Expert predictions: Stock market could be good in 2009

Stock market forecasts tend to be sunny, and 2009 is no exception. Wall Street gurus are again predicting gains. But this year's bullish market call comes with an asterisk.

Wary stock strategists, unsure how the worst financial crisis since the Great Depression will play out, are hedging their bets. Rather than just sharing an opinion about what they think is the most likely outcome for stocks in their '09 outlook reports, some strategists are including worst-case and best-case market scenarios that reflect lower-probability outcomes — but ones that can't be ruled out.

Welcome to the new world of uncertainty on Wall Street.

After a year of tumult, highlighted by the near collapse of the financial system in 2008, the worst recession in almost 30 years and the biggest stock market decline since 1937, many investment pros appear hesitant to declare with 100% certainty that stocks will finish the year in the plus column.

In his 2009 outlook, for example, Morgan Stanley's Abhijit Chakrabortti lays out his base case — a 975 year-end close for the Standard & Poor's 500 index, or an 8% gain, based on Wednesday's close of 903.25 — as well as a scary bear case (-56%) and a super-optimistic bull case (+32%). Three distinct market scenarios are also outlined by LPL Financial chief market strategist Jeffrey Kleintop.

"The road to recovery is likely to be a bumpy one," Kleintop wrote in his outlook piece titled "Time to Opine on 2009."

"What happens further along the road depends on which fork the financial crisis takes us down. The heightened uncertainty … surrounding the economy and policy backdrop generates a wider range of possibilities than for most years."

A recent Citigroup survey of institutional investors reflects the wide disparity of potential performance outcomes for stocks next year. More than 20% expect the S&P 500 to rise 11% to 22% in 2009. But more extreme predictions — both pessimistic and optimistic — were also evident. About 15% think stocks could fall as little as 12% or as much as 39%. And about 15% said stocks could post gains ranging from 44% to 55%.

Here are three potential outcomes for the battered stock market in the new year:

1 ... Base case

This scenario assumes an economic recovery around midyear and a rebound in the stock market, which is a forward-looking animal, by year's end. It is deemed the most likely outcome given the time needed to ease the current stresses undermining investor confidence and zapping the strength of the financial system, credit markets and broader economy.

The base case is, in effect, the consensus opinion on Wall Street. A review of a half-dozen year-end S&P 500 price targets from top strategists suggests that stocks could rebound 8% to 22%.

The key underpinning of this outlook is a belief that the panic that gripped investors around the globe last year will begin to ease in the early stages of 2009, paving the way for a more normal functioning of financial markets in the months that follow, according to Kleintop.

An immediate economic recovery, given the dearth of consumer confidence caused by a weak holiday shopping season and rising joblessness, is wishful thinking. However, the outlook is expected to brighten when there are visible signs that the unprecedented government intervention that began in late 2008 — and that is likely to continue with the incoming Obama administration's massive stimulus plan — is starting to work.

"Let's not fall into this despair trap," Tobin Smith of ChangeWave noted in a recent self-described "rant" titled "As 2008 Ends, There's Hope for 2009."

"The U.S. economy will recover," he wrote. "We as a country are a 'going concern,' and this ain't the end of civilization as we know it. The monetary and fiscal policy of 'no Depression at any cost' will save us from the unnecessary brutality the U.S. witnessed in the 1930s."

As the economy emerges from recession, the profit power of U.S. companies will improve, providing investors with a real fundamental reason to buy stocks. Another building block that supports this base case, according to Morgan Stanley's Chakrabortti, is that stocks are priced attractively after a 38% drop in 2008. Based on analysts' 2009 profit projection of $77.35 for the S&P 500, the market is trading at 11.7 times next year's profit stream, below the long-term historical price-earnings ratio, or P-E, of 15, according to Thomson Reuters.

Even if you plug in more dire earnings predictions, such as the $53 expected by Chakrabortti, the market is selling at 17 times earnings, which is not considered expensive. "Valuations," he says, "are highly supportive" and a reason to be positive on stocks.

Other factors bolstering the case for double-digit gains in '09 include the fact that expectations for economic growth are super-depressed and investor skepticism is super-high. Those acute levels of pessimism increase the chances of an upside surprise if things don't turn out as bad as doom-and-gloomers warn.

"Risk aversion turns to greed later in 2009," Thomas Lee, U.S. equity strategist at JPMorgan Chase, predicts in his outlook report. "An economic recovery will spur risk appetite. At some point after mid-2009, the tailwinds of lower gas prices, fiscal stimulus and housing stabilization should generate a sustainable rally."

