With the financial mayhem transforming itself into an economic crisis during the past quarter, the key question today for equities addresses the length and duration of this downturn. The majority of forecasts suggest signs of economic stability will occur during the 2nd half of 2009 such that 2010 will be a decent year. With greater than $4 trillion of global stimulus already announced and the extrapolation of the duration of downturns into the recovery of the current cycle, this scenario is becoming consensus. Hence, early cycle equities have begun to discount this prediction. I believe it is too early to make such a definitive judgment.

In my mind, there are three broad categories of stimulus that a government can deliver to kick start an economy: monetary policy, short term fiscal stimulus and spending focused on the longer term. Systemic risk reduction will continue to drain monetary policy of its impact this cycle; be it due to the continuing refusal of the banks to loan money or the remainder of the financial system, including hedge funds, using incremental capital to reduce leverage. As for fiscal stimulus, the impact of the US package last summer provided a short term blip to consumption, but that’s now a thing of the past. In fact, I suspect any plan tabled during the first half of 2009 to have a muted impact on spending even if its represents a greater proportion of GDP. The reason is wealth destruction.

During Q3 alone, Merrill Lynch estimates that US$3 trillion of wealth was lost by households. Combined with the reality of diminishing job prospects, the same Merrill report suggests household saving in the US will rise to 5% over the next 15 months compared to approximately 2% now, with consumer spending being suppressed by an equal amount. That leaves the supply side of the equation. President Obama’s proposed infrastructure program will have an impact, but it will take longer for structural-oriented stimulation to boost the economy then the bulls think.

Furthermore, I believe qualitative aspects of this cycle are dissimilar from recent downturns for a couple of reasons. Shifts in demographics and the distribution of societal wealth are different this cycle relative to previous post WW2 cycles, and not in a positive manner. Lastly, the elimination of ten years’ worth of equity earnings during the past year will make most equity investors incredibly cautious about jumping back into equities. Based upon the $53 estimate of 2009 earnings for the S&P500 by Morgan Stanley, the broader US markets are not cheap.

While equity market volatility has fallen concurrently with certain credit benchmarks, uncertainty will continue to dictate market sentiment as we approach the late January fiscal announcements out of Canada, and more importantly, the USA and China. Investors should remain focused on capital preservation, generation of yield, and special situations, such as merger arbitrage positions. Yield will continue to be best captured from non-vanilla equity instruments, including preferred shares and high grade corporate bonds.

Now that 2008 is over, and with good riddance, the US dollar should reverse its current flow-driven weakness, and reassert its counter-intuitive strength until the time when there is greater clarity that economic stability is pending. At that point in time, investors will become more comfortable owning other currencies. This step will reduce the bid for the US dollar. In turn, such an event will breathe life back in to dollar-based commodities. Once this situation occurs, the yield curve will steepen, as the market begins to discount an economic recovery. This development will hurt government bond pricing but cut the interest rate spreads on corporate bonds. With less default risk priced into the credit markets, banks will start to lend again, companies will be able to grow, and equities will benefit from the tremendous amount of cash on the sidelines.

But the market is not there yet. In fact, I believe post the enthusiasm around the inauguration of President Obama, together with his proposed package of fiscal stimulus, equity markets will retest their November 2008 lows on cathartic selling, and that will likely represent the bottom for equities. However, the only certainty of financial markets today is uncertainty. It’s too early to jump into common stocks with two feet.

Andrew McCreath, Senior Portfolio Manager
Sentry Select Capital Corp.
Toronto, Ontario