This blog post originally appeared on RealMoney Silver on June 27 at 8:51 a.m. EDT.
"To predict the behavior of ordinary people in advance, you only have to assume that they will always try to escape a disagreeable situation with the smallest possible expenditure of intelligence." -- Friedrich NietzscheWe are now almost six months through 2011. The past two months in the U.S. stock market as well as the drama on the world's economic stage (especially in the eurozone) have formed the backdrop for one of the more difficult market environments in a while. The sanguine backdrop over the first four months of the year has been supplanted by pain and uncertainty over the past eight weeks. What does the balance of 2011 hold? How do we profit? For some possible answers, it's time to grade my 2011 surprise list.
"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." -- Woody AllenFor those new to RealMoney Silver, a little background. In late December over the past nine years, I have taken a page from the book of former Morgan Stanley strategist/now Vice Chairman of Blackstone Advisory Services Byron Wien and prepared a list of possible surprises for the coming year in late December. Byron "Brontosaurus Rex" Wien has had a remarkable (and almost uncanny) record of his surprises becoming reality ever since he started this exercise back in 1986. His picks in 2009 were particularly accurate, but his surprises for 2010 were considered by some to be off the mark. Thus far in 2011, many of his more important economic and investment forecasts -- a 1500 S&P 500 target by midyear (we are now 230 points below that forecast); rising interest rates, with 5% yield on the 10-year U.S. note (we are now at a 2.88% yield); an improving domestic economy, with 5% GDP growth (the first-half GDP run rate was likely under 2%); and an expected resolution of the eurozone sovereign debt crisis -- have not panned out well. But to be fair, there are still another six months to go. To his credit, though, he has been very right on the price of gold and agricultural commodities this year. My surprise list is not intended to consist of predictions or forecasts 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 the potential for large payoffs, and to disprove Nietzsche, who said that we live the same life over and over again. Wall Street research is still very much conventional, almost universally bullish and consisting of nonvariant "groupstink" despite the attempts of reform over the past decade. Mainstream and consensus expectations are just that, and, in most cases, they are deeply embedded into today's stock prices.
If I succeed in at least making you think about outlier events, then the exercise has been worthwhile. Too often we are played as suckers as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein's weapons of mass destruction, the heroic home-run production of steroid-laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank ( Citigroup ( C)), the uninterrupted profit growth at Fannie Mae ( FNM) and Freddie Mac (FRE), housing's new paradigm of noncyclical growth and ever-rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff's investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods. While my surprise list for 2010 hit on some of the important themes that dominated the investment and economic landscape that year, I failed to expect the announcement of further quantitative easing and, importantly, did not accurately gauge investors' animal spirits that followed the proclamation of QE2. So, Last year's surprise list had relatively poor results. Only about 40% of my surprises were achieved in 2010, well under the success ratio in previous years. By means of background, about 50% of my 2009 surprises were realized, 60% in 2008, 50% in 2007, one-third in 2006 , one-fifth in 2005, 45% in 2004 and one-third came to pass in the first year of our surprises in 2003. In summary, investing based on some of my outlier events (particularly leading up to, during and immediately following the financial crisis) would have resulted in high-return investment yields from several improbable and/or long-shot scenarios, would have protected investors somewhat from the market's downdraft and then would have prompted them to participate in the market's historic recovery from the generational low. But that was yesterday, and we now face the present with a more-than-usual amount of uncertainty.
"I don't want to make the wrong mistake." -- Yogi BerraWhile it is still early in the year, my most important surprises for 2011 - namely, the likelihood of below-consensus corporate profits and economic growth, a tepid jobs market, a disappointing housing recovery, lower consumer confidence, a sideways stock market, a weak Chinese equity market and growing political partisanship -- have been materially on target.
That said, as we approach this year's halftime intermission, here are my grades for my surprises for 2011. 1. In line with consensus, the domestic economy experiences a strong first half, but several factors conspire to produce a weakening second half, which jeopardizes corporate profit growth forecasts.
