Managed futures programs – alternative-investment vehicles that enabled professional money managers to take positions in a wide variety of securities and derivatives – posted strong returns in a year that was marked mostly by investment losses. The average managed futures program returned about 14%, according to the Barclay CTA Index, and 11.4% as measured by the Stark 300 Traders Index.  By comparison, theStandard & Poor’s 500 Index and the tech-laden Nasdaq Composite Index each plummeted nearly 40% in 2008, while the Dow Jones Industrial Average nose-dived 33.8%.

Computer-Based Trading

Managed futures funds are managed by commodity-trading advisors, or CTAs, who monitor and trade in up to 150 to 200 different futures markets that run the gamut, including such asset classes as:

• Stocks.
• Fixed-income investments.
• Currencies.
• Agricultural products (commodities).
• Metals.
• Energy products (including – but not limited to – crude oil).

The positions the traders take can either be “long” (buy the underlying asset) or “short” (sell the underlying asset), based on expectations of future price movements.  These managers often employ “leverage” – using borrowed funds to buy on margin – which allows them to maintain larger positions in the underlying assets than they otherwise would be able to if they paid upfront in full. Buying on margin is a tactic that can dramatically increase returns when the manager has made the correct market call, but which likewise magnifies the losses when the investment manager is wrong

CTAs typically trade managed futures using a systematic investment process based on the pricing trends of the underlying markets.  Most traders do not consider overall market fundamentals. Nor do they study reports that depict the latest statistics on the global markets or the supply-and-demand dynamics for the various commodities. Instead, they use computer-based algorithms to create models that detect pricing trends and look solely at technical factors behind the numbers.

Linus Nilsson is a senior analyst within the Managed Futures Team atMan Investments (OTC ADR: MNGPY), a global “fund-of-funds” manager that allocates about $2 billion to externally managed futures funds. Nilsson points out that virtually all underlying manager trades are directional in nature using an unbiased strategy and says that CTAs are just as likely to be short as long in any given market.

“The computer-driven model tells them what to trade, when to trade, which side to trade, and when to get out of those positions,” Nilsson said. “Managers look at technical price trends, rather than fundamentals, and then manage the risk around those trends.  Everything is price-based and we generally focus very little on macro issues.”

According to Nilsson, managed futures perform very well during prolonged crisis situations, though high volatility is not imperative for trends to be established and profitable trades to exist.

“As long as you have trends that are exploitable, managed futures funds will make money,” said Nilsson.  “Looking at the equity markets from 2002 to 2006, basically we had a very smooth non-volatile trend and CTAs were able to take advantage.  Likewise, crude [oil] rose from 2006 to mid-2008, a nice trend that saw prices continue to print new highs all the time.”

By contrast, Nilsson claims that managed futures funds also benefited from the dramatic reversal in the prices of energy and other commodities over the second half of 2008.

“After a little pain, CTA models recognized the shift in prices, realigned fund allocations, and went short to the end of the year to take advantage of the new trends. It was a beautiful environment for managed futures.”

Paul Wigdor, president of Superfund USA Inc., a public managed futures fund that oversees $1.7 billion in assets apportioned across 18 countries, confirms that his firm’s managed futures product incorporates no fundamental overlay and the traders’ personal views do not influence buying or selling decisions.  They seek price trends in the marketplace and rely on technical factors which suggest whether markets should go up or down.

“We use a fully systematic trading system that is all computer-driven, black box-driven, quant-driven … whatever you want to call it,” Wigdor said. “We don’t care about embargos or what news may be coming out of the Middle East or China.  Our systems look only at price and consider such factors as volatility, resistance and support levels, relative strength indicators, moving averages, and how they all interrelate.”

Wigdor also points out that his firm’s fund has an exit strategy every time a trade is made so the managers are better able to control the risk.

“We put a ‘stop limit’ in each time we take a position,” Wigdor said.  “When a trade moves in our favor, we may ratchet up or down our stops as appropriate.  When the models pick up that the trend has reversed, we get stopped out of trades and losses are limited.”

Removing Emotion From the Investing Equation

Curtis Lyman, managing director of HighTower Advisors LLC, and principal of its West Palm Beach, Fla.-based Alpha Wealth Division, recognizes the need for some trend-following quant-driven modeling as part of his asset-allocation process.  He believes that rules-based computer-driven trading often makes the most sense and is comfortable including managed futures within his clients’ portfolios.

“Frankly, the ‘black box’ is one of the reason we use managed futures,” said Lyman.  “We like the fact that a portion of our portfolios loses the human element altogether and we would be far less comfortable if a manager had the ability to swing from a chandelier and load up on one position or another based on emotions.”

In Lyman’s opinion, quantitative trading allows for a pretty good control of risk, at least for that allocation of the portfolio.

2008: A Study in Stock Market Chaos

For investors who want to gain an understanding of managed futures as an asset class, Superfund’s Wigdor believes that 2008 stands as an effective case study for how managed-futures programs are supposed to work.

“In the first half of the year, we were long commodities across the board – everything from gold, oil, corn, soybeans, wheat, and oats,” Wigdor said.  “We were also long currencies from commodities-oriented countries like Canada and Brazil.  If you remember, money was flying into long-only commodities products and they did very well during the first six months of 2008.”

Wigdor is quick to remind his investors that these positions were established because of the pricing trends of these commodities markets and the computer-driven models did not consider fundamental issues whatsoever.

“In July and August, we experienced a big correction in commodities,” he added.  “Oil plummeted; others markets followed.  Our stops got triggered, though not until we suffered sizable drawdowns, or peak to valley declines.”

Wigdor explains that computer models never try to pick the absolute top or bottom of any market, but are merely trying to capture the majority of the price movements.  He notes that portfolios will always experience some giveback when markets reverse as the models attempt to validate that the trend has ended.  While long-only funds may also recognize the price shifts, they are not set up to take advantage of the reversal.

“There is always going to be some lag time as the models determine if the trend has reversed or this shift just represents noise in the markets,” Wigdor said.  “By October, we reestablished positions and this time were short many of the same commodities markets that we had previously been long.  We continued to be short equities and interest rates and finished the year with returns of 30% and 46% in our two U.S. funds.”

Likewise, Nilsson said that Man Investment’s investors benefited from exposure to managed futures in 2008, since that asset class was one of the few that actually delivered positive value to investors.

“A large number of CTAs did very well in 2008 and managers who were short equities throughout the year, and were fortunate to be long commodities early and shift to short positions late, were greatly rewarded,” Nilsson said.

Investors have seen a number of “false starts” this year, but Nilsson says he sees several promising possible trends and said the fund is slightly short the U.S. dollar and generally short sovereign debt.

A Competitive Comparison

Nilsson also believes that many investors have shied away from managed futures because of the miconception that it’s an especially risky asset class.  In reality, he believes that CTAs are actually better able to control risk, particularly in volatile environments like those experienced last year and in the first part of 2009.

