“Forecasts tell you little about the future but a lot about the forecaster” Warren Buffett
- Global Recession
- DM Equities Down at least 10% for the Year
- ECB Rate Cuts
- Income Worship
- Australia Loses it’s Shine – AUD plummets
- Value of Liquidity Increases
- USD up 10%
- Real Estate Prices Fall 5%
- More Fallen Giants
- Obama Loses Election
- Pension Problems
In hindsight, making my 2011 predictions was relatively easy because I thought that there was a fairly high likelihood of a bunch of non-consensus events happening which would surprise market participants and make me look quite clever. Because of this, I predicted the seemingly contradictory moves to 2% on the 10 Yr Yield and a Silver price spike to above $40 per ounce (and got out before the crash, with thanks to Cullen Roche at PragCap!).
This year I feel that it’s much harder to be contrarian, the world is distinctly gloomier and furthermore, I am finding it hard to even get a handle on “where consensus is?” I think these predictions are probably more aboutdegree of difference from what many market participants are saying.
In caution, I refer to Bob Farrell’s Market Rule #9 – “When all the experts and forecasts agree — something else is going to happen”
1. Global Recession
The US Economy continues to substantially outperform UK and Europe’s austerity based misery; but it still enters recession barring substantial fiscal policy change. In the aftermath of the global financial crisis, PIMCO identified the forces of deleveraging, re-regulation and deglobalization would actt as restraints on potential economic growth for developed world economies. These are increasingly compounded by strained public sector balance sheets and political forces that tend to polarize rather than unite.
My template is that this is just an extension of the 2008 recession, the return to the spotlight of the ongoing Balance Sheet Recession we have been mired in for 3 years. As Niall Ferguson terms it, we are in a “Slight Depression”. The great worry is that we are very light on policy tools to engender a 2009 style cyclical recovery.
“I think there’s a larger camp that says we’re going to muddle through; we’re going to get slow growth. I would point out that that’s never happened. We never muddle through. A market economy does not want to have a static state. It either accelerates or it decelerates, and these forward looking indicators say decelerate.”Lakshman Achuthan
Achuthan makes a very interesting point here given that “muddle through” has become a very common “go to explanation” for many market commentators. If what he says is correct, and it usually is, then there is great concern to be taken from the pronounced deceleration in most economic activity indicators globally.
HSBC Flash PMI Index
2. Developed Market Equities Negative for the Year
The Street consensus is, as it always is, for a good year in equities with around an 11% increase on the S&P 500 to 1360 (this is exactly the number they had for Year End 2011 too!). In recessions equities get whacked by at least 20%. I say this as fact until someone proves me wrong. I do not care for strategists telling me that recessions are priced in; I strongly suspect that this is absolute nonsense. Markets are incredibly good at whistling idly by until the evidence smacks them in the face.
“When the music is playing, you’ve got to get up and dance. We’re still dancing.” Chuck Prince, Citigroup CEO as of 2007
I think we are probably in a renewed cyclical bear within an ongoing secular bear market.
Andrew Smithers recently updated his CAPE and Q Ratio data to include Q3 earnings reports, at that date the S&P 500 was at 1131 and the market was overvalued by 26.5% according to the Q Ratio, and was overvalued by 37.5% according to CAPE. Historically these valuations are getting close to extremely elevated.
Operating Margins are at near all time highs too leaving much to go wrong, although this partly due to operating efficiencies and productivity gains.
There is the possibility that we have a horrendous trifecta of falling margins, contracting P/E multiples and cyclically enhanced earnings tailing off as the economy rolls over. As I have noted elsewhere, European valuations are considerably less stretched – perhaps with good reason!
However, I believe Mr Market’s way is to attempt to cause the most pain to the most people – in this regard – I postulate if perhaps the most painful trade for the majority of market participants is actually up?
3. European Crisis
The Great Denouement – I don’t believe the can gets kicked into 2013. Austerity leads to slower activity, which requires more austerity, which forces further slowdowns. We are in a death spiral. Every day that the cost of funding is above the GDP growth rate, and this is the case for every single Euro economy as of today, their debt dynamics get worse.
Whichever metrics you look at – absolute bond yields, spreads over Bunds, the TED Spread, financial sector equity and bonds prices, investor sentiment, European PMI numbers etc we can see that the situation is getting out of control. I think markets will force a resolution.
Fate would dictate that the PIIGS have a massive amount of debt rollover in 2012 – more than 300bn Euros from Italy and 100bn from Spain, much of it focused in Q1.
It is also a big year for bank debt rollover, commercial property refinancing and probably financial equity issuance too. Where does all the money come from and at what cost?
The ECB steps up to plate taking rates down further to 0.5%, but only after making politicians sweat for as long as possible forcing bank recaps via nationalisation or rights issues.
I quite like the idea of owning German assets like Bunds for the possibility that in a Euro End-Game scenario they would be converted into Deutsche Marks and therefore receive a substantial appreciation relative to other currencies on that redenomination.
4. Income Worship
There were two main trends playing out in 2011, Risk ON/Risk OFF and the outperformance of dividend stocks. Many investors and professionals embarrassed themselves with doing little more than whipsawing themselves from bullish to bearish based on the most recent press release from the most recent emergency Euro Summit. The market ended flat after months of persistent, record volatility and now investors are watching as many dividend-paying stocks break out to new multi-year highs, regardless of political turmoil here and abroad.
A portfolio of unsexy but high-yielding utilities trounced the market and investors are now paying attention. GMO demonstrated that over the course of 3 years or longer, the dividend stream becomes a larger and larger part of the investor’s total return on an investment. The lesson investors will take away from 2011 is that you can buy and hold, but only if you are being paid handsomely to wait.
Focus on the sustainability of dividends and a requirement of “strong balance sheets” was starting to bore me by Q3 2011 but I strongly suspect it’s only going to get more and more prevalent as the buy on every dip cyclicals disappoint investors. There will be a global dash for finite yield.
I think we’ll see companies forced to give back some of the large cash reserves on their balance sheets as the year progresses. “Use it or lose it!” I expect Tech companies like Cisco, Dell, Microsoft and maybe even Apple to start paying more shareholder friendly dividends.
The only things that don’t work in this space are financial credits and EM bonds. EM bonds in particular strike me as a risky trade because so many big institutional players own around 30% of these relatively immature and shallow markets. Big Boys all trying to fit out through a small fire exit leads to losses for everyone. EM Bonds have also seen a lot of hot money flows from the carry trade and retail investors. Who am I to call out Bill Gross but I don’t think this is a “safe spread”.
5. Australia Loses its Shine
This is a holdover from my 2011 predictions. I think it offers potential as a nice asymmetric trade going into this year. Australia loses its shine as its own consumer debt/housing bubble finally comes to light. House prices as a multiple of income are way too high and given the lack of constraints on land – they are setting themselves up for a fall. Sentiment is resolutely bullish, everyone believes the banks are in great shape, they are perceived to be insulated from the problems in the rest of the developed world. There is a lot of carry trade money that could potentially have to unwind.