predicting the future year


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1. China finally decides that a nuclear capability in the hands of an unpredictable leader on its border is not tolerable even though North Korea is a communist buffer between itself and democratic South Korea. China cuts off all fuel and food shipments to North Korea, which agrees to suspend its nuclear development program but not give up its current weapons arsenal.

2. Populism, tribalism and anarchy spread around the world. In the United Kingdom Jeremy Corbyn becomes the next Prime Minister. In spite of repressive action by the Spanish government, Catalonia remains turbulent. Despite the adverse economic consequences of the Brexit vote, the unintended positive consequence is that it brings continental Europe closer together with more economic cooperation and faster growth.

3. The dollar finally comes to life. Real growth exceeds 3% in the United States, which, coupled with the implementation of some components of the Trump pro-business agenda, renews investor interest in owning dollar-denominated assets, and the euro drops to 1.10 and the yen to 120 against the dollar.  Repatriation of foreign profits held abroad by U.S. companies helps.

4. The U.S. economy has a better year than 2017, but speculation reaches an extreme and ultimately the S&P 500 has a 10% correction. The index drops toward 2300, partly because of higher interest rates, but ends the year above 3000 since earnings continue to expand and economic growth heads toward 4%.

5. The price of West Texas Intermediate Crude moves above $80. The price rises because of continued world growth and unexpected demand from developing markets, together with disappointing hydraulic fracking production, diminished inventories, OPEC discipline and only modest production increases from Russia, Nigeria, Venezuela, Iraq and Iran.

6. Inflation becomes an issue of concern. Continued world GDP growth puts pressure on commodity prices. Tight labor markets in the industrialized countries create wage increases. In the United States, average hourly earnings gains approach 4% and the Consumer Price Index pushes above 3%.

7. With higher inflation, interest rates begin to rise. The Federal Reserve increases short-term rates four times in 2018 and the 10-year U.S. Treasury yield moves toward 4%, but the Fed shrinks its balance sheet only modestly because of the potential impact on the financial markets. High yield spreads widen, causing concern in the equity market.

8. Both NAFTA and the Iran agreement endure in spite of Trump railing against them. Too many American jobs would be lost if NAFTA ended, and our allies universally support continuing the Iran agreement. Trump begins to think that not signing on to the Trans-Pacific Partnership was a mistake as he sees the rise of China’s influence around the world.  He presses for more bilateral trade deals in Asia.

9. The Republicans lose control of both the Senate and the House of Representatives in the November election. Voters feel disappointed that many promises made during Trump’s presidential campaign were not implemented in legislation and there is a growing negative reaction to his endless Tweets. The mid-term election turns out to be a referendum on the Trump Presidency.

10. Xi Jinping, having broadened his authority at the 19th Party Congress in October, focuses on China’s credit problems and decides to limit business borrowing even if it means slowing the economy down and creating fewer jobs. Real GDP growth drops to 5.5%, with, only minor implications for world growth. Xi proclaims this move will ensure the sustainability of China’s growth over the long term.

ALSO RANS

Every year there are always a few Surprises that do not make the Ten because either I do not think they are as relevant as those on the basic list or I am not comfortable with the idea that they are “probable.”

11. Investors recognize that the earnings of companies in Europe, the Far East and the emerging markets are growing faster than those in the United States while the price earnings ratios in those regions are lower than those in America. Global investments become more broadly represented in institutional portfolios.

12. The Mueller investigation of the 2016 presidential election fails to implicate any members of the Trump family in collusion with Russian operatives.

13. Artificial intelligence gains visible momentum. Service sector jobs are automated, particularly clerks in legal and finance professions, as well as workers in fast food outlets and healthcare. Economists begin to question the unemployment data because the rate drops below 4% while so many people still appear to be out of work and seeking government assistance.

