Three key trends for investors and savers in 2010

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Market Beat

In case you missed it, Treasury Secretary Timothy F. Geithner this week promised America that there won’t be another financial crisis in 2010.

“We’re not going to have a second wave of financial crisis,” Geithner said in an interview with National Public Radio. “We’ll do what is necessary to prevent that. We cannot afford to let the country live again with a risk that we’re going to have another series of events like we had last year.”

Well, there it is. And you wonder why the stock market is at 14-month highs?

Anyone who has deep-seated doubts about the financial system’s health may view Geithner’s explicit guarantee as a dangerous sign of government hubris, or simple naivete.

But his promise does address what is for some investors the preeminent question about 2010: Can the world avoid another calamity on the scale of what fueled the markets’ meltdown from September 2008 to March 2009?

To frame it another way: Your financial planning for the new year would be a lot easier if you knew that the chance of another collapse was remote even if markets were likely to be volatile.

There are plenty of serious risks, whether or not Geithner chooses to publicly acknowledge them. The Treasury’s massive borrowing binge could spark a global crisis of confidence in the dollar. The commercial real estate crash could exceed already dire forecasts. New debt bombs could explode in fragile European economies such as Greece.

But the strongest argument against a second financial collapse is that the credit crisis has eased dramatically as central banks have flooded the system with money. Although it may not be evident in banks’ lending, many key barometers, including new issuance of corporate bonds and the rates banks charge one another for short-term loans, show credit has begun to flow again worldwide. Fear has subsided.

If we assume that Geithner is right about the absence of another financial mega-crisis in 2010, I think there are three important trends that either got underway or accelerated in 2009 that also will be crucial for investors and savers in the new year:

* The Great Deleveraging rolls on. Many Americans piled on excessive debts in the 1980s, 1990s and first half of this decade. On that much, everyone agrees. Now, that total household debt load of $14 trillion is being worked down -- voluntarily, as people pay off credit cards, for example, or involuntarily, as banks force foreclosures.

Consumer credit excluding mortgages fell for a ninth straight month in October, a record stretch of declines, according to Federal Reserve data.

But debt reduction has a “long, long way to go,” says Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, N.Y. The question is whether it can proceed without tipping the economy back into recession.

One ticking time bomb: a jump in 2010 in the number of homeowners with so-called option ARM loans who will see their loan rates reset at higher levels.

An obvious implication of consumers’ need to reduce debt is that people will save more and consume less than before. That will be a continuing drag on the economic recovery. I know we’ve all heard that a million times, but that doesn’t make it less true.

And with banks facing more loans on which they can’t collect payments -- from consumers, small businesses and commercial real estate borrowers -- the pressure will be enormous on the Federal Reserve to keep short-term interest rates near zero for as long as possible, to allow the banks to fund themselves for nearly nothing.

The upshot: no imminent rate relief for savers, who now are lucky to earn 1% or 2% on their cash.

* Corporate earnings keep improving. Expectations of a profit recovery helped stoke the stock market’s turnaround in March. Wall Street has largely been pleasantly surprised since then.

In the fourth quarter of 2008 operating earnings of the Standard & Poor’s 500 companies plummeted 67% from a year earlier as the economy crumbled.

But that was the worst of it. In the first quarter of this year S&P earnings were down 35.5% year over year, according to Thomson Reuters. The decline narrowed to 27.3% in the second quarter and then 14.1% in the third quarter.

Starting with the current quarter, earnings are forecast to begin rising, albeit from extremely depressed year-earlier levels.

Sales have edged up for some firms this year as the global economy has begun to rebound. But a big part of the profit-recovery story has stemmed from companies’ slashing of their payrolls, driving the U.S. unemployment rate above 10% for the first time since 1982.

Here is the depressing reality: The jobless have sacrificed for those still employed and able to enjoy this year’s snap-back in their 401(k) account balances. That’s because the improving trend in earnings has given investors the confidence needed to bid stocks higher, which in turn has underpinned faith in a sustained economic recovery. The latest data on the economy have mostly been positive, which also has supported stock prices.

If no new financial crisis hits in 2010, the global economy will have a better chance of keeping its momentum. Though U.S. stocks are overdue for a pullback (doesn’t everyone say so?), buyers may quickly return if they believe that the odds of a double-dip recession -- and another drop in corporate earnings -- have faded.

* Many investors keep looking for a middle ground on risk-taking. That means cash is likely to keep pouring into bonds -- at least until some people discover, to their surprise, that it’s possible to lose money in fixed-income securities too.

Small investors usually are prone to chasing hot stock markets. Not this year. Even as the U.S. equity market has continued to rally Americans have shunned domestic stock mutual funds. Each week since late August more cash has been pulled from the funds than has flowed in via new purchases, according to the Investment Company Institute’s data.

The opposite has been true of bond mutual funds: They’ve taken in record sums this year, week after week. The Pimco Total Return bond fund alone has swelled to $202 billion in assets, making it the largest mutual fund in history.

Starved for interest income at the bank and in money market funds, and fearful of the stock market, many investors understandably have turned to bonds as a middle ground. Government, corporate and municipal bonds offer a way to get annualized interest yields in the 3% to 6% range.

But if the economy stays on the recovery path, and global investors bet on an uptick in inflation, longer-term interest rates almost surely will go higher in 2010. Remember: The Fed controls short-term rates, but the marketplace sets long-term rates.

If long rates do rise, existing bonds issued at lower fixed rates will lose value. That will be reflected in falling share prices of the bond mutual funds that investors now can’t get enough of.

I don’t want to overstate the risks here. With high-quality bonds, it’s very unlikely that you could lose in any given year anything close to what you can lose in stocks, as 2008 demonstrated. And if steady interest income is all you care about, and you can tolerate a drop in your bonds’ principal value, rising market rates may not faze you.

Still, the unprecedented amounts of cash flowing into bond funds this year suggest that a lot of newbies have joined the ranks of bond holders.

Investors “are behaving as if bonds are riskless, and they’re not,” says Jason Trennert, chief investment strategist at Strategas Research Partners in New York.

Here’s a big question that will loom if 2010 proceeds without another financial crisis and with the economic recovery intact: If long-term interest rates rise, triggering losses for bond investors, will they flee back to short-term accounts paying next to nothing -- or will they find no other good alternative but to jump into the stock market?