Annual Forecast Issue
1/13/2009 11:07:59 AM
This week's letter is part III of a three part series. The focus this week is on where we are going in the year ahead, also known as my annual forecast/predictions issue.
Some of what you will find in this issue is based on extrapolation of current trends or interpolation of data available now. As such, it will be pretty clear that I am drawing a line in the sand and we will see if the tide comes up to cross that line. Other predictions are really starting points for discussion of possible tradable "events". Some will be more far flung than others but the important point is to get out of our comfort zones and realize that a lot can happen in the coming year.
I could add a lot of build up, drum roll please.
but that would only prolong the inevitable and I am not one to procrastinate. Besides, as stated earlier, this is really food for thought and introduces subjects for debate. In fact, many of these themes will be revisited during the course of the year as we look to take advantage in our trades.
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Assassination Attempts on world leaders
Unfortunately, the world we live in is not a safe place and discontented and deranged people will have an impact. A leader in a major country will be successfully assassinated in 2009. A leader in another major country will live after an unsuccessful attempt. There will be a number of less than peaceful changes in the leadership in smaller countries as well as 2009 is marked by changes in leadership and attempts at such change.
We don't have a good trade idea on this. It is simply something that we mention as food for thought. It will arrest optimism when other things seem to be falling in place and prevent a significant bull market from taking off.
Financials find a bottom
Shares in brokers, investment bankers, and exchanges will find a bottom in 2009 as earnings and revenues decline from 2008 levels. Insurers and banks will also continue to disappoint but share prices will find a bottom.
Look to take long positions in oversold exchanges, broker dealers, investment banks, national banks, or insurers. If financials rally prematurely, take short positions before the correction occurs and then reverse that trade when prices move down to good values.
The recession that began in December 2007 will end in 2009 but won't be officially declared until 2010 as unemployment continues to be a major theme in 2009.
Public company earnings will continue to deteriorate and analysts will continue to play catch up continually revising their estimates downward.
This is the backdrop that provides ideas of where to invest for an economic recovery as well as where to position during the recession. Dividend payers that appear secure in their dividend payment trump other choices at this time.
The Obama Plan
The effects of the Obama economic stimulus plan will only begin to be felt toward the end of 2009. Equity market participants will become disillusioned while waiting for the plan to gain traction and several rally attempts will fail before the bottom will finally be put in. The November 2007 low will be retested.
The U.S. debt will expand to nearly double current size due to efforts to stimulate the economy and the monies committed to TARP, etc.
We will have to see some specifics and undoubtedly there will be a trade in companies that provide services to do infrastructure build out. See Employment below.
Recall that I have been harping on unemployment as the harbinger of the recession. Unemployment will peak as a lagging indicator well after the recession is over. Unemployment will continue to move higher, even as Obama readies his massive stimulus plan, which is expected to create one million jobs (we have heard figures as high as five million jobs). The economy lost 2.8M jobs in 2008. In the last month reported, the economy lost 524,000 jobs! If Obama's plan is able to create one million jobs, that will counter only two months of job losses.
Unemployment will reach over 8% (currently at 7.2%). How much over 8%? I don't know as the Obama plan and the job creation and stimulus to the economy will have a lot to do with the severity of this number. I would argue that unemployment would actually move into double digits without this plan. As previously stated, the effect of the stimulus plan won't be felt until later in the year and unemployment will grow until that time.
There will be a trade, as long as it isn't already crowded, to buy shares of one of the large recruiting firms, paycheck processors, or temp agencies at some point in the year. It will depend on what values we can find by looking for oversold companies that have strong fundamentals but that investors have cast aside.
China further loosens the peg of the Yuan to the U.S. dollar
China holds over one trillion dollars in U.S. debt and doesn't want to go further in that direction. The amount of dollars they are being paid for imports into the U.S. are used to buy dollar denominated commodities. China decides to let the Yuan float more against the U.S. dollar in order to cease the incessant build up in U.S. debt. The lack of sustained buying of dollar denominated debt instruments allows prices of these assets to drop and yields begin to rise on long bonds. In fact, China may begin to sell some of their current holdings of U.S. long bonds which would reverse the current trend. The Fed eventually steps in to buy these instruments after prices have declined 30% or more from peak.
