Without a doubt we have had a wild ride over the past three and a half years. From a near collapse of our over-leveraged financial system in 2008 to a "recovery" near the old highs, we can't say it hasn't been exciting. As interesting as the recent financial debacle may be to history buffs, I for one am only really interested in what may happen next rather than what we already know. I'm going to try and approach my expectations for the 2nd half of 2011 with a macro view of the economy (both global and domestic) which is somewhat in contrast to the way I normally assess investment opportunities which is from a bottom up "chartist" perspective. From many years of painful experience I have learned that trading my economic expectations alone can be dangerous as macro events (EU bailouts, QE2, Japan disaster) can easily change those fundamental assumptions and invalidate your investment ideas in a hurry. To mitigate this is why I primarily use a stock picking approach, which embodies a "trade what you see and not what you think" methodology. Without further ado, here are my "expectations" for the second half of 2011 coupled with the "what I see" component which I believe helps frame the discussion.
Global Economy Expectations:
I think there are remarkably significant problems in the so-called developed economies of the world. The euro zone is reeling from multiple economies that have far too much debt to ever realistically pay off and there has been a lackadaisical effort over the past three years to fully resolve the problem. No, loaning countries that already cannot pay their debts more money is not a viable solution. The United Kingdom has embarked on a fiscal austerity plan that at first glance will save them from long-term default but will kill growth in the process. Ireland, which is very closely tied to the U.K. economy and the EU zone countries, is in deep trouble and there is no current workable solution on the table. Greece, Portugal, and perhaps Italy and Spain are all caught in a vicious cycle where their borrowing costs are increasing due to fiscal issues making it harder for them to operate and increasing the chances of default at some point. Germany, the big man of Europe, is faced with a sense of nationalistic spirit and there are rumblings as in Iceland that the average citizen is fed up with bailouts. Japan is a special case and there is no easy answer to their woes, which started much earlier than the recent tsunami but are a prime example of why you must handle your problems when you can because you may never get a better opportunity to do so. We should take heed of this in the U.S. and fix what's broken now while we still have the financial stability to do so.
The resource economies of Canada, Australia, and New Zealand may be affected by the global problems of the rest of the developed world but as long as the emerging world economies can keep up the pace of growth they should come out better than most. Mining, logging, and agricultural exports in demand in China and other developing economies should help them withstand any global downturn better than their peers.
The emerging market economies headlined by China, Brazil, and Russia are going full steam with inflation being their biggest single worry right now. It is a huge problem because it represents a Catch-22 situation in that they must continue to stimulate growth to raise the standard of living for those citizens that have not yet benefited from their emergence and yet doing so stokes the fires of inflation. Inflation as we all know comes directly out of your pocket or in the case of those living in poverty, directly from their mouths and stomachs. This has the potential for domestic instability and China in particular is doing everything in its power to prevent it. It remains to be seen how successful it will be because the global imbalances caused by excess liquidity being made available by the Fed to keep our "zombie" banks in business are wreaking havoc with commodity prices across the globe.
Global Economy (What I See):
I like the emerging market economies and if you can withstand the volatility I believe there is still opportunity there. I'm going to use the iShares ETF symbol EEM as my proxy for emerging markets here but charts for other instruments will look much the same. Based upon this monthly chart I can see while there was some heavy selling in 2009 (big surprise) and some further distribution during the correction of early 2010, the past 10 months have been equally balanced between buyers and sellers, sort of a holding pattern. My regression channel analysis shows a very tight up-trend and based upon the upper channel we have a potential for about 16% upside before we take out the old high or hit any significant resistance. So EEM is a hold or a buy as long as you can stand the bumpy ride and news shocks. (See Chart) If we can take out the old highs, then money flows will increase as greed takes precedence over fear.
The EU zone economies for now I would avoid and Japan is also not attractive at the moment. The same goes for the U.K. (a quasi EU zone economy) and the rest of the developed world ex-USA (we'll discuss U.S. prospects a little later). I only see the ‘hope' that things will be resolved which in essence is just speculation of further stimulus and bailouts. Hardly a case for investing your hard-earned money in these dangerous times. While the trend has been positive since the bottom in 2009, I see a potential top around 18% higher but the important thing to note is that it will still be nowhere near its 2007 highs. Significant overhead resistance (where investors tend to sell out their positions if they bought near the highs to break even) will prevent a full recovery and probably prevent realizing the 18% potential. I am using the iShares ETF IEV Europe 350 Index fund as my EU zone proxy. (See Chart)
U.S. Economy Expectations:
Frankly I didn't expect much from the U.S. economy last year and at first the effect of QE2 caught me by surprise. Only later were my fears confirmed that the financial system was still broken when I realized that QE2 coupled with 0% interest rates was "flushing" money overseas instead of stimulating the domestic economy. This continues to this day and is stimulating inflation both in the U.S. and overseas, which threatens to de-stabilize developing economies as the price of basic staples rises past the ability of people to feed their families.