14. Cyberattacks become more prevalent and begin to affect consumer confidence. A major money center bank suspends deposits or withdrawals for three days because its system is penetrated. Numerous retail organizations report that customer personal information has been obtained by hackers. Those invading corporate information systems appear to be smarter and more innovative than the internal employees protecting the computer data, suggesting that the systems themselves need to be upgraded.

15. The regulatory authorities in Europe and the United States finally get concerned about the creative destruction of Internet-related businesses.  As a result of pressure from retailers and traditional media companies, they begin an investigation of anti-competitive practices at Amazon, Facebook and Google.  The public begins to think these companies have too much power.

16. The risks in Bitcoin are so great that regulatory authorities restrict trading.  Among their concerns are: no regulatory oversight; no safety and soundness measures; no recourse in the event of mistaken or miscalculated transactions; high cyber risk; no deposit insurance.

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What’s neat about this isn’t what’s changed. It’s what’s stayed the same.

The line, “One million titles, consistently low prices” seems like marketing guff. But it helps explain why Amazon has dominated where others have failed.

The allure of the Internet in 1995 was betting on change. New paradigms born. Old strategies discarded. Something requiring radically different thinking.

Yet Amazon’s focus from day one was as old as it gets. Selection and price. Businesses have pursued the idea for millennia.

Jeff Bezos once explained why this was critical:

I very frequently get the question: “What’s going to change in the next 10 years?” That’s a very interesting question.

I almost never get the question: “What’s not going to change in the next 10 years?” And I submit to you that that second question is actually the more important of the two.

You can build a business strategy around the things that are stable in time. In our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, “Jeff I love Amazon, I just wish the prices were a little higher.” Or, “I love Amazon, I just wish you’d deliver a little slower.” Impossible.

So we know the energy we put into these things today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it.

This is one of those important things that’s too basic for most smart people to pay attention to.

***

Things that change are amazing. They can fuel massive growth.

But change by itself is hard. Investors have to spot it before it’s obvious. Consumers have to change their behaviors to make it viable. Those two points repel each other like magnets. And things that change tend to keep changing. A company whose pitch is “We’re doing this entirely new thing” likely has to reinvent itself and its product line every year, maybe more. Each iteration is a front-line battle where you’re exhausted from the last war but overconfident from its victory. So the odds keep stacking against you. An investor hoping to ride successive changes in multiple industries over a 40-year career faces tenth-degree difficulty. Practically a claim of clairvoyance.

Change often creates bursts of opportunity. Huge opportunity, yes. But businesses and their investors need more than slippery bursts to succeed. They need endurance. And endurance resides in long-term bets. Things you can pour energy and capital into today with a reasonable chance of still bearing fruit ten years from now. Which tend to be things that are stable in time.

This might seem heretical to venture capital. Marc Andreessen was once asked how his investment style compared with Warren Buffett. He replied:

[Warren is] betting against change. We’re betting for change. When he makes a mistake, it’s because something changes that he didn’t expect. When we make a mistake, it’s because something doesn’t change that we thought would. We could not be more different in that way.

Seems directionally true. But I don’t think it’s that black and white. Both investors pursue the same things; they just weight them differently.

Every successful investment is some combination of change that drives competition and things staying the same that drives compounding. There are so few exceptions to this, regardless of size or industry.

Buffett has owned GEICO stock since 1951. During that time the company went from exclusively selling auto insurance to government employees in cafeterias, to selling several kinds of insurance to everyone on their iPhones. Analytics went from abacus to AI. These are not small changes. But one thing stayed the same, which is that an insurance company selling directly would have a cost and convenience advantage over those paying brokers. That’s been the driver of Buffett’s GEICO bet for 66 years. It’s timeless.

Andreessen Horowitz partner Frank Chen recently talked about two trends in insurance startups. One is better software. “Software will rewrite the entire way we buy and experience our insurance products,” he said. Second is capital structure. “We expect to see more crowdsourced insurance companies … it should be a cheaper way to pool capital.” Both innovations promise lower cost and added convenience. Which is as timeless as GEICO’s edge.