“Dating back to the 80’s,  managed futures actually have similar risk profiles to equities and, at times, they are much more stable,” Nilsson said.  “Plus, they often outperform the more traditional asset classes over time.”

The following chart with data from both Stark & Co. and Bloomberg LLC depicts the risk/reward profiles of both managed futures and U.S. stocks.

Hightower’s Lyman admits that volatility, at times, can be quite high in managed futures funds, though these days, everything is relative, especially given the intense price movements in traditional stocks and bonds over the past year.

“Investors really must look at managed futures from a longer-term perspective of at least five years,” Lyman said.  “You have to give [the programs] time to work.  In fact, during periods of big drawdowns in managed futures, other asset classes are probably doing well because of the non-correlation characteristic.  Bear in mind, the addition of managed futures to a well-balanced portfolio will most likely lower its volatility and enhance its returns over time.”

Not Just for the “Rich and Famous”

Historically, managed futures has been an asset class reserved almost exclusively for institutional players and high-net-worth investors qualify as “accredited investors” – meaning they have an income of several hundred thousand dollars and a net worth of more than $1 million. Lyman believes that certain liquidity issues still prevent many smaller investors from participating.

“While the underlying futures markets are very large and liquid, most of the managed futures products themselves trade in L.P. (limited partnership) structures which often do not provide the daily liquidity that is important for many investors,” Lyman said.  “Instead, participants typically can access their money by selling units on a monthly or quarterly basis, as predefined by the managers of the fund.”

Lyman sees some opportunities for traditional retail investors to diversify into managed futures through mutual funds that may provide daily liquidity, but he does not believe that many of the biggest and best managers will offer access through investment vehicles of that type.

“To get daily liquidity, these managers may have to disclose insight into their trading methodologies,” Lyman said, noting that most managers would be reticent to share such closely guarded proprietary information.  “Through mutual funds, retail has certain tools available to access this asset class, but the products are not exactly the same as those available to accredited investors.”

Superfund’s Wigdor likes the idea that the asset class has been democratized and that more investors now have the opportunity to invest in managed futures.

“What sets us apart from other managed futures firms is that we concentrate on providing greater access to many types of investors.” said Wigdor.  “Right now, we offer monthly liquidity with no holding periods, no lockups, no short-term redemption fees.  We continue to work on making this alternative investment more mainstream and therefore available to previously uptapped markets.”

And given the recent risk-adjusted performance relative to more traditional asset classes, greater access may be a pretty good thing.

Source: Managed Futures Programs – Once Restricted to the Wealthy – Are Going Mainstream

[Editor’s Note: This is Part II of a two-part story.  To read Part I, which appeared yesterday (Thursday), please click here.]

Managed futures programs – alternative-investment vehicles that enabled professional money managers to take positions in a wide variety of securities and derivatives – posted strong returns in a year that was marked mostly by investment losses. The average managed futures program returned about 14%, according to the Barclay CTA Index, and 11.4% as measured by the Stark 300 Traders Index.  By comparison, theStandard & Poor’s 500 Index and the tech-laden Nasdaq Composite Index each plummeted nearly 40% in 2008, while the Dow Jones Industrial Average nosedived 33.8%.

“Managed futures funds like drama and volatility, so 2008 was a banner year,” said Curtis Lyman, managing director of HighTower Advisors LLCand principal of its West Palm Beach, Fla.-based Alpha Wealth Division.  “While I don’t know what is going to happen tomorrow, some of the major dislocations in the marketplace still exist, which could offer the potential for a good environment for this strategy moving forward.”

While investors who participated in managed futures programs reaped significant performance benefits both on an absolute and relative basis last year, many retail investors and even some institutional players are still unaware of this product and the characteristics that contributed to the lofty returns.  And while the entire asset class still only holds about $225 billion, according to Barclay Trading Group (NYSE ADR: BCS), it has grown significantly over the past two decades as investors learn about its performance history and strong diversification features.

“Managed futures, as an asset class, is still relatively unknown,” said Paul Wigdor, president of Superfund USA Inc., a public managed futures fund that oversees $1.7 billion in assets apportioned across 18 countries.  “We are trying to build this asset class  by educating advisors, investors, and the media about this product.  We are not trying to replace the more traditional asset classes, but merely to educate people about the need to diversify beyond just stocks and bonds.”

The Lowdown on Managed Futures

Before making an investment in a managed futures account, an investor must first develop some insights on the overallfutures market. Afutures contract is considered a derivativeinstrument, whose value is determined by the movement of the underlying asset or market. The contract represents an agreement to buy or sell an underlying asset at a predetermined price and date in the future.

Managed futures funds are managed by commodity-trading advisors, or CTAs, who monitor and trade in up to 150 to 200 different futures markets that range from equities to fixed income to currencies to agricultural products to energy to metals.  The positions can either be “long” (buy the underlying asset) or “short” (sell the underlying asset) based on expectations of future price movements.  These managers often employ “leverage” – using borrowed funds to buy on margin – which allows them to maintain larger positions in the underlying assets than they otherwise would be able to if they paid upfront in full. Buying on margin is a tactic that can dramatically increase returns when the manager has made the correct market call, but which likewise magnifies the losses when the investment manager is wrong.

CTAs typically charge investors management fees in the range of 1.5% to 2%, and may also earn incentive fees of 20% to 25% on any new profits generated by the managed-futures fund.  While some investors may claim that such fees seem excessive, performance is always quoted on a “net of fees” (after fees have been paid) basis, so the returns these funds generate can be accurately compared to the gains or losses generated by more-traditional investment vehicles.

Other factors that are important to note:

• The managed-futures industry is highly regulated by the U.S. Commodities Futures Trading Commission (CFTC).
• The future exchanges offer tremendous liquidity,
• And the existence of clearinghouses to guarantee transactions reduces the counterparty risk.

“Our fund is publicly registered and regulated by the SEC and CFTC,” said Superfund’s Wigdor.  “In light of Madoff and other scandals, our clients take great comfort in its transparency.  We file 10-Ks and 10-Qs; our auditor is Deloitte & Touche and our [net asset value] is computed by PNC Bank (NYSE: PNC).”

A Look Back at the Beginning

While managed futures remain an untapped market in many investment circles, the earliest futures market was actally formed in the mid-1800s when the Chicago Board of Trade was established to provide an outlet for Midwest farmers to sell their products to East Coast merchants.  The farmers were able to lock in prices and often hedge their operations against poor weather conditions or other situations that could adversely impact future sales.

In the early days, agricultural-based contracts dominated the futures markets and the first financial futures were not introduced until 1975. Today, more than 70% of all futures transactions are based on financials as their underlying securities, with contracts related to stocks and interest rates among the most frequently traded, according to Man Investments.

