Seeking Alpha
Long/short equity, research analyst, portfolio strategy, commodities
Profile| Send Message|
( followers)  

2012 will be a decisive year for stock markets and economies worldwide. After a huge recession in 2007-2009, followed by a sharp “recovery” until May 2011, we now find ourselves at a major juncture that may reveal the fate of stocks and economies for the next decade.

It seems that almost the entire world is stuck in three camps with different outlooks as to what the future brings: one group thinks the worst is over and that the economy will continue to recover, the second group thinks we had a temporary recovery but that we are now entering a double-dip recession, and the third group (perhaps those who are too uncertain or afraid to make a directional call) thinks the economy will muddle through directionless and flat for some time. All of these scenarios are still possible, but I favor scenario #2 – that we are on the verge of a disastrous recession led by slowing global growth, economic shocks, the onset of deflation, falling commodity prices, downgrades and failed expectations.

Since it is still possible that the worst is over and that we may be approaching a major bull market, investors who decide to short the market must be extremely cautious and hedged in case the bearish thesis is proven wrong (keep an eye on the May 2011 highs and the October 2007 all-time highs). At the same time, those investors who truly believe the economy is on track for a full recovery must also be extremely cautious and hedged in case of a sharp recession, flash crash or major volatility. Making a directional bet without protecting your portfolio is foolish.

In order to accurately present our bearish thesis for 2012, I will present you with the themes to watch over the course of the next 6-12 months. These investment themes and events will reveal much information about the future viability or failure of global stock markets and economies, and may be the major deciding factors of our future.

Emerging Markets

The collapse of the emerging markets, especially China, India, and Brazil, will have a huge ripple effect on the rest of the world’s economies, and will plunge most countries back into a global recession.

It is our view that emerging market growth has reached an unsustainable level and that a slowdown is taking place. A slowdown is generally not such a calamitous situation, but with expectations for China, and emerging markets at such extremes, the failure to meet or beat these lofty forecasts could mean big shocks to global economies and stocks.

Our reasons for severely doubting the continuation of the emerging markets theme stem from a long list of dangerous warning signs (See: China, Emerging Markets Point To Double-Dip):

Emerging Market Warning Signs

  • Surging inflation that threatens sustainable growth
  • Soaring money supply that fuels bubbles in stocks and real estate
  • Credit bubbles
  • Massive and understated loan exposure
  • Tightening monetary policy that could “put the brakes” on the economy
  • Inverted yield curves that usually appear before recessions
  • Real estate bubbles evident in ghost towns and empty malls
  • Overconfidence buying at auctions
  • The infamous “skyscraper indicator”
  • Fraudulent companies that have attracted investment from around the world when they are nothing but “shell” companies with unproven financials
  • Most importantly: The stock markets of China, Brazil, and others have been deep into bear-market territory in 2011 – down between 20 percent and 30 percent from their peaks

The problems continue to surface – from slowdown in manufacturing (visible in the PMI of Brazil, and China, which point to economic contraction), to slowing economic growth (shown in GDP and inflation), to mass speculation gone wrong (seen with major failures in the Chinese high-speed rail, fraudulent companies, real estate bubbles), and most notably – failing stock markets, which tend to lead the economy by a few months to a year.

Since we believe emerging markets are the key to the fate of global economies, investing in or against countries like China, Brazil, and India, may prove to be the most profitable bets over the next year or two. That said, investors looking for emerging market exposure should look at China (NYSEARCA:FXI), Brazil (NYSEARCA:EWZ), or broad emerging markets (NYSEARCA:EEM). On the other hand, investors who see the ongoing trouble and potential upcoming catastrophe in these markets may look to short China (NYSEARCA:FXP) or triple-short emerging markets (NYSEARCA:EDZ). Our favorite play at this time is EDZ, as we expect emerging markets to fall sharply as investors begin to realize and accept a worldwide recession. As always, however, a purely directional bet must be hedged and protected; those who are long emerging markets should protect their portfolios through some short exposure (FXP, EDZ, or put options), while those who are short should protect their portfolios through some long exposure (buying stocks of favorite companies or call options).

European Crisis

Perhaps one of the largest threats to the global economy, Europe’s tremendous instability could ensure a global economic catastrophe. Similar to Lehman Brothers’ role in triggering or exacerbating the financial meltdown of 2008, Greece’s massive financial troubles may drag all of Europe into a domino-like economic collapse. Since many of the European countries are economically tied to each other through the euro, the financial collapse of any eurozone country could severely impact all the other countries. And with the eurozone countries attempting to stop the contagion by bailing out the failing countries, they could be dragged into the financial mess themselves.