- The improving momentum of domestic growth at the end of 2010 continues into the first half of 2011 but proves ephemeral by the summer.
- That improving momentum turns out to be nothing more than a brief respite and "recession fatigue," as reality and a new normal sets in.
- Americans remain in a foul mood, as the jobs market fails to improve despite the recent downtick in claims.
- Over there, multiple country austerity programs move Europe back into recession by year-end 2011. (Share prices of many large multinational industrials falter in the year's second half.)
- China continues to tighten, but inflation remains persistent, economic growth disappoints (see surprise No. 15), and it's stock market weakens further.
- Political gridlock and inertia in tackling the deficit incite the bond vigilantes. The yield on the 10-year U.S. note rises above 4.50% by the spring (see surprise No. 2).
- Trust continues to be lost, as the uncertainty brought by changes in the administration (see surprise No. 7) and the emergence of a third political party (see surprise No. 8) adversely impacts consumer and corporate confidence.
- Housing fades under the pressure of higher mortgage rates and the supply of shadow inventory coming onto the market in an avalanche of foreclosures. (A housing czar is named to implement a Marshall Plan for housing.)
- An across-the-board spike in commodities pressures corporate profit margins and real disposable incomes (see surprise No. 3).
- Price controls are briefly considered (and then rejected) by the Obama Administration as oil soars to over $125/barrel.
"The first thing we do, let's kill all the lawyers." -- William Shakespeare, Henry VI, Part 2Increased hostilities between the Republicans and Democrats become a challenge to the market and to the economic recovery next year. As the 2012 election moves closer, President Obama reverses his seemingly newly minted centrist views, as newly appointed Vice President Hillary Clinton becomes the administration's pit bull against the Republican opposition.
"The day the Fed came into being in 1913 may have been the beginning of the end, but the powers it caused took a long time to become a serious issue and a concern for the average Americans." -- Ron Paul, "End of the Fed"On the other side of the pew, as Chairman of the Subcommittee on Domestic Monetary Policy, Congressman Ron Paul's fervent criticism of monetary policy and the lack of transparency of the Fed leads to further friction between the parties.
"'Refudiate,' 'misunderestimate,' 'wee-wee'd up.' English is a living language. Shakespeare liked to coin new words, too. Got to celebrate it!'" -- Sarah PalinSarah Palin, who can see the 2012 Presidential election from her home in Alaska, continues her barbs against the opposition party and holds a large lead to be her party's Presidential candidate in early 2011, but continued verbal and nonverbal blunders and policy errors coupled with an announcement that she has separated from her husband causes Palin to announce that she will not run on the Republican ticket. Massachusetts' Mitt Romney, Wisconsin's Paul Ryan and South Dakota's John Thune emerge as the leading Republican Presidential candidates by year-end 2011. The resulting bickering yields little progress on deficit reduction. Nor does the rancor allow for an advancement of much-needed and focused legislation geared toward reversing the continued weak jobs market. The yield on the 10-year U.S. note, despite a stuttering economic recovery visible by third quarter 2011, rises to over 4.25%, as the bond vigilantes take control of the markets. The rate rise serves to put a further dent in the U.S. housing market, which continues to be plagued by an avalanche of unsold home inventory into the market as the mortgage putback issue is slowly resolved. During the second half of the year, housing stocks crater and the financial sector's shares erase the (sector-leading) gains made in late 2010 and early 2011. Grade A-: With the exception of the Palin surprise, spot on. The current discord in the budget debate has been totally partisan. (Time will tell on the direction of interest rates during the third and fourth quarters.) 