GENERAL ECONOMIC OVERVIEW –
As I started putting together this year’s outlook I’m reminded of the axiom that says that the economy is not the market. What this saying is getting to is that you may have a firm understanding of the components of the broader economy but at the end of the day investors are going to do what they are going to do. Investors may be motivated by seeking opportunities they perceive will be performing in 6 months and therefore front running hot areas, investors may be moving as a herd and bidding up a specific sectors, or investors may be sheltering all of their money in cash-like instruments in total fear like we saw in early 2009. The framework we’ve lived in for almost all of 2010 was one where investors heeded threats and actions by the government to spur the investment markets and they also saw improving fundamentals for corporations. As a result of both of these key variables, investors put money to work and drove the SandP 500 and DJIA up around 11%. As we know, one key factor that helped provide outsized gains is that the Fed helped to engineer a movement of money flows from cash to other assets as it attempted to make safe money worth less and as is the case it typically forced money to seek higher returns as compensation. So, is everything bad in the economy? No! Is everything coming up roses? No! It is clear though that we have more disconnects or divergences in the economy that will be the source for opportunities for gains and tremendous losses in the coming year.
TWO DIFFERENT WORLDS – CORPORATE / CONSUMER
As we enter 2011 we must note that there are two distinct worlds within the US economy. We have a corporate environment where big business has outperformed modest expectations and is squeezing more out of less, while we have a consumer world where folks endure actual unemployment or the threat of it, diminished household savings, and little opportunity for income growth. The last two years has destroyed the store of wealth for many Americans as housing values have continued to flounder. It is easy to see why the stock market’s appreciation is important to the Federal Reserve as an increasing market gives us the feeling that our invested wealth is growing which can ease fears.
Large corporations obviously had to reduce headcount in the downturn, but have yet to increase their employee rolls significantly. In addition, they have taken the opportunity to raise massive sums of money by issuing debt at historically low interest rates, allowing corporations to have record amounts of cash on the books. This capital will allow them to make acquisitions or endure a downturn that may come. The main challenges I see in 2011 for corporations are that they must get consumers back to their old habits of spending, they must be able to pass on price increases or suffer margin compression, and they must be able to manage government imposition in their industries.
Consumers have noticed a slight uptick in their situation of late with an improvement in job opportunities and a reduction in personal debts. The challenge for the average Joe is to keep to his new found religion and somehow continue reign in his pent up desire to spend himself back into debt oblivion. Is the average person back to their 2007 and 2008 way of life? No, not hardly. We have somewhere around 9.5% unemployment with the prospects for these levels to hang around for many more years. According to Fed Chairman Bernanke, these high levels could remain intact for 4 or 5 more years. When he gives us this timeframe he is suggesting it will take that long to get back to an average 5.5% or 6.0% unemployment rate. Finally, Joe-6-Pack must attempt to keep up with the inflation that the Fed Chairman wishes to saddle him with. Of course the worst harmed folks are those that are older and poorer. Those will be the collateral damage from Bernanke’s efforts to spur inflation and resuscitate the financial and banking systems.
I know that it is clear that I’m not a fan of the Federal Reserve. I am a big believer in the notion that our central bank is the cause of the wild boom and bust cycles we’ve endured. The Fed’s very nature is corrupt and makes it aligned with interests that are not the same as the interests of the US citizenry. The Fed is supposedly an independent body that works to provide price stability and maximum employment. As you examine the work of the Federal Reserve in the longer term you see that they have delivered very little of either of these goals. Since the crisis in 2008 and 2009 the Fed has uncorked extraordinary measures to save the financial system. Even today in 2011 we see that they labor to provide enormous liquidity to credit markets and prop up asset values. Ben Bernanke and Alan Greenspan have talked at length that the best way to fix the crisis is to increase the perceived values of stocks and bonds. The Fed is prepared to do anything and everything to avoid the grips of deflation as it has manifested itself for the last 20 years in Japan or how it did in our country in the 1930’s.
