Saturday, January 1, 2011

Outlook 2011: Climbing the Wall of Worry?

Let me first wish all my readers a Happy New Year full of health & happiness. It's that time of year where I reflect on what lies ahead. Last year I wrote about Black Sloths and commented:
...the global pension crisis will not disappear overnight. It is a long-term structural issue that will plague governments for years. In fact, part of me thinks that the Fed and other central bankers will try to engineer inflation to partly offset future pension liabilities.

My worst fear is that they will fail miserably, creating another generation of paupers. I hope I am wrong, but this remains my worst fear for the next few years. I do hope monetary authorities and governments take the pension crisis more seriously.
Governments around the world are taking a closer look at pensions, especially public pensions, but I'm not convinced they're moving in the right direction. I worry that instead of bolstering retirement systems around the world, we are weakening them, leaving far too many people exposed to the vagaries of "sophisticated" wolf markets. This virtually guarantees more pension poverty down the road.

As for monetary policy, the Fed continued engaging in quantitative easing (QE) in order to reflate risk assets and is engineering inflation, including inflation in emerging markets.

I still maintain that the financial oligarchs and power elite have vested interests to keep the current financial system alive for as long as possible. Their worst fear is to be trapped in a prolonged period of debt deflation. That's why I still think the dips will be bought and that liquidity flows will continue driving risk assets higher in 2011.

But every year is different. The easy money was made in 2009 following post-deleveraging blues. Going forward, it will be much harder to make money off broad market moves, and deleveraging hasn't gone away, but I also think the world isn't half as bad as many bears scare us into believing.

Before you sell all your stocks or do anything extreme, take a step back and read some predictions for 2011. Let's begin with Larry MacDonald who reports in CTV, Reasons to be both bullish and bearish in 2011:

In 1931, The New York Times celebrated its 80th anniversary by asking Henry Ford and other luminaries to forecast what the world would be like in 2011, another 80 years ahead. As the archives on the newspaper’s website reveal, Mr. Ford envisioned more success “in passing around the real profit of life.”

He may prove to be right. Investment strategists, most economists and investor sentiment surveys see higher stock markets and economic growth in 2011. But there are voices of dissent, or at least caution. Here are three reasons to be bullish for 2011 – and three reasons to be cautious.

Bullish: improving economic signals

Recent U.S. economic indicators hint that the self-sustaining phase of the business cycle may be close at hand. Retail sales have trended up since July to a three-year high, while jobless claims have declined, leaving the four-week average at its lowest point in nearly two and a half years.

The widely watched Weekly Leading Index published by the Economic Cycle Research Institute (ECRI) has risen to its best readings since May 28. Money supply and credit aggregates are turning up as well, observes institutional advisory BCA Research, suggesting banks are beginning to lend and firms to borrow.

Bearish: housing sector missing in action

Historically, the housing market leads U.S. economic recoveries. But stimulus so far has been “inadequate to lift home construction and sales,” reports Asha Bangalore, senior economist at the Northern Trust Company in Chicago.

Adding to concerns, the S&P/Case-Shiller Home Price Index has started to go down in recent months and could fall further. “There is still roughly two years of unsold inventory overhanging the market once the ‘shadow’ foreclosure backlog is included,” Gluskin Sheff chief economist David Rosenberg declares.

Bullish: supportive policy

Sparked by earlier fears of a double-dip recession, U.S. policy makers recently announced new measures to boost the economy. Bush-era tax cuts were maintained, the payroll tax temporarily cut by 2 per cent, and unemployment benefits extended.

The Federal Reserve announced a second round of quantitative easing, committing to the purchase of $600-billion (U.S.) in U.S. government bonds by June. The Fed wants to keep five- and 10-year Treasury yields down and encourage U.S. banks to lend rather than park funds in Treasuries, economists say.

Bearish: bond risk

If stimulus leads to growth quickening too much, the bond market could sell off, causing yields to shoot up and undermine the economy. The flash point is currently 3.8 per cent for 10-year U.S. Treasury yields, according to models developed by Peter Gibson, the CIBC World Markets chief portfolio strategist who has earned top rankings in the Brendan Wood International survey of analysts since 1994.

