Croesus was the King of Lydia (modern day western Turkey) from around 560BC to 547BC. His was best known for his great wealth, and the Lydian’s were considered one of the first societies to mint gold and silver coins for use as money. Croesus may have been the wealthiest man around, but he still had a healthy appetite for prognostications.

Pressured by the Persian Empire to the west, Croesus approached the famous Oracle of Delphi to ask whether he should prepare a campaign against them. The Oracle replied that if he did so he would destroy a great empire. Heartened by the advice, Croesus engaged the Persians and a great empire was indeed destroyed – his.

The Oracle of Delphi knew well the art of making statements about the future...keep them ambiguous. A few thousand years later, when asked what the stock market would do, famous banker J.P. Morgan simply said, ‘it will fluctuate’.

Although we’d like to come up with a pithy, Delphic statement and claim forecasting success at the end of the year, we’ll again stick our neck out for 2009 with some predictions. But first, let’s look at our 2008 ‘outlook’.

“In 2008, we again think that the market in general will struggle. As a base case, we are expecting mid single digit returns for the year but see downside risks to this assumption. The message – expect a tougher year in 2008!”

“Ordinarily, we would expect the simultaneous bursting of the housing bubble in the US and the global credit market bubble to usher in a lengthy bear market across global equities. When the global banking sector is impaired as it is, the ability to lend is constrained and the resulting economic slowdown should impact corporate profits.”

If only we had taken ‘ordinarily’ out of that last paragraph! We made the mistake of assuming that government interference in the market, via low interest rates and fiscal policy stimulus would prop up equity prices and avoid the collapse that we saw.

We might be making the same mistake again, but throughout 2009 we will experience unprecedented government stimulus and this should provide support for asset prices. Central bankers are punishing savers heavily by slashing the rate of interest paid on cash. Staying in cash in 2009 will increasingly be seen as an opportunity cost, especially as inflation erodes the value of that cash.

After such a horrendous year in 2008 we expect equities to put in a positive performance in 2009, although the extent of this is obviously dependent on many variables, as we discuss below. Adding to our cautiously bullish view, sentiment currently remains very bearish. This suggests that many investors exited the market in 2008 and may now be sitting on the sidelines in cash.

Supporting this view, it appears that the market, as represented by the ASX200, made a significant low in November 2008. Since then, in the face of increasingly bearish economic news and sentiment, the market has been moving slowly higher. This is bullish action.

In our market comment articles late last year, we suggested that there was a good possibility the November low of 3217.5 would prove to be a medium term bottom. In our opinion, the price action over the past month continues to support this view. As evident on the chart below, a higher level of support has emerged at 3474.1, from which the index has slowly begun to edge higher.

While ever the index remains above 3474.1, the probability is for a continuation of the rally towards the next region of resistance between 4340 and 4442 over the coming weeks and months.

However, in order to gauge what lies ahead for the remainder of 2009, we need to look at the longer-term weekly chart. The most dominate feature is the severity of the current bear market, which at the extremes has erased close to four years of gains in the matter of just over 12 months. Following a decline of this magnitude, an extended period of consolidation and base building is now more than likely.

More specifically, there is a strong chance that the ASX200 remains contained between 3217 and 4444 for some time. Only after a solid base has been established is a sustainable upward trend likely to emerge.

When thinking about how the market will perform in 2009, it is important to remember that the only two variables that impact stock prices are earnings and the price that the market is willing to pay for those earnings.

We can be reasonably confident that company earnings will remain under pressure in FY2009 and into FY2010. This is a negative for stocks. However, the multiple that investors are willing to pay for these earnings, represented by the price-to-earnings (PE) ratio, is low by historical standards. This is a positive.

Let’s expand on these important concepts. Using Bloomberg data as at 05/01/09, the table below shows some important ratios. We’ll use the Australian market, the ASX/S&P200, in our discussion.

Global Equity Index	Price/Earnings Ratio (FY09 est)	Earnings Yield (09)	Price Earnings (FY10 est)	Equivalent 10-Year Govt Bond Yield (current)	Dividend Yield (FY09)
ASX/S&P200	10.1	9.9%	9.6	4.2%	6.3%
Dow Jones Industrials	11	9.0%	14.4	2.4%	3.5%
S&P500	13	7.6%	12.0	2.4%	3.0%
FTSE100	8.2	12.2%	8.5	3.0%	5.3%
DJ Euro Stoxx 50	8.5	11.8%	7.6	3.0%	6.0%

^{Source: Bloomberg}

Based on consensus Bloomberg earnings estimates for FY2009, the ASX200 trades on a PE multiple of 10.1 times. This figure represents what investors are now willing to pay for the markets’ earnings. At the market peak in late 2007, investors were willing to pay around 16 times earnings, indicating bullish sentiment and an expectation of continuing earnings growth.

The contraction in the ‘earnings multiple’, or the price investors are willing to pay to obtain those earnings, has been a major determinant behind the market fall in 2008. Actual earnings declines have also contributed.

As shown in the table above, analysts expect earnings to rebound in 2010, albeit modestly, pushing the PE ratio down to 9.6 times, assuming prices remain stable (which they won’t).

