Jeffrey Dow Jones part one for 2011

Predictions for 2011 – Part One

by Jeffrey Dow Jones
Thursday January 06th 2011, 6:52 am
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One of my favorite things about writing an investment newsletter is that I get to do stuff like this.  I love playing around with ideas and trying to figure out how trends and surprises may impact the world.

If you’re new here, a brief disclaimer: you shouldn’t take these predictions too seriously.  I hope you’re not relying on anybody’s forecasts to come true.  Everybody knows that predicting the future is impossible, but what’s more is that it’s really a game for fools.  So let’s have a little fun with this and try to put it to good use.  Borrow some of these ideas as a starting point for conversation around your dinner table tonight.  Or use them as a litmus test for your portfolio — how will your portfolio respond if these predictions come true?  What if they are spectacularly wrong?

Consensus predictions are boring, so last year I tried to come up with some that pushed a bit against the mainstream.  I missed a bunch, but I nailed a few that seemed crazy at the time.  Never underestimate how wrong conventional wisdom can be.  These are interesting times we’re living in and “black swan” events seem to happen with disturbing regularity.  Rather than passively assuming that the current trends will continue indefinitely, we should be mindful of how rapidly things can change.

With that, let’s put on our Zoltar hats and get started!

Good but below-consensus economic growth, rising interest rates, and a schizophrenic stock market

Here’s the broad story for 2011: we get legitimate economic growth.  It won’t be as much as most are expecting —  the current consensus is now up to around 3.5% real — but it’ll be growth that we can actually feel good about.  It will be enough to justify slowly rising/normalizing interest rates, especially as the Fed finds out it’s only so influential in the bond market, a bond market that at some point will start to get a little jittery.  The growth won’t kill the political will to keep stimulating the economy, but it’ll be enough to keep any additional intervention we do see from being massive enough to really matter.  At some point a new round of uncertainty will creep back in and disrupt the stock market, making for a much more volatile year than basically everybody is predicting.

What we’re seeing now — strengthening economic data, an increased willingness for consumers to spend, and a rising stock market — should continue for a little while.  But I think that the second half of the year is a different story.  It’s where we are reminded that the economy won’t be as consistent as we all came to appreciate in the last few decades.  Economic growth will be lumpy with GDP moving in fits and starts.  Don’t be so down on environments like that; they create opportunity.

We’re going get a pretty big shot of stimulus from this temporary payroll tax reduction.  It will put about $120 billion directly into people’s pockets.  A payroll tax reduction is one of the more efficient forms of stimulus and with its multiplier effect, this could represent upwards of one full point of nominal GDP growth.  This alone probably saved the economy from any risk whatsoever of a double dip recession in 2011.

Aside from boosting short-term consumption it won’t change behavior.  The political spin on this payroll tax holiday is that it will inspire confidence in small businesses and give them an incentive to hire new workers!  That’s ridiculous.  Go read up on Milton Friedman and his permanent income hypothesis.  People consume based not on their situation in the present but on their expectations of the future.  You don’t spend based on what last month’s paycheck was; you spend based on what the next few months’ paychecks will be or what your salary will be next year.  Businesses do the same thing.

The economy isn’t going to show significant, stimulus-free growth until more jobs are created.  The majority of that comes from small business and if you want to know what small businesses are thinking and doing, listen to Bill Dunkelberg of the NFIB.  This won’t come as a shock to any of you who owns a small business, but businesses aren’t hiring new workers because demand from their customers sucks.  That’s what it’ll take to get the job creation engine moving again and you can see the chicken/egg nature of this problem.  It has nothing to do with payroll taxes and don’t buy into the “small businesses aren’t growing because the banks won’t extend them credit” meme.  The data simply don’t confirm that, which makes you wonder how exactly a credit-easing program QE2 is supposed to stimulate the economy.

Anyway, everything in this economy is still on steroids.  We’re being propped up with a million different forms of stimulus right now, and what’s more is that those who have injected all the stimulants are afraid to see what happens when they start withdrawing their doses.  The economy will indeed grow but many years down the road we’re going to be asking whether it was all worth it.

It’s fun in Hollywood to leave endings open, to wonder about what happens to the aging hero after the screen fades to black.  Was the price his body paid worth it?  Does he regain his former glory?  It’s one thing to discuss that sort of stuff over coffee, but what we’re doing in the economy is serious business.  What sort of claims are all these policies placing on future growth?

At some point the stock market wakes up to that realization.  All of this revised 2011 growth has been priced in to current levels.  Tactically, I’m also concerned about what happens when the QE2 program ends in June.