If yields breach this ceiling, the Fed will try to hammer them down with quantitative easing. If that doesn’t work, the Fed could raise short-term rates to appease the bond market with the prospect of economic slowdown, Mr. Gibson says.

Bullish: healthy corporations

U.S. corporations are “in phenomenal shape” writes Tony Boeckh in the Dec. 17 issue of the Boeckh Investment Letter. Profit margins, at 8.7 per cent, are way above the long-term average. And cash balances are huge, led by the technology sector with a cash-to-equity ratio that exceeds 25 per cent.

If the recovery picked up, “those cash holdings could be used for M&A activity, capital investment, share buybacks and, of course, higher dividend payouts,” Mr. Gibson writes. Exceptions may be exporters who keep cash balances offshore.

Bearish: state and local cutbacks

“One shock is the sharp pending drag from widespread and accelerating spending cutbacks and tax hikes at the fiscally strapped state and local government level [in the U.S],” Mr. Rosenberg points out. “This promises to be a major macro theme for 2011.”

Funding pressures are going to be more intense when the “Build America Bond” program winds up. “The sector has laid off 250,000 people in the past year and more is to come as this crucial 13-per-cent chunk of the economy moves further into downside mode,” he adds.

We continue on a bullish note which seems to be the consensus. Bob Doll, Chief Equity Strategist of BlackRock makes his 10 predictions for 2011:

1. US growth accelerates as US real GDP reaches a new all-time high.

2. The US economy creates two to three million jobs in 2011 as the unemployment rate falls to 9%.

3. US stocks experience a third year of double-digit percentage returns for the first time in more than a decade as earnings reach a new all-time high.

4. Stocks outperform bonds and cash.

5. The US stock market outperforms the MSCI World Index.

6. The United States, Germany and Brazil outperform Japan, Spain and China.

7. Commodities and emerging market currencies outperform the US dollar, the euro and the Japanese yen.

8. Strong balance sheets and free cash flow lead to significant increases in dividends, share buybacks, mergers and acquisitions and business reinvestment.

9. Investor capital flows move from bond funds to equity funds.

10. The 2012 Presidential campaign sees a plethora of Republican candidates while President Obama continues to move to the political center.

I tend to agree with most of these predictions, especially the ones I put in bold. One of the key things to watch for is how capital flows out of bond funds into equity funds. While stocks are likely to outperform bonds, I'm not bearish on bonds. I don't see inflation in the US and backups in long bond yields present opportunities for investors to pounce.

Importantly, the Fed will do whatever it takes to make sure bond yields do not wreak havoc on the financial system. The problem is that some feel we didn't need QE2 and there is way too much stimulus in the pipeline. Maybe the bond market is worried that another round of QE will propel yields higher. One portfolio manager told me: "we don't need more QE; it's going to backfire big time!". The same portfolio manager sees the curve flattening in 2011 as short rates rise in anticipation of Fed rate hikes in 2012.

And what about Doll's prediction that the US market will outperform all other markets? It might very well be the case, but Bernard Lapointe wrote an interesting comment in the Sceptical Market Observer claiming that 2011 may be the year for Japanese stocks. Who knows? I see liquidity flows continuing to drive US stocks higher.

As far as commodities, the biggest risk I see going forward is the price of oil overshooting $100/barrel. Forget the "imminent collapse of the euro zone" (won't happen) and pay attention to oil because the biggest risk to the recovery is the price of energy. I remain bullish on energy and alternative energy where I see a long-term secular bull market developing (and potential bubble). Higher energy prices will be positive for the Canadian stock market.

Finally, listen to Barton Biggs, Traxis Partners and Jeffrey Gerson, Gerson Guarino & Meisel Group founding partner provide their predictions and outlook for 2011. Gerson says the housing double dip is likely to worsen in 2011 and will pressure the economy. Gerson is approaching the markets in a cautious and tactical manner because he believes the market is unlikely to regain the highs as soon as many might think.

Barton Biggs, however, is extremely bullish. Although he believes the market is overbought he says the market can continue to rally higher in the early portion of 2011. I agree with Biggs, especially on emerging markets, which is why I believe markets will climb the wall of worry.

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