Short the long bonds and use the capital to establish other long positions or to return interest. Cover the long bonds after price has fallen 30% from peak.
The Residential Housing Market
The housing market will continue to slide ever downward as the large supply of excess inventory continues to be absorbed and homeowners continue to go through foreclosures adding additional homes to existing home inventories.
Homebuilder sales continue to slide and one major publicly traded homebuilder is taken private to prevent bankruptcy.
The volume of new mortgages and refinances written will begin to increase. Even though prices are down and inventories are growing, buyers are out there and homeowners will continue to take advantage of the low rates available.
It is late in the game to short homebuilders but it is possible to do so after a significant rally. It might be better to look at title companies to see which are seriously depressed in areas that are likely to be able to stabilize in the near future. Remember that even though we have a nationwide climate of falling home values, real estate markets are localized and home sales will begin to occur, albeit at lower prices. In addition to title companies, mortgage brokers who were able to survive the downturn will be positioned to take advantage of the growth in mortgages being written. Bank of America will benefit from this trend through their acquisition of Countrywide Financial.
Fears about the lack of credit will fade as the TED Spread moves below 50 basis points signaling the "all clear" sign for inter bank lending. The focus will shift back to reigning in the quantitative easing responsible for flooding the financial systems with an abundant money supply. The early reaction to the credit crisis and the huge increase in the money supply will actually prevent the dreaded deflationary scenario from getting rooted, although inflation will continue to be mild through the year.
De-leveraging continues to take place as debt-laden businesses continue to face a challenge to obtain more credit and some collapse.
With credit readily available to credit worthy companies, large companies that have not been heavily leveraged will benefit most of all as funds are available for them to expand and acquire weaker competitors.
Commercial Real Estate
Everyone seems to be wearing rose colored glasses about commercial real estate.
Commercial real estate prices, which rose sharply in the recent past, will fall at an increasing rate, flying in the face of consensus.
Retail tenants will balk at higher rents and tenants will choose to relocate or discontinue business rather than pay them. Eventually, rent hikes will be reduced and a healthier business environment will ensue but not until after some mall operators will be tested and some will go under and be picked up by healthier players.
Commercial tenants will renegotiate lease terms to help them weather the recession storm. Commercial real-estate funds will absorb these losses which will reduce their profitability in the near future.
There are a number of commercial real estate trusts and we would look to purchase shares at truly rock bottom prices with a belief that the trust will remain solvent. We have been monitoring this space and will likely make a trade recommendation at some point later in the year.
There will be another major natural disaster in the world in 2009. The question is, does it hit a large population center and are the disruptions to the local economy meaningful to the economy as a whole?
This isn't one that you can get too far in front of. It will have to be played as it occurs.
Unfortunately, there is likely to be another major terrorist attack in 2009. It will, of course, focus on a modern country led by infidels. I hope that I am incorrect in this, but it is an ever present danger that will eventually rear its head. Increasingly, nations that cooperate with the infidels will see terrorist attacks directed against those in power. Pakistan is a likely target as is Turkey. Turkey's population is overwhelmingly Muslim but is ruled by a secular government.
There are numerous companies with a hand in the anti-terrorists programs being put in place or strengthened by governments that fear attacks. In addition, private companies, in the oil industry and others, are constantly taking further measures to curb attacks on wells, pipelines, and storage facilities. We will look at adding a company in the midst of providing these solutions that is currently trading at a depressed price, thereby representing a good value.
Increasingly, piracy is on the rise and is taking place in waters that are far from the rule of law. The pirate attacks will grow more brazen and more effective measures will be put in place to deter them.
We don't have a good idea how to trade this phenomenon. We are on the lookout for companies that are able to market a solution to ship owners or navies to deter or combat these pirate attacks.
There will be continued conflicts erupting in Africa and the Middle East. Russia will be drawn into a conflict. The U.S. will look to exit current conflicts in Iraq and Afghanistan. Tensions will grow with Iran and the government there will make a significant miscalculation, eventually drawing the U.S. into taking military action, but not in 2009. The defense budget will see some cuts but not a large percentage. It is clear that threats still loom and we still have troops in harms way.
