December 2011


The annual stab at predicting. Always fraught with problems, always fun to try.

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

Heraclitus, Fragments.

INFLATION:
Inflation through money creation, via the Federal Reserve, will continue unabated. Bernanke has said as much already, and the effects of raising rates in a Presidential cycle, simply will not happen. The real question with inflation is what will the ‘demand for money’ look like, and what effects will it have?

The demand for money will remain high. Credit destruction will ameliorate the credit creation, thus keep the rate of CPI inflation somewhat constrained. CPI inflation will rise, driven largely through oil prices that keep energy costs and transport costs high through the CPI that includes these prices. The smoothed version will show lower increases. The inflation through the PPI however is a different story altogether. Here rising prices will continue to hurt the higher cost producers, which largely are the smaller capitalization stocks and private businesses.

EARNINGS:
S&P500 earnings increased 17% YoY to November 2011. This was due to what? Certainly there will be an inflation gain in there, particularly when you consider the relative weights of the capitalizations that make up the index.

Energy and Healthcare keep increasing their prices due to inflationary pressures created by the Central Banks. With regard to healthcare, these price increases are engendered through subsidy or oligopoly pricing enabled by the government. This type of inflation will continue in any industry that is the recipient of government subsidies.

The takeaway however is that ‘earnings’ will continue to increase in the S&P500 index. Earnings have benefited from the ability of businesses to cut employment. How much fat is left on this bone is debatable, but, increased earnings, in a still lowish inflation environment, could well drive a P/E expansion, which is just another way of saying expect the market [as an index] to rise beyond expectations of the consensus.

Therefore, the stockmarket, the index, will enter a trending volatile period. With sentiment low, decreasing institutional participation, the market will climb the proverbial wall of worry, in part on an improving and inflated earnings growth.

DEFICITS:
Will continue to grow. This obviously is another driver of the inflationary pressure that will continue to exert an influence. Industries that continue to hold government contracts and influence can and will increase their prices to government who are not price sensitive, that is to say they will pay higher prices that could not normally be passed onto the individual without reducing volume units supplied.

We saw one debt ceiling crisis last year, I’m sure Obama, and other candidates, would like to avoid another, their credibility, competence and morality were severely questioned due to the last debacle, in a Presidential cycle, they will want to avoid a repeat performance: thus debt ceiling restrictions will prove no barrier to further expanding the deficits.

BONDS:
Will due to the deficits continue to be sold. Sold to whom? There will be the usual support from the big shops like PIMCO who got badly burned this year on a ‘short’ call on US Treasuries. Various Pension Funds and Insurance Companies, but after that the primary buyer will again be the Federal Reserve, essentially monetizing the debt. As Bernanke is willing and able to create ever increasing fiat money, at least for the moment, interest rates will remain low. They will not be allowed to express a ‘market rate’ which would trigger in very short order another plunge into deep recession. Avoid Bonds like the plague. The returns are virtually nil. They will however provide a tailwind for equities.

PRESIDENTIAL CYCLE:

Year 1: The Post-Election Year
The first year of a presidency is characterized by relatively weak performance in the stock market. Of the four years in a presidential cycle, the first-year performance of the stock market, on average, is the worst.

Year 2: The Midterm Election Year
The second year, although better than the first, is also is noted for below-average performance. Bear market bottoms occur in the second year more often than in any other year. The “Stock Traders Almanac” (2005), by Jeffrey A. and Yale Hirsch, Hirsch notes that “wars, recessions and bear markets tend to start or occur in the first half of the term.”

Year 3: The Pre-Presidential Election Year
The third year or the year preceding the election year is the strongest on average of the four years.

Year 4: The Election Year
In the fourth year of the presidential term and the election year, the stock market’s performance tends to be above average.

In his study “Presidential Election and Stock Market Cycles,” Marshall Nickels of Pepperdine University analyzed stock market bottoms in relation to the presidential cycle. In the period from 1942 to 2006, there were 16 presidential terms and 16 market lows corresponding to those terms.

Three of the lows occurred in the first year of the presidential term, 12 in year two, one in year three and none in year four. Of the 16 bottoms, 15 occurred in the first half of the term and only one in the second half of the term.

