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Wednesday, 1 April 2009

The First Quarter in a Tough Year

by Todd Harrison

Commentary: Where we were and where we're going

As last year drew to a close, we revisited our 2008 themes and weighed them in kind.

Some of them came to fruition, others were early, but most hit the mark.

When we entered 2009, we offered a fresh set of forward-looking expectations. With a conscious nod that we must stay humble, or the market will do it for us, it's time for reflection as the first quarter comes to a close.

Theme 1: The Not-So-Quiet Riot

January thought: The age of austerity officially has arrived and we'll see a steady stream of social strife as the rejection of wealth increases in size and scope. While societal acrimony began to percolate last year, this dynamic will manifest through social unrest and geopolitical conflict as we edge ahead.

Update: This theme continues to build with each passing day. From public outrage over AIG bonuses, to vandals attacking the home of the former CEO of the Royal Bank of Scotland, to North Korea threatening war against Japan if they interfere with this week's missile launch, the world is an angry place.

The socioeconomic mindset remains the single greatest risk as this crisis evolves from financial to economic to social. If peaceful globalization is to arrive, the persistent trend of protectionism must give way to an orderly destruction of debt. As it stands, current policies are pointing in the wrong direction.

Theme 2: Hedge Fund Overhaul

January thought: Early last year, I opined that 50% of existing hedge funds would eventually cease to exist. The perfect storm of 2008 will expedite that process, as will reactive regulation following the Bernie Madoff scandal.

Update: Most funds typically require a 30- to 60-day notice on redemptions, so the post-Madoff fallout may not be felt fully until after the first quarter ends. Continued migration from this sector, coupled with an abatement of risk appetites, will continue to pressure this once-proud industry.

Theme 3: Seismic Readjustment

January thought: Entering September, we offered that the disconnect between equity and credit would manifest as a car crash or a cancer. Four months later, despite lower prices and massive government intervention, the equilibrium between equity, credit, commodities and currencies remains elusive.

Update: The government introduced new methodologies to combat the crisis, from the recently announced Public-Private Investment Program to the expansion of the Term Asset-Backed Securities Loan Facility and other synthetic solutions. In the process, the inherent obligations of future generations have grown at an alarming pace.

The most intuitive relief valve for these imbalances is the measuring stick that denominates financial assets. Recent calls from China and Russia to dump the dollar as the world reserve currency speaks to the growing unease of foreign holders of dollar-denominated assets.

Theme 4: Motion and Movement

January thought: My sense for 2009 is that -- all else being equal -- we'll see wild movements and a wide range. Perhaps the S&P 600 will be a nadir and one, if not two, 20% bear-market rallies filled with false hope and empty promises.

Update: A vicious downdraft began the year and took the tape of the S&P to 666, following by the first of our perceived 20% lifts. While we've seen a rush to judgment that a new bull market has begun -- and technically, that's true -- I remain of the view that it's cyclical rather than secular.

Theme 5: Pension Panic and Puny Munis

January thought: Unfunded pension plans and bankrupt municipalities should jockey for mindshare in 2009 as the financial crisis evolves. The government will fight fire with fire, perhaps allowing citizens to withdraw from their retirement accounts without tax penalties. But that solution is transient at best.

Update: The former chief regulator for the $2.7 trillion municipal bond market acknowledged last week that the governing board failed to save taxpayers upwards of $1 billion of losses due to opaque financial products, news reports said. My sense is this represents the tip of iceberg.

On the pension front, it recently came to light that the Pension Benefit Guaranty Corporation, the federal agency that insures the retirement funds of 44 million Americans, departed from its conservative investment strategy and piled much of its $64 billion insurance fund into speculative investments just months before last year's market collapse.

Theme 6: The Employment Conundrum

January thought: While it's no stretch to assume a further uptick in unemployment --remember, it was 25% during the Great Depression -- the ironic twist is that those with jobs will feel the pinch. Expect relative pay cuts, rather than salary bumps, to be a central theme this year despite folks working twice as hard to absorb the productivity chasm.

Update: While unemployment continues to rise, those left at work are being asked to pick up the slack without additional compensation. According to Mercer, a human resources consultant, 25% of companies surveyed have instituted salary freezes for 2009. Projections indicate that will rise to 33% by the end of the year. Pay cuts remain an intuitive next step.

Theme 7: Industrial Revolution

January thought: The entire spectrum of industries, from finance to media to retail to philanthropy to academia, will be forced to reinvent themselves and the leaders coming out of this crisis won't be the same as the leaders that entered it.

Update: We use the forest-fire analogy because it's so very apt, scary and dangerous, yet necessary for a fertile rebirthing. A snapshot of once-venerable icons such as General Motors (GM) , General Electric (GE) , Citigroup (C) and AIG (AIG) supports the notion that market leadership, and leadership within individual sectors, will look drastically different once this process of price discovery passes.

Theme 8: A Yen for Japan

January thought: There aren't many folks talking about Japan as a relative winner in the global marketplace. There is clearly risk to that region. But remember, they have a 25-year head start down the deflation road. You can't spend relative performance but I expect Japan to outperform U.S. equities this coming year.

Update: The Nikkei ended the first quarter 8% lower compared with a 13% loss in the Dow Jones Industrial Average, a 12% drop for the S&P and 3% hiccup in the Nasdaq.

Theme 9: Alpha Bits

January thought: Now that the equity epitaph has been written for the "buy and hold" strategy, it may be time to begin looking for babies in the bathwater. There will be deep value opportunities in small and micro-cap stocks, creating an environment where real value investors step up and stand out.

Update: Small cap underperformed large cap, and small value underperformed small growth in the first quarter, which generally means that investors are paying up for earnings and stability over cheap assets. I continue to believe this is a second-half story and tremendous opportunities will present themselves in companies with little, if any, debt, strong balance sheets and trustworthy management.

Theme 10: You Gotta Believe!

January thought: Last year was a harsh reminder that profiting is a privilege rather than a right. This is no garden-variety, one-and-done recession. It will be a prolonged process as we attempt to regain respectability on a global stage after years of mismanaged affairs.

Update: The socioeconomic ramifications of the financial crisis will reverberate for many years. Just as the creation of wealth and conspicuous consumption created an altered state of reality, the unwinding of the debt bubble and the attendant austerity will require patience, prudence and financial staying power.

These are scary times and the decisions made now will affect future generations and their standing within the world. As society is a sum of the parts, the onus is on each of us to remember our name is our word. Honesty, trust and respect are core constructs of any stable foundation.

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