Stocks May Steady in '09, but Troubles Won't Vanish

No one disputes that 2008 was a year of crisis. For the coming year, many observers are expecting a year of transition. But with so much uncertainty, investors are still searching desperately for answers.
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The major indices plummeted more than 35% over the past 12 months as the U.S. fell into a recession, and investors certainly are hoping to avoid a repeat in 2009.

However, the most they can probably expect realistically is that the stock market has ended its painful search for a bottom and that equities will find their footing.

No one disputes that 2008 was a year of crisis on Wall Street. For the coming year, many market observers are expecting a year of transition. Of course, with so much uncertainty clouding corporate earnings outlooks, investors are searching desperately for answers to some of the most troubling questions outstanding.

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Fortunately, market strategists are ready to put a bitter 2008 in the books, and in

some

cases at least, make encouraging predictions for the coming year.

U.S. Equities Will Rebound in the Second Half

Without a doubt, Wall Street wants to wish good riddance to the past year, but forgetting about the damage that has been done won't be easy. Of the Dow's 30 components, 28 are set to finish the year with losses. Twelve of them likely will end 2008 with declines of greater than 40%, including

General Motors

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,

Citigroup

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,

Alcoa

(AA) - Get Report

,

Bank of America

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and

American Express

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.

However, buyers will slowly return to equities as the year progresses, says Paul Nolte, director of investments with Hinsdale Associates, no matter how reluctant they are to invest initially.

"The underpinnings of the markets continue to improve, but it is still too early to say that the worst is finally over," Nolte wrote in a recent research report."We are expecting that the second half of the year is not only good for the market, but also we should begin to see the effects of the huge monetary 'dump' and the economy should also begin to improve."

Neil Hennessy, manager of Hennessy Funds, says that the large stimulus package proposed by President-elect Barack Obama, said to include $850 billion over two years, will give investors more confidence and could help the U.S. move quicker toward a recovery. The question, though, is when the program is finalized and rolled out.

"A fiscal stimulus plan will start to work in six to 12 months, but people are going to be in front of that in the stock market," Hennessy argues. "There is so much fear and trepidation on the downside, when buying comes in you'll see a frenzy to the upside."

The U.S. Won't Have Another Great Depression

According to the National Bureau of Economic Research, the U.S. economy has been in a

recession since December 2007

. As global conditions have also deteriorated badly since that time, it should be expected that the U.S. economy will get worse before it gets better. That has led some to wonder whether the U.S. will experience a depression.

Larry Adam, chief investment strategist with Deutsche Bank, argues that the U.S. won't experience a 1930s-style depression because many of the same factors surrounding the Great Depression, such as increased interest rates, higher taxes and widespread bank failures, have not been repeated.

"The contraction in growth has accelerated to the downside as a result of the credit crisis, and the U.S. is likely to be in the midst of the worst economic contraction since the early 1980s," Adam writes in a research note. "However, due to unprecedented global fiscal and monetary stimulus, we do not believe the mistakes that created the Great Depression and the Japanese implosion in the 1990s will be repeated."

Corporate Bonds Will Rally

Perhaps one of the most telling signs about the severity of the credit crisis of 2008 was the unbelievably high interest in one-month Treasury bills the government auctioned in December -- at 0%, the lowest auction rate ever. More shocking was the fact that three-month T-bills briefly traded in the secondary market below zero percent at -0.01%.

All the while, yields on investment-grade debt from corporations have surged as investors flocked to T-bills, making it more expensive for companies to raise money. Punished harshly in 2008, U.S. corporate bonds look to rebound in 2009 as the credit freeze begins to thaw more rapidly.

Paul Mendelsohn, chief investment strategist with Windham Financial, says that corporations that went into this crisis with fairly good balance sheets are now burning through cash, and that by the second or third quarter of 2009, they will have to sell bonds to raise money.

"This Treasury bubble and the risk aversion is going to abate somewhat, and that'll begin to push yields back up," Mendelsohn said. "That's going to be positive for higher-grade corporate bonds. About the time that Treasury yields come back, corporations are going to need to raise cash."

More Hedge Funds Will Collapse

Challenging market conditions led to rumors of poor performance at leading hedge funds. In some cases, market downturns were exacerbated by the liquidation of assets by heavily leveraged funds who quickly needed cash to meet redemption requests. According to Hedge Fund Research, a source of hedge fund performance data, the current year is on pace for more than 920 fund liquidations, easily outpacing the 2005 record of 848 and last year's liquidation total of 563.