We will attempt to sort the wheat from the chaff in our trades here.
Obama will push for and eventually succeed in abolishing the embargo on Cuba. The Castro brothers will be replaced as leaders in Cuba whether by coup or choosing to step down.
We won't be able to capitalize on this immediately but we will be looking at companies positioned to do well when relations thaw. In particular, there will be a lot of import/export business and tourism will be a high growth industry. However, this trend will take years to build sufficient momentum, so we are going to look for creative ways to benefit over time.
BRIC continues to grow
The economies of Brazil, Russia, India, and China will continue to outperform. Russia will struggle the most in 2009 as the revenue loss from the lower price of oil will affect not only Russian oil company profits but tax revenues to the Russian government.
We have already taken positions in two Brazilian companies, RIO, and PBR. Both are profitable. We would like to get exposure to China and India. For India, we are looking at Infosys (INFY) but would like to purchase in the $23 - $24 range. For China, there are a number of stocks we are looking at but will have to wait for best positioning.
We are leery of taking a position in Russia but would likely look at Gazprom at around 100 RUB. The dollar will eventually devalue versus the Russian Ruble and the share price of Gazprom will also move higher so in real dollar terms, this will make a good investment. The downside is the link between Gazprom (Russia's largest company) and the Russian government. The risk of foreigners taking flight from shares of the Company means that it could be a bumpy, but eventually profitable ride. The shares are available as a pink sheeted ADR as OTC:OGZPF which we would look to purchase under $14.00.
Demand for Oil
Clearly one of the tenets for emerging economies to become modern economies is increasing demand for oil. The Brazil, Russia, India, and China (BRIC) economies will all continue to expand. The U.S. and European Union will use less oil, so demand for oil will soften but will be met by production cuts by OPEC which will cause oil to trade in a lower range between $25 - $70 per barrel. After 2009, the U.S. dollar will fall relative to a basket of currencies and primarily from China's unlinking of the value of the Yuan to the U.S. dollar. This will cause dollar denominated oil prices to rise once again.
Given that oil prices will start the year at the low end of the range, when share prices of oil and oil service companies are truly on sale, we would look to profit by buying them on the cheap. This may be tied into our BRIC trades as well but there are plenty of companies in this space that can be bought at seriously depressed prices soon.
Enrollment in Advanced Education Increases
As more workers become unemployed, they will turn to increasing their education to become more marketable. Some of this may even result from provisions in Obama's plan to stimulate the U.S. economy.
There are crowded trades in advanced education companies that we would look to initially avoid. If we can get an entry price that we perceive such an institution being undervalued, we would be interested in taking such a position.
The natural reaction to the credit, financial, and housing crises is to look for someone or something to blame. It is also to examine what went wrong and to attempt to fix the things identified as causing the problems encountered.
Lawmakers will call for further regulation in a number of areas as constituents look for scapegoats and are eager for safeguards. Some markets would be much better off operated under the watch of regulators. In particular, Credit Default Swaps (CDS) will be traded under a regulated exchange with certain market makers put on the fast track to get this going.
In addition to the CDS market, Obama will appoint a new czar of finance who will reinstate the uptick rule to short stocks. The czar will fight for power with Congressional representative who want to retain authority. The SEC, which has lacked the power to act independently of Congress, will with rise to prominence under this Czar, or it will be relegated to a bureaucratic role.
As it becomes clear who holds the big stick and what their agenda is, there will be trades to be made, based on exploiting inefficiencies or getting out in front of companies that will benefit from technology that must be deployed, etc. This is probably the safest technology trade to make, but it depends on the specifics which company will benefit from this implementation.
Flight to the long bond
I have been watching the prices of U.S. long bonds move beyond historical values, so much so that I believe investors are front running the Fed more than they are moving to the safety of these assets. I believe that the Fed will not act to purchase these assets at these prices and will likely wait to counteract a sell-off of these assets by China. Although this isn't purely a China play, we believe they are the 900 pound gorilla in the room, so it is best to recognize them.
