David’s 2009 Predictions By: David Overfield

January 2009

First let’s remember 2008

Wow, what a year we’ll remember for quite a while.

• Housing crash 40% to 50% in some areas. Even parts of the Bay Area in
serious decline.
• Massive foreclosures (unprecedented historically)
• Rising unemployment (from 4.5% to 7% in 1 year)
• Collapse of huge companies:
o Bear Sterns
o Lehman Brothers
o Merrill Lynch
o Morgan Stanley
o WaMu
o Wachovia
o AIG
o Freddie & Fannie
• Credit crunch (even money market funds returned zero)
• $700 Billion TARP
• The largest decline in:
o Auto sales
o Home sales
o Home prices
o CPI (negative…now that’s not supposed to happen)
o Consumer sentiment
o Home builder sentiment
o Treasury yields (even negative briefly…huh? I pay you to return my
money later)
• $50 Billion Madoff scandal
• Oh yeah, and the stock market fell 50% in 12 months

The only comparable time in US history? That’s right, the Great Depression.

Background
With the 2008 year in review out of the way, is 2009 a year for some optimism?

Deflation is the name of the game for 2009. Asset prices will continue to decline as
consumers, business, and investment firms deleverage.

How can we have deflation with a fiat currency? Think about that. The USG (US
government) can create money (USD or US dollars) out of thin air and call it
currency via legal tender laws. How can prices ever go down? Can’t the
government just print more money and solve that problem? I want to hear your
thoughts.

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There will be a surplus of government intervention to combat mass unemployment.

I expect we get close to 10% unemployment (U3) by year end.

Consumers will continue to cut back on spending which leads to lower GDP and CPI
numbers.

Regional banks will get in trouble as their commercial RE loans fail.

Predictions that the US faces Japanese style deflation will increase in the MSM
(mainstream media).

While 2008 was the year of a major crash on Wall Street (banks, brokers); 2009
crash will be the crash on Main Street (industry, commerce, retail, government).

No “inflation” present in the economy. Thus lower prices for assets: RE, stocks,
wages, and even consumer goods.

Layoffs and retail bankruptcies will be the major stories. The retail sector seems
the most likely to fall apart completely. I expect many retailers and restaurateurs
to go into bankruptcy in 2009 starting in late January as they close out their books
for the holiday season. Some major name brands will fail that were previously
considered blue chip companies.

The stock market lost $7 trillion so far and the real estate market (residential &
commercial) will lose about the same. This loss of capital plus a huge slow down in
the velocity of money has caused US GDP to go negative. This is something
recently thought not to be possible. However I expect it continues in negative
territory through most of 2009.

Defaults grow beyond comprehension and models for these debts:

• Residential mortgages
• Commercial mortgages
• Credit cards
• Education loans
• Auto loans

Stock Market
The market has already had its worst crash since the Great Depression. The market
fell 50% in just 12 months. As a comparison the S&P fell only 48% over 3 years
during the 2000 tech bear market.

The markets have been in an uptrend since the market low in November around
748 on the S&P. This appears to be a bounce/retrace of the October market crash.
A standard 50% rebound would have the S&P peak between 1000-1100.

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Naturally I expect this rebound to be short lived and for new lows in 2009 as
companies report very low earnings.

Dow

5000 - 7500

S&P 500

450 to 750.

NASDAQ

1100 - 1300

I expect 2009 will continue to be a “traders’ market” with high VIX (volatility), no
clear trend, and fundamentals that don’t make sense. My expectation is that VIX
stays above 40 for much of the year and if we see another big multi-day sell off,
then it will go above 70.

The market may recover in 1st half of 2009 just the market did in 1930 following the
1929 crash. Take a look at the stock market chart for the Dow from 1929-1940.
The crash in October 1929 through early 1930 looks eerily similar to today’s market
chart.

The one market I expect to hold up better than the whole market is surprisingly the
tech sector. In general tech is priced lower than it has in the past which appears to
be because of the prior market crash in 2000.

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RE Market
The Real estate market has gone from being loved by all to being despised by most
in a short 2 years. It wasn’t that long ago that everyone was leaving their jobs to be
house flippers, RE agents, or RE investors. Doesn’t that sound like 1999 when
everyone seemed to be a day trader?

