January 2009

Portfolio Comments

Market View

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The Library: articles by Steve TeSelle

2009 Forecast

Portfolio Comments

Many of my return forecasts for 2008 were wrong. I predicted an 8-12% return for US stocks (-38% as of mid-December). I did say we could get negative returns if the economy performs worse than expected, but I was thinking negative 5-6%, not negative 38%. The debt markets caused all sorts of trouble, much more than I guessed. The only investment that performed well was US Treasury bonds. I thought they were over-valued last year; I think they’re even more over-valued this year.

What’s interesting to me about 2008 is that in market extremes, it’s even more obvious that stocks or bonds are priced incorrectly by the market, and yet those are the times we’re most likely to question ourselves. I suppose that’s normal; only an arrogant few are unburdened by self-doubt. But if I gave the facts about this market to the average person, without giving the date, most would agree that it offers a great opportunity to own stocks. Having lived through the last twelve months, however, most of us don’t feel that way. If I accomplish nothing else with this newsletter, I hope I encourage you to stay invested.

Source: Vanguard

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 Market View

Mark Twain wrote that history may not repeat itself, but it sure does rhyme a lot. The key is to figure out which periods sound similar. If the current period rhymes with 1929-1932, when the US stock market fell 82%, we still have much more stock market pain to go. But everybody agrees the market was terribly overvalued in 1929, more like the sound of tech stocks in 2000 in fact; those tech stocks subsequently fell 80% over the following two years. 2008 more closely resembles 1974. The factors involved are different, but the performance of the market in the early 1970s is remarkably similar to today. You may be cheered to know that stock returns were 37% in 1975 and 24% in 1976.

Stock markets rarely stay in one place for any extended period of time. Investors are constantly assessing the future, sometimes incorrectly. Once it becomes clear that Bush does not rhyme with Hoover, I expect the US stock market to rebound strongly. By almost any valuation measure, stocks look cheap. At some point, value will become more compelling than fear.

This does not mean that good news about the economy will start filling the airwaves. Expect dour news for several more months, probably into the second half of 2009. But the stock market will start to turn up long before the economic news turns cheery.

Interest rates on US government bonds are at all-time lows. This is another case of fear triumphing over valuation. Bonds from any issuer other than the US government yield interest rates so high that investors are pricing in depression-level defaults. Yet the Federal Reserve and Treasury are throwing money around like confetti on New Year’s Eve, which is the correct policy response, but which means inflation is the bigger worry a couple of years from now. One of the worst investments to own in the not-so-distant future will be a US Treasury bond that won’t keep up with inflation.

Commodities have lost their luster. Markets are probably over-shooting again, this time on the down side. In the oil market, a barrel of the stuff now costs $40; in the summer, it cost $150. I keep coming back to $60-70 as the marginal cost to produce a barrel of oil. That should serve as the anchor around which the market price flops.

Investing outside of the US has only hurt US investors in 2008. The decoupling argument, that other countries could grow even if the US were in recession, fell flat on its face. Indeed, it’s becoming clear how many countries relied on the commodity boom to run their economies (history rhymes a lot). Countries such as Russia and Venezuela look particularly vulnerable. Even China does not look as invincible as it once did. There’s still a case for investing overseas, but within reason.

The dollar has recovered, in spite of our troubles. That’s because other countries have troubles, too, and the US is still seen as the safest place to invest. From here, I have no idea what might happen. We could be in a holding pattern for a while, as the dollar doesn’t appear to be dramatically over or under valued versus other currencies.

Within the US market, companies that used fork loads of debt to goose their returns are struggling. If you could guess correctly which of those companies will survive the next several years, you could make a lot of money. But that’s a risky game. I’ll stick with companies that have solid finances. I won’t quadruple your money, but I won’t lose all of it either.
 

Sources: The Economist, Wall Street Journal, Value Line

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The Library: articles by Steve TeSelle:

• College Savings Options
• Retirement: What's the Target?
• Fun Facts About Taxes
• Understanding Your Finances
• Risk, Anyone?
• A Primer on Asset Allocation
• Debt, Friend or Foe?
• Life Insurance Basics
• Calculating a Return

  To read them online, simply click on the title. To obtain a printed copy, please call us at 303-733-4999, or e-mail me at steselle@doratocapital.com.

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  2009 Forecast

  An Insight Into Dorato’s Investment Style

  2008 is a reminder of the fallibility of forecasts, at least of mine. Use the 2009 forecast as you will.

  Based on a Price to Earnings (PE) ratio of 11, US stocks are more reasonably priced than they have been for many years. I expect the US economy to turn up in the second half of the year, as credit starts to flow again, and as consumers emerge from hibernation. I expect 15-20% from US stocks. Opportunities are wide-spread, across all sectors; some of the highest earnings growth will come from companies in technology and health care.

  Developed foreign stock markets have similar return potential to the US market. I don’t expect any boost from currencies, so I expect a return in the 15-20% range. Japan may lag because of large public debt, and because of a political system that can’t seem to make difficult choices.

  Emerging markets had an awful year in 2008, down more than 50%. Valuing emerging markets is hard, due to the lack of information. There are probably good companies selling at reasonable prices, but also a few that will stumble without the wind of strong economic growth at their backs. Market cycles tend to persist for years at a time, so I expect 2008 to be the beginning of a cycle of emerging market underperformance. I expect returns in the 5-10% range.

  Bonds split into two markets in 2008: US Treasury debt, and everything else. US Treasuries gained 5-25% depending on the maturity. Bonds in every other category lost money. I expect the bond market to return to more reasonable pricing. That means very good returns in corporate bonds, both investment grade and junk. Investment grade bonds could return 10-15%; junk bond returns could exceed 20%. US Treasuries should be the worst performers of the bunch: I expect losses up to 5%.

  Inflation is under control for now. In a year or two, expect to read a lot more about it. Rising inflation is bad for bonds. Inflation-protected bonds (TIPS) can help to offset inflation, but the inflation adjustment is taxable, so these are best held in a tax-deferred or tax-free account.

  Tax-exempt state and local debt lost money in 2008. State and city budgets are under pressure, which makes investors twitchy. The credit crunch hasn’t helped. I expect returns of 5-10% in 2009. The credit crisis will ease, and while budgets will still be under pressure, investors will start to see an end to that problem as well.

  Real estate has fallen back to earth. I expect it to stay there for some time. Credit will ease, but we won’t return to the debt extravaganza of recent years. That will keep real estate prices in check. I expect returns in the 0-5% range.

  As for asset allocation, stocks continue to hold the key to long-term growth. To keep up with inflation, investors should maintain at least 40-50% of their portfolios in stocks. To provide income and diversification benefits, investors can add investments such as bonds, real estate, and commodities. For 2009, I prefer bonds other than US Treasuries. Commodities might also perform well. As always, I suggest investors maintain a balanced asset allocation and try to keep costs down.

   

   

  Sources: Economist, Value Line, Vanguard.

  

• "My computer forecasting models didn't work in 2008, so I'm going back to the one tried and true method."
  

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