As the first month ends in what long-only investors hope will be a better year than 2008, there's only one certainty: the global financial crisis is catching up to Australia.
Economic growth is weakening, exports are tumbling, corporate and consumer confidence is sliding and unemployment is on the rise.
Businesses, particularly in resource-rich Western Australia are becoming concerned not about their nearby states, but offshore neighbours, China.
Gross domestic product (GDP) in the world's third-largest economy increased by 9 per cent in 2008, according to the National Bureau of Statistics of China.
That's the weakest figure since 2001 and the slowdown has been felt by mining giants BHP Billiton, Rio Tinto and OZ Minerals, with the companies deciding to cut more than 20,000 jobs across the firms and trim capital expenditure.
At the time this feature article was written, the All Ordinaries (All Ords) Index was over 50 per cent below the record 6873 points set on 1 November, 2007 as investors' priced in expectations of lower corporate profits.
Some of the tough questions that may need to be asked as the market welcomes February 2009 are:
- Is it time to buy equities?
- Will earnings and dividend cuts be worse than expected?
- What's the true strength of our banking system?
- Will 2008's hyped up investment themes like coal seam gas and gold live up to expectations this year?
- What's the outlook for former market darlings Macquarie Group and Rio Tinto?
For advisory businesses that build multi-manager fund portfolios, the challenge will be sifting through the horde of Australian equities managers and determine who will be able to generate alpha in 2009.
"Given few managers generated alpha in 2008, the pressure will be on to show that at this stage of the cycle, their value proposition of superior stock picking and security allocation will yield results better than benchmark," Matrix Planning Solutions managing director Rick Di Cristoforo says.
"I am expecting them (all managers both multi and single sector managers) to manage their portfolios in a way that represents how they've marketed and described their portfolio in their PDS and in any meetings they've had with us.
"I expect them to deeply analyse the economic and market situation, cut through the noise and invest in asset classes and securities which will provide sustainable performance above benchmark."
Matrix is likely to have a higher weighting towards large cap, quality company equity portfolios that don't have high relative debt and generate their dividends from free cash flow, Cristoforo says.
Business risk of the fund managers themselves will also be a key point to consider, Cristoforo says.
"Clearly we will be less likely to approve products that have any longevity risk of their business in Australia and, for example, where the portfolio managers do not have a clear alignment of interests with investors," he says.
"We need to know our chosen fund managers will be there in both good times and challenging times."
It is likely the group will be underweight towards small cap managers in 2009, mainly because small companies have increased financial risk, lower balance sheet strength and a tendency to rely on debt for growth, Cristoforo says.
For stock-picking advisory firms, the main challenge will be to create a portfolio poised to take advantage of any imminent stock market rally while prices are depressed, without taking on big risks.
Clients won't be happy if they're overweight in cash if history repeats itself like in November 1980 to July 1982, when the All Ords tumbled 40.6 per cent and then soared 38.7 per cent in the following 12 months.
They also won't be happy if the index drops to 2700 in the medium-term, as Incredible Charts founder and technical analyst Colin Twiggs tips.
Hence, AMP Capital Investors chief economist Shane Oliver, who helps manage $101 billion of assets, says investors should be cautious in the short-term.
"I think the first-half of the year is going to remain fairly volatile and it's quite conceivable we might see a retest of the lows and see new lows," Oliver says. Credit markets will remain tough, highly leveraged companies will remain under pressure to reduce debt and Australia will inevitably fall into recession.
But shares may rally in the second-half in response to global fiscal stimulus action and increasing evidence of worldwide economic recovery as equities are good value, Oliver says.
The All Ords may advance to 4500 points by year end, with 2008's underperforming sectors including financials, industrials and materials beating last year's outperformers like telecommunications, consumer staples and healthcare.
"I think risk appetite will generally return as the year progresses . and that will drive up the sectors that were sold down most heavily in 2008," Oliver says.
The resources boom will return because the Chinese industrialisation story hasn't ended and global miners have cut back on so many projects that once growth picks up, supply will again struggle to meet demand, he says.
