other reasons? It’s a good question.

Stock Market, Technical Indicators

Prediction: The US markets will correct sometime this year.
Discussion: As the market struggles to make gains in January 2010, several short-term technical indicators are telling us the market could be overbought. Market “experts” are assuming there will be a 10% correction. If you look at the weekly Fibonacci chart below, the weekly timeframe gives a 38.2% retracement value on the S&P 500 index of 1036. That is just shy of a 10% correction. If the S&P 500 index does not hold there, the next support is the 50% retracement level of 1004. That would be a 12% correction. Either weekly index level is likely sometime in 2010. However, a 50% retracement on the monthly timeframe would bring the index to around 903. That would be a 20% correction.

Fibonacci retracements have proven quite reliable historically, and they work for most markets.  Below we have created a Fibonacci retracement projection based on the January 6, 2010 closing value for the S&P 500. The high point for the run from March 2009 may not have been reached, so these numbers are guesses.

If you look at the weekly Fibonacci chart below for the Russell small cap, the weekly timeframe gives a 38.2% retracement value of  575. That also is just shy of a 10% correction. If the Russell 2000 index does not hold there, the next support is the 50% retracement level of 556. That would be a 12% correction. Either weekly index level is likely sometime in 2010.

Stock Market, Sentiment Indicators

Prediction: Sentiment will turn bearish sometime in 2010

Discussion: We look at sentiment indicators as an indication of a time to buy or sell, or to stand pat.  As of January 9, 2009,  the American Association of Individual Investors Index percentage of bulls was 49.2%, the percentage of bears was 23.0%, and the percentage of neutrals was 27.9%. The Consensus Index published in Independence, MO showed 64% of investors were bullish. Another index, Market Vane, showed bullish sentiment at 57%.  Since a high percentage of bulls to bears is a contrary indicator, the market may be approaching a temporary resistance level. However, a 49.2% bullish reading is not particularly high. 

The Chicago Board of Exchange’s VIX or volatility index finished the week ended of January 1, 2010 at 21.68, indicating some but not much fear; it not a time for loading up on equity investments.  From March 1, 2009 until December 24, 2009, the VIX ranged from a high of 52.68 to a low of 19.47.  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.) 
The New York Stock Exchange High/Low calculates the number of stocks at 52-week highs minus the number of stocks at 52-week lows. On October 11, 2007, the 10-day average was 164, a relatively high reading. On October 14, 2009, the 10-day average was 240. At December 31, 2009 the 10-day reading was 235. This high reading indicates caution.

The New York Stock Exchange 200-day moving average is a measure of the percentage of NYSE stocks trading over their 200-day moving average. At December 31, 2009 it was 85.6%, a high reading. For comparison, on March 9, 2009, the low of the year, the 200-day MA was 3.6%. (T’was a time to buy like crazy, but who knew or had the courage.) 

US Housing

Prediction: US housing prices overall will remain level in 2010 and housing stocks will trade in a narrow range.

Discussion: Key word here is “overall”. I believe housing prices in areas where housing was not overbuilt will be OK, but housing prices in places like California, Florida, Nevada, and Arizona will continue to battle against the rising foreclosure rates. CEO Jess Carbiener of Lender Processing Services, a firm that provides default services for the major banks, says that foreclosures will increase. Why? Because delinquency rates are increasing in every state, not just the four mentioned, and out of that environment you have foreclosed homes flooding the market. The result will be continued downward pressure on home prices.

Working against this trend will be Congress. They will pressure banks to do more workouts to keep people in their homes and keep the inventory of unsold homes down. One of the ways banks can cut down on nonperforming loans is reduce principal of nonperforming loans. So far they have just been reducing interest rates.

On Tuesday January 5th, the National Association of Realtors(NAR) announced that its Pending Home Sales index (PHSI) dropped to 96.0 in November, a 16% drop versus being up 3.7% in October. The first-time home buyer’s $8,000 credit had something to do with it, as activity in preceding months declined.  Congress has reinstated the credit until April 30, 2010, and a surge in activity is expected in the spring. The chief economist at NAR, Lawrence Yun, expects that job growth in the second half of 2010 will support home purchase activity so that between the credit and job growth, overall
US home prices will remain stable or modestly rise in 2010.

Commodities and the US Dollar

Prediction: The US dollar will continue its long-term decline. The increase in interest rates may adversely affect gold and gold mining stocks while inflation and deficit concerns could pull gold and gold mining stocks in an upward  direction.