Residential

RE prices continue to fall and finally the higher end of the market gets hit. The
reason is that the Alt-A, Option ARM, mortgage crisis is even larger than the
subprime crisis.

Notice the two distinct waves above. The first wave was the subprime loan reset
period that pushed the world into global deflation. Sadly the second wave is even
larger.

Interest rates will stay very low as the USG attempts to combat the ARM reset
problem by pushing the indices so low that mortgage payments don’t increase
when they reset and recast.

I expect it will take 10 years for home prices to recover in general.

Some markets will take 20 years like lower income parts of CA central valley. (Can
average blue collar workers in Fresno, Bakersfield, or Stockton really afford a 3000
s/f McMansion at $450k?)

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Finally, I won’t feel good about RE until Eichler homes in Palo Alto trade for less than
$1 million. Come on people - does a 50 year old, 1200 s/f, flat, single story home
sound like a good value? Certainly there is significant demand from tech workers
with good incomes in the peninsula but I don’t believe that there will be enough
loans available with loose terms to maintain the high prices.

Commercial

The commercial market has been slow all of 2008 and will continue to be frozen in
2009. Worse than that is that the loan market is almost completely frozen. Thus
prices will fall and start to accelerate downward as commercial landlords default on
their loans and new buyers have trouble obtaining financing.

Additionally new commercial projects will almost completely stop. 1) there is no

demand for more commercial square footage and 2) there aren’t many C&D
(construction & development) loans available.

Interest Rates
Who would have thought we’d get here? The Federal Funds rate is in a range from
0% to .25%. Zero percent, does that mean money is free?

Fed Funds rate

At zero percent the rate is as low as it can go. Zero percent interest rates were in
Japan for many years so they have some historical precedence.

10 year

The 10 year US Treasury bond is around 2.5% today but had been as low as 1.5%
recently. It should stay below 3% as the government battles deflation.

30 year

After hitting a low around 2.4% it is now at 3%.

There is clearly a US Treasury bubble because who in their right mind would lock up
their money for 30 years at 3%?

If the Federal Reserve can keep interest rates low then I predict we’ll see the long
bond below 3.5% all year. However anything above 5% would be a serious problem
while we battle deflation.

Currency
World currencies are not something I track often. However I have started to read
about them more.

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There is a race to the bottom as every nation is cutting interest rates to see who
can lower their currency’s value and thus make their cost to produce goods and
services lower than competing nations. No one wants high unemployment as the
current government usually gets thrown out.

The British pound seems bound for a freefall. Maybe even parity with the USD in
the next 2 years.

The Euro and USD seem to be range bound between 1.20 – 1.60.

USD

The USD is still the world’s dominant currency for transactions. It is also the reserve
currency of most nations’ central banks.

US dollar has intrinsic value because:

• Most powerful military

• One government (as opposed to EU)
• Oil priced in USD
• Large growing population of innovative workers
• Large land mass of resources
• Trades (like commodities, financial products, etc.) are priced in USD
Euro

The Euro has been rising against the USD and then fallen recently. I have read
rumors that the Euro might even break up as some nations want to restore their
national currency. This has a low chance of happening, but I believe it may happen
during a market collapse.

Yen

I have to give credit to the Japanese. They have created an economy that has low
unemployment, a high standard of living, and a very strong currency. How’d they
do it? Well, they have a 40% savings rate and they actually manufacture goods the
rest of the world needs. Thus their currency has and will continue to strengthen.

For comparison the US has a savings rate under 5% and recently went negative.
(You read that right) Plus we don’t manufacture nearly what we used to in the past.
By the way, creating financial products like CDS, CDO, MBS, hedge funds, funds of
funds, etc. doesn’t count as actually making something.

Precious Metals
This is another area I don’t track too often.

Gold

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Gold prices are likely to fall in price less than other asset prices. It may even rise
over time as a hedge against fiat currency.

Silver

I keep reading how it is an industrial metal and at a historically low ratio in price to
gold. Somehow it is still cheap. I have also read that there are alternatives to silver
that may significantly reduce the need for silver as an industrial metal.

