While I won't go into detail regarding my bearish (realistic) views on the global economy, I've come to realize it would be beneficial to discuss the potential bull case for 2012. While it seems a bit silly to explore the potential (and nothing more than short-term) economic positives for 2012, stock markets don't necessarily correlate with economic fundamentals, and there is a case to be made for at least some equity gains next year.
In the intermediate-term, stock markets are driven by financial liquidity. Low interest rates, growth in the money supply, and a general speculative fervor cause money to be pumped into financial markets. As markets move higher, more and more cheap cash is needed to push equity and commodity prices higher.
What we've seen since about March of 2009 is intense growth in the money supply. Its worked like this:
- Banks, specifically primary dealers, are told by the Fed to purchase treasuries directly at auction from the U.S. treasury.
- The Fed buys the treasuries from the dealers. To pay for the transaction, the Fed simply credits the reserve accounts that the banks have on file. In this way, money is quite literally created out of thin air.
- Loaded with new, electronically printed profits, the banks then decide what to do with the money.
- Of course, in an uncertain economy with undesirable lending rates, the banks realize that they can generate the best returns on a risk adjusted basis by trading in financial markets.
- As more dollars chase the same amount of assets, stocks, oil, food, gold, and most other assets rise in price.
- Since most of the money is not lent out, consumers' wallets don't feel the positive effects of the money creation. Instead, they pay more for fuel, groceries, precious metals, and other raw materials.
- Additionally, low interest rates force money out of savings accounts and into risky assets, particularly stocks.
This basically sums up the reason for our stock market's boom over the past couple of years. The name of the game is liquidity. The more of it there is, the higher asset prices will go. The underlying concept here is the devaluation of the USD. While it hasn't collapsed in the FOREX market, the dollar has lost a ton of value in relation to real assets like oil, food, and gold. Of course, stocks, also denominated in dollars, have also benefited from the dollar's weakness, as more dollars chase them upward. While your purchasing power may be eroded, the value of the assets you own subsequently rise.
A continuation of the processes described in this concept is one of the few bullish cases that can be made for stocks in 2012. The Federal Reserve, desperately attempting to reinflate our burst economic bubble, will likely continue its policy of easing. The Fed may not officially announce it, but it's difficult to imagine a shift in policy.
Also possible is that the economy sees a small, nominal jolt from unprecedented stimuli; consumer borrowings (and therefore spending) continue to rise, and corporate profits continue to make record highs. While structural issues prevent the real unemployment rate from returning to reasonable levels, a drop in those actively seeking a job will lead to a subsequent drop in the unemployment rate as determined by the government. A slew of "positive" headlines could very well propel markets higher for a portion of the year.
Lastly, if the ECB is actually given the mandate to both act as a lender of last resort, and print euros, then the market could be off to the races for another year. While this kind of unprecedented action would assuredly lead to the inevitable destruction of the euro, global equity markets would soar with even more liquidity to work with. Sovereign debts could effectively be printed away, with the consequences left for another year. If this mandate is not granted, a major European default or market-driven crisis seems all but certain.
Conclusion
While my outlook on economic fundamentals is admittedly negative, there is a definite, yet speculative, case to be made for equity gains in 2012. Financial liquidity, barring a European crisis, appears likely to expand as the Fed continues its "accommodative" policy. Low interest rates will keep the savings rate artificially low, and speculation unnaturally frequent. Corporate buybacks also appear likely to continue in 2012; they've got a ton of cash, and most companies are unwilling to deploy their capital in productive asset investment. Buybacks will provide upward pressure for equities.
The key factor here is Europe. Investment gains in 2012 will absolutely be subject to Europe's ability to fund critically over-leveraged governments, thus kicking the proverbial can down the road for another year. Any crisis will send speculative liquidity shriveling up back here in the U.S, and spooked investors could spark a run on U.S. stocks. Most large U.S. companies have significant exposure to Europe; banks' financial exposure to the EU is the biggest concern, and once again, a European crisis could very well set off a Lehman-like run on a major U.S. banking institution.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
