Our thoughts on the year ahead

As is our tradition, we kick off the New Year with our annual Outlook in which we give our take on the lay of the land, and propose our top ten investment themes for 2010. We resume publishing in our normal format next week.

In recent days we have not only heralded in a New Year but also a new decade, so it is worth taking a moment to reflect on the passing of the noughties as well as another 12 months.

The past 10 years have certainly proved a ‘naughty’ time for investors, with the decade starting and ending with two periods of substantial financial stress. The catalysts were of course quite different. The dot com bubble saw a correction of sky high technology and telecoms valuations which were built around a (false) new paradigm. The most recent collapse in global asset prices has ultimately had its roots in the unravelling of loose and excessive credit in the financial sector.

The end result has been that on the face of it the noughties have been the lost decade for equities. Certainly not the decade to be a passive index investor in any case.

In fact, many markets performed worse than they did in the depression blighted 1930’s. The S&P500 for example fell 30.4% in the 1930’s but has dropped by around 38% since 2000.



And of course the medicine applied to both shocks in the past decade, although varying in degree and co-ordination, has had much in common – foremost of which has been an aggressive loosening of fiscal and monetary policies. So are we just creating the foundations for another bubble? And if so where will the epicentre lie next time? Let’s come to that later.

As is common at the start of each outlook we review our predictions from the year before. With the passing of the decade, it is also worth reflecting on our thematic calls as we approach our ten year anniversary.

Incepted after the bursting of the technology bubble, our overweighting of the mining, and resource sector, along with gold in particular has proven well founded. Whilst missing out on easy gains in the early stages of the bull market, our decision to stay clear of the financial and property sectors was vindicated. And although a value based investing style can have detractions in rampant bull markets, it is often the ‘go to’ approach in times of financial stress.

Turning to our predictions at the start of 2009 we were on the mark (in the end)…

“..throughout 2009 we will experience unprecedented government stimulus and this should provide support for asset prices. Central bankers are punishing savers heavily by slashing the rate of interest paid on cash. Staying in cash in 2009 will increasingly be seen as an opportunity cost, especially as inflation erodes the value of that cash. Particularly as official rates converge towards zero.

After such a horrendous year in 2008 we expect equities to put in a positive performance in 2009, although the extent of this is obviously dependent on many variables….Adding to our cautiously bullish view, sentiment currently remains very bearish. This suggests that many investors exited the market in 2008 and may now be sitting on the sidelines in cash.”

Whilst we did not anticipate the even deeper correction that would ensue in the first quarter of 2009, we were right to have full confidence in the unrelenting resolve of central bankers to boost waning asset prices. Ultimately setting the scene for not only a ‘positive performance in 2009’, but in fact one of the greatest market rallies in history.

The pace of the market re-rating has been truly impressive. The UK index for example has been the first major stockmarket to recover its pre ‘Lehman bust’ highs in the space of just 9 months.

So how will the markets fare in 2010?

When considering this question it is worth approaching the outlook from two levels – macroeconomic and microeconomic.

As the last two years have resoundingly shown, investors in today’s globally interconnected market place ignore international macroeconomic trends at their peril. A company may be soundly run, and quite profitable within its own industry at a certain juncture, and (more importantly) reasonably valued, but this counts for little in the near term if global investor sentiment is going against it.

Global attitudes and appetite for risk will necessarily determine what investors are prepared to pay for earnings. And certainly over the past year investors have become increasingly confident, as top level earnings multiples show.

A year ago, the S&P/ASX 200 for example was trading on a estimated full year price earnings multiple of around 10 times. Scroll ahead 12 months and the index earnings price tag has raced ahead to over 17 times.

A move to which we alluded in last year’s outlook:

“We think that investors will gain confidence from the considerable stimulus that will work through the system in 2009 and this should support the PE expansion thesis, despite the fact that earnings will likely remain under pressure.”

So it now seems that investors are pricing in ‘normal’ levels of earnings growth, and a ‘normal’ global macroeconomic environment.

The charts also underlie just how comfortable investors are that market stress is returning to more ‘normal’ levels. The VIX, or volatility index, has collapsed over the past year to around the mean, indicating dramatically less demand for protection from a falling market through the purchase of options.

What then would unhinge the collective view that everything is not so normal, and that significant downside risks remain?

Broadly speaking, a trigger would be any concerns en masse that the current recovery is a false dawn and that the global economy is facing a double dip recession.

We believe that the trigger for such a change in permanent sentiment is unlikely to be a one off event (such as the scare over Dubai’s debt problems) but rather sustained evidence that the improvement seen in key economic data over the past year is reversing.

Let’s not forget though that an integral part of the recovery story of the past year has been the unwavering commitment of governments and central banks to re-inflate the global economy. To date these measures have been successful on a number of levels. It is unlikely in our view that faltering economic data would coincide with aggressive monetary and fiscal tightening.

