Investment thesis: I expect the recovery to pick up speed in 2014 due to the impact of the new chairman of the FOMC. Although I expect bond prices to fall, stocks should go a bit higher as the risk premium declines.
Here are my year-old predictions for 2013, and new ones for 2014.
My 2013 Predictions*
1. The Dow will rise by 2,000 points from 13,000 to 15,000. Actual: up 3,600 points to 16,600.
2. The monetary base will grow by $1 trillion. Actual: up $1 trillion. (I don't distinguish between the monetary base and the Fed's overall balance sheet - they're about equal.)
3. Nominal growth will rise above 5% by year-end. Actual: 6% nominal growth in the third quarter (which I expect to be lower in the fourth quarter).
4. Bond prices will decline. Actual: bond prices fell by 15%.
Overall I did well. I got the directions right, and my predictions were pretty good. I placed my faith in QE3, and my faith was rewarded, at least on the surface. But my predicted chain of causality proved to be a bit flawed. I based my scenario on an acceleration in money growth, which didn't happen. Money growth slowed in 2013, despite $1 trillion in additional QE.
Here is a stab at an explanation for what actually happened in 2013:
1. The Dow rose, not because of an acceleration in growth, but due to a decline in the risk premium. There were no major black swans in 2013, and confidence is returning across the board.
2. Nominal growth remained low despite the third quarter blip.
3. Bond prices fell for three reasons: (1) the approaching taper of QE; (2) the third quarter growth blip; and (3) the choice of Janet Yellen (a vocal dove) over Larry Summers (a fence-sitter).
Looking forward, we need to ask how much further stocks can rise: if the main thing powering the stock market is growing confidence, what's the outlook for confidence? It's reasonably good: all of the financial stress indices remain low, and bank stocks are way up.
Now to 2014.
Predictions for 2014
My macro outlook has two central scenarios: either Janet Yellen succeeds where Ben Bernanke failed, and money growth accelerates, or Yellen also fails, and money growth remains low. The choice of scenario hinges on Yellen's ability to create a consensus on the FOMC that the Fed must do more to meet its dual mandates. This is a political question, not an economic one. It is about group psychology and personalities: what kind of a leader will Yellen be?
Yellen and Bernanke are very close ideologically, but different in personality. Bernanke is a low-key, no-drama academic who placed a high priority on consensus and maintaining the Fed's institutional credibility in Congress. He wanted to cure the recession while preserving the authority of the institution. He did not want a damaging fight with the hawks on the FOMC and in Congress. The price of his conflict-avoidance has been low growth and high unemployment. By choosing not to go to war, Bernanke allowed the hawks to veto unconventional policy choices.
Yellen, by contrast, is an outspoken dove who might be more willing to jeopardize consensus to achieve a more effective policy. She might be more willing to sacrifice institutional credibility in order to achieve the Fed's statutory mandates. I say "might" because this is pure speculation.
Nonetheless, I am placing my chips on the bullish scenario, in which Yellen succeeds in pushing the committee in a more dovish and unconventional direction, and money growth accelerates. I'm not talking about the pace of the taper, which is only symbolic. I am talking about moving the needle on money growth and inflation by adopting radical policies. By radical policies I mean things like reducing interest on reserves, new asset purchase categories (such as gold and foreign bonds), and price-level targeting (especially price-level targeting). All the kinds of things that Professor Bernanke preached before he joined the Fed.
Based on the "Yellen goes radical" scenario, here are my predictions for the key indices one year from now. (All growth rates are year-on-year.)
1. Fed policy:
Last year the Fed's balance sheet grew by $1 trillion under "full" QE3. This year I expect a slow taper, given prior guidance. The Fed's balance sheet should grow by another $500 billion to $4.5 trillion. This in itself is meaningless in terms of macro outcomes.
2. Money growth:
Under my scenario, Yellen finds ways to accelerate money growth from the current 5.5% up to 7-8%, which would be a great victory for the doves.
3. Nominal growth:
If Yellen can get money growth up to 7-8%, nominal growth should rise from the current 3.4% to a more comfortable 5%, which would be a major achievement. The Holy Grail would be 6% nominal growth, which would truly be an economic panacea and could rescue Obama's presidency.
4. Real growth:
Real growth on a year-on-year basis is now running at 2%, about half of what it should be. By this time next year, I would look for 3.0 to 3.5% real growth, better than now but still inadequate.
I expect that Yellen will achieve the 2% target by year-end, a somewhat heroic assumption.
6. The bond market:
The 10-year now yields 3%. Assuming Yellen can move the needle on money growth and inflation, the year-end yield should be closer to 4%, but not anytime soon. Bond prices will be lower by year-end.
7. The stock market:
If the foregoing growth and inflation scenarios prove correct, the Dow will be supported by continued earnings growth and higher confidence, offset somewhat by higher bond yields. I predict that the Dow will close the year above where it is now, i.e., around 18,000. The risk to this forecast is on the upside. Cash and bonds remain unattractive. There's an even chance that we could see the Dow at 19,000 by Christmas.
Just as was the case last year, everything hinges on Fed policy effectiveness. I am giving Yellen the benefit of the doubt on the theory that the committee will grant her some initial deference as the new chairman. The $64 question is how much personal risk she is willing to take to achieve her goals.
*"2013: The Year Of Printing Money", Dec. 16, 2012
Additional disclosure: I am long stocks and bonds.