Art Hogan, chief market strategist with Jefferies, says that the hedge fund industry will see a consolidation in 2009. By the end of next year, he expects the total number of hedge funds to be roughly half of the number at the start of 2008.

"It's been a disastrous year for them in terms of returns," Hogan said. "There's a structural problem with the way hedge funds charge investors that will likely change. That's going to cause them to shut their doors or consolidate into other funds. You can't pay your talent if you're not getting performance fees. That'll cause an exodus."

Hogan also says that the

Bernard Madoff $50 billion Ponzi scheme

has shaken investor confidence and will likely force a massive overhaul to the hedge fund system.

"Rightly or wrongly, with what's happened with the Madoff case, there will be a call for more regulation," he said. "That won't create an advantageous environment for growth."

The Fed Funds Target Will Remain Close to Zero

At its Dec. 16 meeting, the

Federal Reserve

established a target range for the federal funds rate of zero to 0.25% in order to promote sustainable economic growth and to preserve price stability. According to the Federal Open Market Committee, weak economic conditions are expected to warrant "exceptionally low levels of the federal funds rate for some time."

As market observers expect macroeconomic headwinds to persist for much of 2009, some say it's not out of the realm of possibility that the Fed leaves interest rates nearly at zero, not feeling any threat from inflation.

"They're going to keep it there for most of 2009," said Robert Pavlik, chief investment officer with Oaktree Asset Management. "I just don't see any type of real strength that would have them consider raising that. They'll be watching the signs very closely, trying to determine if it's time to raise rates."

IPOs and M&A activity will increase

According to Renaissance Capital, which operates the Web site IPOHome.com, initial public offerings dried up in 2008 as a result of extreme risk aversion and credit woes. There were only 43 IPOs over the last 12 months, down from 272 in 2007, making it the slowest year for U.S. initial offerings since 1979.

Total proceeds were slashed to $28 billion from $59.7 billion in 2007. That figure would've been worse if not for

Visa's

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$17.9 billion offering in March.

Meanwhile, analytical firm Dealogic said that global M&A volume dropped 29% from the record level in 2007, with deals valued above $1 billion falling 33% from a year ago. A record 1,309 M&A deals were withdrawn in 2008 for a total value of $911 billion, according to Dealogic, the second-highest annual total behind the $1.16 trillion of deals withdrawn the year before.

Jefferies' Hogan says that M&A activity should pick up in the first half of the year, while the IPO market should improve in the second half of the year -- provided that equities rebound.

"There aren't a lot

of companies that have a lot of cash on their balance sheets, and they will look at competition and try to make accretive acquisitions," Hogan said. "In terms of IPOs, it takes strong equity markets to drive an IPO market. Unless we see a rebound in equities, you can't get deals done. A lot of deals that were shelved last year will be brought back out if we do see an extended period of stronger equity performance."

Expect More Bankruptcy Filings

In addition to the credit crisis, 2008 could also become notorious for the number of retailers filing for bankruptcy. Among the biggest were

Circuit City

,

Sharper Image

,

Linens 'N Things

,

Steve & Barry's

,

Mervyns

,

KB Toys

and

Tweeter

.

Windham Financial's Mendelsohn says that a "devastating" Christmas shopping season will impact more retailers and will likely put smaller shops out of business. However, a quick recovery in the credit markets might ease some retailers' pain.

"It all depends on the credit markets and how well they free up in terms of debtor-in-possession financing," he said. "In better times, a lot of these stores would've been able to reorganize and survive. That's not going to be the case here."

Mendelsohn adds that under normal circumstances, an investor could buy distressed assets and the retailer could reorganize, making some money on the investment. "In 2009, if the banks aren't going to put up the debtor-in-possession financing, then these companies are going to close up and the bonds will end up at zero," he says. "It's a dangerous area to be playing, unless the banks start to put the money out there."

The year also saw the largest bankruptcy in history --

Lehman Brothers

. In an effort to put off bankruptcy, a host of companies have eliminated jobs, pushing the unemployment rate to a 15-year high of 6.7%. Now, there's little wiggle room left as the calendar turns over to 2009.

"These companies have been hit relatively hard already, so to the extent that Chapter 11 bankruptcies will continue into 2009 depends on how long and how deep the job cuts will be," Pavlik said. "Depending on how a possible stimulus package is positioned, that may help save some businesses, although I'm not sure how long-lasting that impact will be."