Research Investment Roundtable

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.

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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?