Greece is in no way the only problem. Italy, Spain, Portugal, Ireland, and others are all at huge risk of collapsing and dragging the rest of the world into their mess. Unemployment levels have reached over 20 percent in some countries, with youth unemployment nearly double that. The strongest countries, Germany, and France, have been greatly impacted by the massive financial upheavals – having already entered bear markets, as their stock markets have been down approximately 30 percent from their peaks. Europe’s leaders, together with central banks, have attempted to fix these disastrous conditions; but unless the contagion can be contained and limited to Greece, we can expect financial meltdown in “snowball” fashion to ensue – as collapse and default spreads from country to country, dragging financially responsible countries like Germany into the mess created by Greece, Italy, Spain, and others.

Just take a look at the massive leverage taken on by European banks; more than twice that of American banks before the 2008 crisis.

Bank

Leverage

Tangible Equity

Landesbank Berli

53.04

1.43%

Dexia SA

52.83

1.49%

Deutsche Bank-RG

37.82

1.83%

Danske Bank A/S

30.68

2.55%

Credit Agricole

30.56

1.97%

ING GROEP-ADR

26.37

3.36%

Commerzbank

26.32

3.39%

UBS AG-REG

25.40

3.19%

Barclays PLC

23.93

3.60%

Nordea Bank AB

23.67

3.67%

BNP Paribas

23.33

3.59%

Credit Suiss-ADR

22.86

3.51%

Soc Generale

22.21

3.71%

Lloyds Banking

21.14

4.17%

Royal BK Scotland

18.91

4.29%

Fortis Banque

17.75

5.61%

Source

Middle East Upheaval

Problems continue in the Middle East, following upheavals in Egypt, Tunisia, Libya, Syria, Yemen, Algeria, Iraq, and a number of other countries. Citizens revolted over oppressive regimes, unfair treatment, poor economies, high costs of living, and other injustices.

Just look at the massive upheavals in the region:

(Click charts to enlarge)

Source

We warned readers in January and June 2011 that all of the instability in the region was a sign of more trouble to come. A number of countries’ citizens have attempted, or succeeded in, ousting leadership. Even if the political upheaval were to subside (which it hasn’t), the economic effects would still materialize; the revolutions and protests have undoubtedly put a strain on the region’s economy and will likely affect segments of the rest of the globe. The United States’ and others’ involvement in such matters will affect their own economies, as they attempt to stabilize the region, feel some trade disruption, and may engage in new wars.

Moreover, we warned in January 2011 that a housing bubble may have formed in Israel, and could affect the rest of the region. A housing bubble in Israel is not confined to Israel, and could affect other parts of the world as well. It may be the case that the United States’ real estate bubble preceded bubbles in other parts of the world, and that the bursting of these other bubbles (in countries like China) will follow. Regardless of whether or not stability returns to the region, economic damage has been done that may trigger a worldwide crisis – especially with the addition of slowing emerging markets, a European banking crises, and economic contagion.

Keeping an eye on developments in the region could help investors monitor the major risks that lie ahead. Aside from mass public discontent and revolts, potential trouble in the region encompasses revolutions, war and oil shocks. With the war in Iraq officially over, the US and the rest of the world will begin to monitor Iran with more scrutiny, as it has already stepped up its military campaigns, threatened to disrupt the oil trade, and has revealed that it has developed dangerous nuclear capabilities. A watershed event involving any of these risks could easily escalate into a major crisis.

Commodities

Perhaps the most telling of the future state of the economy, commodity prices and related stocks signal an economic contraction – even a sharp recession. Commodity prices saw massive gains over the past few years, with sugar (NYSEARCA:SGG), cotton (NYSEARCA:BAL), silver (NYSEARCA:SLV), gold (NYSEARCA:GLD), and others rising hundreds of percent from their lows to their 2011 peaks. Gold has seen the most notable rise, as this historic store of value rose more than 600 percent in just 10 years! In my opinion gold is the asset class most indicative of a commodity bubble – as it has risen based on fears over the future of stocks and economies as well as over-confidence in continued emerging market growth, and reveals the massive speculation on the part of investors and institutions.

Considering the emerging market slowdown, it is no surprise commodity prices have fallen. Since commodity prices are cyclical, and tend to rise and fall with growing and contracting economies, we can understand why commodity prices have fallen together with the slowdown taking place globally. Moreover, since commodity prices have seen such massive gains due to speculation over emerging market growth, we can expect commodity prices to crash (many already have) as the economic reality sets in for investors. Expectations have simply been way too high, and must come crashing back down to reality in order to factor in the slower-than-expected growth. To make matters worse, a hard landing for China and economic or financial shocks are still likely as real estate bubbles begin to implode and as bank loans and debt lead to a serious credit or liquidity crunch. In short, the rising prices in commodities, stocks, and other risk assets are likely unsustainable and due for a sharp fall.

