Wednesday, December 30, 2009

The Non-Consensus View of Things to Come

For many years, I have begun each year with a back-of-the-envelope analysis of the prospects for stocks, bonds, and the economy in the coming year. In this first look, I am only interested in how my views compare to the published consensus estimates. The reason is simple--many studies have shown that the consensus view is almost always wrong. So, in effect, the one place investors can be sure that the financial and economic markets are NOT going is where the current consensus is now pointing. It may sound almost sacrilegious, if not foolish, to use the consensus estimates of the smartest, most respected strategists and economists in the world in this way. My own experience and the aforementioned studies have convinced me, however, that to get the coming year right, so to speak, it is necessary to be sure I am not following the most widely accepted view of things. I'll have more to say about this in coming letters, but here's how we at Donaldson Capital Management view the financial prospects for the coming year in comparison to the consensus view of the Bloomberg Survey. Our view was constructed this past Monday in our Investment Policy Committee meeting in discussion among all four of our portfolio managers.
  • Economy: The consensus is for 2.6% GDP growth in 2010. We believe economic growth will be closer to 3%. Thus we are more optimistic about the year-ahead economy than the consensus.
  • Inflation: Consensus for core CPI is 1.3%. We believe the core rate will be closer to 1.5%. That's close enough, however, to say we agree with the consensus that inflation will remain tame.
  • Earnings: The current estimates by analysts is that S&P 500 company earnings will grow by over 20%. Our estimate is similar to the consensus.
  • Interest Rates: Bloomberg economists predict that the 10 year T-bond will yield right at 4.0% by year-end 2010. We believe interest rates on T-bonds will be more in the range of 4.5%.

In summary, we agreed with the consensus on core inflation and corporate earnings, and diverge on the strength of the economy and interest rates. In trying to move away even farther from the consensus, we would lean toward higher earnings growth than investors are now forecasting and higher core inflation. If our non-consensus financial view of the coming year were to prove correct, we believe it would have big implications for stocks.

We believe our non-consensus view would result in stocks moving strongly higher during the first six months of the year, on the back of better-than-expected earnings and economic growth. Stocks would then flatten out or retreat modestly as this better-than-expected growth would prompt the Fed to start raising interest rates sooner than Wall Street is now predicting.

In our estimation, if the economy unfolds the way we currently see things, stocks will likely end the year with a low double digit total rate of return. On the heels of the big turnaround for stocks in 2009, we would be very pleased to see another good year for stocks.

Blessings to you all and may you have a happy, safe, and prosperous New Year.

Greg Donaldson