This article was originally published in three parts on Street Insight on Dec. 27.Every December, I take a page from former Morgan Stanley strategist Byron Wien and prepare a list of 25 possible surprises for the coming year. These are not intended to be predictions, but rather events that have a reasonable chance of occurring, despite the general perception that the odds are very long. I call these "possible improbable" events. The real purpose of this endeavor is to consider positioning a portion of my portfolio in accordance with outlier events -- with large payoffs. After all, Wall Street research is still very much convention and groupthink, despite the reforms over the past several years. Mainstream and consensus expectations are just that, and, in most cases, are deeply imbedded in today's stock prices. If I succeed in making you think about outlier events, the exercise has been worthwhile. About a fifth of last year's predicted surprises actually happened, which was down from the prior two years -- nearly one-half of our prognostications proved prescient in 2004 and about one-third in 2003.
25 Possible Surprises in 20061. Anti-American rhetoric in South and Central America becomes kinetic in 2006 and has broad market and economic implications. Presidential elections in nine Latin American countries put a plethora of left wingers in power, causing consternation in the Bush administration. Coupled with more aggressive nationalistic moves by Venezuela's Hugo Chavez, we see a turn to sweeping anti-American policies. This new wave of socialism and left-wing presidents contributes to a series of moves to nationalize certain industries, and supply disruptions in certain countries in South America are destabilizing, resulting in much higher commodity prices during the year (including oil, natural gas, copper, tin and grain). The CRB Index approaches 375 (now at 326). Fears of stagflation befall economies and markets dependent on imports of goods from South America, like the U.S. Crude climbs to over $80 a barrel, and the Dow Jones Industrial Average bottoms at 9000-9250 during the early summer (and closes the year at the 10,000 level). Gold trades above $675/ounce sometime during the year.
2. Senate Judiciary Committee hearings on secret domestic wiretaps authorized by President Bush -- made without applying for a warrant from the court that handles sensitive national security issues -- find that the surveillance operation was far broader than admitted by the administration. A special prosecutor begins an aggressive assault on the White House that results in Vice President Richard Cheney taking the fall for the administration and resigning by midyear. The president's popularity plunges as memories of Watergate are resurrected and the Democratic party takes a large lead in preliminary presidential polls. Condoleezza Rice is selected to replace Cheney as vice president. 3. The Federal Reserve, responding to the appearance of continued economic strength in fourth-quarter 2005 and in January 2006, continues to take the federal funds rate higher, just as the economy is about to sour. Bernanke pushes for and proceeds with a 50-basis-point increase in his first meeting as chairman of the Fed. (It turns out to be the last rate change over the balance of 2006.) As the Fed and ECB continue tightening and the Bank of Japan ends its easing, bond yields initially rise early in 2006, but in the second half of the year, the 10-year U.S. note's yield dips to 3.65% as the market's focus moves toward potential rate cuts by the Fed and a potential recession in late 2006 or early 2007. 4. By early in the second quarter of 2006, the consumption binge of the last decade comes to an abrupt halt. Retail sales turn negative as the American consumer (the straw that has stirred the drink of the world economies) folds like a cheap suit and several former high-flying specialty retailers -- such as Abercrombie & Fitch ( ANF), Williams-Sonoma ( WSM), Urban Outfitters ( URBN) and so forth -- exhibit surprisingly poor same-store sales. Weakness in personal consumption is exacerbated by many of the external shocks discussed in this piece: rising commodity prices, lower home prices (leading to weakening job creation and the lost ability to extract equity), stretched affordability of the first-time and repeat home buyer to purchase a new home, the absence of personal savings (and a safety net), rising debt-service requirements (proliferation and reset of floating-rate and interest-only loans), changes in credit-card payment requirements, etc. 5. There are a number of small-scale terrorist acts in the U.S. A failed attempt to contaminate a major region of the U.S.'s water supply sends already high agricultural product prices (in large measure reflecting South America's instability) to record levels, creating another inflationary scare.
6. After the 50-basis-point increase in the fed funds rate and an uneventful January in the markets, stocks drop abruptly, then quickly rally back. However, a conspicuous slowdown in retail sales hits equities again, and stocks only recover half of those losses. The rise in commodity prices and the CRB Index (affected by political unrest in South and Central America and a rise in agricultural prices due to a terrorist act) bring the DJIA down to the 9000-9250 level in early summer, where it settles in for the balance of the year, though another sharp year-end rally brings the DJIA back to about 10,000 by year-end. Volatility during this period rises dramatically -- the S&P 500 routinely has 2% daily moves, acting more like a commodity than a stock index. Mutual fund inflows drop precipitously. 7. With confidence in the markets and economies deteriorating, merger-and-acquisition activity slows to a crawl. One large private-equity firm returns over $5 billion to its investors. 8. The best-performing equity strategy in 2006 is short selling; the worst is aggressive growth (long only). The junk-bond market records its worst performance in over a decade and underperforms almost every asset class in 2006. The cable stocks, old media and high-yielding stocks (like regional telecom companies) are among the best sectors. General Motors ( GM) muddles through and ends the year with a gain of 25% (leading all other components of the Dow Jones Industrial Average) after Steve Miller (with financial assistance and the managerial support of Wilbur Ross) takes over the helm in a broad management shakeup. Coca-Cola ( KO) is a close second (buoyed by more stock purchases by Warren Buffett), and Verizon ( VZ) is the third-best performing member of that index. On the downside, the popularity of the exchanges (Chicago Mercantile, International Securities Exchange, Nasdaq Stock Market Inc., Chicago Board of Trade, etc.) wanes, and the stocks lead most sectors to the downside in 2006. 9. Corporate profits for 2006 are flat, decelerating sharply from the 7% increase recorded in first-quarter 2006. 10. The U.S. dollar's strong momentum and new paradigm bullishness in 2005 yields to weakness in 2006. As trade tensions mount with China (which in turn fails to ante up on its continued financing of U.S. consumption), inflation abruptly rises (within the context of supply disruptions) and the focus comes back to the U.S. current account deficit (reaching $900 billion or 6.9% of GDP in 2006) and a stagnating economy as a consequence of reduced confidence in the president. The current surge in tax revenue, which produced a reduction in the federal deficit, is reversed as tax-revenue growth normalizes back toward that of nominal GDP. Contributing to an expanding deficit are the Medicare prescription drug plan; spending on unmet infrastructure needs; the Homeland Investment Act (which encouraged repatriation of foreign profits to be taxed at low rates); hurricane rebuilding efforts;a pickup in bonuses (and other nonstandard income); and the normalization of individual nonwithheld and corporate taxes (both having previously benefited from a rising stock market and an increase in the value of homes, which served to increase capital gains).