I’ve been a big advocate for emerging markets for the last year and a half. In fact, I still like a few of them, but the truth is that I like less of them every day. Emerging markets have hit the ball out of the park with amazing returns in countries like Singapore, Malaysia, and Chile in recent years, but the stress of all of that growth is bubbling to the surface. Further, the countervailing approach of the US FED is at odds with their interests. I wanted to write a much larger summary of my views of the brewing “economic war” between these countries and the US, but in the interest of getting this document done I will simply suggest that I’ll post this later. Overall there will still be emerging winners, but I choose to reduce exposure from the over-weighted positions I’ve had and move to other areas to capture those better risk-adjusted gains.
12 FOR 2011
1) US MARKETS - Dow / SandP500 +6%. I fully expect that US domestic investment markets will move higher in the year, although I believe that they will fulfill the old adage that you can “Sell in May and Go Away”. I believe that US corporations will continue to post strong financial numbers however they will detail that they do not have the power to raise prices in the current economic environment. They will see margin compression resulting from increasing commodity prices and an inability to charge higher rates to end users will be the reasons for a mid-year end slide in index performance that will be substantial. The US will perform well on a relative basis since we’ll continue to see that other areas in the world are full of their own land mines. Global investors will seek US companies as a safe haven and a relative value trade in comparison to other global opportunities (which I’ll cover below). Large companies which pay dividends and multi-nationals will do better in this environment.
2) JOBS – We will end the year at a 9.0% jobless rate. The increase will be lauded as real improvement, but those out of work will be much poorer. Obama will gain traction in a re-election bid due to the overall improvement in the job market.
3) HOUSING – The housing mess will remain with us. Foreclosure problems will still not be cleared and we will finally begin to see our enforcement bodies begin to prosecute the outright fraud that took place by banks, mortgage companies, and investors. Overall national housing prices will fall another 5% to 10% from year end 2010 levels. The home builders have been destroyed and out of favor for more than 3 years now. Homebuilders may actually be a safe haven as they can be seen as having nothing left to destroy in a downturn in the markets. Finally, the housing markets in China, Canada, and Australia are set for a complete meltdown ala 2008 and 2009 in the USA. I advocate moving out of positions in Australia and Canada if you hold one of those ETFs.
4) USD – The US dollar will continue to fall for the next several months, but as with all of these predictions I suggest that the USD will strengthen against most currencies (Swiss Franc, Euro, and Yen) near the the April and May months. We’ve had a specific theme over the last year where I described the purposeful devaluation of the dollar as a choreographed dance conducted by the Fed. There has been a rhythmic wax and wane in value, but the intent has been to send the value down. The willful destruction of the dollar’s value is a by-product of the printing and easing employed to boost asset prices. Trouble in Europe and in emerging countries will over-ride the Fed’s artfully controlled slide of the dollar.
5) INTEREST RATES – Higher then lower, then a move higher. All of that to say that we end up exactly back to these levels at year end on the 10 Yr, let’s call it 3.5% to 3.75% which is about 40bps higher than today.
Overall, I believe commodities will be a very volatile bunch this year (as if they aren’t already). In general, I believe in the short-run we will see a strong spike in almost all commodities including oil, gas, silver, gold, grains, copper, sugar, coffee, and cocoa. This short-run blast will be the backdrop for a correction in the April and May time frame. Essentially we’ll see the move higher and then we’ll again see commentary that high priced oil and gas will dampen economic growth and destroy the resurging consumer. Those highs in April and May will be the top for equities and commodities. Once we endure a correction of 10% to 15% the equity markets will resume their climb, but I believe the damage will be done for the commodity bull market for at least the remainder of the year. (The commodity bull market is not over, but won’t reach highs again in 2011.)
6) OIL - $105 to $110 will be the high for the year with a drop to the high $70’s or $80’s in the following correction. Energy etfs like XLE and KOL will be a good target for this early run but timing an exit is critical.
7) WHEAT, GRAINS, CORN, HOGS, CATTLE, AND SUGAR – Like oil, I predict a big ramp higher in the short run. Unlike oil though, we’ll see a less significant correction here. This area is still a long term buy based on consumption and demographics in emerging countries. There is no way to keep the new middle class in India, China, and other emergent countries from eating more meat, grains and sugar. Increased demand will force higher prices. Isn't great we still have all of those cool ethanol subsidies to ensure that farmers grow all that corn for a wasteful non-green green energy? The point here is that the ethanol mandate contributes to the consumption of farmland that could actually be used for food rather than an inefficient fuel. Those politicians sure did get the message didn't they?