See the China trade above.
The Metals Trade
With the backdrop of the Obama Stimulus plan, who has their hands up to ask for preferential treatment? American Steel Companies - The NY Times reports that Chairman and CEO of Nucor Steel stated that the industry is asking Obama to include a "buy America" clause in every contract so that U.S. Steel producers will benefit from the steel required for infrastructure build out such as bridges, mass transit updates or upgrades, and electric power grids would all require large amounts of steel. The New York times reported steel production is down 50% since September.
There will be multiple trades in metals that are possible. Alcoa (AA) is Aluminum Company of America and is the largest aluminum company in the United States. Aluminum production is currently down and there is a lot of foreign competition. A better way to play this is when demand is beginning to pick up and the scrap yards are full of aluminum ready to be recycled. If we can time entry into these undervalued stocks, we could see share prices soar as aluminum prices begin to firm and then move higher.
Steel companies will move lower for awhile with suppliers to them, such as Cliffs Natural (CLF) moving lower as well. With coal being moved by the railroads, the entire supply chain is available to invest in, but it is too early and some of the trade is quite crowded at this time. The rally in bulk shippers (Baltic Dry Ship Index) is anchored by the fact that China's steel industry still needs ore brought to them. We already have some exposure to this and will likely get further exposure as we chose to invest in China.
With the decline in new home building, the demand for timber has fallen off a cliff and so have prices of assets in this area. Still, timber land has value and the trees grow in value every year they remain uncut, so these assets are actually moving up in value as share prices are moving down.
It will be possible to purchase high yielding timber assets through taking a long position in assets such as Rayonier (RYN). The question is really one of timing to determine when the value is there and the dividend is safe.
The automobile industry is really multiple industries that are interdependent. There are the U.S. headquartered companies, which are global concerns, and there are the foreign headquartered companies, that do a lot of business in the U.S. All these companies are hurting with no immediate relief in sight, as people don't make a lot of high dollar durable goods purchases during times of uncertainty.
In point of fact, there is a crowded trade that is seeking to take advantage of the fact that people will be keeping their cars a bit longer. Used car dealerships and automobile maintenance companies are sure to get more business as new car sales decline, along with dealer service, which tends to decline as the cars age and owners look for less expensive methods to maintain their vehicles. Auto parts stores should do well with both retail business for do-it-yourselfers as well as supplying mechanics with parts to keep the used cars on the road.
A previously stated, we prefer to avoid crowded trades and many hedge funds and mutual funds have already staked out their positions in these sorts of companies. We will be looking for such an investment for the U.S. market but if we can't find a good candidate, we may look for something international.
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Market Outlook and Conclusion
Our outlook for equities is that they will eventually retest the bottom. Equities are dangerously poised to break out of a trading state and may enter another downtrend. Valuations will be affected by the continued reduction of expectations as analysts continue to revise estimates lower, and investors have to go through the psychological devastation that is ahead for earnings reporting for Q408. Here is a news flash. Q109 isn't going to be any better. In fact, it will be worse.
The credit markets continue to improve, which means that credit will be flowing to credit-worthy borrowers and the credit crisis will indeed pass in 2009. The TED Spread ended the week at 1.20, which shows continued improvement as it works its way down to the 0.80 level in coming weeks.
The asset bubble known as the U.S. housing market will continue to deflate which will continue to act as a drag on the economy. We are about three years into a six-year cycle of housing adjusting downward. Housing purchasing activity will pick up but prices will continue to decline due to significant inventory of existing and new homes.
Oil continues to move lower. This helps to reduce inflation and will help the economies to gain traction more quickly than would otherwise be expected. Eventually, OPEC will reduce supply of crude to the point where oil prices stabilize but that isn't going to happen immediately. I also expect that the U.S. dollar will remain strong in early 2009 as the U.S. leads the way out of recession before Europe emerges.
We are now waiting for the retest of the lows before committing more funds to long positions and actively looking to add to short trades where we feel the assets have moved to excess, such as in the long bond trades.
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