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December 30, 2008

Scenarios for 2009: Straight Lines, Moonshots, EKGs, etc.

Nothing is ever a lock in the world of capital markets, and nothing ever happens the way it feels like it should, so let's think about some scenarios for 2009. None of them are pure plays, so to speak, and people will likely find something appealing/unappealing in more than one. They are, however, ways to mull some directions things could go from here.

To explain my motivation in a different way, I generally think it's important to have in the back of your head what you're expecting, what you're worried may happen, and what you think is impossible. In my own case, I then try to insulate yourself to varying degrees from the latter two scenarios, while positioning for the former.

1) The Straight Line Lower
This one is the favorite of uber-bears and logicians and the Schiff-ian sorts, and it works out pretty much as described: The economy and markets sink deeper into depression as it becomes obvious to all sentient sorts (and most semi-sentients) how egregious credit market excesses have been. We see massive wipe-outs in retail, commercial real estate, tech (yes), insurance, etc., plus a give-up on GM later in the year. Bears are on TV non-stop, and at least one bear gets a column in a major magazine/newspaper/webthingie, assuming any sort of media industry still exists 12 months from now.

In terms of key bits and pieces of the financial machinery, the dollar tumbles, gold soars, Russia collapses, and global markets tank, with worldwide trade tumbling by something like what happened during the Great Depression, on the order of 30% or more. There are no signs of inflation, what with deflation everywhere we look. We maybe get out of the year without a new war though, and the Colorado snow pack looks decent, so we have that going for us.

Dow: 5,000. Nasdaq: 900. S&P 500: 500  Oil: $25 Gold: $1700

2) The Non-Boring Flat Line
No-one is talking about this, so it's at least worth throwing into the mix: The market races higher early in the year as Obama-nomics looks real and fun, and then tanks mid-year as the economy refuses to get off the floor despite lots of happy-talk, a few new bridges across things, and some state bailouts. Later in the year markets pick up again as strategists counsel patience, and chatter begins about a first-half 2010 recovery. We end the year essentially flat.

Turning to the financial bits, the dollar surprises by only falling 10% against the major currencies; gold strengthens and then falls off a little; trade is crummy, but there are strong spots. There are a few surprises, like some sovereign wipeouts – Spain? Italy? Australia? other? -- but essentially flat-lining the year is a big surprise to all concerned.

Dow: 8400  Nasdaq: 1500  S&P 500: 900  Oil: $60  Gold $1000

3) The Double Dip
In the scenario we mess with the 2008 lows year in the early in the year as worries increase that this is Great Depression 2.0. And then, however, expectations mount that something good has to come out of all this stimulus stuff -- damn the bears, look at the credit spreads and the 30-year mortgage rates! We hit mid-year confounding the critics with a 30% gain in the major indices, perhaps even a few pro-Ben Bernanke magazine cover stories, like "How Ben Did It!".

Things turn south, however, in the second half, perhaps on renewed signs of U.S. weakness, perhaps on some outlier events, but the upshot being the same, that global trade is not going to come back anytime soon at levels that justify prices at then-current levels. Markets start saw-toothing lower, a process that accelerates into the end of the year, leaving us lower than where we started.

Turning to the bits and pieces, the dollar weakens a little in the first half, but surprises everyone by strengthening again in the second half, as dollar gets squeezed on renewed fears of Great Depression 2.0. Gold falls early in the year, and then surges in the second half, ending the year considerably higher. The long bond ends the year closer to 5%.

Dow: 7500  Nasdaq: 1330  S&P 500: 765  Oil: $50  Gold $1200

4) The Moonshot: Nouriel Who?
The markets, to a chorus of carping all year long, climb a wall of worry. Consumers spend a little, businesses buy a little, and the Fed bails a lot, and the result is a surprisingly strong economy-like thing. Investors can hardly believe their good fortune in having repealed financial gravity, so they celebrate by taking stocks higher at every provocation through the year, despite some sharp falls here and there. Wells Capital Jim Paulsen is the hero of bulls everywhere, and "Nouriel Who?" pictures are on NYSE traders' end-of-year celebratory t-shirts.

Is it pure froth all the way? No, of course not. There will be some sharp declines here and there. There will also be plenty of bankruptcies to keep bear-ish sorts from feeling entirely left out, and those will be viewed, in moralizing fashion, as just the sort of thing the Schumpeterian/Austrian economist/doctor ordered (even if they aren't).  There will also be a sharp increase in inflation, but that will be shrugged off as "the price you pay", and something that the Fed can manage by "mopping up" all the liquidity it introduced. The year will close in this surreal fashion, albeit with bears pointing to myriad signs that the market is propped up solely by government deficits, and that Treasury yields are climbing and this game can only go on so long  …

Turning to the numbers, the markets soar in the U.S., if less so elsewhere; gold starts the year strong and then weakens; oil strengthens; the long bond yield climbs sharply; and global trade, while weak, is non-zero.

Dow: 12,000  Nasdaq: 2100  S&P 500: 1210  Oil: $90  Gold $700

***********

And where am I in all of this? Probably closest to some variant of the double-dip. And what scenario am I most worried about from a portfolio standpoint? Much less the Straight Line than the Moonshot. The latter, given my views of the long-run credit cycle and its implications, is the thing I need to protect myself against.

Feel free to add your own scenarios/caveats/etc. in comments, as my musings here are neither comprehensive nor especially detailed.

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