Oliver expects oil, which hit a record US$147.27 last year, to average at US$45 in 2009.
But make no mistake. There will be dangers for investors, with the best advice to keep their eyes peeled for warning signs.
It's possible another major corporate failure, big bank collapse or even the bankruptcy of US carmakers General Motors, Ford and Chrysler - who are said to affect three million jobs - may occur, adversely impacting the economy, confidence and stocks in Australia.
Such a scenario is something Griffin Financial Services principal Ray Griffin believes offers much concern.
"I just remain very vigilant," Griffin says.
His clients have been sitting on up 20 per cent and some even 100 per cent cash amid the financial crisis. That's up from around 5 per cent to 10 per cent when times were good for long investors.
"There is enough negative data in the economic pipeline that is yet to emerge and be brought to account that makes me somewhat concerned," Griffin says.
"The most prominent missing ingredient I should say is confidence at both consumer and business level."
Griffin says his focus on 2009 is constructing a portfolio which generates competitive rates of income without extraordinary levels of risk for his mainly retired clients.
"If you look at portfolio construction now, there is not going to be a great deal of capital growth for quite some time. The challenge is: Where do we get our income from?" Griffin says.
With interest rates falling and investors expecting corporate earnings and dividends to drop, financial planners and dealer groups will have a difficult task in picking the right stocks or balance of funds.
The Big Four, who at current stock prices yield more than 9 per cent look attractive, he says. However, he is cautious of higher unemployment and corporate collapses flowing through as bad debts for lenders.
"There are still things being triggered in the economy that are yet to bubble to the surface," Griffin says.
"On that basis we're happy to sit with more cash than we ordinarily would.
"The challenge is when do we move the cash weightings back into the longer-term assets?
"We're not trying to get this spot-on . we expect that in the second-quarter we will have started to see enough momentum in the economy to see where we place that extra cash."
Another difficult asset allocation question for 2009 is what percentage of clients' money should be fed to Australian equities? Numerous commentators have argued that international stocks deserve a higher-than-usual allocation on theories including expectations of surging Chinese economic growth to a possible 75 per cent rally for the US Dow Jones Industrial Average.
"It's a real challenge" Griffin says.
His clients generally have 35 per cent allocated in direct Australian stock holdings and 10 per cent towards international share funds.
"I have to say that subject to actual earnings Australian shares remain attractive at the moment and for the next few years but someone would have to work really hard to convince me that now is the time to go heavy in international shares," he says.
"The macro conditions just don't support it."
Financial advisers may have a long time to plan this out though, according to Griffin.
"The world may take a decade to get over what happened in 2008, there isn't going to be spectacular capital growth around for quite some time," he says.
One person who's very patient when it comes to portfolio construction is Wollongong-based Bailey Robert Group's (BRG) investment analyst Leith Thomas.
As major coal, oil and mining stocks soared to records in the first-half of 2008, Thomas urged BRG's financial planners not to be suckered into the rally and instead, buy after a correction.
Coal players including Macarthur Coal and Gloucester Coal are now only worth a quarter of their July 2008 records, while energy companies like Woodside Petroleum and Australian Worldwide Exploration halved by year end.
"Six to 12 months ago, our valuations showed Woodside Petroleum and BHP Billiton to be overvalued, at a time when many others where buying them" Thomas says.
"Being patient allowed us to preserve client's capital by investing in cash and then taking positions at prices 50 per cent below these highs".
Given the high demands placed on the energy sector from factors such as the high world population growth rates, exposure to oil, coal and liquefied natural gas are a logical long-term play.
Among other reasons, Thomas also prefers BHP Billiton over Rio Tinto as its debt-to-equity ratio is 33.1 per cent, compared with 189 per cent gearing for Rio.
Coal seam gas players, particularly Arrow Energy and Origin Energy, sparked massive interest from investors last year but our valuations suggest that their prices are currently above intrinsic values, he says.
"I think the long-term demand is definitely there," Thomas says. "I think it's a matter now if they can get it out of the ground viably and on-sell it to the refineries or to the end users," Thomas says.
