Stocks: Five Trends to Watch in 2009

From deflation to geopolitics, here are the market factors that could make investors money in 2009or keep them up at night

With the U.S. government determined to throw virtually everything in its toolbox at the recession in hopes of minimizing the economic pain, it may be all but impossible to single out any one policy element that started the recovery rolling. Indeed, there are so many moving parts right now in the economy—though the public perception may be that Bernanke, Paulson & Co. are spinning their wheels instead of moving the wagon forward—that it's tempting for investors to throw up their hands and find a nice quiet place to hole up until the recovery comes.

But you might be missing some opportunities to protect your portfolio or make some money. And that requires keeping your ear to the ground. BusinessWeek asked economists and investment strategists to identify five trends that bear watching in 2009 and that could provide clues about how to position your investment portfolio.

Deflation vs. Inflation

Deflation clearly has the upper hand over inflation for the foreseeable future, and the Federal Reserve's decision on Dec. 16 to knock down the Fed funds rate to a record low of zero to 0.25% drives home that fighting deflation is now the central bank's priority.

What few people mention, however, is the potential benefits of deflation for U.S. consumers, starting with the plunge in energy costs and a discernible easing in interest rates. That may hurt people who thrive on investment income but it's more likely to spell relief for individuals who still have jobs and companies looking to borrow or who want to refinance existing mortgages or other debt, says Dan Peirce , portfolio manager in the global asset allocation group at State Street Global Advisors (STT) in Boston.

That suggests some of the battered sectors in the equities market such as retailers, restaurants, and apparel chains may be able to beat market expectations in 2009, he says. If that's your belief, Peirce points toward sector-oriented exchange-traded funds or mutual funds that focus on consumer staples or even consumer discretionary stocks. Peirce says investors should not be dissuaded by all the front-page headlines about the auto manufacturers, which are part of consumer discretionary group but account for a much smaller portion of the sector than they once did. Even some of the more diversified media companies that focus on advertising and broadcast operations may be good bets in light of the beating they have taken, he adds.

Some strategists will tell you that as long as the deflation risk outweighs the potential for serious inflation, the bond market offers more attractive returns than equities. The real (inflation-adjusted) yields on 10- and 20-year Treasury Inflation-Protected Securities, or TIPS, compared with the nominal yields of regular Treasury notes of comparable maturity suggest that inflation will be extraordinarily low over the next 10 to 20 years, says Peirce. While the TIPS market has already priced in expectations of hugely negative inflation over the next two years, Peirce says his group doubts it will be that severe.

Although inflation probably won't be a credible threat again until at least 2010, it will become a concern much sooner in the next expansion than it had been in each of the last three expansions, Dan Laufenberg, chief economist at Ameriprise Financial (AMP) in Minneapolis, predicted in a report published Dec. 19.

If inflation returns sooner than expected, the place to be is in equities with exposure to rising commodity or asset prices, including energy and steel producers, says Hank Herrmann, chief executive at Waddell & Reed (WDR). Reducing your portfolio's allocation to fixed income would also be a good idea since inflation would push yields higher and bond prices lower, he says.

Government Stimulus

Another trend to watch is what form the government stimulus package takes and how quickly it works its way through the economy. There's been talk of a stimulus as big as $1 trillion but clearly the focus will be using the money in a way that gets the biggest bang for the buck.

The best results will come from "anything that allows the private sector to be more efficient and more productive," says Laufenberg at Ameriprise. That would include a large-scale effort to computerize medical records and wire schools and libraries for Internet access. And if the Obama Administration wants to preserve jobs, the answer isn't to bail out troubled companies since part of the package is likely to be requiring downsizing and job cuts farther in the future, he says.

Spending on public infrastructure projects that many states say are already in the planning stages would produce results more quickly than tax cuts, and would also be more likely to boost tax revenue over the long term than cutting taxes would, Laufenberg says.

Others, like Herrmann at Waddell & Reed, argue that tax cuts are quicker to stimulate the economy as long as they are permanent, not temporary. He believes a reduction in payroll taxes will come first and will result in higher consumer spending, which would benefit discount retailers such as Wal-Mart (WMT) more so than more expensive ones. A tax cut to corporations that accelerates the depreciation schedule on plants, property, and equipment could jump-start capital spending on technology and industrial machinery, he says.