Investors weigh the importance of change and timelessness differently, but every great company has some element of both. The extremes are where things don’t work.

Take three companies in the 1990s: Sears, Beenz, and Amazon.

Sears bet the Internet changed nothing, to its detriment. Beenz bet the Internet changed everything – creating a points-based currency valid only at online merchants – to its detriment. Amazon bet the Internet changed distribution, but rooted its strategy in things that have never, and will never, change. It nailed the center of the Venn diagram of change on one side and timeless on the other. One drove competition, the other drove compounding. Every successful company does this.

***

In the last 100 years we’ve gone from horses to jets and mailing letters to Skype. But every sustainable business is accompanied by one of a handful of timeless strategies:

  • Lower prices.
  • Faster solutions to problems.
  • Greater control over your time.
  • More choices.
  • Added comfort.
  • Entertainment/curiosity.
  • Deeper human interactions.
  • Greater transparency.
  • Less collateral damage.
  • Higher social status.
  • Increased confidence/trust.

You can make big, long-term bets on these things, because there’s no chance people will stop caring about them in the future.

 

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Speaking in London, Federal Reserve chair Janet Yellen Tuesday predicted that the “the system is much safer and much sounder” and explained that the Federal Reserve is prepared to deal with numerous enormous shocks to the economy.

In her conversation with Lord Nicholas Stern, Yellen also went on to list the reasons that, thanks to central bank intervention, there is unlikely to be another financial crisis “in our lifetimes.”

For those who have lived through more than one business cycle, however, alarm bells tend to go off every time an economist, central banker or high-ranking government official declares that there’s little to no danger of economic turmoil in the near future.

There is a long history of spectacularly bad predictions being made shortly before economic crises. Famously, shortly before the Crash of 1929 — one of the earlier crises that occurred on the Federal Reserve’s watch — Herbert Hoover proclaimed that “We in America today are nearer to the final triumph over poverty than ever before in the history of any land.”

But, we certainly don’t have to go back that far.

Indeed, in the late 1990s, it became nearly routine to hear economists announce that “the internet changes everything” and “the business cycle is dead.”

Economist Rudi Dornbusch — a close associate of current Fed vice chair Stanley Fischer — even wrote a July 1998 column in the Wall Street Journal titled “Growth Forever.” Dornbusch concluded that the possibility of an imminent recession “is remote” and the country “will not see a recession for years to come.” So sure of the benefits of the “new economy” was Dornbusch, in fact, that he declared, “This expansion will run forever.”

Then came the dot-com bust of 2001. After that came a short expansion from 2002 to 2007. After that came the Great Recession.

Meanwhile, from 2000 to 2015, according to the federal government’s data, real median household income was flat. Only over the past two years have we seen any of that expansion that many were venturing to say was permanent back in the late 1990s.

Economists and policymakers were no more insightful when examining the possibility of a new crisis post-2007.

In 2005, for example, Milton Friedman could have been paraphrasing Yellen’s Tuesday comments when he concluded that “the stability of the economy is greater than it has ever been in our history. We really are in remarkable shape.” Friedman went on to give Alan Greenspan credit for the expansion.

In early 2007, Ben Bernanke predicted, “We’ll see some strengthening in the economy sometime during the middle of the new year.”

As late of mid-2007, Bernanke was downplaying any problems associated with the sub-prime housing market, allaying any fears of a bubble or bust and claiming, “I don’t know whether prices are exactly where they should be, but I think it’s fair to say that much of what’s happened [i.e, enormous home price growth during the housing bubble] is supported by the strength of the economy.”

If housing bubbles do prove to be a problem, Bernanke concluded, it’s “mostly a localized problem and not something that’s going to affect the national economy.”

The US would officially begin to contract in December 2007, followed by a financial crisis the following autumn.

Even on the eve of the crisis — in September 2008 — John McCain announced that “the fundamentals of our economy are strong.”

