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Research Investment Roundtable

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When the going gets tough, the tough go…bargain hunting for cheap stocks.

Though weak corporate earnings are forecast to make 2009 a rough-and-tumble year indeed, there’s not a better time to scoop up sale-priced equities.

So say our panel of investment experts, who, in mid-October, are expecting a market recovery in the second half.

The United States is expected to be bogged down in recession, which is likely to extend worldwide. But the liquidity crunch will eventually ease somewhat, as government rescue programs proceed through the system.

The only good bets in bonds seem to be those with short-term duration. As for equities, our experts particularly like the energy, health and oil sectors — and even a few banks.

It will be a big-cap year, and companies that pay dividends are highlighted.

Despite challenges going forward, change is absolutely in the air, with a new president and plenty of good buying opportunities in the market.

The Roundtable Members are:John Buckingham (Laguna Beach, Calif.) Chief Investment Officer, Al Frank Asset Management, managing $500 million in assets. Editor, The Prudent Speculator newsletter. Manager, the $150 million Al Frank Fund, with an annualized five-year return of 6.40 percent, through September 30, 2008.

David N. Dreman (Aspen, Col.) Chair and CIO, Dreman Value Management. Forbes columnist (“The Contrarian”). Managing editor, The Journal of Behavioral Finance. Manages about $15 billion in assets, including the $5 billion DWS Dreman High Return Equity Fund, with an annualized five-year return, for Class A shares, of 3 percent, through September 30, 2008.

Moshe A. Milevsky (Toronto, Canada) Associate Professor of Finance, Schulich School of Business, York University. His new book is Are You a Stock or a Bond? (FT Press).

Robert L. Rodriguez (Los Angeles) CEO, First Pacific Advisors, LLC. President and CIO, FPA Capital Fund, Inc., with a 10-year annualized net return of 11.73 percent, as of September 30, 2008. His FPA New Income Fund — 10-year annualized net return, 5.56 percent — hasn’t had a down year in more than 32 years, as of October 2008.

What’s your forecast for the stock market in 2009?

Rodriguez: It’s going to be a tough period. Investors have been delusional. It will be a long time before we see 1,400 again. I’ve prepared my firm for one of the worst periods ever, a huge typhoon. I hate to be so negative, but I’ve been focusing on this for several years now. We have a very long journey ahead of us.

Dreman: We’ve got a terribly oversold market and probably the worst panic in the post-war period. It’s a horrendous mess. The markets are swinging almost out of control. People are terrified. But there are stocks as cheap as I’ve ever seen. We’re down so much, I think we’ll have some recovery next year. Markets tend to pick up at least six months before the end of a recession. We’ve probably had one now for close to a year. If it goes for two, that’s exceptionally long.

Buckingham: I’m very optimistic. Equities have underperformed their historical norm dramatically this year; so in the next 12 months, there’s a strong likelihood of outperformance. But there’s a major crisis of confidence among investors. Treasuries are the only perceived safe asset — and that’s the problem. We need to fix that. It’s why yields on short-term Treasuries have gone down to next to nothing. We might have a rally this year, which may give way to a one-year decline before we rally later next year.

Milevsky: Stock markets go up on average, and I don’t think ’09 will be an exception. My prediction is mildly positive for next year. Markets tend to be very forward-looking — they’re leading economic indicators that anticipate next quarter’s earnings. Eventually they’ll look beyond the turbulence and price in a recovery, even though people will continue to default on their mortgages.

What will happen in the bond market?

Rodriguez: It faces an unprecedented volume of new Treasury securities, which will place pressure on the intermediate and long ends of the Treasury curve. Credit quality is paramount. My bond fund for yields is still very, very defensive. With the amount of Treasuries the government is going to sell, we’re unwilling to take either credit risk or maturity risk.

Since June 2003, I’ve had a buyer’s strike on the purchase of long-term Treasury bonds. For six years, I’ve carried barely [more than] a one-year duration.

Buckingham: The bond market is a mess. There are certainly tremendous opportunities; so I think it will be faring better next year.

Milevsky: If you have a bond with a credit risk attached, it may not do very well if we continue to see increases in default rates. On the other hand, risk-free government bonds will do well if interest rates continue to decline.

Dreman: You don’t want bonds, particularly long-term bonds because [with inflation] you’ll get inflated away. If you want bonds, I’d [recommend] only very short-term ones, two years or less. Every 1 percent increase in yield drops the price of a 30-year bond 16 percent.

What’s your outlook for the U.S. economy?

Milevsky: By the time people read this, the recession everyone believes we’re in will be officially declared. In a kind of domino effect, we’ll see smaller banks that have exposure to real estate tumble.

