by Jeffrey Dow Jones
Thursday December 30th 2010, 7:13 am
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This week we’ll recap the predictions we made at the beginning of the year.
As expected, I got some right and some wrong. My broad thesis for 2010 was that after the recovery of 2009 it would be a reminder that things were still really tough out there. And for the first half of the year, that was spot on. All the forthcoming economic data would confirm that thesis and so would the development of Europe’s sovereign debt crisis. We also had the flash crash, evidence that beneath the surface these markets are still very unstable and volatile, full of mechanisms that neither the participants nor the regulators fully understand.
But something changed around mid-summer. Rumors started circling about a new round of asset purchases (QE2) by the Fed. And this was what I got dead wrong. I underestimated the Fed’s maniacal drive to prop up asset prices and force interest rates lower. In a lot of ways it was another dose of stimulus, a reminder that the Captain Ben will do everything in his power to keep the economy rolling.
1. No inflation and the dollar hangs in there: RIGHT
Keep in mind that at the time this was a very contrarian forecast. The Dollar was in a major slide at the end of 2009 with all sorts of investors around the world piling in on the short Dollar trade. Everybody was freaking out about the coming Inflation. 2010 was when those issues were supposed to come to a head and the Dollar would disintegrate.
But none of that happened. We had one of the lowest year-over-year increases in the CPI in history. The US Dollar index even rallied about 12% — 12%!! — before selling back off and closing the year up about 2.5%.
And here’s the CPI:
I don’t see any inflation or Dollar collapse, do you?
2. The stock market disappoints: WRONG
My prediction was that the S&P would end the year lower than it began. The S&P 500 actually gained 12.9%.
I don’t feel too bad about this one. One of my sub-predictions was that we’d see a drawdown of 20% or more, which classifies as a major drawdown. The S&P dropped a little over 17% from April through July, and that’s a pretty significant move. We also had the flash crash.
I mentioned I had it totally wrong about the Fed in 2010. Coincidentally, their first asset purchase program began in March 2009, right before the market started to recover. It concluded in March 2010, right before the market started to go down. You might say the big drawdown this year was actually because of Greece and the EU debt crisis, but allow me to submit that
- Greece is small
- The EU debt crisis is still getting worse
…and lately the market has been going up, up, up.
Everybody knew that the risk of the unwind or cessation of that Fed purchase program would be a falling market. No surprise, in late summer when rumors of a second round of Fed asset purchases (QE2) would commence, the market immediately started going back up again.
Can you guess what one of the main themes of my 2011 predictions is going to be?
3. Real estate falls further and then stabilizes: WRONG, sort of
Instead of falling and stabilizing, real estate stabilized and then fell. I was early on the timing.
The Case/Shiller Index was 145.77 last December, and the most recent reading (October) was 143.52. I know that is technically a decline which means I technically got this right, but it wasn’t exactly what I thought we’d see and so I can’t give myself credit here.
To be fair, based on other leading indexes and data sets it looks almost certain that Case/Shiller will continue to fall, perhaps significantly, in November through January.
It’s possible that I just jumped the gun on what I thought would be the final leg down. While I missed this prediction this year, it seems highly probable that it has now begun to materialize in line with the way I initially thought. Instead of happening through the spring/summer of 2010, it looks like that will happen this winter through mid-2011. We won’t get the year-end Case/Shiller data until next February and when we do, I think it’s a very likely that second dip I predicted will be clear and take us to a new low in real estate.
4. Hedge funds return to prominence: WRONG
The market gained about 10% this year. I don’t know of a single major hedge fund index that came anywhere close to that.
True, there wasn’t a single major hedge fund index that had anywhere close to a 17% drawdown. But still. The sector disappointed.
Hedge funds used to have a major advantage over traditional funds. They could employ all sorts of strategies that the average investor or the mainstream mutual fund simply couldn’t do. They still do that and still have a natural advantage. But wow, there are a boatload of mediocre hedge funds out there nowadays.
Some of you may know that our real business is asset management (not making silly predictions). We manage several different funds, one of which is a fund of other hedge funds. Let me tell you: this job has never been more difficult than it is today. We look at so many different funds every day and so many of them are total garbage. Amateur investors always get hoodwinked by flashy recent track records, but there’s much, much more that goes into assessing whether a fund is good or not. That’s where having the council of a professional can help out and it’s why many institutional investors should think twice about doing this stuff on their own.
I think that good hedge funds will outperform the market in the years to come, but I find it less and less likely that the majority of hedge funds do. After all, a mediocre hedge fund isn’t really much more than a mutual fund with a different fee structure. That shouldn’t be construed as applause for the mutual fund industry, which has countless more reasons to be ashamed of itself, but rather acknowledgement that investors can no longer just blindly throw money at any old hedge fund and assume it will outperform. There’s no question that this is the sector investors have to go to if they want the best risk-adjusted returns. But don’t attempt to navigate these waters without the help of a professional.
