CLSA Investing At The Bottom; 2009 a year of possibly extra-ordinary gains Russell Napier

At the crux of Russell Napier's assertion remains the view that 40 per cent of the Global population living in China, India and Russia cannot survive by catering to 14 per cent of the global population that comprises the US.

Asian surplus economies of Japan, China, Taiwan, Hong Kong-SAR Of China and to a marginal extent India, have invested most of their FX Reserves into US Treasuries that yield 0 per cent in short term maturities and 2.3 to 2.5 per cent in 10 year Treasuries.

As domestic consumer centric demand replaces exports, and as Consumer led investments replace fixed capital formation by Industry, most of the Asian currency surpluses will turn back towards Asia. This will lead to a rout of the US Treasuries, perhaps even a massive Bear market in US Bonds that could last years.

But what would outshine everything else in Asia would be instruments for consumer growth-Banks, Real Estate-Residential & Commercial, Consumer Durables, Entertainment, Retail, Hotels, Tourism and Gems and Jewellery industries.

What could go into declines might be IT and BPO industries, Export led garment and apparel industries, leather and jewellery meant for Western markets.

The lead towards consumerism will however have to come from China-the only Asian nation with nearly $ 2 trillion in FX reserves and a population striving for more.

US bond and equity markets are pricing in an unlikely gross deflation. As
the risk of deflation fades, a significant rally in equities will occur,
heralded first by a material rise in corporate bonds and then by higher
copper and TIPS prices.

The earnings cycle is likely to turn back up by mid-2009 and this will sustain a bear market rally into 2010. Thereafter, the bear will return and we will see US equity prices bottom at almost 50% below current levels sometime around 2014.

Equities rally as deflation risk passes

US equities now trade at below fair value, based on q ratio and cyclically adjusted PE, but will likely fall much further.

However, there is likely to be a significant rally in equities before the final fall.

The market is pricing extraordinary levels of deflation into stocks and bonds.

Deflation is unlikely in the US because of deposit insurance, bank recapitalisation, the actions of Freddie and Fannie and the manipulation of the fiat money system.

History suggests that a material rally in corporate bonds will precede a true rally in equities and that copper and TIPS prices should rise.

Worst of earnings cycle behind us

S&P Index earnings have fallen by 50% since June 2007 and are 20% below 1998 levels in real terms.

As equities bottom before earnings, the market is already capable of coping with a further 8-20% decline in earnings.

The priced-in 54-60% decline in earnings represents probably the second-largest decline in the US since 1871.

Even deflationary contractions usually see earnings bottom within two years and thus the earnings cycle should be turning by mid-2009.

The stock market should bottom before that, between end-2008 and 1Q09, with a rally lasting some 18 months or longer.

Rally through 2010, then real bear market begins

US equity prices need to fall by 50% to reach record-low valuations.

A major bear market in US Treasuries and/or the US dollar will be the catalyst for the final leg of the equity bear market.

Retiring US baby boomers and export-led economies changing to a domestic consumer-focused model will drive the bear market in US Treasuries.

By 2014, US equities will be at historical lows, representing great long-term value.

If the world suddenly loses faith in US Treasuries, the bear market in these instruments could come sooner and the rally in equities may not appear.