Commodities
I have added some energy related reading to my weekly list. We had a historical
bubble and collapse in 2008. Oil prices hit $147 and then fell 67% to under $40.
How’d that happen?

Energy

Oil

Coal

Natural gas

There are two competing forces. A dwindling supply of cheap energy balanced by a
rapid slow down in world consumption. Which force will win? I don’t know but I am
slightly leaning towards low energy prices in 2009.

I do wish the US was energy independent but that seems so far off. I don’t believe
there is the political will, however maybe Obama will put us on that path.

Political
We have a new president in Barack Obama. His economic team has serious
credentials but this reminds me a quote by Warren Buffett.

“When a management with a reputation for brilliance tackles a business with a

reputation for bad economics, it is the reputation of the business that remains
intact.” – Warren Buffett

Monetary policy (government manipulation of interest rates) is used up as rates are

already at/near zero.

Fiscal policy (government spending) starting with $1 trillion in 2009 has just begun.

At some point the government will have to monetize the debt created. There is just
too much to pay back. Even with “inflation” (i.e. increasing the money supply) I

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don’t see us paying back all the debt created to alleviate the current economic
crisis.

The FDIC may need a bail out from USG in 2009 when more banks fail. The FDIC
may run out of money on its balance sheet but it won’t be allowed to fail.

Others
The Detroit 3 auto makers don’t have a viable business model. Their costs are too
high, too many plants, too many expensive workers, way too many retailers, etc.

Their cost structure should be the same as the imports in the south. No union and
starting wage of $14/hour. As I see the world economy, why shouldn’t auto workers
in the US make around the same as in South Korea? We are in a global market now.

New auto sales fall by 50%.

Many states will get into big trouble, maybe need a bailout or go bankrupt (not sure
if a state can file for bankruptcy like a local municipality). The huge pension plans
offered to state/county/city workers will have to be reduced. There won’t be money
to pay them. One problem is that most government workers seek “safety” and their
unions will fight even more than the UAW to keep the promises made to them. I
don’t see how California won’t make wild reductions to spending and enact large
tax increases.

Number of hedge funds should decline dramatically; my estimate is a reduction in

number by 60% to 80%.

Wild Cards
These are events that are unpredictable and uncertain in outcome/effect. They
could have a significant effect on all the predictions.

Russia

I don’t see much hope for Russia other than high energy prices. There doesn’t
seem to be a culture of stable economic growth.

China

I see negative (<0) growth rate in the either 2009 or 2010. It sounds strange since
we are used to them growing 10% a year consistently but if other countries aren’t
buying as many of their products (Wal-mart), then where is their growth?

As a side note I think now that they have regained control over Tibet, I believe their
next target is to reclaim Taiwan. In fact they already started Panda diplomacy.

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http://en.wikipedia.org/wiki/Panda_diplomacy

My thought prior to Panda diplomacy in December 2008 was that China reclaims
Taiwan the week after Obama is inaugurated. Would the US really stop this?

Taiwan will “return” to China, it is just a matter of time.

Middle East

This region will always be unstable because of the need for the region’s oil and the
internal conflicts between the different people groups.

Explosive issues:

• Oil shipping lanes

• Sunni / Shiite relations
• Israel’s existence
• Iranian nuclear ambitions
• Pirates!!! (off the Somali coast, what is this the 18th century???)

Israel

Tied to the middle east and in the news because of aggressive military action the
Gaza strip the first few weeks of 2009.

Terrorism

Is 2009 the year Al Qaeda strikes in the US again? I don’t think so. They have
plenty of targets in Afghanistan closer to home.

US

Mark to market accounting rules render all banks instantly insolvent. The result of
realistic marks to level 3 assets would deplete the capital base of most/all banks.
The cascade of failure would be worst than the Great Depression.

The CDS (credit default swap) market explodes. Probably the contracts will be
outlawed or regulated soon.

The market for UST (US Treasury) & Agency debt collapse.

Long term predictions:

S&P 500 hits 400

Dow hits 5000

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Double digit unemployment

Structural changes to entitlements like: Medicare, SS, pensions, private retirement

accounts, etc.