Discussion: Commodities should be a part of every portfolio as protection against fiat money declines. Oil and fertilizer prices, key expenses to the farmer, will continue to rise. Oil could rise to over $100 a barrel in 2010.  The intermediate price point could be $85 a barrel. The pleasure driver and the employed worker will come back to the roads. More importantly, the US government has restrained local oil exploration. Therefore, countries like Russia, Brazil and OPEC can control much of the world’s supply. They have pricing power if they chose to use it. Russia already does so with its East European customers. Working against pricing power though is the need of certain members of OPEC….Venezuela and Nigeria…. to keep oil revenues high. Those two countries can only do this by keeping the oil spigot open. Another factor supporting higher oil prices is the the diminishing supply of new oil. Experts believe the world has reached production capacity. That will eventually play out in a powerful way.

Gold is a protector against inflation and the decline in the dollar and other fiat currency as long as investors believe it provides protection against declining currencies. Inflation and dollar declines are going to happen due to the tremendous amount of debt,,,,some $9 trillion by some estimates…. the Congress and President are going to approve over the next ten years. True that gold has industrial and commercial uses…jewelry for example. The gold investor has been in charge in 2009. However, the coming increase in interest rates is typically a negative for gold and gold mining companies.  We think the bull market for gold could continue in 2010 as long as the dollar remains weak.

Gold has made an approximate 38% retracement (1170) from it’s high of 1226. It settled at 1104 at year end. Even if it goes a full 50% retracement, gold could be safe from further bearishness for a while. Our gold mining mutual fund has had an 18% annual return for the last 15 years. We think there’s a good chance that performance will continue. Here’s why. One author has followed the historic ratio between the Philadelphia Gold and Silver Index (XAU) index of gold stocks and the price of gold. He found that the ratio has averaged 0.24. Presently it is 0.15 (168/1104). Assumption=increases in stock prices of mining companies. However, given the leverage factor (increases in gold prices flow right to the bottom line of miners), gold mining stocks could easily plunge if gold moves to the 900 to 1000 area.

Pressure on the dollar could come from China and Europe as they seek to raise interest rates. China may have some bubble in higher end real estate, and could seek to cool that sector by raising rates. If other countries raise rates before the Federal Reserve raises the Fed funds rate, investors will seek better returns elsewhere in the world.

Iran

Prediction: Military action involving Iran could be the wild card that messes up all economic and market predictions.

Discussion: Iran continues to be defiant. It is moving ahead with nuclear arms production. It exports weapons to Lebanon and Palestine. It has some sort of relationship with Venezuelan President Hugo Chavez. It has missles capable of attacking naval vessels in the Persian Gulf shipping lanes, stopping oil exports. It controls suicide bombers in Iraq and Afghanistan. It was caught shipping hundreds of tons of weapons to Hezbollah, so it must be assumed that it has hundreds of tons of weapons stored for its own use. Internally, it is quelling most democratic demonstrations in a brutal manner to forestall any uprising that would take down the clerical theocratic government. It looks every bit like a nation getting ready for war. A middle-east war with Iran would throw all assumptions and predictions about the economy and the markets out the window. That’s one major risk to our predictions that we cannot get a handle on.

Valuations

Prediction: US market valuations will not become overvalued in 2010. Asian market valuations do have potential to become overvalued.

Discussion: 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 December 31, 2009, according to Barron’s,  the historical PE ratios for DOW, 18.09, was higher than 14.45. The historical PE ratio for the S& P 500 was 19.64 using estimated 2009 earnings of $56.  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 have earnings yields of over 5% as of December 31, 2009.

Using a forward PE ratio for the S&P 500 and 2010 operating earnings of $75, the current forward 2010 PE is 14.72 (1104/75), very close to the 130 year historical PE. This suggests the S&P 500 is presently reasonably valued. The question is: can we trust the earnings estimate?

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 is 5.53, and the S&P 500 Index is 1.15.  Both are all lower than the 10-yr Treasury note yield of 3.84% plus 2.0% and the 30-yr Treasury bond yield of 4.67% 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% (that could change in 2011). 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 2.64% and 1.97% 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 overvalued.

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 2010 ranges from $60 to $80 with a median of $75 versus the historical $59.21 for 2009, an implied growth rate 25% relative to 2009. With a PE at 14.72,  the PEG ratio of the S&P 500 is presently under 1.00, which suggests the broader S&P 500 market is undervalued.