My bearish commodities and gold thesis stems from the over-speculation, massive publicity, and extreme expectations on the part of investors. The reasons to be bearish on gold and commodities are numerous (which is why I have published "Gold Bubble: Profiting From The Impending Collapse of Gold"), but to sum up the signs already pointing to evidence of an upcoming crash:

  • Most commodities are already down big. Sugar, Cotton, Silver, Copper, Oil, Gold, and others have already seen major declines of 20-40 percent. Though it may seem like a buying opportunity, the bounces we have seen off of these lows could be a trap before the next big downturn. (See Copper And Oil Signal Recession)
  • China and emerging market weakness bodes poorly for commodities. Since commodity prices rely on continued global growth, the slowdown in emerging markets may bring a sharp halt to the commodity theme and could send prices tumbling.
  • Global economic slowdown and recession signals deflation. Since recessions are generally accompanied by slowing or negative growth, asset prices normally fall during such times. Furthermore, when asset prices fall inflation usually declines and may even reach negative – signaling a deflationary period. Deflationary periods bring asset prices down and strengthen currencies, especially the US Dollar (NYSEARCA:UUP).
  • Dollar strength threatens gold prices. Since gold and commodities have risen to a large extent due to falling currencies (especially the US Dollar), a Dollar comeback could be deadly to the gold theme. In fact, the Dollar has already seen a sharp rise over the past few months, and may be staging a comeback. A stronger Dollar may be signaling upcoming deflation and the onset of a recession. Moreover, a stronger Dollar signals falling gold prices. We predicted a Dollar comeback in late April 2011 (See Dollar 'Demise' Looks Overblown).
  • Technicals in gold are bearish. Gold soared on its way to $2000/oz but failed at around $1950 before falling sharply to $1500. Based on technicals, gold has shown a bearish “double-top” pattern in September 2011, massive selling volume, and has even fallen below its 200-day Moving Average – an indicator that is heavily monitored by traders, and could signal that gold has officially entered a bear market.

If our thesis is correct, gold and commodities are due for major drops over the next few months to years as global economies slow down. On the other hand, if stock prices continue to rise, gold is likely to suffer as well, since many people have bought gold as protection against failing economies. It is my opinion that gold will suffer in either case.

Therefore, in order to profit from the falling commodity prices in 2012, investors should look to short gold or buy the dollar. For more sophisticated investors, I recommend pair trades, put options, or combinations. I favor buying put options on gold miners (NYSEARCA:GDX) to take advantage of the big drops in gold-related companies over the next few years.

In the energy space, we are keeping an eye on Oil (NYSEARCA:OIL), Natural Gas UNG, GAZ, and Solar TAN, FSLR, JASO. Though oil prices would likely fall in the case of a recession, and may have already peaked in 2011, I would still rather own OIL than GLD. On the other hand, natural gas makes for a great low-risk, contrarian play on energy and a potential oil shock. Natural gas has dropped tremendously over the past year, and many have given up on it as an investment due to the huge supply that has been added. However, with alternative energy sources constantly demanded, and with most investors already giving up on natural gas, it may be time to get in. Reasons to buy natural gas? Capitulation on the part of investors, the oversupply may already be priced in, it provides a great hedge in case energy and commodity prices continue to rise, and it appears that the oversupply of the past few years is on the decline:

Maybe offering a bit of hope for natural gas prices under pressure from unseasonably warm temps, Baker Hughes reports the number of rigs drilling for gas dropping a bit more this week to 818, down from 941 a year ago. The number of rigs drilling for oil continues to climb, now at 1,196 against 756 last year.

Source: Seeking Alpha, Market Currents

The decline in natural gas rigs points to declining supply in the future. Since most investors are factoring in higher and higher supplies, the declining supply could help natural gas prices climb.

Volatility and Fear

Big stock market drops are usually accompanied by increased volatility and fear, measured by the VIX VXX, TVIX. The VIX soared during the financial crisis of 2008, but declined significantly in 2009 and the second half of 2010. It even reached levels below 20, in the range of 15-20. Such low levels signal complacency and low levels of fear. When the VIX reaches such levels, investors should be careful and realize that an upcoming downward reversal may be under way. Additionally, when the VIX begins to rise sharply, a significant drop in the markets could take place.