8) GOLD AND SILVER – As much as I love gold and silver I believe that we’ll see the blow off top run here in the next few months. I think silver easily gets to $35 and gold could hit $1,500. I am prepared to sell my positions in both and even my physical metals that I have in the safe-deposit box. I fully realize that if a Euro collapse does hit then there will be a total parabolic blow off beyond anything we can really grasp. At that point silver would likely be $100 and oz and gold near $3,000 or more. While I calculate that part of the reason that commodities will fall will be more significant issues in Europe in April and early May, I reason that another stick save will be provided by the ECB, IMF, and US FED. Could this happen? Yes, of course, this is why I posted the video below because if views like these become more prevalent then we could see a country like Italy or Ireland doing what they should do (default) rather than chaining their citizens to unpayable debt and a life of financial slavery. Again, gold has traded as its own currency and stress in Euroland makes gold more valuable.
EDIT - 1/14/2011 - Just to be clear, I still think gold and silver run higher, but then fall back in the same pattern as the overall market and commodities like oil. Therefore, this is why I'm prepared to sell as the blow off top pushes the metals to euphoric highs. I just wanted to make this clear since I got a few emails asking me why I'd sell if they really did move that high. I don't expect that "sugar high" to last....(actually I do expect sugar to go nuts and stay high for a while, just not the shiny metals on a sugar high).
9) COPPER – Emerging market central bank’s efforts to combat inflation will work this year to make copper a loser in this battle. While we’ll see the same type of action I’ve described above, but copper will be impacted more and we could see copper in negative territory for the year despite an early move higher.
10) BANKS – The steep yield curve benefits banks and I look for the biggest beneficiary in this environment to be the regional players like Regions and Zions Bank. These will become M and A targets and they have already largely dealt with their real estate messes on balance sheets because regulators forced them to. Big money center banks will still do fine, but not as well. While we’d all like reality to come home to roost for the JPMorgan, Bank of America, and Wells Fargos, the fraudclosure mess won’t impact them, no matter how disturbing the news is regarding the way they sold and securitized loans I’m afraid this will be a big nothing-burger. Last, it is clear that the “Fed has their back” so if things were to somehow implode we know that there is a backstop out there called the US Taxpayer and he has a bottomless pocket to save all financial institutions. XLFit and KRE are +8% at least.
11) MUNICIPAL BONDS– We’ll see continued pressure on many municipalities as they will need to face the stark reality of their budget crisis. There will be opportunities to buy municipals to capture outsized gains but don’t be fooled, there are real risks and we will see municipal defaults. Typically this has not been common, but the problems with underfunded pensions and poorly negotiated contracts will force city and state leaders to do what they need to do and default. Personally, I’d avoid them since most munis are long dated and you are taking serious interest rate risk on top of the credit risk of municipal institutions that are run by political hacks.
12) CORPORATE BONDS – Wait for commodity and market ramp. That move higher will continue to push corporate bond prices lower and finally put them in an pricing area where they again become interesting. Please note that I usually target buying corporate bonds that are less than 7 years in maturity. I do not subscribe to the hyper-inflation theories and therefore I do believe that a chance to buy solid company bonds yielding a 6%, 7%, or 8% rate will be great. (No, I haven’t seen these yet, but I expect good opportunities). I look to add to bond positions in April and May near the height of the commodity and equity euphoria.
BONUS - DOMESTIC POLITICS
HEALTHCARE REPEAL – FAILURE - Republicans have no stroke and can’t repeal the beast. They may be able to starve some provisions of the reform and hold it hostage, but frankly I don’t believe that they are truly committed to anything like that.
The Tea Party will be angered as they realize they have been co-opted and the RNC leadership simply adopted their speech and changed nothing. 2011 will open the way for new “radical” independents that will further sweep out Democrats AND Republicans that will all be seen as tools of industry and fixtures of the political class.
