Those who have knowledge don't predict. Those who predict don't have knowledge.

Lao Tzu

This time last year, I wrote that the New Year tradition of making forecasts for the year to come was an even more perilous exercise than usual. My reasons at the time were linked to the lack of visibility on the economic situation and the uncertainty on the banking landscape.

It is clear that the measures taken by the authorities have succeeded in restoring confidence to the banking system and have brought stability - and even a boost - to economic activity which had come to a complete halt following the failure of the Lehman Brothers investment bank. But the authorities have achieved this at the expense of their own financial situation which has deteriorated to such an extent that most industrialised countries have seen an unprecedented increase (in peace time anyway) of their budget deficit and their debt levels. In other words, the remedy for a crisis caused by excessive debt in the private sector and banking sector is supposed to be an unprecedented level of debt in the public sector. Such a situation could lead to serious problems in the longer term, especially since the impact of demographic trends on pension systems is also likely to weigh on public finances in some years’ time.

Against a backdrop of near-zero interest rates, the stabilisation of the economic and banking situation, and the outlook for economic recovery have set off a sharp rally in risk assets. 2009 served to remind us that in the short term, cheap money gains the upper hand over fundamentals, and that it is important to know exactly what is factored into prices. One year ago, the markets were anticipating a very negative scenario. All it took was for that scenario not to happen for the markets to start rising again.

The current recovery is artificial (driven by public spending) and statistical. Businesses restoring inventory may help to spur growth of 4% in the US economy in the fourth quarter 2009 and the first quarter 2010. There is however no avoiding the fact the deleveraging process embarked on by Anglo-Saxon consumers (less consumption) and the banks (less credit) will weigh on growth in the years to come.

So while the traditional new year forecasting exercise seems once again difficult, this year it has less to do with the lack of visibility on the economic situation and more to do with the sheer range of possible scenarios for 2010. I have said on a number of occasions that while the recovery in share prices since March has not been based on solid fundamentals, it is relatively easy to construct a favourable scenario for equities. Such a scenario is based on a continuation of the situation of the past few months in which the bad news is ignored and good news is amplified, the authorities pull out all the stops to maintain a dynamic of recovery and the low levels of interest rates push investors towards the stock markets. The inflation that so many analysts predicted would accordingly be reflected in the financial sphere and not in the real economy. Similarly, while the current environment marked by uncertain growth, near-zero money-market rates and lack of inflation is in principle favourable for government bonds, we could also imagine a situation in which long-term interest rates rise sharply giving way to a bond market crash. In this scenario, bond yields would surge not due to inflation, but rather due to an imbalance in supply and demand for government bonds, with investors no longer able or willing to finance the increase in supply (due to budget deficits) at current yields. If we combine both, we could even imagine what might seem at first sight a rather perverse situation in which equities would become the safe haven for investors who have lost confidence in government debt. Finally, there is always the chance that the economic recovery may turn out to be unsustainable but where bond yields increase nevertheless precisely due to the high supply of government bonds. Such an environment would, on the contrary, be highly negative for the stock markets.

But deploring the lack of visibility or discussing possible scenarios does not count as an investment strategy. Doing nothing is also a decision and the fact that money-market investments are today offering almost no returns is increasing the opportunity cost of such a decision. After all and with just a touch of exaggeration, with short-term rates touching zero, the stock and bond markets cannot return less than a money-market investment in 2010 unless they fall.

 

I felt this little introduction necessary to show that there is no point in being too dogmatic at this time. It will be important to be ready to review one’s investment strategy over the year. In the words of Keynes: "When the facts change, I change my mind. What do you do, sir?"  With that said, here are the ideas that will underpin our investment strategy for 2010:

- The recovery in share prices since March 2009 has not heralded the start of a new structural bull cycle for the US and European stock markets. In 1982, when the markets began their last bull cycle, the situation was completely different. The table below compares the situation at the time with the situation today:

United States	1982	2009
Fed funds rate	18% and only one way to go (down)	0% and only on way to go (up)
10-year bond yield	15% and falling	3.8% and ?
Budget deficit-to-GDP ratio	-3% and moving towards a surplus	-10% and steady or falling from here
Household debt-to-personal disposable income ratio	62% and rising	123% and falling
Inflation rate	10% and falling	0% and rising (inflation) or falling (deflation)
Savings rate	10% and falling	4% and rising
Unemployment rate	10.8% and falling	10% and rising
Tax rates (highest marginal)	69% and falling	35% and rising
Global trade barriers	High and falling	Low and rising
Profit margins	6.0%	10.0%
S&P500 P/E ratio	8.0x	20.0x
S&P500 price-to-book ratio	1.0x	2.2x
S&P500 Dividend Yield	6.0%	2.0%