As we have often stated central banks know their history and are likely to be extremely reticent when it comes to tightening too soon. Many governments with creaking balance sheets (the UK is a case in point) might start to feel the need to pull back on fiscal stimulus, however monetary policy is likely to remain loose for some time in our view.

Key interest rates are therefore likely to remain low. Low interest rates should keep a lid on borrowing costs, adding significant support to corporate (non-financial at least) earnings.

Availability of credit should also continue to improve as well. Banks have adopted increasingly conservative lending practices over the past year or so. And who could fault this given the origins of the global financial crisis. However, government support and rights issues have enabled financials to repair their balance sheets, and with the recovery in the general business environment gaining some traction, we expect 2010 to be the year that the wheels of credit begin grinding in earnest.

Nevertheless, there are still significant headwinds to the recovery at both the micro and macro-economic level. Foremost of which in our view are the still elevated levels of unemployment in many countries across the globe, specifically the US.

Of course one argument is that unemployment is a necessary result of the pains of the past two years. Costs have been cut to restore profitability, and jobs have been cut as a result. Companies will expand again and re-hire as the business cycle heads upwards again. This notion has complete merit of course as long as the recovery does not stagnate and those displaced become permanently out of work. Enter the policy makers again…

Having averted financial sector Armageddon in 2009 we believe that 2010 will be the year governments and central banks throw all hands on deck to restore employment growth.

With the global economic revival finely balanced, putting people back into work is a vital part of the rescue jigsaw. Consumer spending is a substantial driver of economic growth (around 70% on average in the West), and to date has been boosted by various intermediate government incentive programs. A sustained improvement in jobless figures will provide a more sustainable and decisive leg up in our view.

A jobs revival and increase in collective well being (combined with an increased propensity to lend by banks) will also set the platform for a longer term recovery in the property markets. The personal-wealth-bolstering effects of which should further spur consumer spending.

However, a significant turnaround in unemployment data will not be achieved overnight.

As such, whilst we believe that the globe will avert a ‘double dip’ there are enough bumps in the road to recovery to vindicate an even more highly selective approach to stock and sector selection in 2010, particularly in the early quarters.

The property market recovery rebound for one is on shaky foundations. In the US delinquencies remain at elevated levels and the impact of the expiry of the first home buyer incentives in April will be closely followed. In the UK the fact that many house builders have swung from a deep discount to significant premiums to net asset values causes further alarm bells to ring (for value investors at least).

Given that the general going is unlikely to be plain sailing this year we continue to favour recession resistant businesses as we enter 2010. Whilst underperforming growth last year, defensive exposures, companies with robust cashflows and recession proof products are likely to find increasing favour with investors. This is particularly so in a low interest rate environment.

And the ongoing presence of low global interest rates (and future inflation) should continue to add fuel to the commodities story on which we remain resolutely positive. A key part of which is the emerging markets demand side, particularly China which has shown little real signs of unravelling. Over the past decade the behemoth has gone from the seventh largest economy in the world to third, and is closing in on Japan to take second spot.

We expect China’s consumption of metals, energy and soft commodities to continue at a robust rate, underpinning global demand whilst the West at large emerges from recession.

Also key to the resource story is the demise of the US dollar. And we see no long term respite for the greenback. A massive fiscal deficit (current and future) is likely to see the dollar’s mantle as the reserve currency of choice increasingly eroded through the year ahead and beyond.

And so enter gold as an investment destination which we continue to favour. Having broken through the US$1,000 mark in 2009 (as we forecast in last year’s outlook), the precious metal in our view is now preparing an assault on US$1,500 in 2010.

So, after a decade in which two bubbles imploded, are we seeing the early stages of another bubble, gold, commodities, equities generally?

Certainly there is every chance that a bubble is forming as we speak, however if history is anything to go by (and it usually is), it will take several years to play out. For the moment our primary areas of interest; gold, resources, and defensives do not appear overcooked from a longer term perspective. We will of course revisit this diagnosis throughout the course of 2010 and beyond.

After having their confidence shaken in 2008/early 2009, many an investor will be approaching 2010 in an optimistic fashion. We would urge an air of ‘caveat emptor’ as a New Year and new decade (the ‘teenies’ apparently) gets underway. A new calendar does not mean that a correction in certain areas of the market is any less overdue.

And as such patience and discipline remain important virtues as ever. The markets may have emerged from the gloom of 12 months ago in spectacular fashion, but complacency has no place in any investing manual.

As ever we will look to guide Members through 2010 as successfully as possible.

We would like to take this opportunity to wish all our Members a Happy New Year and we look forward to presenting a number of new investment opportunities in the weeks ahead.

All the best,

Fat Prophets