The Joys of Non-Correlation

For most investors, the main appeal of a managed futures account is its ability to provide significant diversification to a well-balanced portfolio.  Because the managed-futures asset classes are largely non-correlatedwith stocks and fixed-income products, an allocation can reduce the overall portfolio risk, while offering the potential for yield enhancement, particularly during challenging times for traditional assets like those experienced in 2008.

Hightower’s Lyman agrees that non-correlated assets can be a welcome addition, which is why he incorporates managed futures into portfolios of his more-sophisticated clients.  He believes managed futures play an important role in his clients’ overall risk-adjusted returns.

“The addition of managed futures offers the potential to smooth out portfolio performance because of their low correlation with equities,” Lyman said, noting that he builds client portfolios that are designed to provide consistent returns over time and that are broadly diversified across various asset classes.

Managed-futures assets can be particularly beneficial during some of the stock markets roughest stretches, he said.

“Since we are always looking to reduce volatility through the inclusion of low-correlated asset classes, managed futures represent an investment we need to consider,” said Lyman.  “From a performance standpoint, if you look at the 10 worst months for stocks since 1987, managed futures on average have dramatically outperformed.”

However, it’s important to note that investors use managed futures as only one piece of a well-diversified portfolio. In fact, due to the highly regulated nature of the futures markets, most investors will limit this part of their portfolio to no more than 10% of their total assets. And as the various asset classes rise or fall in value over time, investors will need to periodically rebalance their holdings to make sure that they do not exceed that 10% allocation limit.

Lyman has not experienced any problems working within the regulatory framework and says the portfolios of his most-aggressive clients tend to allocate an average of 5% to 7% of their holdings into managed futures.

Source: Managed Futures Can Put Investors in the Black – Even When Stocks Are Deep in the Red

After all, most mutual funds, exchange-traded funds (ETFs) and managed accounts offer long-only strategies. And why not? After all, the strategy is simple: These portfolio managers buy securities and hope to take advantage of price appreciation.

But the ongoing financial crisis proved those investors wrong – for several reasons. After all, what do you do in a trendless (sideways) market? And what about a declining market?

In either situation, the profit payoff from a purely long portfolio doesn’t figure to be very large. And that’s no surprise. After all, when bear markets arrive – as they periodically do – long-only money managers are typically limited to raising additional cash, or seeking conservative investments with limited downside, meaning the upside potential is also fairly small. And as investors have seen all too often during the current financial crisis, money managers who insist on “fighting the tape” can often generate big losses for their clients.

That’s where long-short investing strategies come into play.

If the markets head up or down, you’re positioned to profit. And given the wild volatility we’ve witnessed in the last year, any investor not playing both sides of the market, simultaneously, quite frankly, deserves it if they drown their portfolio.”

Unfortunately, many investors have learned their lessons the hard way for the past year and a half as virtually all classes have declined in value, resulting in sizable losses within their portfolios.

“This environment has exposed the flaws in traditional asset allocation theory, Capital Asset Pricing Model (CAPM), or whatever label you choose to put on it,” said Tom Samuels, managing partner of Houston-based Palantir Capital Management Ltd. and manager of the Palantir Fund, a global all-cap long-short mutual fund. “While Markowitz (Harry) and Sharpe (William) still have their firm believers, sophisticated investors are realizing that they cannot achieve true diversification merely by being long a variety of asset classes.”

Samuels believes the majority of long-only returns are influenced by the direction of the overall markets and that long-short investing strategies provide one of the few ways to achieve true portfolio diversification and risk control.

“Long-short represents the only asset class that can effectively handle both sideways and bear markets,” Samuels said. “The asset class allows investors an opportunity to systematically approach the markets and individual risk parameters differently than being long-only.”

The Long and the Short of a Newly Popular Investing Strategy

A long-short money manager has the ability to both buy and sell stocks to help reduce risk during such less-than-optimal investment environments as a trendless market or even a bear market.

The long-short strategy often serves as a hedge from overly bearish markets by allowing investors to take advantage of upside potential (long positions), while also benefiting from downward movements of certain investments (short positions). In choppy markets – like those of today – the strategy can help investors book some gains as they focus more on capital preservation, and not simply appreciation.

In reality, investors should consider incorporating some form of a long-short approach as part of the overall asset allocation of their portfolios, experts say.

Brian Lipton, founder of Gaithersburg, Md.-based YellowWood Financial Advisors Inc., seeks out investments that are not correlated with traditional stocks and bonds. Lipton views long-short investment products as another piece to the portfolio construction puzzle, and has incorporated hedged equity mutual funds as part of a tactical allocation – a way of reducing exposure to the risk of a long-only securities position.

“We realized long ago that we cannot ‘time’ the markets,” said Lipton. “We typically allocate about 20% to 30% of our equity portfolios in a tactical manner. Hedged equity represents a part of that allocation that helps satisfy certain risk elements and, of course, allocations that reduce long-only exposure in this environment have been beneficial. We have found that hedged mutual funds have been a very good choice during periods of intense volatility and could work well during other times as well.

Lipton’s firm uses one fund that goes long on favored positions, short on out-of-favor positions, and another fund that buys equities and hedges them with short positions on various indexes.

“While the latter fund is 100% hedged today, that percentage could change based on their views of the market environment,” Lipton said. “Security selection is still important.”

Hedging Plays: Make Macro Calls, Dodge Market Falls

At Palantir, Samuels looks for opportunities to hedge long positions, while also seeking profits on the short side. In managing his long-short fund, Samuels will make macro calls on the markets and the economy, micro calls on companies he believes to be either under- or overvalued, and also employs market-neutral arbitrage trades by pairing long and short positions in similar securities.

“Right now, we are short the dollar by owning the [PowerShares DB U.S. Dollar Bearish Fund (UDN)], an unlevered ETF that inversely mimics the movements of the U.S. currency,” said Samuels. “That position represents a macro call against the dollar and the ETF shot up dramatically when the Fed announced its intent to aggressively buy Treasuries to lower rates. Additionally, we believe this short trade provides nice cover as some domestic companies may struggle relative to their international counterparts.”

Samuels’ fund is also betting against U.S. Treasuries through short positions in an ETF that tracks long-term government securities.

“Historically, central banks have had mixed records of holding rates down, particularly when their currencies begin to fade,” Samuels said. “Shorting Treasuries provides an opportunity to make money on that macro call, while also serving as a hedge against certain long industrial and consumer-related domestic equities that may struggle in a rising interest rate environment.”

Dave Walker, YellowWood’s director of operations, points out that his firm has begun using a long-short commodities-based fund as a way of employing this non-traditional investment strategy.

“We have been allocating a portion of certain clients’ portfolios into long-only commodities funds for years, but gains and losses have recently come so fast and furious that we chose to move into a hedged product,” Walker said. “We realize we cannot time these markets on a daily basis by investing long or short. But based upon the trends in the global economy and surrounding specific categories of commodities, a hedged commodities fund allows us to participate in this alternative asset with lower risk and volatility. We will trail indices when there is a quick rebound but, more importantly, we expect to curb the downside.”