A year later, the unemployment rate would reach 10 percent, foreclosure rates were surging and total employment would collapse from 116 million to 107 million. Employment would not return to pre-crisis levels until late 2013.

Millions of workers would need to change careers, be retrained, scratch for other forms of income to avoid foreclosure or eviction and put off retirement indefinitely. The economy was so weak for so long, in fact, that the Fed felt it necessary to keep the key target interest rate near zero for seven years to add “stimulus.”

Of course, just because Janet Yellen says the economy won’t experience a crisis anytime soon doesn’t mean a crisis is imminent. A truly strong economy isn’t going to be “jinxed” by a declaration that things are fine. On the other hand, given the record of eminent economists and Fed board members in the past, Yellen’s predictions are hardly anything that should inspire confidence.

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Now here are The Ten Surprises of 2017. I will discuss them in detail in my February essay.

1. Still brooding about his loss of the popular vote, Donald Trump vows to win over those who oppose him by 2020. He moves away from his more extreme positions on virtually all issues to the dismay of some right wing loyalists. He insists, “The voters elected me, not some ideology.” His unilateral actions throw policy staffers throughout the government into turmoil. Virtually all of the treaties and agreements he vowed to tear up on his first day in office are modified, not trashed. His wastebasket remains empty.

2. The combination of tax cuts on corporations and individuals, more constructive trade agreements, dismantling regulation of financial and energy companies, and infrastructure tax incentives pushes the 2017 real growth rate above 3% for the U.S. economy. Productivity improves for the first time since 2014.

3. The Standard & Poor’s 500 operating earnings are $130 in 2017 and the index rises to 2500 as investors become convinced the U.S. economy is back on a long-term growth path. Fears about a ballooning budget deficit are kept in the background. Will dynamic scoring reducing the budget deficit actually kick in?

4. Macro investors make a killing on currency fluctuations. The Japanese yen goes to 130 against the dollar, stimulating exports there. As Brexit moves closer, the British pound declines to 1.10 against the dollar, causing a surge in tourism and speculation in real estate. The euro drops below par against the dollar.

5. Increased economic growth, inflation moving toward 3%, and renewed demand for capital push interest rates higher across the board. The 10-year U.S. Treasury yield approaches 4%.

6. Populism spreads over Europe affecting the elections in France and Germany. Angela Merkel loses the vote in October. Across Europe the electorate questions the usefulness of the European Union and, by the end of the year, plans are actively discussed to close it down, abandon the euro and return to their national currencies.

7. Reducing regulations in the energy industry leads to a surge in production in the United States. Iran and Iraq also step up their output. The increased supply keeps the price of West Texas Intermediate below $60 for most of the year in spite of increased world demand.

8. Donald Trump realizes he has been all wrong about China. Its currency is overvalued, not undervalued, and depreciates to eight to the dollar. Its economy flourishes on consumer spending on goods produced at home and greater exports. Trump avoids punitive tariffs to prevent a trade war and develops a more cooperative relationship with the world’s second largest economy.

9. Benefiting from stronger growth in China and the United States, real growth in Japan exceeds 2% for the first time in decades and its stock market leads other developed countries in appreciation for the year.

10. The Middle East cools down. Donald Trump and his Secretary of State Rex Tillerson, working with Vladimir Putin, finally negotiate a lasting ceasefire in Syria. ISIS diminishes significantly as a Middle East threat. Bashar al-Assad remains in power.

ALSO RANS

Every year there are always a few Surprises that do not make the Ten either because I do not think they are as relevant as those on the basic list or I am not comfortable with the idea that they are “probable.”

11. Having grown weary of Washington after a year in the presidency, Donald Trump moves the White House to New York from April to December and to Palm Beach from January to March. He makes day trips to the Capitol on Air Force One for legislative and diplomatic purposes.