Buckingham: I’m not in the camp that we’re going to have a multi-year severe recession/depression. There’ll be more short-term pain — but ultimately, long-term gain. All the steps that the Federal Reserve, the Treasury and the global central banks have taken will prove successful in alleviating the crisis. But it does take time to work through the system. We’ll start to come out of the downturn toward the second half of next year, and the stock markets will begin to anticipate that. But the next three to five months are very questionable.

Rodriguez: In ’09, there’ll be a worldwide recession. The U.S. will have several quarters of negative GDP growth. This environment will extend into 2010. I’m looking for problems to emanate in the insurance industry and municipalities. The economy is heading south very rapidly. I fully expect we’re going to get some fiscal policy initiatives out of the government. The last tax rebate was an abject failure.

Dreman: We’re talking about a serous, worldwide recession. This is a bit like a forest fire now. It’s jumping. It jumped from the financial sector, and now it’s jumping all over into other areas.

How, then, will earnings shape up?

Buckingham: The likelihood is that earnings will not be as good as analysts had projected. With the 4th-quarter earnings that come out in January, you may have a repeat of what’s going on right now: a downturn.

Rodriguez: Earnings are too optimistic. What we’re facing is very severe, and it will hit corporate profits very hard.

To what do you attribute the unprecedented financial crisis?

Dreman: It started with the sub-prime and spread. The regulators sat around and didn’t believe how interactive the entire system was. The Treasury and the Federal Reserve have been behind in the developments in financial markets, and everything they’ve done has been too little, too late. If the Treasury had acted with more of a grasp of the seriousness of the situation, we wouldn’t have nearly the crisis we have now. The SEC has been very strange in all of this. It should have stopped short selling a long time ago. It seems almost desperation now. Things are getting worse, not better.

Rodriguez: The Fed and Treasury have been on the wrong road from the beginning. The Fed has been addressing the symptom — liquidity — not the disease: capital destruction. Finally, last week the Treasury Secretary seemed to start to get it when he said he had authority to deploy capital into banks.

Nobody wanted to leave the party because the punch bowl was so full, and everybody was having a gay ol’ time getting drunk. If you want to know who’s responsible for this mess, all readers have to do is look to the person to their left, and to their right. It’s them, it’s the federal government, it’s the regulators, the rating agencies, the banks. All the regulators had authority to control what was going on. But they didn’t.

What’s the biggest threat to the market next year?

Milevsky: The real estate situation and the mortgage-backed securities that a lot of banks are holding. Insurance companies soon will be scrutinized [in depth].

Dreman: The biggest threat is if the liquidity crunch gets worse and they haven’t found the right delivery mechanism to make the banks loan again. Banks are terrified of being caught with more losses. They don’t even know the extent of their losses in a lot of their mortgage instruments.

What about unemployment and consumer spending next year?

Rodriguez: Unemployment is going to rise very rapidly. Consumers are stopping their spending and starting to pay down debt. We face a very long and arduous journey out of this quagmire.

Dreman: The consumer is tapped out and has to be liquefied in some way — i.e., get more cash. Wages are falling further and further behind.

What about inflation?

Rodriguez: I expect it to decelerate because of the contraction in commodities and a host of other things.

Buckingham: Right now we’re worried about deflation. I’m not that concerned about inflation in the next 12 months.

Dreman: Rising costs push inflation higher. True, oil is down sharply; but that’s short-term. This is panic. Commodity prices will be much higher than they are now, and inflation will continue.

What will happen with interest rates?

Dreman: Depends on how bad the economy is. We have to have lending. As the banks start to gain some confidence — I said confidence, not competence, which has always been a fairy tale — they’ll start to lend again.

Buckingham: Interest rates are historically low. I don’t see a dramatic change.

What about the U.S. dollar?

Milevsky: I’m surprised at the amount it’s appreciated in the last month or two. Long term, I’m bearish. A lot of central banks and sovereign wealth funds — especially the Singapores, the Chinas and the Dubais of the world — are looking at this and saying, maybe we should diversify our currency reserves and hold some of it in euros, yen or yuan.

Dreman: It may actually stay where it is. It’s been rising. If inflation takes hold here more than abroad, there will be a flight from dollars. But if inflation is worldwide, the dollar holds its own.

What sectors do you like for next year?

Rodriguez: I’m not going to communicate to my competition who has taken extreme risk and [let them] work off my nickel! But this week I started to spend a little cash for the first time in a year. The Capital Fund was at 46 percent cash, with the largest exposure in energy. I expect that on this first go-round, we will have spent about 10 percent of the cash. So I’m not aggressive. I’ll be very general: It was in the energy area and some other areas.

