High Risk, High Potential Reward
Last Update: 05-Jan-09 08:36 ET
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Investors face a potentially high reward over the coming year. There is also a great deal of risk. The economic outlook depends significantly on the uncertain success of a stimulus plan. Earnings prospects are highly uncertain. The proper management of these conditions depends greatly on individual considerations.
In Government We Trust
Economic conditions are very poor. The current trends would suggest prolonged recession.
There is, however, scattered longer-term optimism. This is due mainly to the hope that a massive government stimulus plan will stabilize the economy and might even lead to a significant recovery in the second half of the year.
Here are some background numbers to consider:
1) The annual rate of U.S. GDP in the third quarter was $14.4 trillion.
2) There is talk of a $1 trillion (or larger) stimulus package.
3) A stimulus package of that size would amount to 6.9% of GDP.
It is far too early to guess at the timing and nature of any fiscal stimulus plan. Nevertheless, it is clear that the amount of stimulus being discussed is huge.
This does not mean that the stimulus plan will necessarily be successful. Hopefully, the spending will be done in a manner which stimulates demand beyond the initial spending, and in a way which ultimately increases economic efficiency.
The Japanese implemented massive stimulus plans on a regular basis over the past decade with little effect. There is no guarantee that a government managed stimulus plan will work.
The current stock market thinking is that the U.S. plan will be far more efficient than the Japanese failures. This partly explains the recent stock market bounce. There seems to be a consensus that the U.S. needs massive infrastructure spending.
Of course, in 2005 when a massive four-year highway spending bill of $285 billion was passed by Congress, it was widely panned as unneeded pork barrel spending. Such criticisms have faded, and now suddenly it appears as if the country does in fact need many more bridges and highways (and 600,000 or more new government employees).
There is a risk that market opinion turns to skepticism as the actual stimulus plan is subjected to debate among 535 congressmen all eager to get more money for their constituents.
Here are some other facts to consider:
1) The current U.S. federal debt is $6.37 trillion (Excluding intra-government debt in which Social Security, for example, holds U.S. government securities. The debt is $10.7 billion including intra-government holdings).
2) This amounts to about 44% of GDP (74% including intra-governmental debt).
3) This compares with about 59% for the European Union 27 nations as a whole, 66% for the core 15 EU members, and about 170% for Japan.
4) Another $1 trillion in debt would raise the debt/GDP ratio for the U.S. to 51%. $1.5 trillion would put the ratio at 55%.
(Note: Intra-governmental debt should not be included in debt/GDP calculations. There is no difficulty in having one U.S. department owe debt to the Treasury. It is an accounting fiction.)
The numbers above suggest that the U.S. is capable of handing the massive stimulus plan -- if it works. That is, the effective debt ratio for the U.S. would not in itself be worse than that of most western countries. As long as the economy picks up in 2010 and the deficits are subsequently narrowed, the debt is indeed manageable.
Of course, there is again a great deal of hope involved in current stock market expectations. In 2003 when the U.S. federal deficit went over $400 billion, there was extensive handwringing over the long-term implications.
Now, the financial markets seem more focused on the immediate benefits that might result from increased spending, and less concerned with long-term issues. A shift in sentiment toward skepticism regarding excessive government deficits is possible.
Earnings Outlook for 2009
There is still a fair amount of optimism toward 2009 earnings.
The current forecast for operating earnings for the S&P 500 in aggregate for the year as a whole is $81.80.
For as-reported earnings (all charges included) it is $42.40.
That is a huge difference between operating and as-reported earnings. There are expected to be a lot of charges throughout the year.
The price/earnings multiple on year-ahead operating earnings is a very reasonable 11.4.
The price/earnings multiple on year-ahead as-reported earnings is a more troublesome 22.0.
These numbers reflect the high risk that investors face in 2009. There will certainly be a lot of lousy earnings numbers. There will be a lot of charges. If the economy does not start to recover in the second half of the year, stocks are not cheap.
If, however, the operating earnings forecasts reflect a truer underlying trend and charges fade as the year progresses and 2010 looks like a more stable year, then stocks are quite cheap at present, particularly given extremely low interest rates.
What It All Means
The outlook is highly uncertain. There is still clearly a lot of risk in stocks. If the stimulus plan does not work, then the economy will simply be saddled with government debt at a time when demand remains sluggish. The Japan comparison will grow.
If, on the other hand, the economy does stabilize and the earnings outlook for 2010 improves, then there is a great deal of upside potential for the stock market.
It is very easy, for example, to construct a realistic scenario in which the S&P rises 25% this year. That implies a year-end level of 1129. That would still be down sharply from the highs of 2007, but would still represent a fantastic gain for new money invested in 2008.
This high reward/high risk situation has significantly different implications for investors depending on their personal situation.
A young person in their late 20s, for example, could find this the opportunity of a lifetime.
An investment in a 401k twice a month at current stock prices is likely to pay off substantially decades down the road. In fact, a person in this situation, with little invested now but investing a new amount each month, will benefit further if the stock market does not recover in 2009. This person will simply be buying more stocks cheaper for the long run.
An older investor, however, with high risk aversion, has to look at the market differently.
It matters a great deal how much risk a person can accept and when access to capital will be necessary. Many investors have seen a significant decline in wealth the past two years, and may not be able to accept much more. Even a 25% rebound in the stock market in 2009 would not seem like much to many older investors. Nevertheless, the possibility of a solid gain should not be totally discounted in planning asset allocation.
The coming year is likely to remain highly volatile with continuing high levels of risk, but also some potentially high rewards.
--Dick Green, Briefing.com
