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Weekly Market Commentary: December 22nd 2008

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Time to Opine on 2009

The stock market digested a lot of news last week, but managed to post a gain and hang on to the roughly 20% gain since November 20. Last week’s events included earnings reports from Goldman Sachs and Morgan Stanley, the unusual statement issued from the Federal Reserve meeting, the OPEC meeting and announced cuts to output, the auto bailout deliberations, and the unfolding details of the Madoff scheme. The week left the S&P 500 in the middle of its range of the past couple of months. This volatile, rangebound bottoming process is likely to extend into 2009.  

We continue to recommend investors seek to profit from volatility using “volatility-thriving” investments such as covered calls and global macro style funds, which help with highly volatile markets. Keep in mind such strategies are subject to increased risk due to the use of derivatives, and futures, may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses. At least until we pass Groundhog Day, the road to recovery is likely to be a bumpy one. What happens further along the road depends on which fork the financial crisis takes us down in 2009. 

The heightened uncertainty and conditional nature of the current macroeconomic and policy backdrop generate a wider range of possibilities for 2009 than for most years. As a result, we present three scenarios for 2009 that develop from how long the current climate of financial panic persists: a base case that we believe is most likely, a bear case or a continued downturn, and a bull case that entails rapid rebound. 

Base Case

The financial panic that began in September 2008 will subside in early 2009 allowing a normalization of financial markets by mid year 2009. This base case, we believe, is the most likely scenario for 2009.

Why would the base case prevail?

1. Intervention policies implemented by the U.S. government begin to take effect.
2. Market sentiment remains cautious through volatile January markets.
3. Consumers remain cautious after a dismal 2008 holiday sales season
4. Unemployment remains relatively high through much of the first half of the year

The Base case Scenario

1. The economy emerges from recession in the second half of 2009.
2. Inflation turns negative early in 2009, but rises by the end of the year.
3. The stock market, as measured by the S&P 500, posts a return in the mid-teens, as a volatile first half of the year gives way to more consistent improvement in earnings and sentiment in the second half. We anticipate the year-end S&P 500 close to be around 1000-1050. Once the market begins to recover, early cyclical stocks are likely to lead the way, for example the Consumer Discretionary sector and the Transportation industry.
4. The bond market, as measured by the Barclays Aggregate Bond Index, posts a return in the mid- to high-single digits range.
5. In alternatives “volatility thriving” strategies continue to benefit returns in the first part of the year.

Bear Case

The financial panic lingers well into 2010, and financial markets do not normalize at all over the course of 2009.

Why would the bear case prevail?

1. Foreign bank failures continue without the type of intervention seen in the United States.
2. Housing sales break down from the stable levels of the past year and follow the path of auto sales sharply downward.
3. Increasingly aggressive forced selling by financial institutions or a major negative geopolitical event further disrupts the markets.

The Bear Case Scenario

1. The economy lingers in a recession throughout 2009 and into 2010 with a frozen lending market.
2. Stocks post another year similar to 2008, marked by another decline as confidence fails to return and earnings tumble another 20%. The year-end S&P 500 close would be about 560. Defensive stocks would be the best performers on a relative basis, for example Utilities, Consumer Staples, and Health Care.
3. Bonds return in low- to mid-single digits, with additional Treasury gains offset by price weakness in non-Treasury sectors: Corporate Bonds, Mortgage-Backed Securities (MBS), and Agency Bonds.
4. The alternative investment areas of opportunity are: Long/Short, Covered Calls, Managed Futures, Global Macro, Absolute Return, and Market Neutral—all those mutual fund strategies that help with volatility.

Bull Case

The financial panic that began in September 2008 dissipates at the very start of 2009, and financial markets begin to normalize early in the year

Why would the bull case prevail?

1. Evidence of a sharp rebound in market sentiment comes in late 2008 or early 2009.
2. Policy actions take effect sooner than expected.
3. Falling mortgage rates help to deliver a bottom in home prices.
4. The Federal Reserve (the Fed) injects more capital into financial institutions, and lending accelerates.

The bull case scenario:

1. The economy experiences a quick rebound from the recession and a rebound in the credit markets as confidence is restored.
2. Stocks rebound both earnings and valuations snap back as a mountain of cash is returned to the capital markets. The year-end S&P 500 close would be about 1365. A powerful rally would likely be led by the Consumer Discretionary, Information Technology, and Financial sectors.
3. The bond market returns high-single digits as income and price appreciation, from Corporate Bonds in particular, more than offsets Treasury weakness.

Most alternative strategies provide positive results but trail the strong stock market in this bullish scenario.

For deeper insight into these scenarios, including a detailed look at the Great Depression of the 1930s and the impact that the outcome of the 2008 elections creates for business leaders and investors, please review the recently published white paper entitled Outlook for 2009.

Refer Article to a Friend >

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IMPORTANT DISCLOSURES Investing in international and emerging markets may entail additional risks such as currency fl uctuation and political instability. Investing in small-cap stocks includes specifi c risks such as greater volatility and potentially less liquidity.

Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.

The opinions voiced in this material are for general information only and are not intended to provide specifi c advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your fi nancial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

© LPL Financial

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