3. Rising commodities prices becomes the single greatest concern for u.s. stock market and economy. Scarcity of water boosts agricultural prices and causes a military confrontation between China and India. The continued effect of global warming, the resumption of swifter worldwide economic growth in 2011, normal population increases and an accelerated industrialization in emerging markets (and the associated water contamination and pollution that follows) contribute importantly to more droughts and the growing scarcity of water, forcing a continued and almost geometric rise in the price of agricultural commodities (which becomes one of the most important economic and stock market themes in 2011). Increased scarcity of water and higher agricultural commodity prices (corn, wheat, beans, etc.) not only have broad economic consequences, but they become a destabilizing factor and serve as the basis for a developing powder keg in the relations between China and India. China has about 23% of the world's population but only approximately 7% of the world's fresh water supply. Moreover, China's water resources are not distributed proportionately; the 550 million residents in the more industrialized northern area of the country are supported by only one-fifth of the fresh water and the 700 million in the southern region of China have the other 80% of the country's fresh water supply. The shared resources of water supply have been a focal point of conflict between China and India since the 1962 Indo-China War. My big surprise is that in early 2011, tension intensifies based on a decision by the Chinese government to materially expand the plans for the diversion of the 1,800-mile long Brahmaputra River, which hugs the Chinese border before dipping into India, from the south back up to the water-deprived northern China area in an expansion of the Zangmu Dam project, original construction plans of which were announced earlier this year. At first, trade sanctions are imposed by India against China. Later in the year, the impoverished northeastern India region is the setting for massive protests aimed at China; ultimately, groups of Indian rebels, fearful of reduced availability of fresh water and the likelihood of flooding, actually invade Southern China in retaliation. Grade B: While the Chinese-India border clash has not occurred, the rise in the price of commodities has been one of the primary market themes and concerns. 4. The market moves sideways during 2011. While the general consensus forecast is for a rise of about 10% to 15% for the S&P 500 in 2011, the index ends up exactly where it closes the year in 2010. A flat year is a fairly rare occurrence. Since 1900, there have only been six times when the averages recorded a year-over-year price change of less than 3% (plus or minus); 2011 will mark the seventh time.
Neither a borrower nor a lender be;With a return profile reminiscent of the sideways markets of 1953 (-0.80%), 1960 (-0.74%) and 1994 (+1.19%), the senior averages also exhibit one of the least volatile and narrow price ranges ever. The S&P 500 never falls below 1150 and never rises above 1300, as the tension between the cyclical tailwind of monetary ease (and the cyclical economic recovery it brings) are offset by numerous nontraditional secular challenges (e.g., fiscal imbalances in the U.S. and Europe; a persistently high unemployment rate that fails to decline much, as structural domestic unemployment issues plague the jobs market), and the continued low level of business confidence (reinforced by increased animosity between the Republicans and Democrats) exacerbates an already weak jobs market and retards capital-spending plans. Despite the current unambiguous signs of an improving domestic economy, as the year progresses the growing expectation of consistently improving economic growth and a self-sustaining recovery is adversely influenced by continued blows to confidence from Washington, D.C., serving to contribute to a more uneven path of economic growth than the bulls envision. With traditional economic analysis again failing to accurately predict the path of economic growth (as it did in 2008-2009), behavioral economic analysis, linking psychology to the business cycle, gains popularity. Yale's Dr. Robert Shiller and former Fed Chairman Dr. Alan Greenspan write books on behavioral economics that become the No. 1 and No. 2 books on the New York Times nonfiction best-seller list. The sideways market of 2011 will prove to be a good year for opportunistic traders but a poor one for the buy-and-hold crowd as neither the bulls nor the bears will be rejoicing next Christmas. Grade A+: This surprise along with surprise No. 1 are the most meaningful of the 15 surprises. The S&P 500 is up by only about 50 basis points in 2011 (year-to-date). 