That's not to say stocks won't be volatile. Lee says investors should prepare for both violent rallies powered by optimism surrounding the government bailouts, as well as discouraging declines prompted by the reality of horrific corporate earnings until the recovery takes effect.

2 ... Bearish case

It's no fun even to entertain thoughts of another year like 2008, which wiped out $6.9 trillion in shareholder wealth, according to Dow Jones Indexes. But it's better to be prepared for the worst than enter the year overly complacent.

Under this scenario, the financial crisis drags on for another year, putting yet more downward pressure on stock prices. Downside for the S&P 500 is severe, with the benchmark index careening down to 560, a 38% loss, according to Kleintop. Morgan Stanley's Chakrabortti says there is a 25% probability that the S&P 500 could fall as low as 400, a stunning annual loss of 56%.

"Our bear case is driven by much weaker growth and an outright deflationary environment," Chakrabortti notes. Under this scenario, economic growth in the U.S. would come in at negative 2% to 3% vs. 2008, which would be the first year of economic contraction since 1991, according to the Bureau of Economic Analysis.

In short, 2009 would look a lot like 2008, a year most investors want to forget. The recession that began in December 2007 would extend its destructive path for another 12 months, and frozen lending markets would fail to thaw despite the massive response from the nation's central bank, U.S. lawmakers and the Treasury Department.

"The bad news is that our economy is broken, and there is nothing the government can do to fix it," argues longtime bear Peter Schiff, president of Euro Pacific Capital.

Sparking the economic free fall will be another leg down for the already depressed housing market, which would result in a new wave of bank losses, foreclosures, job losses and economic anxiety, Schiff says.

Further deterioration in the outlook for economic growth both in the USA and once-hot emerging economies such as China is likely to drag down both corporate profits and the prices of all kinds of financial assets, ranging from soybeans to stocks.

That could spark a fresh wave of forced selling by large financial institutions, such as hedge funds and mutual funds, that need to raise cash quickly to meet redemption requests from investors, Kleintop warns. The risk of this sell-because-you-have-to-sell frenzy could spark a vicious downward spiral, like the kind experienced in October when stocks were in free fall.

Fears of a hard economic landing could also intensify the deflationary forces already in motion, triggering concern that the U.S. could suffer a lost decade similar to the one experienced by Japan in the '90s after its stock market and real estate bubble burst.

3 ... Bullish case

This case is simple: The turn in the economy, credit markets and corporate profitability comes faster, and the bounce is bigger than even the biggest proponents of a big '09 rebound predict. This optimistic view assumes that the financial panic does a disappearing act at the start of the year, restoring a sense of stability and hope to financial markets and investors.

"Freed from such stark fears, such as depression or something like it, stocks should rise," Lord Abbett market strategist Milton Ezrati said in a recent report, "Recipe for 2009: Add a Pinch of Optimism to That Eggnog."

The bullish case, if it comes to fruition, would result in big profits for investors. Kleintop's high-end, year-end target on the S&P 500 is 1365 — a 51% gain. On the lower end of the mega-bull range is Chakrabortti's target of 1190, or a 32% advance. However, Chakrabortti sees only a 20% probability of this optimistic scenario unfolding.

So how would markets get so well so fast after the worst showing since the Great Depression?

The major wild card would be if the prescription to fix the economy — lower interest rates, government-driven stimulus initiatives and an emphasis on job creation — works sooner than expected and puts a quick end to the recession, helps home prices bottom and helps thaw frozen credit markets more quickly, Kleintop says.

If that were to occur, investor and consumer confidence would enjoy a much-needed boost. Consumers now hoarding cash for fear of losing their jobs would start spending again, propelling a rebound in corporate profitability. And risk-averse investors who now think it is safer to stuff their spare cash under the mattress will start taking risks again in search of larger returns, adds JPMorgan's Lee.

Financial markets, Lee predicts, will refocus their attention on emerging tailwinds as opposed to the gruesome headwinds that kept them on the sidelines in 2008. Stock values will rise as the mountain of cash sitting on the sidelines is put back to work in stocks, creating a demand for shares that has been absent since the financial panic broke out last fall.

Richard Bernstein, chief investment strategist at Merrill Lynch, sums up the new year this way: "We think that 2009 is likely to be better than 2008."

U.S. stocks, foreign stocks, even commodities fall