Market Neutral Pairs

Palantir’s Samuels explains the pairs trading concept through a hypothetical example.

“The market-neutral pair trades entail buying a company in a high-quality security as measured by free cash flow (FCF), low debt, and [solid] profitability, and simultaneously selling a security in the same sector that we perceive to be [of a] lower quality based on these same parameters,” Samuels said. “Let’s say, we liked Intel (INTC) because of where the company is in its product cycle, its low debt position, and its positive cash flow. Conversely, we recognized that [Advanced Micro Devices (AMD)] maintains considerable debt and its last product introduction was under whelming. In this example, we may choose to go long Intel and short AMD.”

Samuels then discusses an environment that has the overall equity market declining by 30%, with Intel and AMD dropping 25% and 35% respectively.

“A properly executed paired trade would have returned 10% to the investor, even as the stock market as a whole lost 30%,” said Samuels. “The long-short manager then has the opportunity to unwind the arbitrage, but only one side at a time, if desired. We may believe AMD is more fairly valued after a drop of 35% and choose to cover our short, while still owning Intel, a high-quality stock that could appreciate should the market rebound. The long-short approach provides us significant flexibility, while the long-only manager has to identify high-quality stocks and then hope that the overall market direction cooperates.”

Client Interaction

YellowWood’s Lipton had not seen sheer panic from his clients – at least not before the Dow Jones Industrial Average recently fell below the 7,000 level.

“For the most part, our clients understand their allocations and we received very few distress calls,” said Lipton. “Nevertheless, we know the concern is there. When the Dow broke below 7,000, some became worried about further significant slides without any apparent market support. We spoke with them more about increasing the hedged positions and they were happy to control the downside better, while giving up a bit of appreciation potential. They were very interested in such investments, particularly given the uncertain environment we are in.”

And these days, a little peace of mind can go a long way.

[Editor's Note: Ron Brounes, CPA, is a regular contributor to Money Morning. A technical financial writer, Brounes, is president of Brounes & Associates, a Houston, Tex.-based consulting firm that provides writing, communications, and educational services for financial services professionals. Back in March, Brounes wrote about how the Obama stimulus package would affect your income taxes.]

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Source: How Long-Short Investing Can Lead to Profits in Today’s Uncertain Markets

[This is the eighth installment of a new series that looks at ways for investors to recover from the U.S. financial crisis. To check out the archive of previous stories in the series, just click here.]

For instance, a 5% to 6% contraction in first quarter gross domestic product (GDP) will look decent vs. the wrenching 6.3% decline the U.S. economy experienced in the fourth quarter. Mix in some still weak – but improving – corporate earnings season and there may be reason to hope that U.S. President Barack Obama’s prediction of an economic rebound in 2010 may not be off target after all.

Eddie Cohen, a market historian who is chief investment officer for Stavis & Cohen Financial, a Houston-Texas financial-management firm, points out that the U.S. stock market has endured three protracted bear markets since 1900 (1906-1921, 1929-1942 and 1966-1982) and sees evidence that the United States may be ensconced on one of those periods again.

While Cohen sees some positive indicators, he continues to advise that caution (or even cautious optimism) be the order of the day.

“Plenty of questions still need to be answered before we can proclaim an end to the bearishness and a definitive market recovery,” Cohen said. “At least, we have started to see some rays of sunshine on the horizon, and that is encouraging.  Still, this environment is not the time to be a hero.”

But there are three significant wildcards at play here that could keep the market from sinking into an even deeper malaise – and that could, in fact, be a catalyst for higher stock prices and perhaps even an improved economy in the months to come. Those three wildcards include:

• There’s an estimated $4 trillion in cash in investors’ hands on the sidelines – capital that could be drawn in to further pump up the markets, should the recent rally continue.
• The federal government has already committed to funding $11.6 trillion in stimulus initiatives, and the sheer magnitude of that government intervention could play a substantial role in determining just how long this downturn lasts – or how quickly it ends.
• Stocks are, in many cases, currently trading at levels not seen since the late 1990s, meaning the market is dangling bargains too enticing to ignore.

Cohen believes that investors need to remain cautious and to understand that market sentiment can literally turn on a dime, especially if the volatility levels remain high [there's some evidence that volatility has diminished somewhat in the past week, and is currently below what is usually expected for the start of the corporate earnings cycle]. However, the Texas investment advisor also foresees some potentially positive developments on the horizon and believes that patient long-term investors who are willing to ride out the short-term volatility may want to commit some money to stocks in profit from these low valuations.

Given that there is “an estimated $4 trillion in cash on the sidelines right now … as investors become more confident, some of these funds could potentially find their way into equities and help drive the markets higher,” Cohen said.

The Quarter That Was

When 2008 came to a close, investors hoped the nightmare had ended and some normalcy would return to the economy and the markets. It was not to be. During the first three months of the New Year, a $787 billion stimulus package, multiple blueprints for rescuing the nation’s banking system and a honeymoon period for a new presidential administration that was one of the shortest in U.S. history made it very clear that the nation’s economic nightmare was continuing.

Much of the data portrayed an economy in decline despite the promises by U.S. Federal Reserve Chairman Ben S. Bernanke’s that better times were coming. The U.S. Commerce Department initially reported that fourth-quarter GDP was down 3.8%, its worst showing in 27 years, though not as bad as many economists had projected. A few months later, however, Commerce Department analysts revised that statistic downward to 6.3% and confirmed that the recession had worsened.

Jobless statistics became the barometer for the nation’s declining economic health, as company after company announced major cutbacks. On Jan. 26 – in a single day so bad that it was labeled as “Black Monday” – about 75,000 jobs were eliminated ad the likes of Caterpillar Inc. (CAT), Sprint Nextel Corp. (S), Home Depot Inc. (HD), Texas Instruments Inc. (TXN), General Motors and others announced major job cuts. Even before that dark Monday, there had already been 170,000 job cuts announced that month – and that’s after a 2008 that saw the recession claim 2.6 million jobs.

“Some of the worst job losses are ahead of us, not behind us,” Wells Fargo & Co. (WFC) senior economist Scott Anderson told USA Today at the time.

One-time global giant Citigroup Inc. (C) fell briefly into penny stock territory and came within a heartbeat of nationalization as the U.S. government finally opted to inject more money into the former financial-sector stalwart. A late-quarter restructuring plan seemed to better position Citi.

Nor did the trouble stop with the banks. Two of the U.S. Big Three automakers – General Motors Corp. (GM) and Chrysler LLC – moved closer to bankruptcy as the government rejected the American carmakers’ plans for reorganizing. Indeed, the Obama administration even “suggested” GM’s CEO pursue other endeavors, and laid down serious guidelines regarding future intervention. Even so, bankruptcy may be unavoidable.