I think we are already in full 2012-election mode and any real work to help promote employment domestically has been forsaken. The Republicans can greatly benefit if the economy worsens between now and 2012, so there is little incentive to make the numbers look better. President Obama, on the other hand, needs to look tough on fiscal austerity if he is to have any chance of re-election. The resulting interplay all geared for the coming election will cripple any efforts to stimulate growth in the U.S. To compound these problems, we have gotten tangled up in yet another foreign war (Libya) and the hawks in Congress want deeper commitments and are now also calling for action on Syria. What this tells me is either 1) our representatives are using these international sound bites to take our minds off of problems at home or 2) they are truly so disconnected to Main Street that they have no clue how bad things really are for some. Either way, this is nothing but bad news. To make matters worse, our economic recovery was based largely on a strategy that assumed if we propped the banking sector up during which time the housing market would recover, the banks could capitalize themselves out of trouble. This situation is no different in principle to the failing efforts of the euro zone. Instead of forcing those entities that cannot pay their debts into some sort of restructure, we are hoping beyond any reasonable logic that time will take care of the issue.
Well we are almost four years into the crisis, housing has not recovered, we have taken on huge amounts of additional debt, debased our currency and still have the same fundamental problems we had when all of this began. This is not going away and just one look at the recent Bank of America (NYSE:BAC) earnings report should tell you everything you need to know. The banks are still struggling even with all that's been done on their behalf and we the citizens have very little to show for it. In short I am not bullish on the U.S. long term but as it stands now there may be some upside. I believe, however, that we are coming to the end of the run within 90 days (barring QE3 or a visit from Queen Elizabeth with a satchel full of crown jewels for a bailout).
U.S. Economy (What I See):
The Fed is not going to change what they have been doing in any meaningful way, so effectively they are powerless to alter the dynamics they set in motion with their plan to bet the farm on a housing recovery. This plan has failed and there is no way out. So after some potential upside near-term target 1372, longer term 1450, I think the equity market will have trouble making the top of its regression channel @ 1533. If it does make it that far, significant overhead resistance looms. I have included a chart of the SP-500 index below. (See Chart)
One of the most troubling aspects of recent market action has been the lack of money flows into the equity market. Money was flowing out of U.S. Treasury notes in early 2010 in enough volume to push yields close to 4% and then reversed when the EU zone fell apart. Even though the equity markets have recovered and surpassed the 2010 highs, I see a troubling move of money into U.S. Treasuries and not an outflow of funds to such degree that the yield on the 10-year has been driven down to 3.32% on 4-26-2011. A year later and yields are going in the wrong direction. Unless this trend reverses, the equity market will not have the fuel to continue much higher. Let's see what the Fed has to say at their first press conference and see if that moves the needle any. Personally I think they have made themselves irrelevant and all their actions have set off a chain reaction of events that they (and we) will be powerless to stop.
Precious Metals Expectations:
Gold and silver are an interesting pair. I think that there may some great long term opportunities here. Obviously there are a couple of factors driving this dynamic. Hedging against a dollar decline (which is really hedging against inflation) and simply the fear of further global instability are the two principal drivers of precious metals prices today. The speculators then add to the froth by jumping in with both feet, using cheap money borrowed from the U.S. taxpayer via the Fed.
I think I am looking for a top sometime in June of 2011 and then a relatively deep correction that will provide another great opportunity to get long. Keep in mind that, simply because it may be in a bubble, doesn't mean after the bubble deflates a little it might not be a great opportunity as long as the fundamental backdrop remains intact. Not all bubbles are created equally. Housing for example lost its fundamental support, so it is not a great investment after it popped, I believe gold and silver will be a different story. Wait for the pop and then see what happens. Below are current charts of GLD and SLV (Precious metals ETFs) for reference. GLD (Gold) has some room before it hits its upper regression channel boundary but SLV (Silver) has already hit and is currently testing resistance.
- Bullish Emerging Markets Longer Term
- Bearish euro zone, U.K., Japan
- Neutral Canada, Australia, New Zealand
- Bullish U.S. equities short term (to 1450 SP-500) Bearish Long Term
- Bullish Precious Metals Longer Term (after major correction later this year)
I wish everyone a prosperous 2nd half of 2011 and I would simply suggest that the best opportunities are the ones you don't have to chase.
Disclosure: I am long SPY, GLD, EEM.