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Predicting the future year.

This will be my annual attempt at predicting the future year. I’ll start this year by using last year’s quote:

You cannot step twice into the same river, for other waters are continually flowing in

Heraclitus, Fragments.

While that is certainly true, what we do know is that while the water is new, the essential component of the river is the same, viz. flowing water.

Inflation.

Which is our river of money being created at an increasing rate by the Federal Reserve. Last year I stated that CPI inflation would be kept in check through the destruction of credit. That will still be a factor this year. As is the desire of individuals to hold cash, or, the demand for money. The rate of new money creation under QE Infinity is accelerating. Will it or can it exceed the rate of new money creation?

This is a central question and not an easy one to answer. The Federal Reserve has indicated that it will continue to expand the money supply until an unemployment figure of 6.5% is reached. This ensures that money creation will proceed uninhibited for quite some time.

Money destruction will also continue, but at what rate? No one really knows. The idea is that at whatever rate might eventuate, the Federal Reserve can exceed that rate and maintain an excess of about 2%, which is the targeted inflation rate.

This also assumes that the other component, the demand for money, which is currently near highs, remains, or maintains those highs.

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This remains a danger; should money destruction slow for any reason, and the Fed not adjust in time, then, the inflation rate could kick higher and create an excess supply, driving individuals to demand less cash. This would, or could drive a reallocation into “things”.

Earnings

This is really a follow on from inflation. Nominal earnings will rise with inflation. This will under an unrestrained Fed policy of expansion see nominal earnings higher. Real earnings on the other hand will stagnate.

Economic theory informs that businesses cannot pass forward taxes. Inflation is a tax, and as such cannot be passed forward to the consumer. Real earnings therefore will either stagnate or fall.

Revenues and margins will come under increased scrutiny. Falling revenues will impact high cost producers far more significantly than the low cost producer who can absorb the extra costs into their margins. In an economy with stagnant wages revenues have to fall or remain stagnant themselves. Commodity price increases however force the reduction in margins to producers, unless, they can pass their increased costs forward, which, as stated, cannot be done. Instead, we see reduction in package weight etc at the constant price. In other words, the price increase is hidden.

The businesses that can best situate themselves to government largesse will be the big winners in the market next year. Banks and financial services will as they did this year, do well. Banks claim a slice of government inflation far ahead of many others. Also larger capitalized companies that have the political connections to benefit will also be ones to watch.

Healthcare once again will be a strong sector. With the demographics of an aging population combined with Obamacare, price pressures will be firmly higher, expanding earnings, and possibly even creating real earnings to boot.

Of course you will have those outliers that just find their time. Josh Brown has made a call for [i] robotics [ii] 3d printing. Both of these are interesting and definitely worth keeping an eye on.

Deficits.

Will continue to grow. Unlike the MMR advocates who claim that deficits “don’t matter”, Cullen Roche being one of the advocates, deficits do matter. They matter for the simple reason that government cannot fund its spending from tax receipts. If this is the case, then, they must either [i] borrow, [ii] increase taxes [iii] cut expenditures [iv] print.

With the current debate with regard to the fiscal cliff…it is clear that the only option all can agree upon is…increase money creation [printing] via demand deposit expansion at the Federal Reserve. The deficits, the larger they are, the greater the risks of creating a fast increasing inflation, which, can quite quickly escape control and become self-sustaining.

Medicare spending, according to this data, is slowing. If accurate, the projected deficits will not be as catastrophic as initially projected, providing some wiggle room.

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Interest Rates.

Will remain low. Bernanke via his commitment to unlimited QE has stated as much. Bonds are a dead asset class for the foreseeable future. This will place upwards pressure for investment money into commodities and common stocks.

I have played around with “stock picking” last year and found that the best results are to be found in the index ETF’s. It is far easier to have an already diversified list that already carries good volume, and let the ETF managers rebalance via the common stocks. ETF’s are a good way to play the market. Of course you will never get the VHC/AAPL etc type of returns. If you can pick these sorts of stock, then, hell son, pick “em.

Unemployment

Will remain high, and possibly even start moving higher again. The inflation of Bernanke will not ultimately allow the repricing of wages without creating new unemployment.

Inflation [amongst other things] is designed to lower wages. Wages are already stagnant. As prices rise, so more and more will be forced to look for higher wages or take action to get wage increases. This will force the high cost producers to bankruptcy, which puts everyone on the unemployment line. We saw hints of this with Hostess late last year as their costs were already crippling the firm.

A cost push inflation as it is called hasn’t really been seen in the US since the 1970′s. Whether we shall see one starting next year is an interesting question…I think no, not with unemployment as high as it is. However, if a point comes where you simply can’t meet the escalating costs of bills, electricity, petrol, food, etc, people become a little desperate.