To throw some numbers and dates out there, I think the market makes its high in the first part of the year and I think it closes the year at least 10% below peak.  It might even have a flat or down year, a prediction which flies so far in the face of consensus estimates — somewhere around 1400 on the S&P —  that you might be wondering just what, exactly, I am smoking.  The answer is nothing and perhaps that’s the problem!  Maybe if I burned one down I could just embrace the awesomeness of the here and now, man, and ditch all these uncool worries about the future.

Want an old school investment strategy that hasn’t really worked in recent years that everyone has sort of forgotten about?  One that I think returns to glory in 2011?

Sell in May and go away.

Municipalities under duress is the dominant issue of 2011

I think this is a good prediction for two reasons.

The first is that the bond market is always the first thing in the world to react to anything.  It leads the rest of the markets, it leads the news media, it leads the water cooler conversations on Monday morning.

The bond market has already started reacting to this:

That’s not the only municipal bond fund to struggle lately.  November was the worst month for muni bonds since the crisis and it triggered a whopping $3 billion of outflows from those types of funds.

While the cracks are starting to appear in the bond market, the stock market hasn’t really reacted to this yet.  And the story certainly hasn’t caught on yet in the mainstream news.

Anyway, 2011 is when that happens.  I think it’s the cause of a little market correction or two and it’s when we start getting concerned about things like our state pension, our state income tax or sales tax rates, or the local civil services we’ve all come to love and appreciate.

I think this is a dominant story because of its size — there’s talk of hundreds of billions of possible muni-bond defaults — but also because of the visceral nature of the problem.  Unlike the EU sovereign debt crisis, this will be an issue that really hits home with Americans.  Schoolteachers getting fired and state workers losing their pensions has a very tangible aspect to it.  It’s the kind of thing that people get emotional about.  This will be a lot more like the housing and banking crises rather than the EU sovereign debt crisis.

And yes, it will move the markets.  If you’re looking for the market to make a big move lower, this could be your catalyst.

For the record, I think that Meredith Whitney’s forecast that there will be $100-$200 billion of municipal defaults is a… “bold” prediction.  What she’s doing is essentially calling for another financial crisis.  I don’t agree with our new American dogma of backstops and bailouts, but I think Whitney is underestimating the government’s willingness to pony up ridiculous sums of money in order to defend bondholders from losses.  We’re not going to see hundreds of billions in defaults, but we will see a record number because the thrust of her research is on target: the states are in big trouble and it’s hard to see how this doesn’t end in tears.

This also has a vaguely European political dimension to it in that relatively responsible states like Texas or Montana might have a little something to say about their federal tax dollars being used to bail out the looming economic disasters of California and Illinois.  It was one thing to bail out a financial sector with a deeply entrenched national footprint, but I think this issue with the states is where some people draw the line and say, “nuh uh, I’m not paying to bail out those yahoos on the other side of the country.  Their problem doesn’t affect me and it’s up to them to solve.”

Either way, bailout or not, it’s the kind of the thing that people everywhere will be talking about and it’s why I think this is the one issue that frames all the economic discussion in the coming year.

Higher commodity prices are the other major story in 2011.  Crude Oil shoots through $100/barrel & commodity prices keep going up.  People start to feel it.

I present to you the other major story for 2011.

This will be a big deal because this is another visceral issue, one that hits home with Americans.  There weren’t any stories like this last year.  The big one in 2010 was Europe, a situation that is truly frightening — it’s a legitimate crisis over there!  But it was over there and everybody here said “meh, whatever” and bought the stock market and spent money because they were tired of being frugal.

This year, higher commodity prices will hit home and you’ll start to hear a lot more bitching and moaning about food cost, gas prices, and utility bills.

We’ve written in the past how the $85-90 range tends to be a level at which crude oil stops correlating with the market.  Above that is where the knock-on effect happens, where it starts impacting the economic decisions that consumers make.  $100 is an important psychological level too.  I can almost guarantee you that if it makes a whole-hearted run toward$100, it will go through $100.  Whether that happens because of legitimate fundamental reasons or simply a positive feedback loop, this is a mechanical phenomena that is impossible to deny.

I also think there will be some decoupling.  Stocks and commodity prices may keep correlating for a little while but at some point the relationship breaks and the economy starts to feel the effect of these higher commodity prices.  Commodity prices can keep going higher, too, as speculators chase assets that are going up in value instead of down.

Keep your eyes on the food and restaurant stocks.  These guys will be super-sensitive to this as higher food prices squeeze their profit margins in two ways: 1. their input costs go up and 2. their demand from consumers go down as people struggle with higher prices and cut back on spending.  The same thing happens with other kinds of retailers, like clothing stores.  Cotton prices are up over 80% in the last six months.

Buckle up for higher gas prices too.  I think the national average gets above $3.50/gallon.  We’ve had quite a run recently and that’s another 15% rise from here.

