After the 2009 Down-and-Up, 2010 Looks Like an Up-and-Down

Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars´ worth of groceries. Today, a five-year-old can do it. – Henny Youngman, comedian

As I start writing this first commentary for 2010, I am well relaxed after a week with my family in the mountains. I also feel a bit anxious. What will this new year bring? What are the core issues and developments that we will be dealing with? As you may have expected, and maybe even hoped for, we´ll start this year off with a bit of a big picture outlook for 2010, a summary of the key factors and issues that we expect will capture our attention and keep us on our feet this year.

2009 forcefully proved a point that I have made on occasion in the past: sometimes, the macro-economic fundamentals don´t matter. They just don´t mesh with the price developments in financial markets. While long-term fundamentals still looked very questionable, most stock markets, commodities and corporate bonds performed very well last year. Now the question is, where do we go from here?

At this point, it looks like there is still some upside momentum left in most financial markets. They still seem to be pointing toward recovery.

Don´t get me wrong. I don´t think that everything is rosy. Mountaineers are well aware of my concerns over the bigger picture and the implications of the EASY MONEY decades behind (and in front of) us. I expect a very ugly bill to be served sooner or later. In my view, there is NO REAL RECOVERY. If anything, I think we are being bamboozled by a big-scale monetary sham. Nevertheless, I am of the opinion that, you may still benefit from another sizeable upward-move in several different asset classes, including equities.

Most Probable Scenario

In our Update of November 11th, we had discussed three economic and financial scenarios: 1) the Boom Scenario – from Bubble to Bubble, (2) the Moderate Scenario – Rebalancing Slowly, and (3) the Doom Scenario – Quick and Really Ugly. You may want to have another look at that Update for a refresher as to what was discussed. So far, it appears that the moderate scenario is playing out and is still very much on target.

As we head into 2010, I expect selective stock markets, precious metals and other commodities to continue their positive price performance. In our portfolio management, we will invest in these markets actively; albeit, with very alert and tight risk management in place should the tide suddenly turn.

The allocation for most of our clients continues to include a good portion of precious metals. We also hold positions in selective other commodities and a variety of Canadian energy and infrastructure income trusts, plus a number of international equity ETF´s. With the equity ETFs, we have over-weighted emerging markets with China and Brazil in the lead, as well as some dividend-paying allocations. Finally, we hold a mix of international currencies and short-to-medium term sovereign bonds.

Yes, I am concerned about the latter part of the year. Several factors raise concern: these entail, amongst other things, growing sovereign default risks, the difficulties of government withdrawal from their market interventions after their extremely expansive monetary and fiscal policies, as well as a number of concerns related to the international currency system. Obviously, the US dollar is a big question mark in that arena.

The credit crisis in America is far from over. Some 140 banks went belly-up in the US in 2009. And there are still A LOT of toxic assets hidden in the balance sheets of American banks. Meanwhile, the US real estate market, particularly on the commercial side, has not found solid footing yet.

Furthermore, the most recent developments on the geo-political front, particularly America´s foreign policies in the Middle East, provide for uncertainties ahead. It is conceivable that these very policies, presumably directed to combat terrorism, may well increase the probability and danger of more terrorism and a larger-scale war.

Last but not least, we are at the end of a secular down-trend in interest rates, which potentially creates what we have termed a "DEBT TRAP".

A Secular Decline in Yields has Ended

Source: Morgan Stanley Research

As the huge mountains of debt in several countries pose a BIG problem, which is exacerbated by the fact that the yield curve is starting to hint at inflation on the horizon (in December 2009, the gap between yields on two-year Treasury notes and 10-year notes widened to 2,85 percentage points, its highest ever), at some point servicing the debt loads will become VERY difficult. I am very cautious about countries with large deficits and debt.

The United States and the United Kingdom come to mind first in this respect. However, there is a long list of other countries that have serious difficulties, including Greece, Iceland and Spain. While these economies are not as important as the US, for instance, they may provide the literal droplet that runneth the bath over.

On the other hand, there are developed countries that are starting to look more promising and do offer investment opportunities, amongst which I would prominently mention Norway, Switzerland, Germany or Australia.

The following chart lists the ten most vulnerable countries on a debt-to-GDP ratio. In regard to public debt, you may also wish to visit the world debt map on Wikipedia.

The Ten Most Vulnerable Countries on a Debt/GDP Ratio

Source: Credit Suisse Global Equity Strategy

Positive factors as we head into 2010

On the positive side, assuming none of the possible risks and potential shockers serves up any unpleasant surprises, the following factors could very well facilitate more upward momentum in equity and commodity markets:

- Official statistics imply a "recovery": Whether you trust recent economic data or not, these statistics are watched by billions of investors. Currently, the statistics make a strong case for economic recovery. Corporate profits are up. And, price inflation, albeit starting to show up here and there, is still very low.

Consequently, more investors can be expected to participate in financial markets. And, governments may have an opportunity to keep their loose monetary and fiscal policies in place for a while longer.

- Global power shift: The world is experiencing a period during which the center of economic and political power is shifting, mainly to Asia. It appears as though the world is rapidly transforming to a more balanced, multi-polar order. Capital rules this process. And currently, capital is flowing increasingly toward economies with more rapid growth, with the emerging markets of China, India and Brazil in the lead.

This process has picked up on some of the slack of the Western economies and will continue to do so, but not without some hiccups along the way. The larger trend will still prevail. While equity prices are starting to look toppish, this paradigm shift may provide room for more upward movement.

- Market resilience: During the recent bad news on Dubai and Greece, financial markets were hardly affected. Markets still appear to be well-supported on the downside.

- Liquidity on the "sidelines": Many investors missed the up-move in 2009. They are starting to invest as their patience is diluted with every uptick in markets. Many investors are still left with a lot of cash, which is generally not a sign for a market top. And, it may well provide for another strong leg up.

Summing things up, we might call 2009 the year of the ‘down-and-up a lot´ in financial markets. Quite possibly 2010 could be a year of the ‘up-and-down a lot´. We shall see. In any case, one thing appears certain: we will not have any difficulties in finding sufficient interesting things to discuss and write about.