5. Food and restaurant companies are among the worst performers in the S&P 500. (This surprise is an extension of surprise No. 3.) Several well-known multinational food companies and a host of domestic restaurant chains face margin and earnings pressures as they are unable to pass on the violent rise in agricultural costs on to the consumer. Profit guidance for 2011 is taken down by Kellogg ( K), Kraft ( KFT), General Mills ( GIS) and many other exposed food companies. Publicly traded restaurant chains such as Darden Restaurants ( DRI), McDonald's ( MCD), Yum! Brands ( YUM), Brinker International ( EAT) and Ruby Tuesday ( RT) all take a hit owing to the abrupt contraction in profit margins as product demand swoons in the face of higher prices. As a consequence, food companies and restaurant chains are among the worst performers in the S&P next year. Grade F: Food and restaurant stocks have performed well. 6. The shares of asset managers suffer. I expect a series of populist initiatives by the current administration beginning by a frontal assault on mutual fund 12b-1 fees. The asset managers -- Franklin Resources ( BEN), T. Rowe Price ( TROW) and Waddell & Reed ( WDR) -- are exposed, and I am short all three of them. Grade C-: Asset management stocks have performed well this year. 7. Vice President Joe Biden and Secretary of State Hillary Clinton switch jobs by midyear 2011, 18 months before the 2012 Presidential election. It is generally recognized that President Obama has been seriously weakened politically, but the situation gets worse early next year. A sustained and high level of unemployment and a quiescent housing market fail to revive, forcing the administration to consider some radical changes in order to survive in the Presidential election of 2012. (While such a switch is unconventional, this move can be accomplished as the twenty-fifth amendment sets out that the majorities in both houses of Congress would have to confirm Vice President Clinton and Secretary of State Biden would only have to be confirmed by the Senate.) The other benefits to the switcheroo:
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry. -- William Shakespeare, Hamlet
- Hillary Clinton would have almost a year and a half of experience and credibility in the Vice President's office.
- She would be well-prepared to campaign for a Democratic ticket.
- An Obama/Clinton ticket would be viewed by many as unbeatable. Clinton is a relentless campaigner and she would be a far more effect drawer of votes than Biden. (Consider how many votes Obama and Clinton combined received in the 2008 Presidential primary campaign.)
- Clinton will be seen as very capable of deflecting the women's vote from Sarah Palin in 2012.
- Clinton still likely harbors dreams of the White House. She would immediately become the overwhelming favorite to garner the Democratic Party's Presidential nomination in 2016. She will only be 69 years old at that time.
- On experience alone, Clinton would be considered far more qualified than most of the other Republicans now being considered (e.g., Bobby Jindal, Mitt Romney and Tim Pawlenty)
- Fears of former-President interference in the White House have dissipated. Bill Clinton has stayed out of the limelight and has been discreet with regard to his private life.
Insider trading charges expand. The SEC alleges, in a broad-ranging sting, the existence of extensive exchange of information that goes well beyond Galleon's Silicon Valley executive connections. Several well-known long-only mutual funds are implicated in the sting, which reveals that they have consistently received privileged information from some of the largest public companies over the past decade.The next SEC target is directed at some of the world's largest tech companies, including one of the leading manufacturers of flash memory cards, one of the largest contract manufacturers and a big producer of integrated circuits. A high-profile very senior executive in one of these companies is implicated and is forced out of his position. With the depth of the investigations moving toward the center of some of the largest hedge and mutual funds, many of the more active traders are temporarily in "lockdown" mode as the hedge fund community's trading activity freezes up. Grade A-: The SEC has been very busy this year. Arguably, 2011 has been the most active year of insider trading accusations and trials -- and the year is only half over! 14. There is a peaceful regime change in Iran. Grade F. 15. China overplays its economic hand by implementing multiple tightening and by its unwillingness to allow its currency to appreciate. The region's GDP climbs by only 5% in 2011. Grade A-: The rate of China's economic growth is decelerating. Last week, the HSBC Preliminary Flash China June PMI fell to 50.1 -- that is almost at a contractionary reading. Doug Kass writes daily for RealMoney Silver , a premium bundle service from TheStreet.com. For a free trial to RealMoney Silver and exclusive access to Mr. Kass's daily trading diary, please click here.