12. The Democratic Party is sharply divided on strategy, with Bernie Sanders and Elizabeth Warren arguing for a shift to the left and others wanting to remain in the center. A lack of leadership gives rise to widespread speculation about sharp losses in the 2018 congressional elections.

13. Donald Trump’s intimidation tactics prove effective in discouraging companies from moving some U.S. manufacturing abroad, but he fails to bring jobs back. The wage differential is just too great. This becomes his biggest first-year disappointment.

14. Trump’s first major international confrontation comes, not unexpectedly, from North Korea. Kim Jong-un threatens to set off a nuclear bomb in the mid-Pacific, calling it “a test.” Trump’s advisors try to restrain his desire to punish the country severely.

15. India comes back into the investment limelight. Its economy grows at 7% and corporate profits for established companies are strong. Its stock market leads other large emerging countries, along with China.

16. Trump’s efforts to get out of the Iran deal fail. The other countries signing the agreement believe Iran’s weapons-grade nuclear production has been restrained and force the U.S. to remain a participant.

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One of the things I failed to learn after writing a book was the simple fact that methodically demonstrating a thing with data and evidence doesn’t resolve that issue. I shouldn’t have been so naive, given that some people still are flat-earthers, or are anti-vaxxers, or Holocaust deniers, or claim that global warming is a Chinese hoax.

Which is why, despite all of the earlier discussions about the folly of forecasts, I find myself once again compelled to bring up this subject. Blame it on the time of year, when all of the forecasts for 2017 are being rolled out, while the old ones that were so-often wrong are forgotten instead of being reviewed.

So please consider this column a public service. Here is a round-up of some of 2016’s forecasts, and a look at why they didn’t quite work out as expected:

• Get Ready for $80 Oil: “When oil drilling activity collapses, oil supply goes down too.” That may or may not be true, but one thing we know is that oil never got anywhere near $80 this year, peaking at about $53 earlier this week. The error here is assuming you can: Accurately measure a drilling activity slowdown; figure out what that impact will be on supply; and determine how that will affect prices. This forecast, made by Raymond James, tried to thread that needle. It didn’t happen.

• The recession of 2016: “Central bank bungles, oil price fluctuations and overregulation indicate contraction.” This forecast, published in the reliably ideological Washington Times, commits the classic analytical error of infusing emotional politics into forecasts. The author opposed the Federal Reserve’s program of quantitative easing as well as government regulations, so of course these things will cause a recession! Only, they didn’t. Economic analysis colored by political bias equals awful investing advice.

• Recession sign is in play and has 81% accuracy: Recessions have followed consecutive quarters of corporate earnings declines (whenever that happens) four out of five times, according to JPMorgan Chase & Co. strategists. There are at least two reasons for this: First, as we have discussed before, relying on a single variable to explain a complex system such as the economy is a poor approach to analysis. The world is just not black and white. Second, it confuses correlation with causation.

• Billionaire Sam Zell Says Recession Likely in Next 12 Months: This one blames the Fed and the strong dollar, which fell in the six months after Zell’s prediction. We have discussed Zell’s call before, but a few words about the halo effect, or the tendency to give people successful in one field more credibility than is warranted in other areas. Although we have to give credit to a billionaires’ ability to make money, they probably don’t have a comparable ability to foretell recessions.

• Why Gold Will See $2,000: Gold bugs are too easy to debunk. But as a reminder, the market has managed to figure out that China and India are net buyers of gold, and have been for thousands of years. That isn’t what is going to drive its price, which never reached more than about $1,375 this year.

Debate Night Message: The Markets Are Afraid of Donald Trump: “Wall Street fears a Trump presidency. Stocks may lose 10 to 12 percent of their value if he wins the November election, and there may be a broader economic downturn.” So wrote Justin Wolfers in the New York Times on Sept. 30, based on a “close analysis of financial markets during Monday’s presidential debate.” This looks like another classic error of causation and correlation. This prediction, for all we know, may yet prove true. But we have to note that since the election, the Standard & Poor’s 500 Index is up 6 percent.