But then a funny thing happened on the way to Great Depression II. Citi, Bank of America Corp. (BAC) and JPMorgan Chase & Co. (JPM) each announced promising results for the first two months of the year, surprising investors and igniting a late-quarter stock market rally. In an interesting parallel development, a “surprise” announcement by Wells Fargo & Co. (WFC) last week added fuel to that already-existing rally in financial-sector stocks, and in the market in general.

Some confidence returned to the boardroom – at least within the healthcare sector – as major deals involving Merck & Co. Inc. (MRK) and Schering-Plough Corp. (SGP) ($41.1 billion) and Roche Holding AG (ADR: RHHBY) and Genentech Inc. (DNA) ($46.8 billion) moved forward.

Electronics retailing giant Best Buy Co. Inc. (BBY) reported better-than-expected profits as consumer activity suddenly picked up (at least, above the dismal levels of the fourth quarter). The credit markets began to thaw a bit as corporations issued new debt and the U.S. Federal Reserve offered up a plan to buy U.S. Treasuries as a way of keeping interest rates low.

Though the Dow Jones Industrial Average declined 13.3% for the quarter, March was its best-performing month since October 2002. The tech-heavy Nasdaq Composite Index declined 3.07%, but enjoyed a March that was actually its best month ever. The Standard & Poor’s 500 Index declined 11.67%.

Some of the late-quarter economic reports seem to reflect this brighter outlook. In manufacturing, for instance, factories continued to struggle as industrial production fell to the lowest level in almost seven years, though a favorable durable goods report offered some optimism as the first quarter came to a close.

Home sales likewise offered some cause for optimism, rising in February as buyers took advantage of low rates and a tax-break for first-time homeowners. Retail sales statistics were a bit better than expected – especially after removing dismal auto sales from the mix. And inflation – a much-feared foe with the level of government spending that’s taking place – remained well under control, even as talk of deflation also seemed to subside.

Stocks continued their strong run, even after the quarter closed. Since then, in fact, the Dow has rallied 6%, the S&P 8% and the Nasdaq 8%.

Sound Strategies to Follow No Matter Which Way the Market Moves

Nat Levy, a principal with Houston-based McNeil, Levy & Friedman LP, is a five-decade veteran of the financial-services sector, and has seen his share of uncertainty. In the near term, it rarely pays to prognosticate – so he doesn’t.

“I am unable to predict short-term market or economic movements and don’t know of anyone who can do more than guess at this,” Levy says.

Even so, at a time when many investors are talking about “new rules,” or “new realities,” Levy says it pays to stay the course.

The one prediction he will offer is that some investors will look back on miscues they made today with more than a little regret.

“Right now, we find ourselves in one of those “if only I had…’ periods,” said Levy.  “My one educated guess is that in five years from now we’ll look back and think “If only I had invested in this; if only I had remained invested in that, etc.’.”

Stavis & Cohen Financial’s Cohen points to the usual suspects like automakers and banks as industries that continue to face considerable challenges in the periods ahead.  While he sees signs of renewed housing activity in terms of new and existing home sales, he acknowledges that prices continue to fall each month, foreclosures are increasing, and the newly laid-off workers could exacerbate those trends.

Cohen – like Money Morning – believes that commercial real estate may be the next shoe to drop; vacancies are increasing, rents are under pressure, and banks may not be willing to loan large sums of money to related companies looking to refinance.

Because inflation could become a problem, Cohen says investors should have some exposure to gold in today’s environment.

“The unprecedented level of government intervention has added significant liquidity to the marketplace, but, ultimately may lead to higher levels of inflation,” he said. “Gold can serve as a potential hedge against such price pressures.  Additionally, as the country’s debt and deficit positions mount, the dollar could remain under pressure and gold can be viewed as an insurance policy against a weak currency and the uncertain times faced today and in the future.”

Cohen states that investors can invest in gold directly by purchasing bullion or through funds or exchange-traded funds – one being the SPDR Gold Shares exchange-traded fund, or ETF, (GLD) that track the price movements of the so-called “yellow metal.” His firm uses a manager who buys bullions and stores it in a vault, which he says gives his firm’s clients the opportunity to access a product whose price moves more in lockstep with the market price of gold, and is even more cost effective than gold funds or ETFs.

In terms of stocks, Cohen believes investors should consider small-cap shares.

“Historically, coming out of recessionary times, small-caps are among the best performing equity asset classes,” he says. “Granted, many of these companies may have struggled during the dire economic times as investors shun anything other than industry leaders. Now may represent a decent time for cautiously optimistic investors to again look at small-cap companies, particularly when combined with some exposure to gold as a hedge against renewed downside pressures on stocks.”

Cohen recognizes that the newly enacted government programs could prove helpful in jump-starting the U.S. economy – which should enable the recent upward move in stock prices to continue. In particular, he sees some successes in the Fed’s attempts to get corporations and municipalities borrowing again.

“The credit markets definitely are showing signs of life,” said Cohen. “In the first quarter, domestic companies issued over $350 billion in new investment-grade paper and interest rate spreads between [corporate bonds] and Treasuries are coming down. Likewise, according to Lipper, investment-grade [municipal bonds] were up 4% to 5% in the first quarter and investor demand for such offerings seems to be on the rise. In fact, the state of California moved up a recent sale of $4 billion in bonds by a day to accommodate the demand for what turned out to be one of the largest tax-exempt offerings since 2007.”

Mortgage-market distress could also create some investment opportunities for investors who do their homework, Cohen says.

“I am a firm believer that challenges create opportunities, and no products have experienced more significant challenges over the past few years than mortgage-related securities,” said Cohen. “Amid the subprime debacle and related credit crisis, all mortgage products have struggled and even the higher-quality paper is being priced as if it is a toxic asset. We use a fixed-income manager who has been buying up more stable mortgage-backed issues at what he perceives to be tremendous values because of the negativity that has enveloped the entire asset class.”

A market historian to the end, Cohen likes to return to what he knows best when attempting to analyze just where he believes the markets will head next.

“Dating back to 2000 through mid-March, the equity market lost about 3% in value, so history may suggest we are about halfway through what some would call a secular bear market,” Cohen said. “During such times, it is quite common to experience periods when markets really take off. In fact, during the last few weeks in March, equities rose over 20% and some investors have pointed to that move as evidence that the market had bottomed and the turnaround had begun. In reality, since October 2007, we have seen six rallies of various magnitudes.”

Source: After a Tough First Quarter, Investors Have Cause For Cautious Optimism

[Editor's Note: This look at the U.S. economy and stock market is the latest installment in a series of Money Morning quarterly reports that will examine such topics as gold, housing and oil. These reports will now be a regular feature at the end of each quarter.]

On an individual level, the benefit will come from the mix of tax benefits that are part of the package.

On Feb.17, U.S. President Barack Obama signed into law a massive $787 billion stimulus package aimed at jump-starting the domestic economy. While the jury is still out on its future success, average Americans are left to ask: What’s the best way to benefit?