The problem now with the sector is that there aren't many choices. Arrow trades on a lofty price-to-earnings ratio of around 40 and doesn't pay dividends, while Origin is trades around 24, nearly triple that of the All Ords.
Other players including Queensland Gas and Sunshine Gas have also been gobbled up by larger predators.
Like Griffin Financial Service's Ray Griffin, Thomas says Australian shares are more attractive than international counterparts.
"There's a lot of uncertainty internationally because there are so many more variables to consider so we think there's better opportunity in the Australian equity space," Thomas says.
BRG clients have 80 per cent of their holdings diversified through Australian equities, cash and fixed-interest. Clients normally have an international equities' allocation of 20 per cent, but currently it's at 7 per cent (with the rest in cash) which has been the case since November 2007.
"I think it's going to be a very long time before we get back to levels we saw in October 2007," Thomas says. "History shows there has always been some sort of a bounce. A pretty accurate forecast might be that the All Ords rallies to the high-3000s to low-4000s in the next 12 months but I can't see things taking off rapidly."
Perpetual senior portfolio manager Matt Williams, who heads the $3 billion Perpetual Wholesale Industrial Fund, agrees that there won't be a rapid turnaround in the market and there's time to plan out a good investment strategy.
"I think the factors that saw the end of 2008 will remain for this year, the biggest factor is availability of credit and credit market dislocation."
There are positive signs for local banks though, according to Williams.
Banks are lending to each other as funding costs ease following the Australian Government's move to guarantee all bank deposits for the next three years and all term wholesale funding.
The dividend yield is higher than the 10-year bond yield for the first time since the early 70s, but the market hasn't seen earnings downgrades and dividend cuts yet.
Still, valuations have eased and dividends are likely to remain attractive even if companies were to trim them. "Taking a medium-term perspective, you'd be more a buyer than a seller of the market," Williams says.
In regards to stock picking, the stocks he likes are stocks Perpetual's Wholesale Industrial Fund didn't own during the bull run of 2003 to 2007 due to their high price.
"ASX 12 months ago was $60. Today its $30," Williams says.
"This has brought it right back into our buying zone and it's one we've become a substantial shareholder in the last six months at around the $30 mark.
"Computershare would be another one and Brambles. Brambles this time last year was $14 and now it's under $7, so this sell-off is providing opportunities in companies that we previously hadn't owned because of valuation grounds."
Perpetual's Wholesale Industrial Fund dropped 36.79 in 2008, outperforming the benchmark S&P/ASX 200 Accumulation Index's 38.44 decline.
Williams continues to favour communication giant Telstra Corporation, the fund's largest holding.
"Telstra we felt was a solid defensive play to be in the last 12 months and it's certainly proven that until the misstep with the broadband network tender," he says.
The stock still outperformed the index and the business is in a much better shape than before Sol Trujillo led the company.
"They've taken big steps with the transformation project, the benefits of which we are yet to see," Williams says.
"Going forward, it's a pretty solid investment not withstanding the regulatory situation."
Despite being of attractive value, it's hard to say if Telstra's stock price can get back up to its tech-bubble price of around $10 in the medium-term.
He expects investment bank Macquarie Group will be dealing with a very difficult operating environment due to the credit crunch and falling asset prices.
"It's outperformed its global peers, a lot of them who have been major casualties of this credit crisis," Williams says.
"But not withstanding that, the fact is that its shares were almost $100 in 2007, and is now around $20 because a couple of its principal ways of making money, for example securitisation of assets is finished for the foreseeable future.
"So it makes their outlook quite difficult." The fund owns stock of the Big Four banks but favours Westpac Banking Corporation the most at 8.59 per cent of fund's assets.
"It's been more on the conservative side. It's best place to deal with the economic slowdown," Williams says.
"Overall in the Wholesale Industrial Fund, we're underweight the banks as we move into this period where we'll see what kind of bad and doubtful debt cycle we'll experience."
Lenders may potentially raise more capital, after the over $8 billion they already raised in the final quarter of 2008, Williams says.