• This Dow rally will end March 23: This forecast was made on Feb. 16, so at least it didn’t have much shelf life. Studies have shown that people prefer false precision to accurate ambiguity. The forecaster who tells you that the future is inherently unknowable, and all forecasts 12 months out are just guesses isn’t as well received as someone saying with certainty that the Dow Jones Industrial Average will top 21,000 on the day Donald Trump is inaugurated as president. Why don’t investors recognize this? The answer is quite simple: It is just human nature.

Those who make forecasts for a living, or are asked to do so by the news media, should use the opportunity when they make a prediction to point out the absurdity of the exercise. My own 2017 predictionsattempt to do just that.

The bottom line remains: forecasts and predictions are exercises in marketing. Outrageous and wrong forecasts are typically forgotten, and when one randomly happens to come true, the guru is lauded as the next Nostradamus. It is an expensive and fatuous practice, and the finance industry should give it a permanent rest.

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Ray Kurzweil, the author, inventor, computer scientist, futurist and Google employee, was the featured keynote speaker Thursday afternoon at Postback, the annual conference presented by Seattle mobile marketing company Tune. His topic was the future of mobile technology. In Kurzweil’s world, however, that doesn’t just mean the future of smartphones — it means the future of humanity.

Continue reading for a few highlights from his talk.

On the effect of the modern information era: People think the world’s getting worse, and we see that on the left and the right, and we see that in other countries. People think the world is getting worse. … That’s the perception. What’s actually happening is our information about what’s wrong in the world is getting better. A century ago, there would be a battle that wiped out the next village, you’d never even hear about it. Now there’s an incident halfway around the globe and we not only hear about it, we experience it.

Which is why the perception that someone like Trump sells, could be false and misleading. But more importantly, what actions we take based upon that information. If I respond differently, then my perception has directly changed my actions, which has unforseen ramifications when multiplied by millions.

Brexit could be an example of exactly this.

On the potential of human genomics: It’s not just collecting what is basically the object code of life that is expanding exponentially. Our ability to understand it, to reverse-engineer it, to simulate it, and most importantly to reprogram this outdated software is also expanding exponentially. Genes are software programs. It’s not a metaphor. They are sequences of data. But they evolved many years ago, many tens of thousands of years ago, when conditions were different.

Clearly our genome is not exactly the same. It to has evolved. This may have been through random mutations, in which certain recipients thrived in a changing environment.

How technology will change humanity’s geographic needs: We’re only crowded because we’ve crowded ourselves into cities. Try taking a train trip across the United States, or Europe or Asia or anywhere in the world. Ninety-nine percent of the land is not used. Now, we don’t want to use it because you don’t want to be out in the boondocks if you don’t have people to work and play with. That’s already changing now that we have some level of virtual communication. We can have workgroups that are spread out. … But ultimately, we’ll have full-immersion virtual reality from within the nervous system, augmented reality.

One of my favorite novels is Asimov’s “Foundation” series. The planet Trantor….entirely covered by a city. Is that what we want?

On connecting the brain directly to the cloud: We don’t yet have brain extenders directly from our brain. We do have brain extenders indirectly. I mean this (holds up his smartphone) is a brain extender. … Ultimately we’ll put them directly in our brains. But not just to do search and language translation and other types of things we do now with mobile apps, but to actually extend the very scope of our brain.

The mobile phone as a brain extender. Possibly true for 1% of all users. Most use facebook or whatever other time wasting application, and essentially gossip. A monumental waste of time. Far from being a brain extender, for most, it is the ultimate dumbing down machine. Text language encourages bad spelling, poor grammar etc. So you can keep your brain extenders.

As far as directly connecting your brain to the cloud….that sounds like ‘The Matrix”, which is of course the subject of philosophical musings about the brain in a vat. The potential for mind control would seem to be a possibility here. Not for me thanks.