After two years in office Obama’s Utopian ideals and naive hopes should now be completely dashed. If he hasn’t realized that there are really bad people on earth that should not exist; he clearly is not a smart guy. Obama’s new approach to Gitmo does make me somewhat hopeful that he is beginning to get it as we have not heard much more about Gitmo other than it isn’t going to close. His stupid and uninformed criticism of Bush’s approach to the problem of detainees during his election campaign has clearly revealed itself to be without merit. Obama’s worldview that the USA is bad and should apologize for ever coming to the Middle East or interacting within that society is ultimately one that positions our country in weakness. One cannot change what has happened in the past and likewise our very presence in that portion of the world has brought light and the idea of liberty to people in darkness. This issue (Gitmo) will be a huge issue with left leaning folks that will be absolutely disappointed with Obama’s broken promise. Don’t Ask Don’t Tell Reform in this lame duck session was an attempt to appease this faction for the Gitmo miss-step.
RISE OF CHINA AND RUSSIA – REALIZATION OF THE TRUE NATURE OF OUR ENEMIES – Use of 3rd Party proxies will increase and further illustrate the impotence of the US in global theaters and the strategic failure of our military and politicians to realize the coordinated global threat that these two powers represent. North Korea, Iran, and Venezuela will continue to be thorns in our side and the two Communist powers (Yes, Russia is still run by these goons – they just call themselves different names) will ensure that the USA is entangled in skirmishes and wars that will bleed us to death (in terms of soldiers and financially). Note that these attacks will be in the form of military confrontations, digital attacks, and even economic sabotage.
There you have it. Up, then down, and slight up again is the direction I see things. Volatility will be the name of the game and the theme will be that everywhere else in the world is laden with risk, so US and global investors will fall in love again with US stocks more as relative value and relative risk trades.
The drum beat of financial war will increase in intensity as the US attempts to devalue its currency therefore strangling emerging countries that are dependent on exporting. Other than China, these protests from the likes of Thailand, Brazil, and Chile will fall on deaf ears. Foreign central banks are in a tough position as they try to balance strong growth against killer inflation. Unlike in the USA, these countries citizens actually riot and remove governments when their central banks screw up. So, the stakes are high for these nations and the inflation monster is real and scary. As we continue to pressure them with attempts to devalue the dollar we will see more outrage and attempts to control capital inflows into their countries. Chinese and Indian leaders will try to slow their economies to combat out of control inflation but I do not see them able to slow their markets in a gentle fashion. These efforts will lead to abrupt corrections in those emerging countries and this will have serious negative repercussion in commodity markets.
Europe is still the overhanging wild card. Let me highlight, it isn’t the unknown that the current format of EU will collapse and the Euro will be destroyed, it is more about the timing. The revolving door of “who’s imploding” will continue until one smart player finally opts out and outright defaults. Once they default they will essentially quit the EU and the Euro and resume their own currency. This will be a scary and tough time for the world and for that brave country, but that country will emerge stronger and more capable due to the shedding of the mess of their own making. If this event happens in 2011 then the gold and silver trades I mentioned will happen and a parabolic spike will occur. I don’t believe it will happen this year and this is why I have only mentioned it. Until that time we’ll see Portugal, Spain, and Italy come under attack from bond traders and more bailouts will be a certainty. Riots will also come with the deals to “save” the countries and “bail” them out.
Finally, don’t assume because I’m suggesting the US stocks will outperform others that I believe we have a healthy market. I am not saying that at all. In fact, I think we are over-valued from a historical perspective at this moment using the lens of the Shiller SandP P/E ratio model, AAII Investor Sentiment, and Put/Call ratio. In addition, we have tremendous structural issues related to government overspending and a scary Federal Reserve that has tremendous interest rate risk on its balance sheet. Despite those concerns I don’t think that they will impact the overall outcome this year.
Having typed all of this I know the moment that I publish it, we'll slam down 3% to 5% simply because the market is over-bought! The message here is that despite a coming dip we'll see buyers come in an thrust this market higher through April or May. These are just overall market ideas and my thoughts organized to give me a framework and benchmarks to note as we move through the year. Please share your thoughts and give me your predictions.