Although that may dilute share prices, it's important to remember that Australian banks aren't sitting on piles of toxic debt currently battering European and US banks.
"From a global point of view, the Big Four are in a much stronger position going into this downturn," Williams says.
Despite the All Ordinaries well off its highs and trading on a price-to-earnings ratio of around 7.8, it's too hard to say whether the market as a whole has seen its lows, according to Williams.
Aviva Investors senior investment manager Richard Dixon, who leads the firm's $923 million High Growth Shares Fund, says the market probably hasn't hit the bottom yet, but volatility is likely to have peaked.
"I think what we might have seen the back of is the forced panic-selling in the last quarter from the Lehman Brothers failure and the risk that created to the financial system," Dixon says.
"Partly tied in all that is the huge redemptions and de-leveraging from the likes of hedge funds and funds in general de-leveraging their positions."
"The S&P/ASX 200 is likely to continue to retest its recent lows in the next six months."
But there's value in the market depending on how long investors' choose to keep their money in stocks.
"If you're looking on a one-year view, value is okay to good, whereas it's probably great on a three year view," Dixon says.
"There are a lot of stocks that are looking cheap on a valuation basis including price-to-earnings and dividend yields. But the problem is that those are subject to change."
Quasi-retailer Wesfarmers has already cut its dividend and gone to the market for a $2.8 billion capital raising on January 22, on top of the $2.5 billion it already raised last April.
Wesfarmers needs the funds to repay debt obtained from its $18.2 billion purchase of Coles in 2007.
Rio Tinto, the world's third-biggest miner, backed away from its plans to increase dividends by 20 per cent per year and flagged the sale of some of its crown jewels to repay loans from its $58 billion purchase of Canadian aluminium giant Alcan.
"Clearly both companies have large debt hanging from their respective large acquisition of Coles and Alcan," Dixon says.
"Anyone that's made acquisitions in the last two, three, four years that were debt funded are in tricky situations. The timing of those two companies was quite unfortunate; it was nearly the top of the asset price cycle."
Aviva Investors' High Growth Shares Fund has around 8 per cent of its money between Rio and Wesfarmers. The fund lost 32.83 per cent in 2008, beating the benchmark S&P/ASX 200 Accumulation Index by 561 basis points.
Dixon is confident in the companies in the long run and is continuing to favour the portfolio's top holdings including Origin, pharmaceuticals firm CSL and gold miner Newcrest Mining.
"Origin has been a huge performer for us last year," he says.
The stock, which the Aviva Investors fund has held since the Boral de-merger, rallied nearly 80 per cent in 2008 even after BG Group plc failed in a hostile takeover attempt for the company. "We really backed management under Grant King to crystallise the value in the company's coal seam methane portfolio. They delivered with a $10 billion transaction with ConocoPhillips (including $6 billion cash in the door) for a per cent stake in those assets," Dixon says.
The stock is still undervalued, he says.
Dixon is also bullish on CSL if it can complete its $3.5 billion transaction of North Carolina rival Talecris Biotherapeutics.
"It'll add huge synergies and is likely to be very accretive to their earnings and to the valuation of the stock," he says.
Even if CSL needs to make concessions or the deal is blocked by US regulators, the company has already raised the equity to further strengthen its balance sheet.
Newcrest Mining has become a simpler business and its unfavourable hedging has been removed under chief executive Ian Smith, Dixon says.
Some gold exposure will be essential to a portfolio as a safe haven especially with the US running its printing presses at "full tilt".
This will eventually weigh on the Greenback, favouring gold, he says.
"Newcrest is the most diversified, highest quality gold stock by a huge margin in the Australian market and possibly globally. We're bullish on it with a longer-term view," Dixon says.
Aviva Investors High Growth Shares Fund winners of calendar year 2008 included overweight positions in Newcrest and Origin, along with an overweight position in Telstra.
Goodman Group and Babcock and Brown proved to be winners on the short side in 2008, following on from large gains generated by the demise of failed Centro Group in 2007.
