The Status Quo-The Best of All Worlds

In my recent posts I reiterated my view that we are pretty close to the levels where I expect the market to finish the year. Barring a major geopolitical shock, I don’t expect a major selloff, nor do I see a significant upside for the markets. At the same time, I am beginning to look ahead to 2010 and what to expect from the markets over the next few months.

Recently, I also made a point that the first quarter (actually February and March) will once again be a trying time for the market. Here are a few points that explain my position. The last few weeks of the year we will likely chug along fine, partially due to the positive seasonality bias combined with unwillingness of money managers and the sellsiders to rock the boat and finally get paid this year. There are still few attractive alternatives to equities, and the Fed policies and weak US dollar continue to encourage risk taking. At the same time, the charts are extended, and the buyers are fatigued. So we will see a narrow band trading for the rest of the year. Volume will likely remain low, driven by traders' day-to-day biases.

The best thing for the market in my opinion, is status quo (SQ). I define SQ as mild economic recovery with slightly improving jobs data, low rates, and stable US dollar, slighly above the the present levels. Of course, status quo also implies NO political shocks, NO economic shocks, NO corporate scandals, and NO emerging markets meltdowns. Wishful thinking?

Other scenarios that I considered could all potentially be negative for US equities. Higher unemployment and weak US dollar will be a major drag on the economy. Strong employment and sharp recovery, combined with rebounding US$ and rising interest rates - will also be bad for the market. So, any significant changes will initially be perceived as negative and therefore will require a correction to adjust to the new set of variables.

We will likely get through January OK with the help of seasonality and a New Year optimism. The greed of sellsiders and buysiders, having their comp reset back to zero will carry the bullish tone for a little bit. Keep in mind, analysts are now starting to move to 2011 earnings forecasts, making valuations more reasonable.
But as we get deeper into the first quarter, I really don’t see the SQ scenario holding. Admittedly, the timing is very difficult to nail, but I expect it to come in the second half of the first quarter.

Although I generally consider multiple potential scenarios, I think the following one is most likely. I broke it down into three layers, all basically leading to the same path.

1) Economic: Recovery continues to accelerate, both globally and in US. Eurozone, which generally lags US by 7-9 months, begins to shorten the distance. US GDP registers 3%-3.5%, while unemployment declines to below 10%. Emerging markets heat up, as exports begin to come back. No one questions recovery anymore, although it still remains shallow and spotty. Fed finally decides to pull the artificial stimulators and starts to reconsider its zero rate policy. The FOMC languages changes, implying the inevitable changes to the interest rate policy much sooner that most economists and investors expected. The carry trade begins to unwind and the US dollar starts making a come back.

2) Political - as world economies begin to recover, the foreign Central Banks begin to tighten money (effectively raising rates), putting real pressure on the White House to support the US dollar. Political pressure from both allies and the likes of Russia and China, begin to force the government's hand. Politicians no longer preoccupied with Healthcare reform wake up to the potential of escalating trade wars. One of very few tools the Fed has in its bag to help the dollar is to raise rates.

3)Corporate: It was obvious, looking at the November's 8% increase in productivity, (which is by the way one of the largest % increases in the last several decades) that businesses squeezed their operating budgets and reigned in SG&A expenses very effectively. This, of course, was the right strategy during recession and in a period of declining revenues. If we assume that recovery continues to take hold, the strategy will need to change. To retain market share and start growing revenues again, the companies would need to spend. This would cause an increase in expenses, which will typically precede an offsetting revenue growth by a few quarters, depressing earnings. Analysts will have to adjust their earnings forecasts down, making valuations less attractive. This will spook the investors.

So to summarize, the above developments will likely result in the following - higher interest rates, somewhat stronger US$, lower unemployment (but still in high single digits, as some jobs are lost if not forever, than for a very extended period of time), residential real estate prices improve, while inventory still remains high. Commercial real estate will benefit in some regions (mostly in New York and California) as foreigners use their strong currencies to take advantage. Lower than forecasted corporate earnings will hit stock prices effectively making it more difficult to raise equity to grow or acquire.

Here how I see the above impacting various markets:

US Equities - negative, especially as we get into the mid February.
European Equities - neutral, markets remain mostly range bound through the first few months of 2010, supported by capital flowing to Europe instead of US.
Emerging markets exchanges are leading the way, Asia (China, HK, Singapore, Malaysia, Taiwan, Korea),Brazil, and some of the laggards - Turkey and Thailand.
Commodities (basic materials and energy) finally decouple from the US currency and rally despite stronger dollar, as demand improves, fueling inflationary fears. Gold doesn't benefit as much, given already its bubble level achieved in 2009. Natural Gas rebounds strongly, given an unusually cold winter in US, but still continues to lag other energy commodities, given more and more of cheap supply coming from shales, despite cuts in production.

So be careful what you wish for. Sometimes the best of all worlds is no change at all.