2010 and Beyond: Change as the Norm

With the stock market up 26% in 2009, one could look back on the year with enthusiasm. Just about every asset class rallied for one of the best general market performances in ages. Gold was up 24%, bonds rallied by 13%, and emerging markets screamed ahead 79%. Wherever you looked, there was money to be made. But the story is not fully explained with just these numbers. As a friend reminds me, “There are lies, damn lies, and then there are statistics.” Statistics can be misleading – let me explain.

When viewed in the context of the past two years, the numbers from the past year start to look pretty weak. Remember, the S&P 500 was down 37% in 2008 setting the stage for a rally of some magnitude. When combined with the upswing of 26% in 2009, it leaves the index down by more than 20% for the past two years, and far more if you go back to the highs.

To give you a better context, over the past eighty years a 20% down market in just one year would be one of the worst returns on record (actually – 6th worse). Not a warm and fuzzy feeling. To truly understand the impact of the last two years and how statistics can mislead, I will give you a little primer on geometric compounding where it is far easier to post eye-popping percentage increases when you start from a small base.

Bank stocks are one of the better examples. By early March 2009, Bank of America stock was down 97% from its high in 2007, and then for the remainder of the year surged ahead a whopping 385%. This very statistic was recently published in the Wall Street Journal. But look at the numbers another way: Citigroup, another high-roller, went from a high of $30 to a low of $1. For it to go up by 300%, it has to climb back to only $3, which is roughly where it sits today. For anyone who purchased Citigroup at $30, your 300% return from the lows is not making you feel any better. Citigroup would still need to go up a further 1,000% from today’s price to return your money (or 3,000% from the low of $1… you start to get my point).

To avoid this recasting of statistics, you need to look at returns in their full context. A comparison of the one and two-year S&P 500 charts helps to illuminate the difference.

2009 S&P 500 Performance (1 year)

This past year had a rough start before it screamed ahead. When viewed over two years, however, the picture is much clearer:

2008 – 2009 S&P 500 Performance (2 Years)

The impact of all this statistical ping-pong is that despite the returns of 2009, the general market has still lost quite a bit. For it to come back to the previous high, the equity markets would have to see another 35% return from where we stand today – a tall order in an uncertain world. For many family’s savings and retirement accounts, they face a similar picture. The emphasis, therefore, is not on where we’ve been but where we are going next.

An Uncertain Recovery

The current recovery has many flaws. Home prices dropped an average of 7.3% last year. One out of every five mortgages is underwater, many by 20% or more. Real estate prices are primed to soften as mortgage rates start to increase. Consumer credit (credit cards and personal loans) is significantly throttled back, making it tougher to find “balance transfers” and other forms of credit to replace lost home equity borrowing. And of course, there is unemployment to consider. Officially 1 in 10 are looking for a job. An additional 1 in 10 are unofficially looking for jobs. In total 2 in 10 people over the age of 16 are looking for work. Only 5.7 in 10 have a job. 4.3 in 10 simply don’t work. The following chart that plots employment rate stretching back to 1969 paints a bleak picture.

After 2008, it was not hard to post strong returns if you recover only a minor part of your lost asset value. Given that there was significant risk aversion (i.e. over-selling) at the end of 2008, you could argue that 2009 was simply a correction of sentiment rather than a solid recovery of value. Add to this the unprecedented government stimulus pumped into the economy, I am far from concluding that we are back on track to robust growth.

Additionally, big questions regarding the nature of America’s economy and national character still loom large. A trillion dollar bailout of the financial system succeeded in ensuring those bankers will receive their exorbitant bonuses yet has failed to revive the main street economy. As we’re seeing across the nation, unrestrained populism threatens political and economic stability. The results of the recent Massachusetts special election are a stark reminder of the aversion to change that permeates America. Ironically, universal healthcare became a galvanizing issue in a state that already has it.

The reality is that change is afoot in America. Business as usual, from banking to real estate to healthcare, is no longer viable for the long-term as those models are either broken or untenable. As witnessed by the host of proposed banking regulations and taxes, Populism will win in the battle between bankers and the people. And despite a clear connection between the current economic malaise and the former administration, voters will place blame wherever they wish.

Uncertainty is high as we look at the future of the nation. As Heraclitus so poignantly captured, “nothing endures but change.”

2010 and Beyond

As we look forward into 2010, we are focused on the certainty of change in the world and how it will impact our investment direction. With change comes opportunity. To understand these opportunities is going to require a broader view of the globe in the context of human nature.

In the short-term China, Brazil and India’s new and crucial role in the world economy is paramount. All three of these nations may be viewed in the context of population growth, natural resources and a drive to middle-class stability. Whether it is China’s need to soothe the population through extreme economic growth, and the individual affluence associated with such growth, or India’s struggle to integrate religious extremism with technological growth, these economies and their success in becoming global leaders will determine the direction of capital flows and investment returns.

And while these economies are racing ahead, we have begun the process of adapting as a global society to a new paradigm. In a manner rarely fantasized just a generation ago, from the internet to the iPhone, the technology is morphing communications at an ever increasing pace. Local disasters are instant news in the world of Facebook and Twitter. Google now sits at the epicenter of social unrest in the world’s largest communist nation. Millions in disaster relief can be raised in days simply through texting. With awareness of social issues coming to the forefront in this networked world, we are witnessing change at a pace never before seen by mankind.

At home, the benefits of the great recession might be felt for decades. US firms that survived the financial crisis are now leaner and more efficient than they were beforehand. Without free-flowing credit, consumers will learn the hard lessons of savings and prudence. And with universal belt-tightening, waste will be squeezed from the system in everything from energy conservation to the efficiencies of the virtual office.

So while I am optimistic in a certain sense – that change is good and it will present opportunities – I am also extremely cautious about the next two years. It took a decade for the market to recover from the crash of the 1930s and the economic malaise of the 1970s. While we have avoided the abyss, we have not fixed the problems. Until then, there are a number of ways in which the market could go side-ways (stays flat after all the gyrations) or even retreats from the current levels.

Looking beyond the next year there is a significant possibility that US monetary policy will start to change, impacting interest rates and inflationary expectations. As you may have read in my last article, “Goldilocks,” the short-term fate of the markets and economy is largely dependent on the Fed and their ability to time their movements. On a longer horizon I expect to see some glacial shifts in energy policy, environmental influences and social interaction.

Balancing the risks that remain from the economic turmoil of 2009 with the opportunities presented in 2010 will be difficult. Being realistic about your risk profile has never been more important. We have already seen a year in which risk and reward have been grossly out of alignment. Safely navigating the continued risks will be our first priority –finding new areas of growth is the second. As we have done over the past year, finding those investment opportunities that capitalize on the changes ahead while buffering us from substantial downside risk continues to be our mantra into 2010.

All the best during these winter months.

Regards,

David B. Matias, CPA