Source: Gluskin Sheff

A passive buy-and-hold strategy is therefore not appropriate in the current context. The best is to adopt an active approach, both in terms of asset allocation and stock-picking;

- In terms of asset allocation, the active strategy that makes the most sense in this type of market in my opinion consists of increasing equities when prices fall and lowering them when prices rise (bearing in mind that as prices tend to fall on negative news it is more difficult to convince oneself to buy, the opposite of which is true when prices rise). In the long term, this strategy is the closest to the objective set by all investors - i.e. to buy 'low' and sell 'high'. One year ago, I had suggested a range of 600 to 1000 for the S&P 500 index, which turned out to be relatively accurate as the index fluctuated in a range between 670 and 1100. For this year, we have revised the range upwards, if only to take account of the appreciation in share prices in 2009 and the fact that a certain number of risks that marked the start of 2009 have (temporarily?) disappeared. Currently, we are applying a range of between 600 and 1200 in our portfolio management with a neutral equity allocation of 900, which is obviously subject to review. If we take the example of the BL-Global Asset 50 fund for which the neutral equity allocation is 50% with a maximum allocation of 65% and a minimum allocation of 35%, the percentage of equities would be adjusted as follows:

 

S&P 500	600	700	800	900	1000	1100	1200
Percentage of equities	65%	60%	55%	50%	45%	40%	35%

 

The result of the foregoing is that we currently prefer a defensive investment strategy, as the market is in the upper portion of our chosen range;

- The range mentioned above could be considered too prudent, especially in a context of very low interest rates. Low interest rates are not, however, a sufficient enough reason to justify investing in equities, especially when, as is the case right now, rates are low due to extremely fragile economic fundamentals. Broadly speaking, equities are overvalued and are pricing in a highly favourable scenario with expected growth in earnings of more than 30% in 2010 (for S&P 500 companies);

- In terms of geographical allocation, I am maintaining my favourable stance on the emerging markets (South-East Asia and Brazil), as the fundamentals of these countries are better than the industrialised countries. However, I believe that in the short term, these markets are overbought and before buying again, I would tend to wait for a price correction, which could be spurred, for example, by the appreciation of the dollar, tightening of credit conditions in China or the abundance of new share issues planned for this year. In the longer term, the challenge for investors will be to identify companies that will benefit from the theme of increased domestic demand in these countries, given that their indices are generally dominated by exporting companies. In this respect, telecommunications stocks currently seem attractive, especially given the fact that prices have hardly risen in 2009;

- As far as stock-picking is concerned, the two themes that continue to dominate our strategy are ‘quality companies’ and ‘regular income’. By ‘quality companies’, we mean companies with low levels of debt that have a strong self-financing capacity, low fixed costs and high levels of profitability. These companies have broadly underperformed in the rebound since March 2009 as investors focused on companies more likely to benefit from the economic recovery. The ‘regular income’ theme means we are giving priority to companies paying out high dividends, on the condition of course that these dividends are not at risk. These have also underperformed during the recovery. In 2010, they could benefit from the desire of many investors to find an alternative to fixed-rate investments and their reticence to buy equities that have already sharply appreciated;

- I do not share the fears that there will be a crash in bonds in 2010. Although public finances in the industrialised world have deteriorated to worrying proportions, the current environment of near–zero money-market rates, the fragile recovery and contained inflation should prevent bond yields from rising sharply. Spreads between long and short interest rates are currently historically high in some countries.

For the time being, the increase in savings in the private sector is offsetting the avalanche of new loans issued on the back of the increased financing needs in the public sector. However, the example of Greece shows that investors will be more discerning as to which countries they invest in. As is the case with equities, an active investment strategy is necessary in bonds, as the objective is to increase durations after a period of rising yields and to lower them when these yields slide again;

- On the currency markets, it is worth remembering that everything is relative. It is easy to draw up a list of factors likely to weigh on the dollar but the situation with the euro is not brilliant either, given the lack of internal dynamic, an increasingly worrying situation in Southern and Central Europe, and a banking landscape that many experts deem much more fragile than the United States. From an economic point of view, the dollar (and the euro) should depreciate against the Asian currencies, but China continues to oppose any appreciation in its currency, which means that the euro is the main alternative for those wishing to exit the dollar. Currently, alternatives to the dollar and the euro are to be found in countries with solid fundamentals that are benefiting from the emergence of Asia. The outlook for the Australian, Canadian and New-Zealand dollars and the Norwegian krone seem good in this respect. In an environment characterised by inflation or deflation fears, a lack of confidence in the main currencies and extremely low interest rates, gold could continue to perform well, especially in light of the fact that gold production stagnated in the last decade.