Bonds

Prediction: Bond prices will decline and yields will rise as the economy improves. The 10-year Treasury note yield could easily rise to 5.00%, bringing up other yields along with it and bond prices down.

Discussion: The prices of Treasury notes and bonds are clearly in a bubble. In the month of December we saw some Treasury value declines  as the rate on the 10-year Treasury note moved from 3.24% to 3.84%. The yield on the 30-year US Treasury bond moved to 4.60% from 4.27% in a month. The yield on the 5-year US Treasury note has moved to 2.53% from 2.03%.

High grade corporate and emerging market bond mtual funds look enticing. Our 2009  strategy has involved some hedging, such as TIPS against inflation, Vanguard GNMA for safety albeit a low allocation, emerging market bond mutual funds for further protection against a declining dollar, a short-term low duration bond fund, and a temporary short bond ETF. We think that hedging will protect against nasty declines that can occur with bonds when interest rates turn up. We are avoiding Treasuries and reducing exposure to GNMAs. For some clients a diversified bond mutual fund portfolio supplied 20% plus gains. We do not expect to see anything like that in 2010.


REITS

Prediction: REIT valuations will remain under pressure during 2010

Discussions: REITS have historically performed well against other asset classes over the last five years. Because they are not closely correlated to equities, they have been a favored separate asset class over the years.  That trend ended abruptly in 2007 and the industry has been in decline from 2007 until recently. The NAREIT Equity Index lost 1.6% in 2009 in comparison to the other market indices.

You would think low interest rates would be favorable. Yet yields on REITS are down, and the fundamentals are not in their favor. The  recession has increased vacancy rates, lowered rents, lowered expansion plans, tightened credit,  and accordingly, lowered future growth rates. Risk is higher than normal for commercial real estate.  We might consider investing in REITS in 2010 if the fundamentals start to show signs of improvement. We currently favor a couple of medical office REITs because of steady cashflow and low vacancy rates and a couple of mortgage REITS because of yield.


Stock Market, for 2010

Prediction: Global markets will be up approximately 7- 10% by yearend, but the US market will struggle due to various constraints.

Discussion: The January Barometer says that whatever happens to the markets in January is the foreteller of what will happen the rest of the year, and it has historical backing. The barometer was not reliable for 2009, which saw a decline in January, but a tremendous 60% rally after March 9, 2009. The barometer is more reliable when the market has reached a year-to-date high in December, as has happened this past December.

The 82-year history of tracking the January barometer effect tells us that of 24 years in which highs were reached in December, 18 years were followed by positive Januarys, and the average return for those years was 17.2%. Of the six that had negative Januarys, the loss averaged 3.5%. We acknowledge Michael Santoli of Barron’s for reporting to us these encouraging stats which were compiled by John K. Harris, a market historian.

According to Sam Stovall, Chief Investment Strategist for Standard & Poors, construction in China is expected to increase in 2010, 10.8% more or less, while construction spending in the US and Europe is expected to decline 6.8% and 4.1% respectively. Citing Global Insight, he says global gross domestic product will increase by 2.5%, but Europe and Japan will increase only 1%. Gross domestic product grew 2.2% in the US during Q3 2009 and forecasts call for a more robust GDP growth rate for Q4 2009. We anticipate that Asia will continue to lead in growth throughout the 2010-2020 decade. Steve Leuthold of the Leuthold Group  has 50% of his total assets in overseas markets. We agree in theory, although our allocations are more like 50% of total equity investments.

Ultimately, the US stock market will rise according to increasing earnings of businesses, and, unfortunately, the outlook is for slow growth. Bloomberg predicts 2.3% GDP growth in 2010. Not enough to fix the unemployment problem in the US. Normally, the year after a recession ends should show robust 6%-8% GDP growth. A number of factors could constrain robust growth. First,  US consumers in total are struggling with lower take-home pay.  High 10% unemployment is the main cause. Second, US consumers in total will experience high mortgage and other debt delinquencies and home foreclosures. Third, bank balance sheets with more nonperforming loans then they will admit to are forcing lending officers to be much more conservative. They are also under pressure to raise capital….not conducive to greater lending. Lower credit availability restrains business growth and personal consumption. F0urth, the housing industry will remain in the doledrums in 2010. Buyers of new homes must come up with a 20% downpayment for a conventional mortage application. The no-doc, no-income lending bubble does not exist anywhere close to what it was.