Here in NZ the price rises in food etc is ridiculous. Petrol is at all time highs with petrol taxes slated to go higher. NZ remains [relative to other countries] low in the inflation being imposed, but we are starting to see significant unemployment as businesses go to the wall. Increasingly the recession/depression is biting here.

Europe in jumping on the QE bandwagon has condemned itself to high unemployment for a significant period of time. High unemployment leads to an increasing disintegration of society and increased violence.

The French, now being taxed to the limit, are no strangers to industrial action and along with the Spanish, who have nothing to lose, will drive a lot of European social unrest.

Gold

Gold will remain volatile, always looking to shake traders out of the trade, nothing new there, but, it will rise. Gold however it is priced or valued is priced or valued against fiat money. Fiat money in the age of constant QE is and must lose value or purchasing power. Thus gold priced against a depreciating asset must gain value. The same argument goes for silver. To trade gold you need some methodology to keep you in the trade for the required time period.

The trade will end, more or less, with the end of the QE experiments around the world and rising interest rates. As that is unlikely to occur this year, you should have at least a year to hold and gain some capital appreciation through that holding period.

Energy

With the discovery, or pending production of shale gas etc, energy is less of a sure thing [stock trading wise] this year. The increased production could lead to new revenue streams for the respective corporations, but commodity prices might fall hurting higher cost producers.

The end of cheap energy might be yet delayed. Industrial production has depended upon cheap energy since the industrial revolution. Predictions of falling and slowing growth have been predicated on ever higher prices in the commodity markets for at least a couple of years now. Now, I’m not so sure. Of course China, India and eventually Africa will and are demanding higher quantities of energy, but with coal reserves, natural gas and new oil finds, it seems, for the moment that new supply will trump new demand.

War

War has always been a political tool to subjugate a home population. A population focused upon an external enemy, focus less upon the real enemy, viz. their own politicians and bureaucracy. This will be a common theme as, wherever you look currently there is economic stagnation and social unrest.

Civil wars are particularly destructive as essentially both sides in any given country lose. How close is America, or a major European country to a civil war? Probably not that close, but that you even have to think about it rather underlines the severity of the situation at present.

The problem is [or part of it anyway] that with constraints on government spending, without a credible threat, spending on the overseas military is likely to be cut. Iraq was never a popular war. Neither is Afghanistan. The US public and the rest of the world, just don’t get it.

Market

The market will have a positive year. While eventually the inflationary policies of the Federal Reserve and Treasury will catch up with them, creating another bust, that may even exceed the 666 lows in the S&P500 of 2009, they likely won’t occur in 2013. Rather, we will see the continued nominal gains continue, certainly through the first half of the year as inflation creates real losses in the economy. Stocks therefore are an inflation hedge, protecting purchasing power rather than increasing it.

Bonds are a deathtrap simply waiting to spring. Shorter maturities are in real terms yield negative, the longer maturities, if not negative are pretty damn close to it. At some point, although not next year, interest rates will rise. When they start to rise, the rise in % terms will be brutal, destroying huge wealth as they rise.

Corporate bonds have enjoyed an easy market. Corporations have sold record amounts into the end of 2012. Some are paying out special dividends, some are buying back common stock. They have found that the cost of capital is far, far lower, than raising equity capital.

Should interest rates rise, and they realistically can do nothing else, investors will be sitting on losses that accelerate. Corporations that sold the debt, could have the option, although I doubt they’d bother, of buying back the debt for a profit. It is however far better to wait. Bond market trends are big, decade consuming trends.

Stay well away.

Regulation.

The cost to business in complying with the endless red tape of legislation spewed out by Congress will as it always has increase. More totally useless regulation will choke off competition and innovation, which are necessary components o9f economic growth. Capital is reduced through the costs of compliance.

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Black Swans

As last year, I don’t anticipate [who ever does] a major stock market disaster, viz. collapse. There will be the usual fluctuations as there always are, but without those, who would win and who would lose money in the market?

The issue, will again as it was this year, be that traders/managers/etc simply cannot believe that the market will rise against a backdrop of increasingly poor economic data. That earnings cannot continue to rise/stay high etc. As such there will be numerous scares panics with acute and severe price declines that will shake traders out of positions. Short term traders, as they have this year, will bitch incessantly about rigged and difficult markets that do not trade to their chart patterns and technical triggers.

The problem of course is that major players know all about technicals, charts, quantitative methods, and, when new edges are discovered, you have non-trading researchers giving them all away in academic papers.

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Will have a huge year to make up for his dismal year. In the early going, he will refrain from too many public calls, preferring instead to make some big gains early on from some real hindsight trades that just happened to come good. Of course, then he’ll start believing his own press, again, and make some big public calls, that, as this year demonstrated, will have very variable results.

Summary

In a word…be long. It will be easier to be long the market, than individual stocks. Individual stocks can obviously outperform the market, but also under-perform the market.

Until next year…

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