Okay, what’s next?

Okay, what’s next?

2009 is set to finish as one of the strongest years of investment market returns in history. Most every asset class will finish the year with a double digit return, recovering robustly from the lows set in early March. While most of the losses incurred in 2008 and late 2007 have been erased, the big question is what is ahead for the investment markets in 2010.

As bad as the markets were at the end of 2008, history provided us with some strong evidence that as soon as the bottom hit, we should have expected a quick rebound. While many were preaching fear in early 2009, we illustrated in the March 2009 edition of Deep Rooted Thoughts the positive performance that followed prior major economic disasters and the likely path this recovery would take.

The guidelines we suggested for how the recovery would unfold benefited those who followed them. We were correct in surmising that the recovery would be broad and that all asset classes would benefit, that being invested in cash in 2009 would be a costly mistake, and that volatility would cause the recovery to come in multiple small bursts throughout the year. While somewhat contrarian thinking at the time, these expectations all came to fruition during the last nine months of the year.

The big challenge today is building confidence around how the next segment of the recovery will unfold. As usual, we are able to find credible economists, portfolio managers, and market historians who have very different views of what we will experience in 2010 and 2011. For those of you in your twenties, thirties and even forties, your focus should be on your biggest asset – your personal capital – and your ability to work and add to your portfolio. For those of you whose working years are drawing to a close or for whom your portfolio is your primary source of income, the near-term direction of the markets is a much bigger concern.

The leadership at PIMCO (managers of the world’s largest bond fund) coined the term the New Normal, or N2, to describe the next several years. In their N2, they have set much lower expected returns for both stocks and bonds. They recognize that much lower returns will result in lower standards of living for many. Their models suggest that we will not have the economic growth and market expansion for the next five years that we have enjoyed during the prior several decades. The highlights of their argument are that growth will be stymied by greater governmental regulation and intervention, higher taxes, less leverage in the financial markets, less liquidity for corporate and individual borrowing, and rising interest rates. If they are right, we should make some portfolio modifications and redouble our efforts to curtail spending.

Others, such as the chief economists at J.P. Morgan and Merrill Lynch, present a much more optimistic outlook based on other data and their expectations for the global economies to return to normal in the next 12-24 months. They point to the enormous amounts of cash on the sidelines that have yet to be reinvested, decreasing consumer debt loads, improving home sales, and historically low interest rates. If they prove to be correct, there will be little need to change consumption habits or modify portfolios.

Before we share our outlook and portfolio modification plans for the coming months, we want to provide you with some of the interesting data points that we uncovered in our research:

The previous statistics from PIMCO are sobering. Clearly the economic growth rate slowed in 2009 and will need help from a number of factors to regain its traction in 2010 and future years. The debt burden will only get erased through higher tax rates or greater economic growth. If we cannot deliver the growth, the burden of retiring the debt will fall to businesses and consumers.

The growing economic importance of the emerging markets has been known for years. Their cumulative economic power is providing them with a more prominent global presence.

This mutual fund cash flow data suggests that stocks may have more room for growth if money flows back into the asset class. What is unknowable is whether or not investor preference for bonds is temporary or permanent. Stock mutual funds have experienced positive cash inflows in most years prior to 2009 so our expectations should be that stock mutual funds will receive inflows in the coming years.

Based on history, experience, research, and current market conditions, we believe the following approaches will be the most prudent way to approach the financial markets in 2010:

Cash should only be held for short-term liquidity needs. The U.S. government continues to encourage all of us to spend our money or invest in stocks and bonds by keeping interest rates historically low. The rates of return on cash and cash equivalents render them unsuitable as investments unless you expect a complete economic collapse. Federal Reserve Chairman Ben Bernanke has said on several occasions that he believes we will have a slow, gradual climb out of the recession. Further, the Fed indicated that it has no intentions to raise interest rates in the first couple of months of 2010. Therefore, it is unlikely the rates of return on cash will rise above 1% in 2010.

In 2009, bonds benefited from a low interest rate environment, improving credit fundamentals, and liquidity. These factors made bonds the investment of choice for all investors and especially for risk averse investors. With interest rates having nowhere to go but up and the recent return to normalized pricing for bonds, bond investors will likely get low single digit returns and could experience some mild losses as interest rates rise. Treasury bonds will get hit hardest by rising rates with U. S. Government Agency bonds following closely behind.

Stocks showed great resurgence in the last nine months of the year, with the growth style of investing dominating the value style. Also, large company stocks outperformed small company stocks. Given the expectations that the style differences and market capitalization differences should reverse at some point in the future, portfolios should be tilted more toward the value style and smaller company stocks in future years. Also, the diversification benefits and market growth potential for emerging market stocks suggests that they should become an increasingly larger portion of your asset allocation.

Alternative investments that involve illiquid, non-transparent, relatively expensive, and overly complicated strategies make less sense than ever in the current environment. Investments in diversified real estate and commodities that are liquid, transparent, and cost-effective may add diversification and inflation hedging benefits to portfolios.

2010 will deliver new challenges and opportunities for the markets. We look forward to navigating them with you.

This update is intended for the use of Oak Wealth Advisors LLC clients. This update should not be viewed as personalized investment or financial planning advice from Oak Wealth Advisors LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to their individual situation, they are encouraged to consult Oak Wealth Advisors LLC. Past performance does not guarantee future results and all investments should be scrutinized before being implemented in a portfolio.