2012 is a Presidential election year. The election will take place in November. It is another one of those seasonal trends that stockmarkets love. The underpinning economic theory however is one of loose monetary and fiscal policy. We already have that, we may get increased inflationary stimulus, we most certainly won’t get less.

The winner? Romney. Obama will join the other ‘loser’ 1 term Presidents.

HEALTHCARE:
Demographics are not the only driver of rising health care costs in the U.S. When passed in March 2010, the Patient Protection and Affordable Care Act—popularly called “Obamacare”—was intended to lower spending on medical care over time. The question is: would it?

After months of debate, several lawsuits, and multiple competing federal court rulings, the Affordable Care Act will have its day in court. That day will determine the nature of freedom in America. the US Supreme Court agreed to examine the constitutionality of the health-care law sometimes known as Obamacare. The main question is its “individual mandate,” specifically whether the federal government has constitutional authority to require citizens to purchase health insurance. For that justification, supporters have looked to the Commerce Clause in the Constitution, which gives Congress the power “to regulate commerce with foreign nations, and among the several states, and with the Indian tribes.”

But for the Commerce Clause to provide sufficient authority to the federal government to mandate that everyone buy health insurance, choosing not to buy health insurance has to be regarded as “activity.” Thus, under the Constitution, and the Commerce Clause, is this possible or likely?

If the Supreme Court does not clarify the question of whether the Commerce Clause applies to inactivity, the individual mandate in the Affordable Care Act may become the precedent upon which future activists justify even further expansion of government power.

The Supreme Court has in its history widened, and narrowed the definition of ‘commerce’. The case that may pertain in this instance took place in the Lochner era of 1905 to 1937. Here the Supreme Court decision struck down a law that limited the number of permissible hours of working in bakeries. The majority of the Court held that the state law [New York] violated the freedom of contract. That the freedom of contract was an integral part of the liberty provided under the 14’th Amendment protecting the due process clause.

I think therefore that the abomination that is Obamacare, will in possibility be struck down by the Supreme Court. US medical costs are seriously out of control.

The thing with Obamacare is this: the law has not been in effect long enough for the effects to be seen. The medical costs have been rising for different reasons. They rise mostly due to the influence the large pharmaceutical companies have upon government. So while the repeal of Obamacare is a good thing from the point of view for the Constitution, it will have little or no effect on medical inflation. For serious inroads here, a game changing innovation is required, possibly from gene therapy.

Healthcare costs will continue to drive medical inflation, and hence earnings. Earnings that will contribute to the aggregate earnings of the S&P500, as will the energy sector.

UNEMPLOYMENT:
Unemployment is a lagging indicator. It lags at the turns. As a stockmarket indicator, not too much attention should be allocated. The economic policies that are required to improve employment are however an issue for employment. The cost of employment at the margin, or the ‘discounted marginal value product’ [DMVP] of employment is the variable that creates or destroys jobs.

Unemployment was also driven by businesses cutting jobs to maintain profitability. How much further this could run is questionable. If there is more fat on the bone, unemployment could well rise as ‘costs’ cannot be passed forward to the consumer. This would suggest that the consumer goods stocks might come under some pressure to cut employment to maintain profitability. Consumers do not have much, if any slack, for increasing discretionary consumption: rising energy costs will further erode purchasing power. As utilities operate more or less as small local monopolies, these costs can be passed forward to a degree.

EUROPE:
Remains a mess. It however limps forward under a mixture of austerity and inflation. This mixed policy bag cannot be good for the majority, and even Germany will feel the effects. The effect, relatively speaking, is a positive for the US.

CURRENCY DEVALUATIONS
With all trying via currency devaluation to capture exports, something has to give: all cannot devalue at the same time. The result will be an increasing atmosphere of tariffs and protectionism, which inevitably raises international tensions, which under the law of monopoly increases the actual number of wars.

