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January 07, 2007

Surprise, Surprise
by Michael Panzner

Last Wednesday, Byron Wien, the thoughtful and well-regarded chief investment strategist of hedge fund Pequot Capital Management, issued his list of Ten Surprises for 2007. According to the press release, Mr. Wien has served up his economic, financial market and political surprises annually since 1986.

Overall, the list of possible outcomes is somewhat benign, with a seemingly bullish bias. Reading between the lines, it would seem that Mr. Wien sees most investors as being unduly negative about prospects for the year ahead. That is despite the fact that risk premiums are at historic lows, bullish sentiment is at multiyear extremes, and a great many markets, including the stock market, are way past their sell-by dates.

Consistent with this latter view, I thought I would go through the list and provide possible alternative scenarios that I believe might be even more surprising to investors than what he is suggesting. Here is what I came up with (Mr. Wien's original list items are quoted in italics):

1. The S&P 500 exceeds 1600 surprising even optimistic strategists and investors. The combination of strong earnings, reasonable valuations and excess liquidity throughout the world drives the U.S. market higher. Market volatility increases substantially with the VIX index rising to 20.

Reversion to the mean kicks in with a vengeance. Earnings fall in lockstep with economic growth. P/E ratios continue their post-bubble downtrend amid rising risk aversion and an increasingly pessimistic economic and financial outlook. The noose of tight credit and rising illiquidity begins to exorcise a decade-long exuberance. Instead of breaking out to the upside, the S&P 500 begins a widely unexpected multi-year descent.

2. Secretary of the Treasury Paulson's trips together with the forthcoming Olympics move China to a more accommodative attitude toward the United States and the West. China revalues the yuan by 10% and eases terms for Western partnerships with Chinese companies.

The beginnings of a hard landing in China as investment and real estate booms abruptly come to an end, a dramatic U.S.-led global slowdown, worsening trade tensions in the wake of rising protectionist sentiment and the fallout from the failed Doha round of global trade negotiations, and a growing realization that America's hegemonic dominance is falling by the wayside cast a dark pall over relations between America and China -- as well as other nations.

3. Despite a world-wide economic slowdown, crude oil remains in short supply because of Asian demand and the price per barrel returns to $80. Development of alternative sources of energy and sales of hybrid cars remain disappointing. There is a movement in Congress to encourage the construction of nuclear powered electric utility plants and local resistance seems to be softening as the "green wave" starts to take hold.

On the heels of a world-wide economic slowdown, higher borrowing spreads, sharply diminished access to credit, and the unwinding of a massive multi-year speculative bubble in oil, copper, and other commodities, those markets continue significant medium-term corrections that will eventually cut the price of oil and other commodities by a third or more from peak 2006 levels.

4. As the standard of living rises around the world, agricultural commodity prices continue to soar. Corn goes to $5.00 a bushel, wheat to $7.00, soybeans to $9.00 and cotton to $.80 a pound. The volatility of cattle prices also attracts investor attention.

With consumption falling hard on the heels of a collapsing credit bubble and a dramatic economic slowdown in the U.S., China, and elsewhere, agricultural commodities also begin double-digit medium-term corrections.

5. S&P 500 earnings grow by more than 10% for another year, exceeding analysts' estimates. Profit margins hold their own as productivity continues to improve.

S&P 500 earnings increase far less than expected. Faltering growth, cutthroat competition in the U.S. and overseas, rising real interest rates, costlier credit, a belated effort by American workers to garner a greater share of economic spoils, and heightened antagonism towards corporate managers on the heels of options and other scandals and bonuses perceived as obscene all serve to pressure profit margins downward.

6. The Federal Reserve does not lower rates in the spring. The 10-year U.S. Treasury yield goes to 5.5% as higher wages cause inflationary pressures to increase and the yield curve turns positive. Real growth in the U.S. approaches 3% once again as housing begins to recover. Credit spreads widen as defaults increase in a service oriented, competitive economy that is brutal to manufacturing companies.

The Federal Reserve lowers rates in the spring -- though less than markets demand -- as a collective realization suddenly takes hold that the U.S. economy is in the midst of a dramatic slowdown. Although the 10-year treasury yield increases, as Mr. Wien posits, the move in long-term yields actually reflects selling of volatile fixed-income securities by leveraged speculators, hedgers, and assorted foreign holders, evaporating liquidity, tighter credit, and a dramatic shift in risk preferences that favors short-term instruments over longer-term issues.

7. The price of gold goes to $800 and silver approaches $18. The dollar is stable against the euro because of renewed economic growth in the U.S. and higher interest rates.

Gold and silver follow other commodities downward on their way towards unexpectedly sharp medium-term corrections. The dollar, meanwhile, rallies strongly on overly negative sentiment, large-scale speculative bets gone wrong, a scramble for dollar-based liquidity to meet margin calls and other dollar-related credit obligations, knee-jerk buying by investors and residents in emerging and other nations seeking a safe haven amidst heightened instability, and the continuation of a technical rally off of long-term support levels.

8. Economic conditions in Japan continue to improve. After being one of the worst equity markets in a developed country during 2006, the Nikkei 225 rises 15%. In this market large capitalization stocks do outperform their smaller brethren.

The Japanese economy gets hit hard as a result of its heavy dependence on U.S., Chinese, and Asian export markets. The Nikkei 225 continues to falter as part of an ongoing medium-term correction, with the shares of large multinationals lagging their smaller brethren.

9. The emerging markets of Asia take a rest. Attention shifts heavily to Latin America and Brazil stands out. It is a country with vast natural resources and reasonable labor costs. The country moves closer to an investment grade rating and the Bovespa rises to 55,000.

Asian emerging markets get slammed by a global slowdown and an abrupt and widespread dash for the exits by overseas investors seeking safer pastures. Markets south of the border are dragged down even more by the combination of a widespread shift in risk preferences and rising political instability emanating from populist socialists movements in Venezuela and elsewhere.

10. Neither of the current frontrunners for the 2008 presidential election in the U.S. proves to have staying power. Rudy Giuliani pulls ahead for the Republicans as fears of terrorism heat up again and Barack Obama gains momentum as he demonstrates that inexperience isn't a terminal liability.

Perhaps Mr. Wien is right on this one -- who knows? More than likely, candidates who successfully feed on and amplify the growing fear and uncertainty of the masses will be the ones who become the frontrunners.

Mr. Wien believes these surprises, which the consensus would assign only a one-in-three chance of happening, have at least a 50% probability of occurring at some point during the year. In previous years, more than half of the elements of the list have proven correct.

Forecasting, of course, is always a difficult endeavor. Still, from where I sit, I believe Mr. Wien's overly optimistic views for 2007 may be putting his enviable long-term track record at risk.

Michael J. Panzner
financialarmageddon.com

Michael J. Panzner is a 25-year veteran of the global stock, bond, and currency markets and the author of Financial Armageddon: Protecting Your Future from Four Impending Catastrophes, published by Kaplan Publishing.

Copyright © 2005-2007 Michael J. Panzner

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