Market Outlook 2011 - Thoughts of a Professional Investor
Most of the analysis presented in my blog and nightly Member Letter looks forward only weeks to months because of the time horizons offered by my primary technical tool, cycle analysis. However, such analysis must be considered within the context of a macroeconomic backdrop as the primary driver of trends. Using such an analytical structure, a framework of expectations can then be built and refined using a recursive process between the economic outlook... based on the Austrian School of thought, of course... and developments within market cycles.
Therefore, before diving into specific market expectations, let's hack through an overview of the economic and political backdrop comprising the foundation of my market outlook.
The current macroeconomic outlook is easily the gloomiest of my career. We have a central bank that will stop at nothing to produce the illusion of economic expansion, and a Congress with no reservations about expanding an obscenely large public debt. These misdirected policies will continue to distract capital from its most efficient uses, increase prices of raw materials, and encourage speculation over production.
The Fed's policy is flawed precisely because its directors believe easy money to be the driver of economic growth. This misconception is seductive in its simpleness and convincing because of the deceptive cause-and-effect relationship such policies carried over the last quarter century. I say "deceptive" because easy monetary policies were not the true driver of the economic expansions that followed. The 1980s and 90s were a period rich in innovation derived from the advent of the personal computer and later, the internet.
The economy reacted favorably to easy money during this period because entrepreneurs were teeming with ideas and ambition. In other words, there was a ready market to put cash to work toward a productive purpose. The economy would have recovered with or without central interference. The unfortunate consequence of the cause-effect illusion was that the Federal Reserve reacted with ever-larger doses of freshly printed money each time the economy slowed because policy-makers believed lower interest rates would create wealth.
The reality is that lower interest rates misdirected capital, enabling inefficient businesses to survive. Eventually this exuberance resulted in mass speculation and a much larger downturn... in the form of the bursting of the tech bubble... than would have otherwise occurred because capital was steered away from efficient producers into the hands of anyone with an idea, good or bad.
Not realizing that misdirected monetary policy was the direct cause of massive misallocation of capital and by extension, the culprit for an abnormally large downturn, our central bank responded by printing more new money than ever before, and another bubble was created in real estate. In this case, the resulting misallocation of capital is tangible in the millions of empty homes and vacant commercial centers scattered around our country.
Still operating with no clue, the Federal Reserve along with Congress are complicit in counterfeiting more money over the last three years than in several decades combined. Unfortunately, there is no innovative industry ready to absorb this money. Instead, banks are lending the new cash in the only arena for which there is a ready market and in which they can earn a high enough spread to warrant the risk: as margin for speculators. The result is a soaring stock market, disconnected from any economic valuation, and soaring raw material prices. The last time I checked, higher input prices were not favorable for economic expansion.
The first irony here... and a sad one it is... is that allowing interest rates to rise as they naturally would without central interference would actually serve to move financial capital away from speculative use and toward production. With higher interest rates in hand, banks would be more willing to accept certain levels of economic risk. Furthermore, higher interest rates would serve to control raw material prices, making industry more feasible. There would, of course, have to be a period of painful contraction in between the interest rate rise and economic expansion as misallocated resources found higher and better uses.
The second irony is that the stock market boom, a stated aim of the Fed, will be a large factor in the next, unavoidable bust. Profit driven by speculation is not a sustainable business model for the banking system. Real wealth is built only by production. Eventually, higher interest rates will be forced upon the economy, stock prices will be driven lower, margin will forcibly contract, and the flaws in central bank policy will become painfully apparent to even those who refuse to see it now. By the time the Fed is forced to withdraw liquidity in order to control inflation, the bonds they purchased during the monetary expansion effort will be priced much lower. There will be no way for the Fed to withdraw enough liquidity.
The first warning shot to this unraveling will come in the form of a dollar crisis, which I believe is just in front of us. Without further ado, let's get to the specifics of my market outlook...
I suspect the first half of 2011 will be dominated by a sense of crisis surrounding the U.S. dollar. This expectation is predicated on the 3-year dollar cycle, which is due for a major low in spring.