WAR:
That the US finally pulled out of Iraq, the question is for how long can they avoid becoming embroiled in yet another war? Already Iran is claiming, due to trade sanctions, to seek control of the oil transport water lanes. The sanctions were put in place due to Iran seeking nuclear weapons. Israel is particularly aggressive in this geographical region, and has strong influence on US foreign policy, which remains Imperialistic. Therefore while the US has ended one war, they will soon be embroiled in another. The Welfare-Warfare-State cannot have it any other way. Again, either US military based stocks and/or major energy producers.

ENERGY:
Oil prices will continue to rise on the back of world-wide inflation. To such an extent that many economies will not be able to afford the prices. Coal will make a comeback, certainly in Chinese consumption of energy needs. In the absence of any real viable alternatives, coal consumption and production will pick-up. The ETF KOL [which I hold] will likely see some price appreciation and provide some diversification via holdings of Chinese coal producers.

GOLD:
Is the ‘bull’ run in gold over? I really don’t know. Gold and Silver tend to appreciate in value under conditions of uncertainty and inflation. We’ll have inflation, we’ll have uncertainty, but I’m not sure that we’ll see gold gaining new highs, at least not immediately. To me gold looks to be heading towards $1300.00oz. At this area, or even a little lower, then, possibly, the gold bull might resume. If gold is your thing, then avoid gold mining stocks, which are just destructive of value, stay with the actual metal itself.

BLACK SWANS:
Will be white. The biggest shock to investors will be the rise in the market, against all expectations, against the news-flow, against the direst of predictions.

SUMMARY:
You want to be in the market, against all better judgments. The two markets that are viable are the market for common stocks, and the commodities markets.

I predict I will lose a great deal of money in DECK today, thanks to seemingly warm weather.

Apparently, we’ve all become Barney Rubbles, walking barefoot throughout the wilderness. The stock is down another $4.5 on no news.

It’s not that flippe-floppe-flye buys or recommends stocks that underperform, it’s that he has absolutely no idea or plan on how to manage the trade.

But, the bull, when he arrives, will again be a monster.

Go here to read all about it.

Back in the heady days of 2007, the US Congress established mandates for the amount of cellulosic ethanol and other biofuels to be used in the nation’s transportation fuel supply. Cellulosic ethanol and fuels based on algae are made from non-edible biomass, and thus avoid the criticism of replacing food with fuel. The Congressional mandates were very aggressive, calling for 100 million gallons of cellulosic ethanol by 2009, 250 million gallons by 2010, and 500 million gallons by 2013. By 2022, US transportation fuel is supposed to include 16 billion gallons of cellulosic ethanol.

In 2010, the mandate was lowered for that year to 6.5 million gallons and for 2012, the mandate set by the US Environmental Protection Agency has been set at 8.5 million gallons. Companies like Codexis Inc. (NASDAQ: CDXS), Amyris Inc. (NASDAQ: AMRS), Gevo Inc. (NASDAQ: GEVO), Solazyme Inc. (NASDAQ: SZYM) and Kior Corp. (NASDAQ: KIOR) have so far failed to reach production levels anywhere near mandated levels. Traditional corn-ethanol makers like Archer Daniels Midland Co. (NYSE: ADM), Valero Energy Corp. (NYSE: VLO), and Pacific Ethanol Inc. (NASDAQ: PEIX) continue to supply the vast majority of non-petroleum based fuels.

Refiners are required either to use cellulosic ethanol or to pay $1.20/gallon for the privilege of not using it. Because so little is available, refiners end up paying for something they can’t buy at any price.

Most biofuels makers have turned to producing specialty chemicals for the cosmetics and pharmaceuticals industries in order to make some revenue. Truth be told, a gallon of a cosmetic component is far more costly than a gallon of cellulosic ethanol, so these companies continue to work on developing substitute chemicals. The payback from these is more certain and nearer in time than is trying to scale up manufacturing of biofuels and facing uncertain political and distribution issues.

To show how hard things have been, the share price of many pure-play stocks pretty much sums it all up:

Codexis trades at $5.53 and its 52-week trading range is $3.91 to $12.24.
Amyris trades at $11.16 and its 52-week trading range is $9.90 to $33.99.
Gevo trades at $5.59 and its 52-week trading range is $5.18 to $26.36.
Solazyme trades at $11.27 and its 52-week trading range is $7.68 to $27.47.
KiOR trades at $9.31 and its 52-week trading range is $8.88 to $23.85.