If I am confident of one thing in this industry — one single thing that a mountain of data backs up — it’s that alternative strategies produce better risk-adjusted performance over the long run than traditional strategies. Hedge funds won’t do in the next decade what they did in the last. But the good ones will beat the market and they’ll do it with less risk.
5. Democrats lose their stranglehold on American politics: RIGHT
Now, I wasn’t too hard on myself for missing the real estate and stock market predictions. So I won’t exult too much in my correctness here, because honestly, I had no idea it would be this bad.
To be clear: this was another very contrarian forecast. At the end of last year the Democrats were firmly in the driver’s seat. They had gigantic majorities in the Senate and House. They passed popular legislation with the homebuyer tax credit and cash-for-clunkers. It’s true that cracks were starting to appear in their approval ratings, but it was looking like their stimulus really was effective and that things were getting better because of it. All they needed to do was hold it together as the economy continued to heal towards November.
Man… what happened??
That’s really a question for the political pundits, not economic guys like me. One of the obvious answers would be the healthcare “reform” act. Another would be totally botching it on measures to create jobs.
But one of the less obvious answers could be the blowback they got from QE2. For whatever reason, the first round of quantitative easing in 2009 went off without a hitch and was very effective. Round two made the market rally, but it was majorly, globally, fantastically unpopular pretty much everywhere else. The “money printing” meme resurfaced and I think some of that may have (unfairly) been lain at the Democrats’ feet. The Fed, after all, is a politically independent entity despite what all the conspiracy theorists may tell you.
But cunning Republicans were able to link that quantitative easing to out-of-control spending by the party in power, and perhaps that was the flaming sabre that they needed to battle their way back in such dramatic fashion. Tea Party, anyone? Once again, everybody reacted emotionally.
6. Gold bubbles: RIGHT
My specific prediction was that gold would see a double digit year. It gained almost 30%.
This was also the year that I thought gold would move solidly into the mainstream and enter the third and final phase of its super bull market. I see ads for gold on ESPN now. I came home one day and Mrs. Draconian, who usually works late into the evening, was watching Oprah. There were gold ads on the commercial breaks. I told her, “I’m selling our gold.” She said, “are you crazy?”
It is well known in certain circles that I am indeed crazy. But in 2010 we saw the introduction of the Gold ATM. That, my friends, is crazy.
Everybody asks me about gold now. Back in 2003 when it was flirting with $400/oz the only people who would listen to me sing the praises of gold were gold bugs. Now the only people who listen to me and my extreme caution of gold are the perma-haters.
And this year the bubble debate sure heated up. It heated up in obvious ways — all sorts of people appeared on television and in print to actively debate whether it was in a bubble or not. And that bubble debate played out in subtle ways as well. During asset bubbles, supporters get particularly vicious in their defense of their beloved asset. Did you try telling your house-flipping neighbor that real estate was in a bubble in 2006? Or that tech stocks were in a bubble in 1999? Odds are you probably got yelled at and called an idiot and berated for not partaking in all the awesome profit!
Gold bugs are singing a similar song nowadays. Back in 2003 they’d just mumble and look away when gold would have a drawdown. Today they let you know how they feel and they do it loudly.
It’s not just crazy to say gold’s in a bubble right now, it’s un-American!
And yes, I do see the irony dripping from that statement.
7. Interest rates rise: WRONG
This one makes me laugh for two reasons.
The first is that even with all the mess and the 10-year yield collapsing to a multi-generational low of 2.4%, remarkably, my prediction of rising rates almost came true. The 10-yr has sold off dramatically since October, pushing yields back to 3.5%, not too far from where we began the year.
This also makes me laugh because of how spectacularly wrong I was about the Fed. Holy cow! A year ago I thought that with the economy showing legitimate signs of strength, Captain Ben would ease off the throttle and let the economy drive on its own. I thought they might start reducing the size of their balance sheet or at the very least, put their purchase program on pause. I thought they might even take a look at raising the Fed funds rate and throw all us responsible savers a bone.
No sir.
When their purchase program was complete, their response was to reinvest the runoff and buy more securities to keep their balance sheet sufficiently large. And when the stock market started showing weakness again in the summer, their response was to gear up for another round of QE.
More and more people are asking how long the Fed can keep doing this. How long can they keep creating electronic dollars and injecting them into the reserve system. I don’t have the answer. We’re sort of in uncharted territory.
Look, this is the last bullet in the chamber. This is really the last tactic that they can employ to get credit and consumption moving in the way they want to. It’s no secret; their goal is to push up asset prices — specifically the stock market — and make people feel more wealthy. Because when people feel more wealthy they spend more and when they spend more the economy grows. Bernanke wrote about this in the Washington Post.
We’ve painted ourselves into a corner. With the debt-load soaring past crucial thresholds, we have become ever more dependent on a steadily growing economy to bail us out of this jam. The problem is that stimulating the economy to grow requires making that debt burden even bigger and more dependent on steady economic growth.
I’m not a poker player but I’m sure there’s an analogy here somewhere.
In the meantime, sorry for getting it 1,000% wrong about the Fed.
