The New Year is traditionally the time of New Year’s Resolutions, “I will eat less and exercise more” or “I will quit smoking”.  New Year’s offers everyone a time to reflect on past behaviors and decisions and commit to resolutions to fix, or prevent, bad behavior.

Unfortunately, the investment community doesn’t waste much time on such resolutions. If they did, the list of resolutions  for 2009 would be extensive:

  “I will not fall for the NEXT bubble. ”

  “I will not fill my client’s portfolio with popular, high commission investment products.”

  “I will not automatically assume any investment that triples in price will continue to go up.” 

and sadly, even:

“I will not park 90% of my client’s money with a guy who has an unverified and mysterious money making machine because it may turn out to be a Ponzi scheme.”

No the investment community looks at the new year as an opportunity not as a time to reflect and prevent future errors, but to make prognostications about the future. Unfortunately such forecasts are significantly less likely to occur than ‘eating less and exercising more’ and only slightly more likely to occur than ‘This year I will date a super model..

As we don’t want to shake up this status quo, it is time for us to make  our ownpredictions.. Unlike most prophets, however, our past predictions have been pretty prescient: 

2008: China is in a bubble about to burst

2007: All the new fund launches mean stocks are going to underperform for the next few years

2006: Long term interest rates are not going up

Of course, we’ll stand behind all of our other musings that were not made at the beginning of the New Year, like our ‘Fannie Mayday’ article from 2004 (which offered plenty of advance notice before the Government’s bailout), and our more recent “Peak Oil” article two months prior  to $140 oil – the very peak of the commodity bubble. 

But enough about the past- if we were truly brilliant our model portfolios would have been up in 2008 instead of down (though markedly less than the S&P 500). This year we’re going to touch on some broad ‘macro’ issues, things to watch out for as the year unfolds. 

Deflation makes inflation seem like a walk in the park

Investors have (until recently) spent mostof the last few decades worrying about two things: skyrocketing interest rates  and a substantial increase in inflation. Why else the flood of adjustable rate and commodity-oriented or ‘real return’ investment products? Can you think of ONE investment product engineered by Wall Street to offer investors salvation from deflation?

Maybe investors  remember the 1970s market but not the 1930s market. Maybe investors just like to worry about more recent problems – Lord knows Wall Street mostly invents products that would have been great ideas had they existed a few years ago.

Well, interest rates have continued to slide – just a few days ago the yield on the ten year government bond dropped  down to about 2% before rebounding, scorching those who recommended ‘shorting treasuries’ these last few months. Why the continued conundrum? Oil at $140  and fears  of ‘stagflation’ were a fantasy that diverted  billions into money losing ‘Jim Rogers’ style commodity investments. Deflation has been the real danger all along.  

Deflation is a general decline in prices, and can be  far more damaging than inflation. Imagine you’re making $150,000 and year and you buy a home for $500,000 with a $400,000 loan  only to see the home and your income decline by 20%, while  your loan balance remains at $400,000!

Deflation hurts debtors. In the extreme it doesn’t even benefit creditors because the debtors can’t make payments -  much like an adjustable rate loan is great to the creditor if rates go from 4% to 6% because the payments will go up, but not so great if the rate goes to 25% because then the payments to the creditor go to zero. Worse, with deflation, the asset behind an asset backed loan is falling in value.

This deflation bugaboo is one possible explanation for the rush to government debt (besides the well documented flight to safety).  At least Uncle Sam can make the payments (so far, so good).

Deflation deflates stocks as well. What value is a $100 billion market cap company that used to earn $5 billion a year when they can now only earn  $2.5 billion because of general price declines? About $50 billion – and that’s if investors panic and other economic problems related to deflation don’t push the company down to $20 billion in value.

Everything is cheap unless the economy cheapens

Most experts now agree, stocks and bonds (except treasuries) are really, really cheap. We’d agree too, except for our natural fear of conventional wisdom. Perhaps the stocks and bonds are correctly priced, the economy is expensive.

While it hasn’t happened since the Great Depression, it is possible the economy could contract by double-digits. Maybe we don’t need so many car dealers and retailers in the new world order. Heck, we once had dozens of different U.S. car companies. 

If the economy doesn’t shrink, stocks should do fine. But just because the economy hasn’t shrunk much in decades doesn’t mean it won’t. Heck, many things happened in 2008 that hadn’t happened in decades – commodities plunging 50% in a few months for one. 

Popular investment ideas will continue to destroy capital

The Rogers quote we like is from Will, not Jim, <i>“It isn't what we don't know that gives us trouble, it's what we know that ain't so.”</i>

2008 was the year that disproved some bad investment theorems that had gained widespread acceptance just in time to destroy some serious money. 2008 investment lore included such zingers as:

•   A diversified portfolio always lowers risk and increases returns
•   Commodities are an uncorrelated asset class that smoothes outs the bumps and offers upside when stocks and bonds sink
•   Gold and gold mining stocks are the perfect hedge against financial catastrophe
•   America is a nation in decline, move out of the U.S. dollar 
•   Real estate has never fallen nationally
•   Emerging markets have decoupled from big countries like the U.S. and can deliver solid returns to investors even while the U.S. sinks
•   Buying companies with borrowed money today is much smarter than it was in the 1980s

Real Estate Crash Year Four: It Ain’t Over Until the City That Packaged and Sold Real Estate Securities Collapses

New York City real estate is currently ‘only’ down about 12% from the peak - as opposed to a near 50% haircut in Miami, Vegas, and some other warm places, but there is almost no amount of government support that can keep a brand new million dollar one bedroom condo from falling to a mere $500,000 when Wall Street sheds more jobs than a automaker running out of lifelines from the government. 

Bailouts Go From Trickle Down To Trickle Up

2009 is the year bailouts will move firmly from the supply side of the economy (loans to banks, car companies, etc.) to the demand side (money to consumers, not producers). With a world teetering on deflation from lack of what very dull people would call aggregate demand, this may make some sense – if government plans for a better tomorrow ever make any sense at all. 

Unfortunately 2009 will also be the year where the strings attached to getting a handout go away. A well structured bailout would carry egregious enough terms that only the truly destitute would apply – in fact many currently healthy banks did not take government money. 

Bailouts go to the needy. Handouts go to anybody.

With housing, an example of a well structured ‘hard to swallow’ bailout would be something like offering homeowners a lower interest rate and lower principal mortgage in exchange for a higher capital gains tax rate on the eventual sale of that home and turning the mortgage liability into a federal obligation that cannot easily be ‘walked away from’. Such terms would keep most homeowners not in serious jeopardy of losing their home far away. 

A handout would be a freeze on foreclosures, co-pays by the government on mortgage payments (don’t worry its coming) and other monies that punish renters and those that didn’t load up on no-money-down condos in 2005.

In 2009, as bailouts become debtor welfare, a (debt laden) friend in need is a friend indeed. A banker in need is a fiend in tweed…

In closing, 2008 is the year (by our own back of the envelope calculation) that has turned more billionaires into millionaires than any year in history. 1929 may have turned more millionaires into thousandaires, but we’ll never really know for sure.

And all those old urban myths from the Depression that professional investors and other high fliers committed suicide when the market tanks. Well it (gulp) turns out there is some truth to those stories…