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2008 was the worst year in the history of the stock market. Every asset class deteriorated in an avalanche of selling: stocks, bonds, municipals, real estate, and commodities. Rather than re-examining what has already transpired, let’s look to what 2009 may bring as a consequence of this tumultuous year.

First of all, expect continued volatility. Even if a rally continues on Obama stimulus hopes, volatility will remain high. A precondition for a sustained broad advance in the equity markets will be greater economic certainty. The heightened volatility in equity markets currently reflects high uncertainty in terms of growth and the inflation outlook. Only when we see stability on these two fronts can we expect equities to regain a substantial portion of what they lost last year. There is a substantial risk that the current equity market bounce, presaged by a second round of economic stimulus (after the Fed’s unprecedented moves in Q4 of 2008) may not deliver the desired level of economic stability.

In the long term, stock valuations are incredibly low, with correspondingly high dividend yields offering an historic investment opportunity. Given the record amounts of cash sitting on the sidelines, investors first want to see a stabilization of leading U.S. economic indicators, as well as some evidence that we are avoiding a long term deflationary outlook, which would include the housing market. The first half of 2009 is likely to experience further deterioration in terms of macroeconomic numbers; however this pessimism is tempered by the observation that equity markets tend to lead an economic recovery by around six months. In a final risk/reward analysis, it makes sense to wait for signs of a sustainable multi-year rally before investing further in stocks; missing the first part of this move is not material given the attendant risks.

Now that Fed Funds rates are effectively at zero, the Fed has embarked upon a policy of “quantitative easing”. Quantitative easing was employed by the Bank of Japan around ten years ago, and refers to the monetary policy whereby a central bank effectively prints money in order to increase the money supply. Since the Fed cannot push rates lower, they must resort to flooding the system with money through purchases of long term agency and government bonds. This policy’s aim is to stop price deflation, which ravaged the U.S. economy during the Great Depression. With ten year government bond yields at 2.45%, the market has already priced in this deflation. Proof of this is borne out by U.S. treasury inflation protected bonds whose yields imply zero inflation for the next five years. There is a very real and dangerous risk that within two years, significant inflation will result from the massive amount of liquidity that world governments are now pumping into the system. The risk is that bond yields will begin to move up when credit markets unlock, because the velocity of money, which is very low today, will suddenly accelerate. This implies that remaining invested in long term government bonds right now is a bad idea. Corporate bond yields, however, now sit at historic highs vs. their equivalent treasuries due to the credit crisis of the last twelve months; we are currently recommending positions in high quality corporate names unlikely to experience any credit problems.

If government efforts to turn the economy around begin working, other geographic regions may become attractive soon, given that emerging markets will outperform the U.S. in the event of a worldwide recovery. Gold is still an intriguing asset class within commodities for the following reason: we are experiencing a competitive devaluation among global currencies. The Euro zone has experienced a massive deterioration in economic conditions reflected in selloff of historic proportions in the GBP and the Euro. While the dollar may gain in relative terms, gold may become the one “currency” which benefits most, especially in light of its increasing physical scarcity and rising geopolitical tension.

For 2008, the Dow dropped 33.8%, the S&P 500 declined 38.5%, and the Nasdaq fell 40.5%.
Grant Rogers Elizabeth Allen

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