Why machines won’t displace humans: We’re going to merge with them, we’re going to make ourselves smarter. We’re already doing that. These mobile devices make us smarter. We’re routinely doing things we couldn’t possibly do without these brain extenders.

To date, I would argue that the vast majority are significantly more stupid because of them.

As to robots and AI, imagine a man, Spock, who’s choice making is driven 100% by logic, rather than by 50% logic and 50% emotion. How long does the emotional decision maker last? Most emotional decisions get us in trouble. The market is an excellent example. Politics is another, ie. Trump.

 

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The bear case rests on two major Federal Reserve policies: [i] the [gradual] withdrawal of QE and [ii] the continuance of ZIRP. If either one is reversed, the stock market reverses.

There is however the interest rate curve to consider, other than the short end which is controlled by the Federal Reserve.

10yr

The 10yr has bottomed. It has also started what looks like a new trend higher. This is in large part because the Fed switched its QE purchases away from the 10yr and back to MBS securities [to hold mortgages lower] and the banks’ balance sheets.

In the short term, a very indefinite period of time, I don’t believe that a rising interest rate effects stocks in a negative manner. After all buying against the trend of rising yields, costs you money. Also currently the real return is far lower, thus stocks, which appreciate nominally, continue to benefit.

At some point though this changes. At some point the relative risk of the so called risk-free return outweighs the nominal [or real] returns on holding stocks. At that point, we see a rotation out of stocks back into Treasuries. Will that point be reached in 2014? I don’t think so, but, watch it nonetheless.

Margin Debt.

Margin debt suddenly started to be discussed again within the last two weeks. Margin creates leverage. High leverage that remains unhedged, creates higher volatility. Higher volatility creates a higher perceived risk. Both of these combine into shortening the ability to hold investments, and magnify losses to the position. That margin debt is again at or near all-time highs argues for an increase in volatility. Data here

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Sentiment.

dumb money

Sentiment is also driven via the media. Whether that be the traditional media or the newer blogoland. All forms of sentiment tend to conform to the current trend. When at extremes, also tend to be wrong.

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Let me start with this last year’s stock market. Retrospectively in a few years the refrain will likely be, oh, that was an easy market it only went up. Because [pretty much] it only went up, it has been a very difficult market to stay long in [lots of Hedge Funds couldn’t or didn’t] and underperformed.

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So of course the question is: does this bull market continue? The answer at least from this chap is:

parabola collaspe

This is based on empirical data, a true statement. It is likely to be true at some point in the future also. The question again is, assuming that it is true, when? That of course is the question that no-one can actually answer although many will try.

One approach is to elucidate the variables that actually created the bull market from March 2009 through to today. Clearly QE must be on the list.

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Also something that should be considered is that in a period of consolidation, the breakout, if it occurs, is substantial and sustained. As can be seen, the consolidation was significant and the breakout higher [for whatever reason] could run a lot farther than many might expect.

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Another argument for the continuation is that current valuations are not in that turnaround zone, the P/E still below 20 at 18.

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Sentiment fluctuates. Until recently however we have had a number of perma-bears. Some quite recently have flippe-flopped, but there are still enough out there to give the bull some legs.

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Interest rates at the short end are going to be held low. This means ongoing credit creation.

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Unemployment remains high. This will allow the Federal Reserve to hold QE for longer, and also maintain the low interest rates until the inflation even on the manipulated CPI ratchets too high. However for the moment unemployment will not make any meaningful improvements.

Inflation also remains according to the manipulated CPI ‘low’. Clearly this is false, however until the mainstream start to shout fire, the general perception is that inflation is low will remain.

In summary, these have been the primary drivers of the surge in the stock market. Should they all remain, then there is no reason why the market cannot move higher in 2014.

I will look at the bear case in part II

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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.

orszag_graphofyear

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.

holtzeakin_graphofyear

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.

flippe-floppe-flye

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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