Can’t tell:

Gold prices

Nationalization of health care

If long term rates go to something around 2% (Google it yourself if you don’t believe
it), then the reset crisis would be different since the reset may actually lower the
payment even though it is now amortized over 25 years not 30.

Change to the US dollar: Will it be replaced as the world’s reserve currency? Will it
be backed by something tangible? Will oil no longer be priced in USD? Will the US
currency change? Will the USD fail? Will it no longer be “debt”? (See Money as
Debt video on YouTube – see favorite links below)

End Game
How does this global economic slowdown end?

True prosperity comes from savings and investment. Not from spending and
consumption. We can’t spend our way to growth and prosperity despite the
pronouncements of Keynesian economists (who are all Keynesian now).

Solutions
How can the problem and the solution be one and the same? The credit bubble
created the illusion of wealth but it was really just debt. Most debts won’t be
repaid. Yet our government’s solution is more debt. Let’s see: lower interest rates
to zero, $700B TARP, trillion or so in housing debt, etc. How can the problem (too
much debt) be solved by the same thing (more debt replacing the old debt)???

There aren’t any magic solutions that anyone can wield to fix all the problems.

Temporary solutions

Some that the TPTB (the powers that be) may try:

• Refi all existing loans into 30 year fixed at 4% without a new appraisal.
• Monetize the debt (USG converts debt to equity)
• The Fed/USG buy all types of debt: commercial RE, commercial paper,
business loans, Level 3 assets stuck on bank balance sheets.
• Jubilee debt (Google it)

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• Currency devaluations
• Inflation

How to Prevent the Same Problems from Recurring

• Banks become a utility-like service
o Limit leverage to 10 to 1 (Investments banks were 40 to 1 or so in the
bubble)
• Ban anything other than a 30 year fixed mortgage with full doc
• Limited/ban slicing of mortgages
• Require portfolio lending (not likely though)
• Regulate CDS as insurance
• Maintain a stable currency with reasonable interest rates that don’t promote
bubbles

What if I am wrong?
I will be wrong on some predictions because the future is uncertain to some degree.

I don’t see hyper-inflation unless oil is no longer priced in US dollars and the dollar
collapses due to lack of foreign demand for US debt. I don’t see this happening in
2009 and we have troops in Iraq and Afghanistan to prevent this.

The economy recovers:

• Unemployment falls or even flattens

• Markets finish higher
• Interest rates rise significantly

Silver lining
With all the bad news in 2008 and the predictions for more of the same in 2009,
where is the silver lining? My hope is that we establish a stable foundation for our
economy and reject the endless cycle of credit inflated bubbles.

A few things I’d like to see us implement for a more stable future economy:

• Most mortgages be 30 year fixed with 20% down and full documentation.
• Achieve a 10% savings rate
• Limit leverage on Wall Street of 10 to 1 including off the balance sheet
entities

Feedback
Constructive feedback is encouraged, especially if you have differing opinions.
Please comment at my web site DavidOverfield.com.

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Favorite Business/Economic Videos

Money as Debt
http://www.youtube.com/watch?v=vVkFb26u9g8

Fred Thompson on the Economy

http://www.youtube.com/watch?v=RKc4XFK0iVY

Rich Dad Predictions 2008

http://www.richdad.com/RichDad/RichContent.aspx?cpid=62

Final thoughts
I don’t see how the TPTB can re-inflate the global economy faster than the
deflationary decline. Credit is being destroyed quicker than new credit is credit
especially because the velocity of the new credit is near zero. This is especially true
with tightened lending standards. Fewer people are going to borrow now =
smaller/slower economy.

Also, look at the chart below of the Japanese stock market following their high in
1989, we may follow that chart to some degree. The fundamentals are similar:
population of baby boomers, highly industrialized economy, and asset price bubbles
in stock market and real estate.

Remember these gems?

Dow 36,000: The New Strategy for Profiting From the Coming Rise in the
Stock Market
http://www.amazon.com/Dow-36-000-Strategy-Profiting/dp/0609806998

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Why the Real Estate Boom Will Not Bust by David Lereah Chief economist for
the NAR
http://www.amazon.com/Real-Estate-Boom-Will-Bust/dp/0385514352/

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