11. There are three large-scale failures on the lines of Long-Term Capital Management -- two in Asia and one in Europe -- precipitated by an astonishingly large derivative loss that two major U.S. and several overseas money center banks are partially on the hook for. 12. A computer hacker launches a successful attack on a widely used open-source application of the Internet (which extends to closed, proprietary sites) causing chaos and turmoil over a month-long period at Amazon ( AMZN), Google, eBay ( EBAY), Yahoo! ( YHOO), AOL and many other sites. The Internet HOLDRs Index drops by 20% in two weeks. 13. Google faces numerous legal and competitive challenges in 2006. Its leadership in search is threatened not by Microsoft ( MSFT) or Yahoo!, but by a cadre of high-profile engineers within the company itself who embark on their own search mission. The new competitive player is taken public by Goldman Sachs ( GS) and has an instant valuation in excess of $25 billion after its IPO. Google's shares briefly touch $200 a share during the year as competition among the older and the new entities intensifies. Further hurting Google will be an attempt by the Federal Communications Commission to extend the definition of decency laws to the Internet and a series of adverse court rulings in the Google Book Search case, in a patent issue that is brought up in the courts by content providers and in a major privacy scandal involving the U.S. government. Most importantly, a suit claims Google has become a Web monopoly and is violating U.S. antitrust law. Microsoft's Vista is more successful than expected, and MSN search experiences a surprising gain of 10 points of search share after hiring two senior Google engineers who introduce massive changes, like eliminating clutter from its homepage. A high-profile, content-rich media company will make available a free video product, hurting the launch of Google Video. Finally, Google will release far fewer services this year, disappointing investors, as the company realizes it must go through a consolidation phase in which it makes its existing services scale better.
14. Apple ( AAPL) (and its iTunes) will not be immune from the problems facing Google as the music industry decides on new ways to control its distribution, just like in the good old days. In other Internet happenings: TiVo ( TIVO) and NetFlix ( NFLX) will merge and the China Internet Bubble will deflate. 15. Amid the market's gloom and doom, Warren Buffett goes on a buying spree (which emphasizes acquisitions in old media and the real estate industry). Berkshire Hathaway ( BRKa) acquires Dow Jones & Company ( DJ) after a proxy contest is instituted by some of the younger members of the Bancroft family. Buffett expands his involvement in the real estate sector after buying Countrywide Credit and a troubled, publicly held, substandard mortgage originator. 16. The bitter differences between New York Attorney General Eliot Spitzer and Ken Langone get more heated and Langone announces his candidacy for the Republican nomination for governor in opposition to Democrat Spitzer. With corporate contributions to his candidacy breaking all-time records and the backing of Hank Greenberg and former Goldman Sachs Chief John Whitehead, Langone narrowly defeats Spitzer in the general election. Langone resigns shortly into his governorship, saying he has made his point, and he directs Nassau County Executive Thomas Suozzi to replace him. 17. Carl Icahn means business this time with Time Warner ( TWX). Enlisting Steve Case to run the company and Calpers (and two other large financial institutions provide the rest of the financing), he initiates a partial tender for a quarter of the company at $22 a share during the second quarter. Like the legendary cult movie Putney Swope, he swiftly gains control of the company's board of directors by the end of the third quarter. Toward year-end, Steve Case -- in concert with Microsoft and Berkshire Hathaway -- pays $18 billion for the AOL division of Time Warner. 18. Citigroup ( C) begins to undo some of the acquisitions that occurred during the Weil regime. Smith Barney is spun off to shareholders. 19. Vice President Condoleeza Rice (see Surprise No. 2), seen as a force of honesty and integrity, emerges as the leading contender for the Republican presidential nomination in 2008. Sen. Hillary Clinton decides to bow out as a candidate. She and the other Democratic presidential hopefuls uncharacteristically throw their early support behind Sen. Evan Bayh of Indiana. 20. There are no further meaningful natural disasters. 21. Osama Bin Laden is found dead. 22. The hedge fund industry suffers outflows -- in marked departure from the last decade -- as the industry (similar to in the mid-1970s) fails to insulate investors from the bear market of 2006. 23. A large corruption scandal in Russia hits the emerging markets late in the year. 24. Japan's Nikkei -- oblivious to the chaos in other world markets -- continues to climb and briefly reaches the 20,000 level. 25. Economic growth continues apace in China and India, but a furious debate regarding the off-shoring of IT and service jobs continues, sparking a round of legislative protectionist initiatives. As a result, trade tensions mount among the U.S., India and China.