Finally another post

Well, its been a long time since I posted anything and so thought that I would post an email that I had sent out to my investment club members written just before the beginning of 2010. I did highlight the sovereign risk issues that would plague 2010. Didn't expect it so early in 2010 though.

Guys,
Just wanted to put my view on what 2010 is probably going to look like for stocks. 2009 was a great year for stocks, a year much better than expected. The S&P gained 22% in the year while my U.S portfolio (lucky me) gained 40.64%. As to our shared portfolio, success was not as sweet as we managed to lag the benchmark, the primary reason being that our portfolio was under invested since I believed and continue to believe that Indian markets are overvalued. 2010 is however a year to watch out for when it comes to making investments because the easy money making period is over for a variety of reasons

1) Analysts tout the improved performance of the U.S economy as a reason to believe that stock markets will go higher. On the contrary, a strong performance of the U.S economy is precisely what will drag stock markets down. The rapid rise of assets in 2009 is due to a tsunami of liquidity in the financial system which combined with the near zero yield in risk free investments is being pushed into risky assets like stocks. An improved U.S economy would lead the Fed to withdraw liquidity (either through higher interest rates or other measures) out of the system which would bring asset prices down. This would lead the dollar to strengthen due to a flight to safety and an unwinding of the dollar carry trade and would further skew the currency mismatches in the financial system.

2) There are some analysts who believe that the EPS of the S&P would be $90. This is higher than any other year in history. I doubt if such a thing would be possible in 2010. Even if it were the case, most of these profits would be derived by cost cutting rather than revenue increases which would tarnish the quality of earnings. Maintaining a standard PE of 14 which would value the S&P at 1260 (a 14% upside from current levels) would be difficult.

3) Sovereign credit risk may turn out to be a wild card in 2010. Dubai has just been bailed out by Abu Dhabi and European countries such as Portugal, Italy, Ireland, Greece and Spain (labelled as PIIGS) have mountains of debt that they may be unable to pay for. These countries have Credit Default Swaps (the same instruments that caused the credit crisis) written against them and if any of these countries were likely to default, the issuer of these CDS instruments (primarily financial institutions) would have to pay up the counterparties. If this were to result in a near collapse of an institution, this could create another credit freeze and given the current public anger against Wall Street a bailout by the U.S government may not happen. However, since these countries are part of the European Union and therefore have Euro as a common currency, it is likely that the richer countries like Germany and France would bail them out. However, Eastern European countries which are not part of the European Union yet have massive amounts of debt funded by the Euro countries in their books and the recent depreciation in their currencies has made it all the more difficult to repay. These countries may default creating similar problems if not smaller in magnitude.

4) An Elliot wave analysis shows that the market rebound is close to a 50% retracement of the S&P. The retracement will be achieved when the S&P hits 1120. Elliot waves have been fairly accurate in the past. The theory states that when such a thing happens, there is a good likelihood that markets will take a turn for the worse.

5) The next financial crisis is going to be worse than the recent one since the mistakes of the past have been repeated. It is also likely that this crisis will happen sooner than later due to sharp rise in asset prices. Whether the impact will be seen in 2010 is too early to tell.

6) The mismatch between debtors and savers are increasing but the currencies are not reflecting this. In fact, currencies are behaving very much in the opposite direction except for the Japanese Yen. All this points to a massive unwinding in the currency market which could lead to another currency crisis. When this may happen is a matter of debate.

7) And lastly, too many people are bullish on 2010. This makes me bearish as history has always shown that when everyone is in one camp the market behaves differently. Dont ask me why!!

I am making an implicit assumption here that what happens to the U.S market will occur with increased magnitude in the Indian markets. Therefore may analysis is more tuned toward the dog that will wag the tail.

regards
raghu