With all your negativity, what prompted you to buy now?

Rodriguez: I’ve always said I’m a scum-sucking bottom-dweller. When there’s blood and pain and chaos in the streets, I’m happiest.

Milevsky: Anything associated with baby boomers moving into retirement is a buy — anything that makes them feel younger, age slower or increase their longevity. So: medical care and pharmaceuticals would tend to outperform.

Buckingham: Health care is an area, and we still like some of the very strong consumer things, like Disney. We invest in dividend-paying stocks across the board. I like some of the beaten-up commodity-related companies, such as Chesapeake Energy, and some of the shipping companies — either dry-bulk shippers or oil tankers. Those sectors have been really battered and bruised, and have great potential.

I also like conglomerates; for example, United Technology or 3M. The financial area would be another — “safe” names would be J.P. Morgan or Bank of America.

Dreman: It’s very hard to pick a sector, but I like some that are getting killed now: oil, natural resources. It’s right across the board. I like oil-exploration development companies, and General Electric, Altria. Also, some of the banks, like J.P. Morgan or Citi, will do OK. Stocks are getting very cheap.

In the past, Fannie Mae and Freddie Mac were two that you favored.

Dreman: Well, the government has appropriated them. They didn’t have nearly the problems of say, Citi. But the government has always disliked companies mixing with government. So it was as much an excuse as anything [else] to take them over because they’re vital to their program to buy mortgages. And that’s exactly what they’re doing now.

What are your thoughts about technology?

Buckingham: These companies have been beaten up worse than other kinds. Tech has underperformed for a couple of years now. The valuations are attractive; and ultimately, tech is a growth area. I like Microsoft, Intel, Cisco, Verizon.

Dreman: I wouldn’t touch it. I don’t think it’s cheap enough yet.

Will ’09 be a big-cap or a small-cap year?

Milevsky: With an environment like this, there’s going to be a premium placed on companies that have the cash to pay dividends. So I would bet on large-cap.

Buckingham: After a big downturn, small-cap stocks [usually] perform best. But throughout this downturn, they actually have performed best. So at this stage of the game, I think large-cap will probably outperform.

Dreman: More of a big-cap year.

Rodriguez: I have no clue. All I’m concerned about is investing in stocks that are market leadership companies with strong balance sheets, which will survive and come out the other side. Tell me about my downside risk; don’t tell me about my upside opportunity.

How will international investing do next year?

Buckingham: The world is interrelated. The idea of coupling, which was a big theme for last year, obviously has not saved anybody. In fact, if you’ve invested internationally, you might even be worse off than if you’ve invested in the U.S.

Rodriguez: The international area will be in worldwide recession. We’re already moving into it right now.

Milevsky: I’m extremely optimistic about [some of] those markets, primarily China and India in the long run. Six or nine months from now, they may actually be pulling the U.S. out of the recession.

Dreman: The downturns here are only sending the foreign markets down more. They are not disconnected.

How will the presidential election affect things?

Milevsky: Within three months of [Democrat] FDR’s taking office in 1933, the S&P was up about 70 percent. He had plans, but he hadn’t really done anything [yet]. It was just that the market felt so confident that he would. Hopefully, we’ll see the same thing.

Buckingham: Stock markets do better under Democratic administrations. I’m not making my investment decisions based on who’s going to be in office, but change will be good. Even if it’s Obama, I don’t think it will be a negative for the stock market.

Dreman: Obama will probably put more money into the average taxpayer’s hands. He’ll try to re-liquefy them more than McCain might. Good for the economy, bad for inflation.

Rodriguez: It’s sure looking like it will be Obama, and I just hope and pray he has the wise foresight and intellect to select someone for the Treasury that’s a fiscal conservative. If McCain is elected, I have more confidence he’ll restrain spending. Tax cuts that focus on temporary spending are analogous to a heroin addict’s getting another fix: They feel the buzz for a short period, then it’s over. The system has to go into “withdrawal” from excessive debt leverage and excessive consumption.

So all in all, you will proceed with caution?

Rodriguez: We’re still very defensive and expect to be that way well into ’09. As [Warren] Buffett says: When others are greedy, you be cautious; when others are cautious, you be greedy. I’m waiting for the time when I can be very, very greedy.

Dreman: This is one of the big buying opportunities of at least the early part of the current century. If you buy something today, there’s really good value. In the short term, you might have to be prepared to take losses. But some of these stocks — really good companies — are so cheap that even though you take a 20 percent loss, there’s a good chance you’ll double your money in two or three years.

Freelance writer Jane Wollman Rusoff is a Los Angeles-based contributing editor of Research and is the founder of Family Star Productions


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