Since July 2011 that is exactly what may be happening. The VIX tripled from 15 to over 45 in a two month span in July and August. Since October 2011, however, it has fallen sharply to 20, as fears seem to have subsided. We may be at a huge inflection point, however, and it appears that a pennant or flag pattern has emerged. Such a pattern is generally the “calm before the storm” as the pennant is a resting period before the next large move up. If the VIX holds these levels and breaks out of the pennant to the upside, the markets may return to their enormous volatility and may see a very sharp drop as a renewed financial crisis takes place. Investors should view this as a cautionary signal for them to avoid taking on too much risk, and to avoid being too complacent. If the VIX returns to an uptrend, a recession could be confirmed.

Technology

The massively popular social-media and new technology space is highly reminiscent of the Tech Bubble of the late 1990s. As I’ve mentioned before (See Is IPO Mania Warning of a Tech Bubble 2.0?), the soaring popularity of companies like LinkedIn (NYSE:LNKD), Groupon (NASDAQ:GRPN), Zynga (NASDAQ:ZNGA), and Facebook, is very discomforting. Not only do these companies have unsustainable and ridiculous valuations of as high as 1000 PE for LinkedIn when it approached IPO, but many of these new companies don’t even make a profit. Groupon has not only shown overspeculation and pathetic revenue, it is one of a number of very popular IPOs that is trading below its IPO price. It appears that the large institutions and investors got into many of these stocks before they went public. Then, once the companies went public, the large institutions and investors dumped their shares onto the average investor or ignorant public who is not aware that the majority of the upside move has already taken place in the private markets. Facebook will go IPO in 2012, but if the top isn’t already in, it will come as the company goes public.

Facebook is already showing signs of a slowdown. Not only does it earn only $2-4 Billion that fails to justify its $100 Billion valuation, but it appears that it’s valuation may have reached a peak in early 2011, when I predicted Facebook would never live up to the expectations (See: Betting Against Facebook).

On the other hand, the large-cap technology names have done very well recently and have what seem to be very attractive valuations. Companies like Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), and Microsoft (NASDAQ:MSFT) look great in terms of valuations, future growth prospects, and cash balances. However, a falling market usually drags with it even the best of companies – and the strong large-cap stocks are not immune to a recession. That said, I would still rather own Microsoft or Google over Groupon and LinkedIn, but that does not mean they make good investments. However, Microsoft does pay out a decent dividend, is a hedge fund favorite, and may stage a nice comeback as it recaptures market share and takes on new initiatives (See: Finding Some Love for Microsoft). The Apple and Google competition will continue in 2012, as the iPhone battles the Android, which appears to be gaining market share (over 50% estimated compared to around 25% for the iPhone). The increased competition for Apple, together with an already-parabolic stock price, extreme expectations, and the loss of Steve Jobs could really hurt Apple in 2012. If Apple and the strong large-cap names can’t continue their run, they may drag the stock market down just as they carried it up.

A number of stocks are also on my radar because they are on the verge of irrelevance and bankruptcy or a recovery. As I predicted on numerous occasions, Netflix (NASDAQ:NFLX) is in severe danger of disappearing (See: Will Netflix Disappear?). I would not go long this stock, and would rather short it using out-of-money put options that would return huge profits if the company continues to suffer. On the recovery side, I am watching Research in Motion (RIMM), Sprint (NYSE:S), Clearwire (CLWR), Nokia (NYSE:NOK), and Kodak (EK) – all which could stage huge rallies as the space consolidates or as these companies become very attractive takeover targets for Google, Apple, Microsoft or other large companies. These companies offer patent portfolios, technology, an existing customer base, and many promising features that could tremendously benefit the larger competitive companies. Watch these stocks if the market continues to rise.

Conclusion

2012 will be a tremendously important year and will likely impact the next decade in the stock market. The possibility still exists for a huge rally that signals a renewed bull market, but I favor the potential for a sharp drop in stocks and a renewed global recession. Slowing emerging markets, European banking crises, the threat of war, unsustainable debt, and extreme overspeculation in unproven technology companies all signal enormous risk in stocks.

Investors should view 2012 as a cautious period that may decide the fate and future direction of markets. A fully directional bet at this point is almost foolish, as investors could lose big if the market drops or rises sharply against their positions. Instead, we recommend hedging portfolios through careful pair trades, options strategies, and buying only favorite companies or stocks at reasonable valuations.

Disclosure: Chart Prophet Capital is long EDZ, GAZ, JASO, EK, GDX and short AAPL, GDX, NFLX through stocks or options. We may initiate positions in any of the stocks mentioned.

Source: 2012: On The Verge Of A Global Recession?