Given the economic headwinds we are facing, we believe these estimates will prove too optimistic. But just because we expect earnings to fall, that does not mean we expect the market to decline.

Assuming earnings actually fall by 10%, a market decline of the same magnitude would see the PE remain at 10.1 times. But we envisage a scenario where investors may ‘re-rate’ the market to a still conservative 12 times earnings, which in rough terms would lead to a 10% increase in the overall market, despite a 10% decline in earnings. (This is because the multiple expands by 20%, from 10 to 12)

Why would this re-rating take place? This is where the other ratios come into play. The earnings yield on a stock (or market) is the inverse of the PE ratio. So a PE of 10.1 gives an earnings yield of 9.9%.

Investors are constantly assessing investment options; cash versus bonds (corporate or government) versus equities and property. Looking at the table above, we see that the earnings yield on equities is far superior to the yield on government bonds. This is how the relationship should be, but the disparity is now extremely wide, signifying a strong preference for the security of government bonds versus equities.

In other words, the risk premium on equities is now high, suggesting that a considerable amount of risk has been priced in to global equity markets. We believe that government bonds are overvalued (given the longer term inflationary path most governments are embarking on with low interest rates and expansionary fiscal policy) so the risk premium has been enhanced by falling bond yields.

But even so, we will likely be in a very low interest rate environment throughout 2009 so there is ample room for equity market PE expansion, especially if the various government stimulus packages begin to have an effect and change investor risk perceptions.

PE expansion will not occur though if more credit market issues unfold throughout 2009. And let’s be honest, there is considerable risk that there are more unknown disasters lurking in 2009. Credit card debt and commercial property in the US and elsewhere are just some examples.

However, if such issues are lurking, they are deep. The charts below suggest investors are becoming increasingly tolerant of risk, supporting the argument for PE expansion this year. Firstly, the VIX, or volatility index, has continued to decline, indicating reduced demand for protection from a falling market through the purchase of options.

The TED spread is a measure of the stresses in the interbank lending market and as shown, the spread (the difference between 3-month US Treasuries and the London interbank offered rate, or LIBOR) has also been falling. This suggests that banks are becoming increasingly confident that governments will not allow any more large-scale financial institution failures and are willing to lend to each other at lower rates.

Lastly, we show a chart of a Moody’s AAA corporate bond index. The sharp fall in recent months suggests investors have been increasingly willing to buy the debt of quality corporates. All these declines indicate a rising tolerance for risk.

Confidence causes investors to pay more for stocks in the same way that pessimism allows brave investors to buy stocks cheaply. We think that investors will gain confidence from the considerable stimulus that will work through the system in 2009 and this should support the PE expansion thesis, despite the fact that earnings will likely remain under pressure.

Whether such PE expansion is sustainable is another question. Investors can have short memories and may interpret the effect of low interest rates and government fiscal stimulus as ushering in a new round of global economic growth.

We would caution against this. There are some major fundamental problems with the global economy. As we have written about extensively this year, and will continue to do so in 2009, the US dollar as the world’s reserve currency is at the heart of the problems.

Being the proprietor of the world’s reserve currency allows a country to borrow more than it can possibly pay back. Can we really expect more borrowing in the US to solve the current problems? We think not. The US is the world’s richest nation but has the largest debts in economic history.

This may not be an issue for 2009 but the reality is that the credit boom, which saw debt levels in developed western economies explode over the past decade, is now over. This debt supported consumer spending which in turn provided Asian nations with large, manufacturing based trade surpluses.

Huge fiscal deficits (replacing private debt with government debt) may offset the adjustment in 2009, but this will not lead to a sustainable recovery and we’ll be back discussing these same issues in 2010.

Given the increasing likelihood that much government stimulus around the world will be spent on infrastructure, and given the ongoing industrialisation of China (albeit at a slower pace) we continue to favour commodities in general, despite, and also because of, a disastrous year in 2008. While we still remain cautious towards the financials, we believe good buying opportunities amongst the big banks will emerge in 2009.

Obviously, we continue to strongly favour gold and gold stocks and believe 2009 will be another positive year for the precious metal. The smart money has been moving into physical gold, and soon enough gold and gold stocks will be demanded by a broad range of investors. Expect some big moves this year.

Oil had a tough year in 2008, tougher than we or nearly anyone else expected. Given the size of the falls, we expect oil to perform better in 2009. We provide great comment on the oil market in out ‘Top Ten Themes’ piece.

There are many stocks in the Aussie market that are trading at attractive multiples, suggesting that stocks are inexpensive. While some stocks are undoubtedly good value, many more are cheap for a reason. Our challenge, as always, is to assess the good from the bad.

If you’re still a keen investor as 2009 begins, consider yourself fortunate. You’ve just come through one of the worst markets that history has concocted. You may not have your wealth intact, but the 2008 bear market was as egalitarian as they come, stripping everyone of their wealth to varying degrees.

2009 will be another tough year, but if we’re right, it should be a vast improvement on 2008. Don’t forget though, the world has changed. The easy gains of the credit bubble days are well and truly over and if we are to make money, we need to be much smarter and more nimble than in years gone by.

This will be our aim in 2009. We wish all Members a Happy New Year and hope 2009 is a success on and off the investment field.

All the best,

Fat Prophets