Your Checklist in 2010

A Bird’s Eye View of Financial Markets

From markets collapsing to last year’s strong performance, we have all experienced the prosperity and the devastation that financial markets can bring to us. What should we expect in 2010? No one can predict the future, but we can all improve our financial lives by focusing on key areas of development in 2010.

The U.S. filled financial markets with ample liquidity to keep it from collapsing. This created an opportunity for speculators to make carry trades. Speculators borrow U.S. dollars and buy assets like bonds, stocks, property and commodities. When U.S. speculators engage in carry trades, they:

1. Borrow U.S. dollars, convert it to foreign currency to buy foreign assets. This drives the U.S. dollar artificially low and foreign currencies and assets artificially high.

2. They unload their foreign assets. They make a profit because the foreign assets appreciated in price as well as currency value. It’s a double win. Then they convert the foreign currency back into U.S. dollars to pay back their loan. The U.S. dollar has denominated, so they are actually paying their loan off with less money.

Of course, this is not sustainable and eventually, the carry trade will become a bubble and burst. When this happens, everything will return to their normal levels. Normal levels mean the U.S. dollar will “snap back up”, interest rate will also go up and asset prices (real estate, financial assets, and commodities, including gold) will fall. I cannot predict if this is going to happen. But this is what would happen if the carry trade bubble burst.

As a reference, the S&P 500’s historical P/E ratio is about 15. Last I checked, it’s currently about 25. The Canadian stock market is in a similar position. Here are a few ways to interpret this information:

1. The market is overvalued for above reasons. Things will return (closer to) normal levels.

2. A strong economic is on its way and the market has already (correctly) priced it in.

Some say that economic recoveries are preceded by a strong rally in the stock market. However, this does not mean that all stock market rallies are followed by a strong recovery. If a strong recovery does not materialize, the market is under pressure to take a fall or investors will have to be patient to keep valuations at current levels.

Just to keep markets at current levels, we have to rely on companies to report strong profits in a hostile environment. Unemployment is still lingering 10% in the U.S. and consumers are saving money instead of living beyond their means. It would be interesting to see if earnings can support the current market.

Public Finances

Public debt to GDP ratios across the large developed economies have reached their highest levels since World War II. According to Paul Krugman, the situation is not yet disastrous but a yellow flag should definitely be raised. He cited Belgium as an example where at 80%, there has not been a run on their debt yet. How does this affect us?

The U.S. and U.K. are on the verge of losing their pristine credit rating. Greece got downgraded and we all know enough about Dubai. A couple of states in the U.S. are having serious financial problems of their own. Governments will need to focus on getting their finances together; i.e. if the private sector cannot take over the baton to grow the economy, don’t count on governments to provide another stimulus package. The best they can (and will do) is to postpone or slow down the execution of their exit strategy.

Finally, some suggestions

Stock markets can, at best, maintain their current levels if not go through another correction. If you want to jump into equities, try to choose stocks that provide cash flow (look for dividend yield) and have a low Beta (correlation with the market). Don’t look for something that has great growth potential. Instead, look for something that is currently undervalued.

In Canada, the government announced that it would start to tax income trusts starting in 2011. The announcement was made in 2006. The performance of income trusts and the general stock market was strongly correlated before the announcement. After the announcement, income trusts have underperformed and some believe that income trusts are currently trade under their intrinsic value.

Interest rates have nowhere to go but up (when rates go up, bonds go down). The only question is when and to what magnitude. If you go long with bonds, you may find yourself disappointed. If you want to invest in fixed income, there are products that hold a mixture of long and short positions. If the money manager’s strategy is successful, these products should provide you with enhanced yields if all stay the same and some protection when rates go up.

I wish you all the best in 2010. While you’re busy making your financial plans, please don’t forget about the victims in Haiti. Please visit your local organizations and make a contribution. Donations can be made conveniently online.

Thank you.