One bright spot is the approximately $1 trillion in cash and short-term investments that businesses are holding, according to a Wall Street Journal survey in November 2009. If that’s true, businesses hold enormous potential for business investments. Their cost-cutting has increased cashflow to the point where hiring and business investing can be financed much more from current cashflow. The most likely beneficiary of business investments will be technology because productivity increases through technology spending, particularly computers and software. New computers and software are cheaper than new bodies.


US Stock Market, Long-Term

Prediction: The US Market will be lucky to deliver any growth over the next ten years.

Discussion:  We think the US market will track the economy and S&P earnings growth. Earnings are the bottom-line driver of stock prices. Earnings in the coming year or two could be stable, with not much growth. We see little growth over the next ten years. Why? Increasing government regulation, trend towards protectionism and socialism, sectors of the economy effectively nationalized (autos, healthcare, mortgage loans, banking), much higher taxes especially on business owners, low consumer demand, foreign competition, continuing loss of manufacturing jobs and manufactured product business, static housing prices, and little or no job growth are a number of reasons. From 2000, the supposed beginning of the secular bear market, to December 31, 2009, the S&P 500 has delivered no market gain. Think about that fact.

There will continue to be bull market cycles, driven by irrational exuberance, followed by irrational despair and pullbacks, during this secular bear market. The Great Recession of 2007-2009 tells us something has changed.

Historical returns have been 10.3% since 1929, but that could be reduced to nothing in the coming years, as some of the brokerage houses have forecasted.

Currently, the S&P 500 seems to be fairly valued if we can accept the earnings estimate of $75 and a multiple of 15. We think a small pull back might be coming if earnings estimates prove too optimistic. A pullback would  provide better a better investment opportunity in foreign markets. 

Bull markets last on average 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.

A number of prominent economists and money managers think the 18 year bull market from 1982 to 2000 is being followed by an 18 year secular bear market, with intervening rallies...lower highs and lower lows.  Count Ned Davis of Ned Davis Research, Inc., A. Gary Shilling among them.

Buy-and-hold has been replaced by buy-and-watch. Active portfolio management will be essential to success during the coming years. Asset allocators will be challenged to avoid the 2008 type of market decline where modern portfolio theory and diversification with bonds didn’t work.

We hope that our cycle timing service will warn us of marco economic and market changes.


Foreign Stock Markets

Prediction: Asian Countries ex-Japan will continue to outpace growth rates of other countries. Europe and Japan will continue to struggle.

Discussion: When we speak of Asia, we have in mind mainly China and India. Not that other countries in the region aren’t putting up good growth numbers. China has surpassed the US as the world’s largest internet market with more than 300 million users but a penetration rate of only 22% compared with 72% for the US. Asia has the largest market for mobile phones. Asia is expected to become the largest market for LCD TVs. In a recent survey, 40 of the top 50 brands favored by Asian consumers were Asian made. Not a good statistic for those folks expecting American exporters to pull the US out of slow economic growth. Rising wage rates in Asia will eventually push Asian companies, particularly banks, to invest in technology instead of manual labor, which is still the trend now.

We like the Matthews group of mutual funds because of their long-term experience in the region. They have their fingers on the problems of valuation, real estate bubbles, over-stimulus of the economy, inflation, excessive loan growth, etc.

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.  Growth rates are better. Foreign consumers do not have as much debt; therefore they have more sustainable consumption patterns. 


Long-term Portfolio Performance and Strategy

Prediction: We will remain fully invested after the correction for most of 2010 with or without a position in a short fund.

Discussion: Since we started investing in January 2001, we have outperformed the market indices in every year except 2003.  In that bull market year, we were not fully invested in stocks (we never are), so it would be a natural thing for us to lag the all-equity indices in such a year. We did well in the down years 2001-2002. We are value-oriented, trying to find best-in-class mutual funds, usually with 5-star Morningstar ratings at a minimum, with best-in-class alpha, team management at helm for a minimum of three years…preferably five, low expense ratios, and other selected criteria. We also invest in great, financially strong individual companies with competitive advantage which we think can outperform and represent long-term holdings.  We believe that asset allocation determines 90% or more of the out-performance and strive to do the best we can with that decision. We will hedge when conditions indicate the need to do so. We use technical indicators,  timing, bad news, and other market events to guide us in determining an entry point for purchases and sales.

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 low cash positions, hedge positions, a preference for best-in-class foreign mutual funds with emphasis on Asia, energy with emphasis on natural gas, best-in-class domestic mutual funds and a few individual huge world-class franchise type company stocks will serve us well in sustaining our investment returns during 2010.