For reasons discussed in the Member Letter, I expect the 2011 low to break below the low formed in 2008, and just as with the spring of 2008, the plunge will renew calls for the demise of the dollar and stoke hyperinflation fears. It is possible, if not likely, that this environment will coincide with a push by the Fed for another round of money printing or the need to bail out a U.S. state.
Recent action in the bond market provides evidence that large investors are ready to flee the dollar:
In fact, bonds are close to confirming the quarter-century fixed-income bull market has run its course (more below).
Major cyclical lows are typically followed by powerful rallies, and I expect the 2011 dollar low to be no different. However, the DX will not be celebrating the resolution of a crisis, but rather reflecting the onset of another. Despite all the fiscal malfeasances unleashed by our central bank and politicians, the euro zone is actually in much worse shape than the United States. By late spring, I suspect a new insolvency crisis to be haunting one of the larger of the heavily-indebted nations, or perhaps we may even see one of the PIGS elect to depart the euro. Whatever the case may be, the next round of trouble in the euro zone should fuel a dollar rally spanning at least a year.
Cyclically-speaking, gold is due to commence 2011 with a bout of weakness lasting through the first month. Once that cycle low is in, the yellow metal, fueled by a plunging dollar, should complete the parabolic move begun last July.
As with the first phase of this parabolic move, silver should handily outperform gold on the way up.
I expect this ratio to decline at least 40 during the next phase of the rally. Furthermore, I suspect gold will tag $1600, implying a minimum silver price of $40 by late April. The peak of the precious metals rally should also roughly coincide with the trough of the dollar panic.
On the backside of the parabolic move, precious metals will suffer a quick and nasty correction, trapping the exuberant masses who chased the move near the top or were too greedy to realize the move had exhausted itself. For the remainder of 2011, gold will then be contained in a sideways consolidation beneath the spring peak.
Like gold, the equity market is due for an intermediate-term correction as 2011 kicks off. Furthermore, with a major low coming for the dollar, I suspect the cyclical bull out of March 2009 will find its peak during the first 4 months of the year. A question remains as to whether the anticipated January peak will mark the cyclical bull's top or whether stocks have another leg higher to unfold into spring.
Either way, I believe the dollar's bounce out of its 3-year cycle low will accompany an accelerated downturn in the stock market, which will then work its way down into its own 4-year cycle low in late 2012 or early 2013. The primary driver of this downturn will be higher interest rates, delivered by a declining bond market.
The bond market is providing a big clue about what is to come in stocks because the recent downturn in Treasury prices is threatening to turn bonds down into a secular bear.
Upward trending interest rates will be no friend to equity bulls, and especially to those with margin balances. Once we receive signal of a confirmed bear market in bonds, we will also know that the Fed's tools have lost what little efficacy they retained. We will also have a signal that inflationary pressures will rise.
In general, I expect commodities to continue their decade-long bull market, but the process will be choppy as markets are torn between a renewed economic downturn and loose monetary policy. Receiving signal of a confirmed bear market in bonds will not necessarily result in an immediate spike in commodity prices. The bond market is great for forecasting, but not very useful as a timing tool. What we do know is that any real economic expansion that may take place down the road will press prices higher because the Fed will be unable to withdraw all their counterfeit money.
My trading plan for the year... subject to change as market conditions evolve, of course... will be to carry a moderate equity short into February in anticipation of a stock market correction. I fully anticipate exiting that short too early in order to prepare for a much larger opportunity... spotting the cyclical low in gold. I intend to be leveraged long against precious metals, along with a bit of a dollar short, into spring. When I believe the dollar has found its 3-year cycle low, I will buy the dollar index in order to capitalize on the typically explosive move out of that low. Depending on market action and the economic outlook at that time, I may also risk a short of industrial commodities such as oil or copper as the dollar bounces. Later in the year, I anticipate playing the short side of equities again by selling calls against every rally.
Keep in mind that these exercises are intent on building a framework of expectations against which to judge the action. As stated above, a trading plan must be dynamic, reacting to economic conditions and, more importantly, to what the market tells us to do.