2009 Macro and Market Outlook

This past year was rough on most investment portfolios. Many are worth a lot less on paper than they were in 2007. But there are always ways to turn those lemons into lemonade in 2009.

Just in third quarter alone, US households lost US$647 billion in real estate, US$922 billion in stocks, US$523 billion in mutual funds, US$653 billion in life insurance and pension fund reserves, plus US$128 billion in private business interests. Total destruction of household wealth in the review quarter – US$2.8 trillion – the worst in recorded history. This compared to the government’s entire US$700 billion bailout package (TARP).

Now I sense that the USD index has probably peaked for the year. The temporary support provided by the global de-leveraging process appears to be fading, and the onset of quantitative easing in the United States should prove to be inconsistent with a strengthening currency. I note that the recent advance of the USD rests on a weak foundation. As sources of support – shortage of USD liquidity abroad and a bid created by the de-leveraging process appear to be fading.

With credit markets showing signs of improvement and some stability developing in equity market, risk appetite appears unlikely to deteriorate in the near future. However, the upcoming GDP releases will likely highlight how the global slowdown is clearly seeping into reduced output with a varying degree on the depth of the slide and timing of various recoveries.

I believe that US Fed Reserve is committed to lower fed funds rate for a significant durations and has strong intention to engage in quantitative easing to keep the Fed balance sheet at a high level. Credit market and economic improvement, currently clogged, are likely to be necessary conditions for an end to quantitative easing. Growing fiscal deficits will lead to an increase in government debt and at some stage, it will make harder for monetary policymakers to contain inflation. It remains a challenge for the US to attract external financing for its domestic spending with all the accompanying risks this may hold for the long term value of the US dollar.

On the Eurozone, my view is that there is no end to the bad news and expect the ECB to cut rates further. The bad news will not be appropriated across the zone given the major discrepancies in economic health among the members. One potential conflict is the direction of unit labour costs, which have taken very different paths within Eurozone countries in recent years. Germany increased its competitiveness by reducing unit labour costs, while at the other extreme Italy has lost much competitive ground.

Malaysia-specific, choppy waters for financial market will continue and I recommend a cautiously optimistic investment stance. Commodities, which reversed course since July 2008, have fallen more than 30% in USD terms and this trend is likely to continue into first 4-5 months of the year with a likelihood of a pick-up thereafter. Inventories are likely to be cleared with support from USD depreciation. Supply cutbacks will be meaningful then and enough to slow the build up in inventories. It would not be a surprise to me if the crude oil prices to again re-test the USD$85/barrel toward the end of 2009 with the marginal production cost of unconventional crude oil hover around US$70-75/barrel along with production cut by OPEC.

I am a firm believer in stocks for the long run – but only if purchased at the right price. One of my favourite valuation methods – ‘Q’ ratio that measure relativity of the value of the stock market to the replacement cost of net assets. If the ‘Q’ ratio is above 1.0, then the market is valuing a company at more that it costs to reproduce it – then stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap as they can be bought in the open market.

Today’s KLCI ‘Q’ ratio is almost never been lower and certainly not since 1997/98 financial crisis, implying quite a degree of undervaluation. My calculation suggests a value of 0.86 as at November 2008 compared to 1.34 a year ago, implying a decline of almost 56% year-to-date.

Another long-term standard of valuation comes from P/E ratio, which shows the same relatively undervaluation. It shows that KLCI is trading at two standard deviation band of last 20 years.

One, however, should be careful in interpreting these results because the underlying assumptions are that the market is mean reverting and as long as capitalism is a going concern. The famous J.M. Keynes pointed out that John Maynard Keynes famously warned that ‘the market can remain irrational longer than you can remain solvent’. In times such as these, and as markets are still cycling between greed and fear following a long and costly plunge, there is no question that tough challenges are ahead even I take a quite optimistic view on political situation in the country.
Sector wise I like banks, plantations, oil & gas, gaming, property, utilities and to some extent, media and consumer. I am cautious with export-oriented manufacturing, automotive, REITs, timber, conglomerates, technology and non-bank financial institutions.