And this is a negative?

I think not. If CDXS can produce, they can sell. It is only a matter of expanding production, backed by Royal Dutch Shell, capital is not the issue. This is a great little stock that has great potential and a government subsidy.

Now this chart goes to the ‘type of market’. In a stable volatile market, which to date we have had, you expect a reversion. However, we are near a breakout point, where the market would change to a trending volatile market. We have had since the September lows a series of higher highs, higher lows, which is a trending market, contained within a wide range, which is our stable volatile market.

Technical analysis confirms this via a trendline study across two timeframes, resulting in a symmetrical triangle. Which way will it resolve? You go with the current trend until proven wrong. All the faster, or shorter timeframes also fail to confirm the end of the current trend: you sit it out. It is volatile, that means that price will reverse against your position, that simply is a fact of financial markets, don’t sweat it.

In gambling, the risk of ruin refers to the likelihood that you bust out and lose all, prior to possibly winning, because you were actually gambling with a positive expectancy. For example using the simple die roll. If I were to offer you $2 for every $1 bet if the numbers 4, 5, 6 were to come up, you would have a positive expectancy bet.

The problem, or question however is: how much would you actually bet? Bet too much, say 100% of your available funds, and there is still a 50% chance that you go bust as a 1, 2 or 3 could come up. Even reducing the bet could result in a total loss as a lower probability of a long run of 1, 2, and 3 emerges.

The problem then with any allocation into a system that trades stocks, has this same problem. How, assuming a positive expectancy system, do you allocate funds? There is no perfect answer, however the methodology that I will follow in the newsletter that is obviously purely optional, it is primarily written on the signal, will be a fairly conservative methodology.

The methodology will run two strategies in one. This is to allow for an adaption to all market environments: the stable market and the trending market. The system incorporates a weekly component that ‘times’ the market, which only constitutes 5% of total funds, and a longer term method that seeks to compound both the capital gains, and the total number of shares held.

The shorter, faster, pure timing method, will, in the correct market, hold ‘short’ positions. The longer term method will always remain ‘long’. The % positions will obviously alter over time as the portfolio grows.

The signals are weekly for the timing component, although as the current newsletter indicates that this is currently a ‘hold’ already existing long positions. Remember this is not a daytrading system, it is a ‘weekly’ system.

The longer term system is simply a ‘buy’. This is how you would stand:
Total Cash $1,000,000. 00
Allocated $500,000 ……50%
Swing component 10% of the 50% allocated
Cash 500,000.00 ………50%

The Swing system was triggered long at the bottom of the market in September. That long signal has not yet been rescinded. It remains long, thus the ‘hold’ recommendation. If there comes a ‘sell’ signal, the swing component, in this case the 10% or 400 shares of SPY will be sold, but not sold ‘short’, simply the position closed, and moved to cash.

The longer term system will remain long. Should the market decline, and seriously decline, this constant position will enter a drawdown. Drawdowns are not pleasant, but they are a reality of system based trading. They are a necessary component.

In a serious decline, there may come a ‘sell short’ signal. This ‘short’ position will be bought with the swing 10%. You can hold it as an inverse ETF, leveraged if you wish, or PUTS. You are now both long and short.

In a reversal, where a buy signal is issued, depending on the ‘trend’ of the market, you may then close the swing short and initiate a swing long, or go to cash, looking for a re-entry ‘short’. In the longer term position, you may increase the total holding from the cash that exists held in the portfolio. It sounds a bit convoluted, but actually it’s fairly straightforward.

As I said earlier, this is purely optional. The newsletter is produced simply for the signal. The method that I follow is purely optional, and you can follow along via the link and the various updates and commentaries that will appear on the blog as we go. It will be very transparent, and all will become clear after a week or two. Essentially the methodology is trying to reduce and eliminate the ‘risk of ruin’ through correct position sizing cognizant of a positive expectancy system.

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