8. Here comes the VAT: RIGHT
I wasn’t expecting a VAT — a “value added tax”, basically a federal sales tax — to actually get enacted in 2010. But I thought that this would be the year when the debate would pick up in a way it hadn’t in a long time.
This was actually one of the first predictions I got correct. When things were looking up earlier in the year, this was a very popular conversation on Bloomberg and CNBC. I never watch the nightly news, but I was out to dinner one night and remember seeing Brian Williams or whoever talking about it.
Any sensible economist or policy analyst will tell you that a VAT is a key part of reconciling our unsustainable budget situation. Politicians and advisors of different stripes have been suggesting this for a while now. Republicans like it because a VAT is a much flatter and more regressive tax and Democrats like it because a VAT can generate boatloads of revenue.
But I feel dirty about giving myself a “RIGHT” on this one because once Europe happened and the political season kicked into high gear, all VAT talk totally evaporated. And I really should have seen that coming. Of course Europe was going to spook the U.S. and of course the middle of a nasty political campaign season would be the wrong place to have an adult conversation about raising government revenue to pay for all the fun stuff we’ve voted ourselves. If we all start to feel better about our country in 2011, and I think we will now that the negativity of the political cycle is behind us, this discussion could move back into the mainstream.
Oh, it will be bad for the economy too. But at some point we have to match expenses with revenues, right? At some point we need to start seriously thinking about how to solve our serious problems?
Right…?
9. Big financial institutions get smaller: WRONG, but
Shame on me for making a consensus prediction!
This one looked like a total no-brainer at the beginning of the year. ”Too big to fail” was phrase of the moment and there appeared to be honest political will to fix that problem.
Then the bank lobbyists got involved.
While the Dodd-Frank financial reform bill did a couple of important things, it failed miserably to address what was seemingly the world’s greatest concern. Rather than focus on the “too big”, which is the obvious and only way to appropriately address it, they focused on the “to fail”. The strategy shifted towards protecting these “too big” institutions from an environment in which they would otherwise fail.
True, we saw 157 bank failures in 2010, the most in a long, long time. That’s a lot of banks that shrunk out of the system. But the superbanks still dominate the industry and are still too systemically important. Now that these banks no longer have to mark assets at market prices, I have a really hard time believing they ever have a scare with insolvency the way they did in 2008. I cannot over-emphasize the importance of that last statement. In a lot of ways, mark-to-market accounting was the chief catalyst for the financial crisis, and suspending it was the most important step towards restoring order in that technically-insolvent sector.
Here’s a chart of the XLF, the Financials ETF:
Really, though, I botched this prediction because I was too optimistic about the timing. Odds are this will be another one that will become true in the coming years. It’ll take a while and it will do it in a boring way, but the industry is on a trend towards a somewhat flatter landscape. There’s a lot of garbage lurking in these banks that needs to get dealt with.
Today there are four banks that dominate pretty much every category of banking. Maybe next year US Bancorp or PNC threatens to join them. TD Bank just made a move and bought Chrysler Financial which is a bigger player than you might think. Since it’s clear now that banks like Citigroup or Bank of America will not be explicitly forced apart, the trajectory they will likely take will be one of slowly eroding market share and influence.
For what it’s worth, the trade that I outlined at the time, to short the big banks and buy the next tier down, would have been a home run. Citigroup had a good year, but JP Morgan, Wells Fargo, and Bank of America all lagged their smaller brethren by a hefty margin.
Perhaps that’s the market’s way of telling us that I had it right about the ultimate trajectory of these large banks. I’m sure you agree.
10. There is a least one significant sovereign default: WRONG
Once again, I underestimated bondholders’ reluctance — no, unwillingness — to take a loss. Ever. Once again, I underestimated the planet’s desperate eagerness to indulge them. And once again, I underestimated the power of fear to push people to do extreme things.
I may have got this one wrong. But make no mistake, both Greece and Ireland this year were in default situations.
Ireland even tried to fight the bailout and tried to honestly restructure their debt and work their way out through budget measures. But the owners of their debt would have none of it. No. They would be made whole. It might mean they’d have to lend them even more money, to throw good money after what was clearly bad, but dammit, they would be made whole!!
Scorecard
The final tally gives me 4 RIGHTs and 6 WRONGs.
Is that good or bad? I have no idea.
I scored these pretty honestly, giving myself a WRONG when I could have manipulated the story and the data into a RIGHT. I notice that a lot of people in this industry are really skittish about taking a stance because they’re afraid of being wrong. In this business everybody is always so concerned about what others think of them.
But my job isn’t to predict the future (thank goodness, eh?) and so there’s nothing at stake if I’m wrong about a lot of stuff. I have the luxury of being able to forsake the comfort of the mainstream.
Maybe that’s the biggest lesson to learn from all this. The next time you take a look at someone’s predictions about the future, try and figure out what they have at stake. Is their business delivering accurate predictions? What are the consequences if they are wrong about what they publish?
Something to think about for next week when we unveil our Predictions for 2011! I already can’t wait to recap those next year!
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