Originally published in the December 27th 2008 edition of the Financial Post section of the National Post.

Prepare for a surprise in 2009! Most U.S. and Canadian equity strategists have a gloomy outlook for the first half of the year based on signs of a deep recession. Strategists have a more positive outlook in the second half of the year when an economic recovery is anticipated. However, an examination of cyclical, seasonal, technical and fundamental influences suggests a different outlook.

Cyclical influences

A study of the four year Presidential Election cycle from 1888 to 2005 shows modest advances in a post-election year. Average gain per period was 2.9%. Gains were slightly higher during the seven occasions when a Democrat replaced a Republican in the Oval office. Average improvement per period was 5.2%. Historically, U.S. equity indices in a post election year have been flat in the first quarter, strong from April to July, weak from August to mid November and strong to the end of the year. Investors tend to respond favourably early in the year to plans offered by the president to fulfill his election mandate. Seasonal and fundamental influences suggest that history is about to repeat in 2009. Look for an Obama rally into the first half of 2009.

Seasonal influences

The usual period of seasonal strength for North American markets from October to April started later than usual in 2008, but is expected to continue into at least the first four months of 2009. Technical evidence of an intermediate low on November 20^th by the TSX Composite Index and the S&P 500 Index continues to build. Favourable annual recurring events will help equities markets early in 2009 including contributions into Registered Retirement Savings and 401 K programs and the restoring of balanced funds to required weights.

Technical influences

North American equity markets have started to recover from intermediate oversold levels. Technical indicators suggest that North American equity indices reached an intermediate low on November 20^th with the S&P 500 Index at 741.02, the Dow Jones Industrial Average at 7,449.38 and the TSX Composite Index at 7,647.11.

Fundamental influences

Central banks and governments of developed nations have pledged to spend trillions of dollars to overcome the credit freeze that started on September 15^th, 2008. President elect Obama is expected to announce an additional fiscal stimulus program in January with an estimated valued of $700-$800 billion dollars. These programs will take time to implement. Initial impact on world economies likely will become notable by the second quarter. Meanwhile, recent technical evidence suggests that the credit freeze already has begun to thaw. Evidence includes a decline in the TED spread, a fall in LIBOR rates and a narrowing in interest rate spreads between corporate and government debt instruments.

Economic news will not help North American equity markets during the first quarter, particularly news on employment and home prices. However, equity markets already have anticipated a significant surge in unemployment and a decline in home prices into the first quarter of 2009.

Corporate news initially will be dreadful in early 2009, but year-over-year earnings and revenues likely will compare favourably as the year progresses. Height of the meltdown by North American companies will occur when fourth quarter 2008 earnings are reported in January and early February. This quarter will be a “kitchen sink” quarter when corporations write down everything that they can find “including the kitchen sink”. Fourth quarter 2008 earnings estimates for big cap companies on both sides of the border currently are too high. Consensus for the 30 Dow Jones Industrial Average companies is calling for an average (median) decline of 7.5% on a year-over-year basis. Earning prospects in the first quarter of 2009 are only slightly better. Consensus is calling for a loss of 6.8% on a year-over-year basis. Earnings prospects for TSX 60 companies are not much better. Consensus shows an average (median) decline of 2.6% in the fourth quarter on a year-over-year basis. However, dreadful results in the fourth quarter of 2008 and first quarter of 2009 already have been anticipated. Quarterly earnings and revenues start to show a significant sequential recovery in the second quarter. Fourth quarter comparison on a year-over-year basis will look extraordinarily strong against exceptionally weak fourth quarter 2008 results. Consensus estimates currently predict that earnings by the 30 Dow Jones Industrial Average companies will record an average (median) earnings gain of 3.1% in 2009 over 2008 levels despite significant first quarter declines. Earnings by Canada’s top 60 companies are expected to follow a similar trend. Consensus for the TSX 60 companies is predicting an average (median) gain of 5.0% in 2009 over 2008 levels.

An important reason for anticipation of an economic and earnings recovery in 2009 is a thawing in the credit freeze and subsequent weakness by the U.S. Dollar. As the thaw becomes apparent, international investors, who purchased U.S. Dollars to buy U.S. treasuries during the liquidity crisis, will begin to repatriate their investments by taking profits on U.S. treasuries and selling U.S. Dollars. A lower U.S. Dollar will boost earnings and revenues of U.S. companies with international operations, increase U.S. exports of goods and services and advantage U.S. domestic producers competing against international companies. Weakness in the U.S. Dollar also will enhance prices of commodities that trade in U.S. Dollars such as gold, silver, copper, crude oil, potash and grain, a positive scenario for the commodity sensitive Canadian equity market.

Other influences

A small possibility of an accident exists that could negatively influence equity markets in 2009. Odds of these events are probably less than 10%, but should be kept in the back of your mind. Possible events include:

• An unexpected international event such as an attack of Iran by Israel.
• A collapse of a major U.S. bank such as Citigroup or JP Morgan
• A collapse of the U.S. Dollar if major holders such as the China, Japan and Middle East oil producers decide to “ diversify” their foreign currency reserves.

In conclusion, the S&P 500 Index and TSX Composite Index are expected to move higher in the first and second quarters of 2008, followed by a brief period of weakness into summer followed by a significant gain in the fourth quarter. The optimal picture suggests a gain of 10%-20% for both indices by the end of 2009.

Don Vialoux, Chartered Market Technician is the author of a free daily report on equity markets, sectors, commodities, equities and Exchange Traded Funds. Reports are available at www.timingthemarket.ca .

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