If the stimulus package helps the economy recover faster than people currently expect, that would cause energy prices and stocks to rally, which argues for increased bets on energy and natural resources mutual funds, says Herrmann.

Laufenberg says that a sustainable expansion will depend not only on government stimulus but on some adjustment in prices, too. Lower interest rates and narrowing credit spreads are part of that process. While the market generally anticipates recovery about six months in advance, there will continue to be a lot of volatility around the economy, especially with a big drop in fourth-quarter gross domestic product and higher unemployment still to come, he says.

There will be plenty of opportunity to play sectors in the longer term, but in the meantime, Laufenberg recommends an index fund that tracks the broader market, as represented by the Standard & Poor's 500-stock index. "I don't know if you'll make money on that trade in the next week or month, but I can tell you that you will make money on that trade in the next two to three years," he says.

Continued Flight to Safety

The internal conflict for investors whose brains tell them it's time to take advantage of low valuations and start buying equities but whose emotions resist any type of risk is likely to continue in 2009, says John Marshall, co-founding partner of the Resource Group, a wealth management firm in Glendale, Calif.

For those investors, annuities could be the perfect way to get through the volatile times ahead, he says. Annuities allow you to take risk in sub-accounts through a broad menu of mutual funds while having your principal guaranteed by an insurance company in return for a fee. "I liken it to an automobile where it's going to cost you a small premium to put in extra safety features," says Marshall. "An annuity in some ways is like putting air bags on your portfolio. Even if you get into a fender-bender, you may not need the air bags, but it may be worth that expense in case you get into a major collision later on."

Some people might argue that this is the worst time to go into annuities because the market has already suffered most of its downside. But if you're a retail investor sitting on sidelines, paralyzed between your logical and emotional inclinations, for an extra fee an annuity can offer peace of mind without having to sacrifice higher returns from riskier bets, he says.

Many insurance firms that offer these structures are starting to recognize they should be charging more, given the losses they're taking in the current market environment. Marshall doubts that the insurance companies will make annuities so prohibitively expensive as to kill demand for them, but they may eliminate some of the riskier mutual fund options and require investors to invest in some sort of balanced portfolio, he adds.

Emerging Markets

Most economists believe the recession will be less severe for the U.S. than for other developed economies, especially those in Europe. The sharp drop in values for assets in emerging markets in 2008 has scared off many investors, but Peirce at State Street sees the decline as more of a correction to the outsized gains made in 2007. "They didn't really underperform that badly relative to past episodes. It reflects that they've come a long way. They've learned to handle their finances more effectively," he says.

Developed international markets may face fundamental challenges that are more daunting than those in emerging markets in the years ahead, he warns. Not only does the population growth and increase in consumer demand in emerging markets bear watching, but many of these economies have an advantage by being much less indebted than most developed countries, says Peirce.

China continues to be very export-oriented and the huge fiscal and monetary stimulus programs it has announced should enable its economy to keep growing at a reasonably fast pace. The process of moving its culture from one based on savings to one geared more toward consumption is a long one but it is happening, he says. As for the rest of Asia, the watershed financial crisis experienced by those countries a decade ago "prevented them from engaging in some of the excesses that we've spent our time doing in the last 10 years," he says.

For the broadest exposure, ETFs that track the MSCI Emerging Markets Index are worth considering.

Geopolitical Risks

One might wish that a global recession of enormous proportion was the only concern over the the next year or so, but unfortunately geopolitical risks continue to simmer. From tensions between Pakistan and India to a looming nuclear threat from Iran and other assorted minefields, the incoming Obama Administration won't have much room to make mistakes, warns Bob Andres, president of Andres Capital Management outside Philadelphia.

Expectations that President-elect Barack Obama will be able to lead the U.S. economy out of its current financial woes are running so high that if he fails to do so it's likely to diminish his international clout to broker geopolitical solutions, says Andres. He cites Vice President-elect Joe Biden's recent comment that the new President is sure to be tested on the diplomatic front.

Anything that damages Obama's ability to handle overseas threats will reduce confidence and would have a negative impact on the stock market, warns Andres. It seems that investors will have to read the international section of the paper as carefully as the business pages in 2009.

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