If you absolutely have to invest in stocks in 2011, do it in sectors and with companies that will benefit from higher commodity prices and won’t be so sensitive to a consumer who may embark on a second round of retrenchment later in the year.  That trade wins in a lot of different scenarios but it gets killed if we have another deflationary panic.  So hedge it out with some bonds, which are highly likely to benefit in such a scenario.

We could be entering a phase a lot like the end of 2006.  Remember 2006 when we thought the carnage of the tech bubble was finally behind us?  Any real risk of recession is at least a year or more away.  Commodity prices have been rising alongside the stock market.  Maybe that relationship breaks as the market gets whiff of a possible slowdown a year or so down the road.  Maybe stocks begin to sell off while speculators continue to drive commodity prices higher.  Maybe there’s another crisis 2-3 years out where everything comes crashing back down together.

I know that history never plays out exactly the same way twice and the details will always differ, but this is an interesting pattern that could be setting up here.  After all, nothing has changed with our fundamental policy dynamic of creating conditions whereby bubbles are easy to inflate and worrying about the mop-up if and after they burst.

Real estate makes a new low, a final low

In some sense this is a bold prediction — there’s no doubt that the consensus view on housing is very negative.  Everybody hates real estate right now and the mindset in most areas around the country is deflationary i.e. prices will stay low or get lower.  But I think we’re a lot closer to a final bottom and a normal market than the consensus seems to think.  I think the major home price indices make new lows in 2011 with the Case/Shiller dipping into the 130′s.  That would represent a 5-10% pullback from the recent bounce.

But I think that’s it.  And 2011 is the year where certain conditions start to work towards clearing the markets, stuff like increases in residential investment and new home starts.

If you still think that it’s all gloom and doom in real estate, check out this chart:

I know that inventories are still grossly inflated and demand is pinched in a number of ways, but this relationship underscores the point that the market has in some ways normalized.

When people can buy houses cheaper than they can rent them, people buy houses and rent them out.  This is what the smart money will be doing in real estate.  The masses were playing Real Estate Tycoon in 2004-2007, which as you can see, was the worst time in history to be doing such a thing.  The average investor — the “dumb public” to use a derogatory term — is always doing the wrong thing at the wrong time.

What, you may ask, is this guy doing right now?

You know what he’s doing: he’s buying gold!

Gold Bubbles On!

I’m feeling increasingly confident that we’re in a gold bubble right now.  I have no idea how far into this bubble we are and I have no idea how far this bubble will go.  I am neither smart enough nor stupid enough to predict when or why it’ll end.  Sadly, I’ve lived through enough bubbles in my young life to have a pretty good sense at how these things play out and how complicated they are to navigate.

We are past the point of investing in gold “as a hedge against inflation” or “because you’re worried about the Dollar”.  The fundamentals have stopped mattering and the price is driven entirely by people expecting that prices will keep going up.  That’s the academic definition of a bubble.

Check it out:

You’re seriously going to sit there and tell me that there’s absolutely no chance that gold is in a bubble right now?  Only once in the last 140 years have we entered this territory before, a time that we all recognize and agree was one of the most dramatic bubbles in modern history.

I appreciate the fundamental argument that a lot of people are concerned about paper currencies right now, specifically the U.S. Dollar.  But this isn’t the first time in history people have freaked out about the Dollar.  Plus, nothing in any other market is confirming that worry — long-term interest rates are low and other dollar-denominated assets like real estate, commodities, or even stable foreign currencies are nowhere near 3.5 standard deviations away from their 130-year trendline.

Gold is 100% speculation right now.  By buying gold, you are speculating that:

1. the bubble will continue
2. or heavy duty inflation will materialize before too much longer

I know that a lot of you that read this newsletter really like gold.  Every single one of you are either rolling your eyes right now or getting ready to shoot off an angry e-mail.  I’m not saying that the party is over.  I’m saying pat yourselves on the back for keeping the faith and make sure that what you’ve still got on the table won’t kill you if it goes *poof*.  I’m saying that as we move further away from $1,000/oz and closer to $2,000/oz, it’s time to start asking questions about why you really own gold or are buying more of it.

If Gold does get to $2,000/oz — and I think it’s even-odds that happens in the next year or three — you need to understand that you are playing with fire.

Anyway, I’ll make two predictions for gold.

1. It ends the year above $1500/oz and makes an honest run toward $1600 at some point.
2. We get a major fakeout along the way (a >20% correction)

I see this being a more volatile year for gold.  There are a lot of gold rookies in the market right now and a lot more will enter in the coming year.  A lot of these guys don’t have a full appreciation for how violently the gold market can move.  I think that we’re due for a reality check, and then another round of enthusiasm to push the market even further into bubble territory.

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And on that controversial note, we’ll wrap it up!

I’ll have a couple smaller, more-specific predictions to add next week.  So stay tuned