2009 - Year of expectations!!!

Happy New Year to everyone. 31st December '08 gave me a feeling that finally the year is coming to an end. 2008 has been the worst year in living memory of most people. Some might argue that things can't get worse than this, but there is lot that has to be seen before we come to any conclusion. Lets just see what was good about 2008 -

• India did relatively well in Olympics 2008. We saw some new heroes emerging.
• Indian sports in general was very good. Golf, badminton, cricket and football had a very good year.
• Central government survived a confidence test vote
• nuclear deal - (long term impacts still in question)
• Launched Chandrayaan-1 from Satish Dhawan Space Centre, Sriharikota

and some other that I might have missed.

what did an average defensive investor gain in 2008?

• Stocks became cheap (after eroding much of the gains seen in the last three years)
• High rates on FD for long term investments, still available
• Better home prices

There were some unprecedented and mind numbing incidents that happened in 2008 which took everyone by surprise. Worst was the attacks in mumbai. Blasts in various Indian cities and many stampede which caused huge loss of human life.

In every sense the year gone by has been quite a shocker to most of the financial gurus and practitioners too. No one in the world ever imagined that oil would fall more than 80% from its peak in 5 straight months. Stock markets recoupled after failing to decouple and created a panic amongst investors.

Lets put things into perspective as the stand today. I would look at financial markets as this blog is about the markets.

First of all there has been some serious breakdown in intermarket correlations. In the last one year stocks and bond prices has moved in opposite direction. (Generally rising bond prices indicate lower borrowing costs and a positively sloping yield curves' presence leads to a rally in stocks, so bonds and stocks are positively correlated). Bond prices across the world first fell remarkably and then started to climb incessantly. Meanwhile stocks remained resilient initially and then sold off as bond prices started rising. So a serious correlation was interrupted.

Secondly, bonds and commodities showed a clear correlation as commodities fell and bond prices started rising. There was a one month lag in bond prices in some countries like India, which is good.

The US dollar gained 17% in last quarter or so. This lead to a fall in commodities which is also a perfect correlation. But a rising USD is in general good for stocks which didn't happen in 2008.

To summarize the correlations -

1. Stocks are bond prices are positively correlated, bond prices (note: bond prices and not bond yields are mentioned here) lead stocks in both bear and bull markets.
2. Bond prices and commodity prices are negatively correlated, commodities lead bond prices by a small margin.
3. USD is inversely correlated to commodities, its leading characteristics have not been very strong.
4. A rising USD is good for US stocks, but not essentially for other markets like emerging markets in general (domestic currency strength is actually good for other markets barring few exceptions like China).

Now this creates a question that why then stocks didn't rally as borrowing costs came down. The answer is the deflation expectation. Markets have been frightened by the expectation that price level would eventually fall so much that prices of goods and services would start falling year on year atleast for a few months. This was very evident from a number of factors. There was massive risk aversion in 2008 as bond price rally lead to yield going to zero for US3 month Treasury. The yields on High Yields (Junk Bonds) started rising and some were quoting a yield as high as 56%. There was a massive sell-off in consumption commodities like copper, platinum and agricultural commodities due to a severe fall in employment.

So what do we 'Expect in 2009' ?

All previous financial crisis like 1907, 1929, 1930, 1970 lead to severe legislation's in US. Like 1907 led to the creation of Federal Reserve, 1929 lead to SEC, 1970 lead to another set of regulations for funds. In India previous market sell-off has led to more regulations like crisis of 1992 lead to the creation of SEBI, then the scrapping of badla system, depositories etc. So its very important to be prepared to for regulations and see how the markets react to them.

Second is to judge whether the worse is behind us.

The US economy is weak and will remain weak for some more time. Unemployment in US would rise to levels of 8% or more, some more banks may fail. Currently following banks have failed. Click here for list of failed banks.

Imports in the US would remain low and western demand would remain sluggish. Some sectors like auto, housing and retail would suffer further damage due to a fall in demand. All these factors are well known now and markets have priced in most of the bad news already. As I wrote previously that reversal signs have started to emerge and we has quite a rise in the world equity markets post November. In fact Indian equity markets are also showing signs of resilience as Nifty is already up around 600 points from where a 1000 point rally was expected. See previous commentary.

The current market scenario shows that markets are indeed rising with some backing of improvement in market sentiment, flows in the credit market and a rising expectation of economic growth. One of the most important indicator that should tracked now is the long term bond prices. Since markets have started pricing in deflationary pressure than a fall in the long term bond prices will lead to weakening of the sentiment and reduced 'Panic Selling'.

2009 is the time to raise your equity weight age and reduce your holdings of bonds and debts. India FD rates are still attractive. However in bear markets there are several events that can create massive buying opportunities. One recent example is Satyam. So every major opportunity should be used to buy sound companies with 10 years of more of stable earnings and a PE of less than 15. Any event that leads to a sudden dip the stock prices of firms which are strong from a business point of view should be bought and kept for few years.

A few caveats - 2009 will bring opportunites but with large risks attached to them, so be ready to evaluate the risks before taking a punt. Inflation may rise again as commodities make an interim come back, stocks might see a final bottom in place in the US along with a relief rally in commodities. Indian markets are better placed in terms of financial health but worse of in terms of investment flows, geo-politics and the stability of the government.

In 2009

Expect cheaper goods, eating joints which increased the prices of food and edible items during last year inflation has not decreased the rates yet. This can happen in few months. Cheaper travelling, better media entertainment and better security might make your weekends.

Happy New Year