“In general, lower-income folks are more likely to see the most actual benefits from these provisions,’” said Gregory Horning, co-founder and director of SC&H Group Inc., the largest locally based management-consulting and CPA firm in Baltimore.

However, Horning believes that for the economy to really rebound, families must repair and reposition their individual financial positions.

“For years, folks have lived on no savings and counted on equity in their homes as a source of spending,’” Horning said.  “Now, home valuations are down and they need to change their lifestyles and cut their monthly spending to repair their personal balance sheets.  While a couple of hundred dollars from a stimulus package may help in the short-run, we must deal with the root of the problem, which requires a new mindset for the American people.  There are no simple fixes; no good answers.’”

Home Buyer Credit

Even so, Horning sees a few provisions within the stimulus package that could prove beneficial to certain individuals.  In particular, he points to the temporary credit for first-time homebuyers as one area that could help.

Under this provision, first-time homebuyers may be eligible for a credit of as much as $8,000 credit on the purchase of their house (or 10% of the purchase price).  The credit is subject to income limitations ($75,000 for single filers/$150,000 for joint) and can be taken for homes purchased between Jan.1, 2009 and Dec.1, 2009.  Because the collapse of the housing sector has been a major contributor to the economic downturn of the past few years, the government is hoping that this credit will encourage renewed housing activity.

“For first time homebuyers who qualify, this provision may accelerate their decision to pursue home ownership and live the American Dream,’” Horning said. “Essentially, the government is subsidizing $8,000 toward the purchase of a home. Coupled with the current lower property valuations, home ownership has become more attractive for this limited group of individuals.’”

Because of the income restrictions and the fact that buyers could not be prior homeowners, Horning acknowledges that the impact on housing and the overall economy will be fairly limited.

Bill Hickl is managing director leader of the Private Client Services Group for UHY Advisors, one of the 15 largest professional-services firms in the country. Though his client base is primarily high-net-worth individuals who would not qualify for this homebuyer credit, he has been fielding a number of calls about this provision.

“Just last week, I spoke with a CEO of a local business who called to talk about his daughter, who was considering becoming a first-time homeowner,’” Hickl said. “He was thinking about helping out with her down-payment and wanted to get some of the specifics.  I let him know that the purchase could be treated as if it occurred in 2008 for tax purposes as the government is allowing for acceleration of the use of this credit by making an election.  By extending her tax-return filing to Oct. 15, his daughter will have several months to complete the transaction and still be eligible for the credit on the 2008 return.’”

Car Buyer Deduction

Another provision aimed at stimulating additional retail activity is a temporary deduction for car buyers. Under this bill, individuals who purchase a car, recreational vehicle, or even a motorcycle in 2009 may be eligible to deduct the state and local sales taxes, as well as excise tax, on the vehicle.  Again, an income limitation applies, so not every car buyer is eligible, but the higher limits ($125,000 single/$250,000 joint filers) increase the potential for more individuals to take advantage.

“This deduction is ‘above the line,’ meaning that taxpayers don’t have to itemize to be able to reap the benefit,’” SC&H Group’s Horning said.  “They will be able to take a full deduction of the sales tax for cars costing up to $49,500; however, should they buy a more expensive vehicle, they will only be eligible for the deduction up to that amount.’”

Horning believe this provision could have some impact on auto-sales activity as individuals who might be considering a new-car purchase in the next few years could push that decision up to 2009 to take advantage of the deduction.

“It probably doesn’t mean people will be buying more cars [overall] than they [otherwise] would have,’” said Horning.  “This just moves up the timing of that next potential purchase.’”

Qualified 529 Plans

UHY Advisors’ Hickl believes that the expanded definition of qualified higher education expenses may also prove helpful for individuals with 529 plans and children attending college in 2009 and 2010.  Under the stimulus package, computers and related technology will qualify as expenses for tax-advantaged savings plans for the next two years.

“I have a son in college now, so we can personally take advantage of this provision,’” Hickl said “Historically, only direct college costs like tuition and housing were ‘qualified’ expenses.  Now, folks can buy their kids computers and use the college-savings account to pay for them.  Most of our clients set up 529 plans and we are speaking to all of them with college age children about this potential benefit.’”

Home Energy Credit

The stimulus bill also increases (from 10% to 30%) the eligible credit for energy-efficiency purchases made in the home.  SC&H Group’s Horning believes that homeowners who have been planning to replace furnaces or water heaters – or to install new energy-efficient doors and windows – should look into such opportunities this year and next.

“For many, these moves make sense even absent the tax credit,’” Horning said. “Such purchases help homeowners to counter higher utility costs and the credit effectively reduces the payback period of the new equipment purchases.’”

Make Work Pay

The single-largest tax provision within the stimulus package is the “Making Work Pay Credit‘” that provides a $400 credit ($800 if filing jointly) to employees who make less than $75,000 ($150,000 if filing jointly) in compensation.  The estimated cost of the provision is $116 billion over a 10-year period.

Even low-income families who don’t make enough income to owe taxes are still eligible for this credit.

Unlike the 2008 Bush tax rebates, which were distributed directly to eligible taxpayers, the government will not be sending any checks this time.  Instead, the credit can be claimed on the 2009 tax return or received each pay period through deductions on the employees’ paycheck.

Horning points out that the recipients of this credit do not need to take any action in order to participate.  In fact, the Internal Revenue Service has issued new withholding tables that employers must begin to use no later than April 1, 2009.  The tables are designed to promptly and automatically deliver the benefit of the credit to employees so that these dollars get put back into the economy more quickly.  Horning believes that – while the afore-mentioned $116 billion outlay represents a significant cost – the amount per individual, on a case-by-case basis, is not substantial.

Ron Martin, a managing director and tax-department head with the Houston office of UHY Advisors, agrees that the provision will have limited impact on stimulating growth.

“Last year, individuals received $600 or so in the form of a tax rebate and could take that money directly to the Best Buy (BBY) and purchase a new TV,’” Martin said.  “This year, they will not receive a lump-sum payment and instead will recognize something like a $10 windfall on each paycheck.  Since they will not be receiving a significant amount of actual cash in hand, this provision, most likely, will not provide much stimulus.’”

The government will be providing a one-time payment of $250 to non-working individuals: retirees, disabled individuals, as well as recipients of Supplemental Security Income (SSI), railroad retirement and certain veteran benefits.  SC&H Group’s Horning believes it will be hard to pinpoint how much this will help jump-start the economy, noting that such payments won’t solve major issues or eradicate the challenges many of the recipients already face.

Alternative Minimum Tax

The one provision designed to actually impact upper-middle class and more-high-net-worth taxpayers is the increase in the exemption amount ($70,950) for Alternative Minimum Tax (AMT) calculations.  Established in 1969 to close certain loopholes that well-to-do taxpayers were using to reduce their tax liabilities, AMT has begun impacting more middle-income earners because the calculation has not been adjusted for inflation over the years.

