Preview

In this issue, I review the broad investment outlook as I see it for 2009 and beyond. I try to focus on identifying value rather than making specific predictions about which asset classes will outperform or underperform in the short-term.

Here is my investment outlook for some of the broad asset classes and the value they represent heading into 2009:

Opportunities in 2009

The big story of 2009 will be the continued deterioration of the real economy and corporate earnings. Unemployment will rise. GDP growth will be slow or negative. Default rates will increase. You name it, it will get worse than it is now. But how much is already priced into various investment classes? Keep in mind that bad economic news often follows long after the market has bottomed:

"Warren Buffett recently suggested that if you wait for the robins, spring will be over. Not only should investors not wait for good news on profits and the economy, they should actually brace themselves for the news to worsen predictably, well after the stock market reaches its lows."

- Bill Hester, Bad News Ends Long After Bull Markets Start, November 2008

In my view, most of the 2008 credit crunch has run its course. Reverberations will continue, but the main earthquake is over. However, a slow economy and flat/falling prices in stocks and housing will continue to drain investor sentiment throughout the year. My personal guess is that investment pessimism (in this cycle) peaks sometime in 2009, which makes it a year of opportunity for investors willing to accept risk.

The key to identifying value in 2009 is to ask what types of businesses have been least impaired by the 2008 credit crunch. Industries with business models that fundamentally failed in 2008 (lending, banking, credit, etc.) will continue to be unprofitable until major restructuring occurs, whereas industries with simpler business models that are less reliant on credit (manufacturing, energy, agriculture, healthcare, basic consumer products, etc.) will recover more quickly. Despite the poor performance of real estate, finance, and technology in 2008, I do not yet see compelling value in these sectors.

As for the timing, I think it makes sense to put capital to work at various points throughout the year. If this recession turns into a depression of historic proportions (I doubt it, but we shouldn't rule it out), then 2009 will be too early to trade liquidity for risk. But taking an absolute stand either way with an all cash/gold or an all stocks/bonds/real estate portfolio is a poor strategy if you have a mixed economic view. The better strategy is to put some capital to work at current valuations and to hold some in case valuations become more favorable.

Investment outlook

Long-term Treasuries (Most Unfavorable) are one of the "danger zone" areas for 2009. Long-term interest rates are at 50-year lows, and the spike in exchange rate due to the crisis seems complete. It makes almost no sense to me to lock in a 2-3% return for ten or thirty years in the face of potentially huge fiscal and monetary stimulus. Like it or not, the people running the show have been quite clear that the U.S. will spend its way out of this recession with borrowed money. In the long-run, all paths point to dollar devaluation and/or higher interest rates. (see The Dollar Crisis Begins for a supporting view)

Commercial real estate (Most Unfavorable) was one of the last dominoes to fall in 2008 and as a result I think it has further to fall. For whatever reason, confidence in commercial real estate valuations was not shaken until the real economy was visibly cracked. Bankruptcies and corporate defaults will be quite negative for this sector in 2009 (more than is already priced in).

Residential real estate (Unfavorable) fell by an average of 18% in the 20 largest U.S. cities in 2008. Because real estate markets are slow and persistent, don't expect the main trend to reverse anytime soon. The only reason why I gave this sector an "Unfavorable" instead of "Most Unfavorable" rating is that price declines have been sufficiently large that I would expect some savvy investors to find great value in foreclosures and distressed selling. But I think most investors should remain wary of increasing exposure in U.S. residential real estate.

Financial stocks (Unfavorable) had a record year to the downside in 2008. Several big bank stocks went all the way to zero. But financial stocks still represent a sucker's value bet to me because of the challenges they face moving forward. In addition to increased regulation and zombie balance sheets, the entire sector simply needs to shrink as a share of our economy. It's possible, of course, that big name financial stocks like Goldman Sachs lead an upside recovery, but it seems to me to be a bet not worth taking.

Technology stocks (Unfavorable) also fell late in the game relative to other sectors. Consequently, earnings projections are still optimistic in light of our slowing economy. My guess is that the 2009 earnings reports in technology will be horrific. I expect this sector to disappoint for the year in full, but I'm looking for value later in the year if investors become overly pessimistic.

Broad stock market indices (Neutral) such as the S&P 500 represent a reasonable but not a compelling buy at current prices. As a result, I think that modest stock market exposure makes sense. I personally think that value can be found by stock picking in this market, but for the average investor a broad index doesn't look too bad. My guess is that stock market values get slightly better in 2009 but not as good as historically low valuations like the early 1940s or 1980s. I would not increase exposure if prices rise from here, but having a no stock allocation seems just as bad a strategy as having an all stock allocation at these levels.

Emerging markets (Favorable) in Asia and South America are a tough call, in my view. The bull case is that their economic growth relies on industries less affected by the credit crisis (manufacturing, materials, energy, etc.) and that stock valuations are better than the U.S after the 2008 crash. The bear case is that their wealthiest customers (U.S. consumers) suddenly are much poorer than they thought they were. On net, I think the bull case dominates the bear case so I like modest emerging market exposure relative to U.S. exposure.

Consumer staples (Favorable) and name-brand consumer companies seem to me to be a good place for finding value within an otherwise mediocre U.S. stock market. As U.S. consumers tighten their wallets, even the best companies will have a tough time being profitable in 2009. This means that reported earnings will be way below their long-run potential, making particular companies seem expensive when they are in fact cheap. Here are some ideas for stocks that might become particularly good bargains in 2009: SBUX, UA, HOG, TIF, TM, MCD, CMG, DKS, BBY.

Oil and commodities stocks (Most Favorable) were completely decimated from June-Dec of 2008. But the fundamental outlook hasn't changed much. Thus, I see value here rather than a dying bull market (as in financials). Global demand for basic goods and materials is certainly lower than it was last year, but I think the market is overestimating the possibility of a global depression. As long as the world recovers sometime in the next 5 years, look for these sectors to lead the charge. If you have no exposure in this area, now would be a decent time to gain some. As my orthodontist used to say: "My idea of diversification is half in Exxon and half in Chevron".

Gold and gold stocks (Most Favorable) continue to be my favorite asset class moving forward. I expect gold to be higher in both dollar terms and stock terms over a 2-5 year horizon. Unless followed by a truly heroic tightening policy (doubtful), today's aggressive fiscal and monetary stimulus will eventually become inflationary. Because valuations have improved in U.S. stocks, I have lightened my gold exposure slightly from last year. At some point I will get rid of gold altogether. But I fully expect gold to continue to outperform as more investors realize that deflationary forces cannot win against a printing press.

Conclusion

A mixed investment outlook calls for a mixed strategy. Few places demonstrate compelling value, which is why moderate exposure to a variety of asset classes makes sense at this time. Investors should be on the lookout for 2009 to present some great buying opportunities, especially in the U.S. stock market.

Perhaps November 2008 was ''the low'' and opportunities have already been missed. As I said, my guess is no, but I'm not willing to stake my entire portfolio on this view. Maintain some risk exposure at this level so that you won't be tempted to buy if prices rise, but keep some reserves in case valuations improve. Develop a mixed strategy for 2009.