It is the time of year when market pundits offer predictions for how the coming year will pan out. Such forecasts should always be taken with large grain of salt, given the dynamic nature of markets and the inherent unpredictability of the future. Moreover, successful investing requires flexibility, humility and openness to a range of possible outcomes. This mindset is particularly important in the present environment, given the enormous uncertainties investors face.

Among them: What are real underlying economic and market conditions, absent government life-support measures? What is the capacity for government debt expansion before bond markets revolt and demand much higher interest rates? How will the markets react when the Fed winds down its “quantitative easing” operations and moves off of its zero percent interest rate policy? Has the housing market really stabilized, or will there be another leg down, driven by higher mortgage rates and continued defaults and foreclosures?

Major uncertainties such as these make it difficult to assign a very high level of probability to any particular market forecast. Rather than have an entrenched point of view or set of expectations, it is preferable to think about the markets in terms of multiple potential scenarios; assess new information on a continuous basis; and adjust one’s investment posture accordingly. That said, we (humbly) offer the following predictions for 2010.

Stocks Have More Upside, Which Will Probably Be Realized Over The Next Several Months, But That Would Set Up A Selling Opportunity

The uptrend is undeniably intact, and there is not yet sufficient objective evidence to “fight the tape.” The stock market rarely tops out when (1) market breadth and all the major indexes (domestic and foreign) are in gear on the upside; and (2) monetary policy remains extremely friendly. Until bearish evidence accumulates, the bull market should be given the benefit of the doubt. We are reluctant to speculate as to how high the stock market could go, or how long it will keep rising. For the time being, we don’t see any significant signs (other than frothy investor sentiment) that the liquidity and momentum-driven recovery in stock prices won’t persist into the first half of 2010.

At some point during the course of the year, we anticipate a sharp stock market sell-off, which will likely meet the bear market threshold of at least a 20% peak-to-trough decline. In other words, we are inclined to expect that the cyclical bull market that started in March 2009 will expire in 2010. However, we are not entrenched in that view, and will take it one week and month at a time.

Our lack of comfort with the economic and stock market recovery is based on its artificial and unsustainable underpinnings. Multitrillion-dollar deficits, zero percent interest rates, subsidies, bailouts, zero percent interest rates, Federal Reserve asset purchases—these extraordinary measures arrested last year’s deflationary spiral, and have succeeded in reflating asset prices, but where do we go from here? The scope of monetary and fiscal stimulus that was put in place in 2009 cannot be sustained. It remains to be seen how much of it is withdrawn, and what effect that will have on markets and the economy. Our sense is that markets will suffer when the government begins to withdraw stimulus, because underlying economic conditions remain fragile. Alternatively, if the government attempts to maintain the level of fiscal and monetary stimulus now in place, inflation fears will escalate and markets will be threatened by much higher levels of interest rates.

Earlier in the rally, investors were compensated adequately for bearing the above-average risks of the present environment, because stocks and bonds were attractively valued. Now, after the huge rallies that have occurred, valuations are no longer attractive in an absolute sense, only relative to abnormally low short-term interest rates.

What are some indicators to watch for signs that the bull is exhausted? On the technical front, we would expect to see deterioration in market breadth and a breakdown in relative strength in leadership groups like technology and emerging markets stocks. Investor sentiment, which moves in the direction of prices, has recently moved towards a bullish extreme, but there is room for positive sentiment, especially among individual investors, to increase further. The narrowing of credit spreads has been a very bullish indicator for the stock market, and spreads are currently at 52-week lows. We would expect rising credit spreads to serve as an early warning mechanism for weakening economic conditions, renewed stress in the banking system and debt markets, and a reduction in investor risk appetite (all of which would clearly be negative for stock prices). A rise in the 10-year Treasury yield above 4.25%, which would violate a key resistance level in yields (see chart below), would be a significant negative for housing and the stock market.

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