SC&H Group’s Horning states that the government has been applying a “patch’” each year in the form of an exemption increase, so the provision in the stimulus bill accounts for nothing more than the enhancement most taxpayers were already expecting. 

On a related note, interest on tax-exempt private-activity bonds issued in 2009-2010 will now be excluded from AMT calculations and Horning believes more investors may consider these municipal securities that are issued to fund stadiums, theaters, and other private-user projects.

“Because of the flight-to-quality and dramatic increase in demand for [U.S.] Treasuries, related yields have declined so much and investors may begin seeing some significant opportunities in other fixed-income securities,’” Horning said.  “While private-activity bonds may find a new class of investor for the next few years – due to the AMT exclusion – I believe that general obligation bonds and revenue bonds that are supported by necessities like utilities may be worth a look, as well.’”

Horning also fears that inflation will rear its ugly head in the years to come as the government struggles to raise revenue to retire the newly issued debt.  He believes that Treasury Inflated Protected Securities, or TIPS, commodities, and other hard assets could serve as a hedge against inflation when allocated within the context of a diversified portfolio.

The Obama Budget

UHY Advisors’ Martin has been talking to clients more about the recently proposed Obama administration budget than the stimulus package.  He sees several moves individuals should be considering now in anticipation of its passage.

“The [Obama] administration has been mindful of the need to get the economy growing again and chose not to override the Bush tax cuts or take other fiscal measures that could hinder any chance of recovery,’” Martin said. It seems that to “recognize the delicate balance between economy, budget, and doing the right thing.  The proposed budget is set to take effect in 2011, so we have the opportunity to visit with clients about moves we should be taking over the next two years.’”

UHY Advisors’ Hickl claims it is not a shocking revelation that taxes will increase on the highest-income earners and is mindful of ways to accelerate his clients’ income levels and other revenue streams into 2009 and 2010, particularly for individuals like athletes with long-term contracts [that include] deferred compensation.

Within the proposed budget, Hickl sees the provision to cap mortgage-interest deductibility at 28% as bad policy.

“Limiting this deduction is actually a disguised income tax increase, in my opinion,’” Hickl said. “Say an individual has a $1 million loan at a 7% interest rate.  The difference between a deduction at the 35% tax rate and one at 28% is $4,900 in additional taxes due.  And that is quite a significant amount.’”

According to SC&H Group’s Horning, some homeowners with cash in hand may choose to pay down their mortgages before 2011, particularly as their investments are declining.

UHY Advisors’ Martin also mentions the proposed change on charitable deductions as an area his clients should focus on prior to 2011.  Like the mortgage interest deductions, under the Obama budget, individuals will only be able to deduct 28% of their qualified donations as opposed to the 35% allowed today.

Since high-income earners make the majority of these contributions, Martin anticipates that charities will be hurt and face a reduction on donations in the years to come.  He does see some ways that careful planning can help alleviate the burden on charities.

“If taxpayers have multi-year commitments through something like capital campaigns, they may consider taking the opportunity to accelerate funding of that commitment to make sure they remain fully deductible before the new rules come into play,’” Martin said.  “Such a move could serve as win-win as the donor gets the full tax advantage of the deduction, while the charity gets its money sooner and can begin putting the much-needed funds to good use.’”

Editor’s Note: Ron Brounes, CPA, is a regular contributor to Money Morning

Source: Seven Ways to Get an Income-Tax Boost From the Obama Recovery Plan

And don’t expect that market to thaw out anytime soon. Even with the country’s energetic new president, Barack Obama, now ensconced in the White House, consumer and business confidence is virtually non-existent and worries continue to churn that the U.S. banking sector would endure a complete meltdown.

The bottom line: The M&A market has all but disappeared.

“Beyond ‘almost none,’ there is really no story at all,” said Ryan Krueger, founder and Senior Portfolio Manager of Krueger & Catalano Capital Partners LLC, a Houston-based money management firm and a hedge fund manager collectively managing more than $150 million in assets.  “With credit markets frozen, there is no M&A. Or, at least, very little.”

Krueger takes a more optimistic tone about opportunities that may present themselves in the future (if not already) based on lower valuations, but believes the timetable on deals could be rather lengthy as would-be buyers feel no need to rush into transactions at this time.

“I [recently] sat down with a banker who pitched me on a company where I could pay 30 cents on the dollar for their cash alone,” said Krueger.  “I also looked at a gold mining company with proven reserves whose share prices are so low that you could buy the entire company for a little more than $400 an ounce for their gold.  Remember, without a ticker symbol attached, gold is fetching more than $800.  There are already some amazing stories and deals to be found.  Patient acquirers with cash will truly benefit.”

Let the Good Times Roll?

Following a stellar 2007 – a year in which global deal volume reached $4.5 trillion – 2008 started out with a lot of promise. Sure, certain segments of the economy were showing some of the ill effects of the housing collapse. And the dreaded “I” word – inflation – had crept into many water cooler conversations as oil prices pushed past the $100 a barrel level.  Still, cash-rich companies seemed prepared to take advantage of distressed situations, as valuations began to look more attractive following a negative 2007 fourth quarter for stocks.

“Early in the year, companies were in acquisition mode as much of the economy appeared vibrant and business prospects for the future were bright,” said transactions expert Steve Albert, a partner with UHY Advisors Inc., the twelfth-largest accounting firm in the United States, and a member of the executive committee of the firm’s Texas practice.  “As details of Candidate Obama’s tax plan made their way onto the campaign trail [last year], people began to see the prospect of higher capital gains taxes for 2009 as a real possibility.

“Sellers of businesses had hoped to close transactions before the end of 2008 to take advantage of lower capital gains before new higher rates took effect in the following year,” Albert added. “This incentive quickly dissipated with the sudden downturn in the economy in the fall. The financial crisis that emerged reversed the sentiment that President-elect Obama would raise capital gains taxes as now unlikely since his plate would be full dealing with all these other national economic issues.”

The expected follow-through in M&A activity from 2007 never materialized as the credit crunch turned into a credit crisis, which then turned into an outright credit collapse.

Through mid-November, Thomson Reuters Corp. (TRI) reported that deal volume had declined more than 30% from the 2007 levels. In fact, the reduction would have been even greater had it not been for a rash of transactions involving financial institutions – with three of the biggest getting finalized right as 2008 came to a close.

Bank of America Corp. (BAC) purchased one-time behemoth Merrill Lynch & Co. Inc. for about $24 billion, although the deal was initially priced at about $50 billion before BofA’s share price underwent a drastic decline. In the other two other deals, Wells Fargo & Co. (WFC) acquired Wachovia Bank for $15.1 billion and PNC Financial Services (PNC) bought Cleveland’s National City Corp. for $5.52 billion, in moves that allowed the acquiring institutions to receive sizable tax breaks from the losses they were assuming.

