Investing in 2009

There is a special challenge for investors planning for 2009. It is easy to get caught up in emotion, especially when so much is going wrong. This causes people to look backward. Investors can meet the challenge by using a sound analytical framework and by looking ahead. For those nearing retirement, this is particularly crucial.

My advice to our investors emphasizes two major points:

1. The news flow is incessantly negative — fraud, corruption, mismanagement, greed, and every proposed solution called a bailout. When this message is repeated in every news source, it is also reflected in current market prices.

2. The market has a gift for us. Our initial rebound target is Dow 11,000. Let us see why.

Basic Rationale

We will not have another Great Depression, and the prices of many stocks are at depression levels. The collapse came in mid-September when the Lehman Brothers failure led to a credit market freeze. Take a look at the chart.

The Lehman failure, permitted by government inaction, made every lender suspicious of every borrower. Normal lending came to a halt, throttling regular business activity. Equity and credit markets had been priced for a moderate recession. Now many expected something much worse, a depression.

Meanwhile, the effect of the government policy has been underestimated. None of us expects the Federal Government to solve all of our problems. We have joined the criticism of the many mistakes.

Enough is enough.

The counter-reaction has been too extreme. People have expected immediate policy impacts. This is naïve. There are lags in implementation and in effect. The modern news cycle has become extremely short. Any new policy has scores of critics – all wanting to get on TV – within hours of the announcement. The reaction gets a pitch in blogs and in the press. The hot-button traders join in.

When the market reacts negatively, as it has for months, it seems to validate the pundit reaction. People are not looking at the actual policy effects, but rather at stock prices. Everything becomes a story of fraud, corruption, and bailouts. This is a trap.

Stories of corruption are easy to understand. Economic impacts are complicated. Successful investing means finding things that others do not see. The wise investor will see that current government policy is exactly the opposite of depression-era actions.

Data will triumph over speculation.

There are already many signs of improvement. Each is important and the cumulative effect is very important.

· No more dominoes falling. A few months ago we faced the risk of failure in many banks and major financial institutions. Whatever one thinks of TARP, it stopped that.

· Credit markets have improved. LIBOR rates are down and bank lending is improving.

· The stimulus package. Whatever the exact size, it will serve to add demand for services and employment.

· Lower gasoline prices. Consumers focus on what is in front of them. This is a boost to everyone’s weekly budget.

· The Fed on mortgage rates. Massive intervention by the Fed has driven mortgage rates much lower and they are still declining. Some homeowners are refinancing and it also helps affordability for new buyers.

· A housing bill. A major housing package will be Job #1 of a new Congress. There will be assistance for new home buyers.

No economic model – even the best – has any ability to forecast these effects. Why not? Models require relevant historic data. This is a collection of policies beyond any precedent. The economic predictions you read in the paper are more speculative than usual.

How to React

Our basic advice is to buy something. If you have been out of the market, Congratulations! It is now time to act.

If you have been invested, it is time to consider your asset allocation. Nearly everyone we talk with is over-invested in real estate, cash (CDs) and bonds. Stocks now offer a better opportunity.

Do not view the market, or the newspaper, or pundits as your investment advisor. Instead, look to the fundamental value of the companies and the stock prices that are offered.

Most investors are fighting the psychological tug that causes them to sell at market bottoms and buy at market tops. Great indicators, including our Gong Model and our Sector Rotation System, are in line with the fundamental analysis.

Are you a skeptic? Take a partial position. If you are out of stocks, buy a 1/3 position. If you are in stocks and thinking of selling everything, move to corporate bonds with a yield of 8-10% with half of your position.

You can make a big return even without an economic boom. Stocks will start to react when it becomes clear that a depression is “off the table.” That gets us to the initial target of Dow 11,000. That is over 20% for the market, and even more in our basket of stocks. It may take a few months, but we can then reassess the economic prognosis.

Some Examples

There are several great themes. We love energy plays in the drilling space. The majors need to replenish depleted holdings. The market has treated these stocks like oil futures. Our favorite is Transocean Energy (RIG), which has locked-in contracts with cancellation penalties. The valuation is so low that a double is easily possible with a more positive economic prognosis.

We also like construction and infrastructure stocks such as Caterpillar (CAT). Investors can wait a lifetime to see companies like this offered at single-digit P/E multiples on normalized earnings.

There are great growth stocks such as Apple (AAPL). The company has a broad range of products, and a low P/E relative to growth if one allows for the cash holdings. Too many people trade on rumors about Steve Jobs, ignoring the company fundamentals.

You can also find some unfairly punished stocks, those that declined with the general selling. We like ResMed (RMD) which works in the sleep disorder field. This is a growth industry where insurance pays the tab. They have an approved home testing kit, avoiding the mega-buck price tag from the past. It is not sensitive to the economy, but has sold off by 1/3.

There are many “Obama opportunities” where one can pounce when the time is right.

Conclusion

Rarely has there been such a great opportunity for investors. With it comes the challenge of putting aside emotions and looking forward. There are many stock ideas that will put some octane in your portfolio. Some investors can find these on their own. For others, this is the perfect time to get some professional help, leaving the worry to someone else.

[We own all of the stocks mentioned in both personal and client accounts.  This article is one of our regular reports to investors.  We have not edited it to reflect changed prices and events.  It originally appeared as part of Seeking Alpha's series where ten managers were invited to provide their thoughts about 2009.  Readers will find many good ideas in the series, which is refreshingly different from the MSM approaches.]