The federal government’s bailout initiative – the Troubled Assets Relief Program (TARP) – also led to additional acquisitions of ailing financial companies. In early December, Capital One Financial Corp. (COF) announced its intent to purchase Maryland-based Chevy Chase Bank FSB for $520 million, and a number of life insurance companies looked to acquire small thrifts in order to access some of the TARP money.

According to Bloomberg News data, the world governments had a major hand in more than one-third of the largest deals of the fourth quarter.

The Ones that Got Away

In reality, 2008 will be known more for the “deals that weren’t” than the “deals that were.” According to data from UBS AG (UBS), almost one-third of all transactions that had been announced in 2008 never closed because funding failed to materialize, valuations plunged after the initial announcements, or buyers simply got cold feet in this challenging environment.

“Completion risk is on everyone’s mind,” claimed Cary Kochman who co-manages M&A for the Americas at UBS. “We are, on a historical perspective, amid the lowest level of deal completion.”

While the proposed $45-plus billion acquisition of Yahoo! Inc. (YHOO) by Microsoft Corp. (MSFT) went sour due to founder ego, greed and internal shareholder disputes, other significant transactions were scrapped because of credit concerns and weak economic conditions.

Historically, M&A activity has declined during recessionary times. That makes intuitive sense as companies avoid taking on much additional risk, regardless of the attractive valuations.

Examples abound this time around. For instance, BHP Billiton Ltd. (ADR: BHP), the largest mining company in the world and the subject of a recent “Buy, Sell or Hold” story here in Money Morning, walked away from its $66 billion offer for Rio Tinto Group (ADR: RTP).  Likewise, Canadian telephone giant, BCE Inc. (BCE), was unable to complete its $42 billion sale to a private equity consortium.

Looking Ahead

Many experts expect the declining level of M&A activity to continue through this year – and perhaps even beyond. Barclays Capital Group (PGD) expects deal valuations in 2009 to fall by another 30% to about $2 trillion, levels not seen since 2005.

Barclays acquired the investment banking arm of Lehman Brothers Holdings Inc. (LEHMQ) after the firm declared bankruptcy in September, a development that turned out to be a major catalyst for the current credit crisis and equity market collapse.

According to the Bernstein Research arm of Alliance Bernstein Holding LP (AB), M&A volume will fall by another 25% this year with a total drop-off in activity of 45% from peaks levels in 2007 to 2010.

Even so, Bernstein expects that counter-cyclical industries such as healthcare may see a flurry of activity, as cash-rich companies seek to take advantage of their struggling competitors.

Larry Slaughter, co-head of European M&A for JPMorgan Chase & Co (JPM), believes that most of the deals that do close here in the New Year will be smaller, since the credit markets remain sluggish despite the coordinated government efforts to stimulate lending.

“You are less likely to see deal sizes beyond the $20 billion mark in 2009,” Slaughter said.  “The balance-sheet capacity of the banking system will make it tough to finance much-bigger transactions.”

UHY’s Albert believes we are in a buyer’s market and that companies that are flush with cash may be able to gobble up the ones that find themselves struggling or in distressed situations.

“In the spring of 2008, transactions were being priced at multiples of 8 [times] to 10 times earnings or cash flow,” Albert said. “Suddenly, after the downturn, multiples are more in the neighborhood of 3 to 4 and sellers are, quite frankly, not very excited about the new valuations.”

According to Albert, “with no access to the credit markets, many companies will not be able to finance their transactions – this situation will create a huge advantage for firms that have maintained substantial cash stockpiles on their balance sheets and would be able to consummate deals without having to access the credit markets. Typical companies included in this group with large amounts of cash are Exxon [Mobil Corp.] (XOM) and Microsoft and such corporations could prove to be winners in the current environment in terms of buying up undervalued firms.”

UHY’s Albert sees opportunities for acquisitions within the energy sector, as struggling smaller companies face additional stress with oil trading in the neighborhood of $42 a barrel, meaning they won’t be able to financially justify drilling activities with crude prices so low.

Albert also noted that a talk of a higher capital gains tax could resurface, should the Obama administration economic plan begin to stimulate growth this year, meaning companies would have incentives to close deals before the new tax rates take effect.

Predicting M&A in 2009

Albert also believes that large companies may look to sell off non-core businesses or even international arms as they streamline and downsize operations.

“More than ever, management must play to their strengths and some may look to unload non-critical operations, particularly those that require substantial cash flow to manage,” Albert said.

Krueger & Catalano’s Krueger suggests that the current challenges will create future opportunities.

“As a result of the deepest most violent collapse in asset prices of all flavors, we are now planting the seeds for future deals,” Krueger said.

By dropping interest rates to historically low levels, he said that the government is practically begging investors to consider mergers and acquisitions again.

“Bottom line, capital will seek a return and risky assets like businesses will look better and better as long as risk-free Treasuries promise less and less in return,” he said.

Of note, Krueger believes companies that possess hard assets represent unusually good values in this environment.

“Materials companies catch my eye for many reasons and I am looking in some cases at multiples of 2 or 3 times cash flow and very little debt,” he said. “A related industry that serves many of these companies is engineering where we are finding backlogs of signed contracts whose value is more than three times the total value of every single share of its stock.  Potential acquirers may find attractive valuations here, especially since the Obama stimulus plan focuses on infrastructure enhancements.”

Would-be buyers also may emerge from abroad as foreign companies attempt to take advantage of the domestic challenges and enter the United States’ marketplace in various industries. Recently, Electricite’ de France SA offered $4.5 billion for a chunk of the nuclear power business of Constellation Energy Group Inc. (CEG), outbidding a unit of Warren Buffett’s Berkshire Hathaway Inc. (BRK.A, BRK.B) in the process. Completion of the deal will enable the French company to participate in the U.S. nuclear industry. Regulatory issues may be drawing out completion of the Constellation nuke group buyout.

Richard Griffiths, director of the Hong Kong-based M&A unit of the Royal Bank of Scotland Group PLC (ADR: RBS) thinks that China and Japan may emerge as significant M&A players this year.

“Japan is likely to continue to [figure] highly in outbound M&A, as it benefits from a lower cost of borrowing and a stronger yen,” said Griffiths. “China remains a key draw for investors and a source of outbound M&A.”

Perhaps Krueger summed up the situation best with the following analogy.

“Mergers and acquisitions right now to me look a lot like my four- and six-year-old kids on the top step of our monkey bars in the backyard,” he said. “They are looking at each other with an unusual combination of smiling mouths and terrified eyes. Neither is going to move an inch until they see the other one flinch and then I have to run over there because they’ll move so fast to grab the same bars they’ll collide.”

In other words, the same financial crisis that froze the M&A business will ultimately set the stage for the next round of dealmaking to flourish.

Source: The U.S. Market for Deals Remains in a Deep Freeze

Editor’s Note: With the New Year under way, Money Morning will continue to help investors look ahead, and will continue to run installments of our “Outlook 2009” economic forecasting series.