2012 Risks - An Alternative View

 |  Includes: DIA, QQQ, SPY
by: William Gamble

In the United States much of the consumer spending takes place before Christmas. In fact the day after the national holiday of Thanksgiving, the last Thursday in November, is called black Friday, because that is when retail stores finally “get into the black” or start making a profit. Since consumer spending makes up 70% of the US economy, growing consumer spending is crucial to the growth of the US economy.

This year the reports of Christmas spending were uniformly positive. Both regular and online sales by retailers were supposed to have broken records. The markets responded positively to this welcome news. But there was one problem. The headline news wasn’t accurate. Today the government came out with the real figures. Instead of robust sales, they showed a marginal improvement of only 0.1%. This is a problem for investors, but it is also a huge opportunity.

Financial headlines and commentary are always filled with predictions. You cannot open a newspaper, watch a television show or visit a web site without hearing all sorts of justifications for the generally accepted trend. If you accept that this trend is correct and invest accordingly, the odds are not good that you will make money, because if the prediction comes true, the market has already discounted it. There is no value to be found by following the herd. On the other hand, if you can discern something that the headlines don’t say, you can do very, very well.

The present assumptions are for slow growth in the US and a recession in Europe. In fact for the past six months it seems that we have heard about little else. With this limited focus, it appears that at least for the financial community only the developed world exists. When emerging markets are mentioned, the general assumption is that “having started on the road to growth, the chances that these markets will continue to grow is good.” While the bulls concede that growth is slowing, they feel that 7 or 8% is certainly the bottom, hardly a recession.

But what if there is an alternative scenario? What if the financial community has things backward? What if the real risk is in emerging markets and Europe only experiences a mild recession? Most commentators feel that this is improbable, but that is exactly the reason why the strategy might be exceptionally profitable.

Europe certainly appears to be a basket case. This is especially true of countries like Spain. It is estimated that there are €176 billion in bad loans and the banks need to set aside reserves of €50 to repair their balance sheets. Worse Spain has an unemployment rate approaching 23%. Still despite these problems there is hope for both Spain and Italy. Both have governments bent on reform, hopefully labor reform. In the present crisis, there appears no alternative, so what seemed politically impossible six months ago may be the only possible solution. Like India after the reform of the License Raj in the 1990s, rapid growth is certainly a possibility.

In contrast to Europe, emerging markets seem positively healthy. The consensus for China is that their tightening has successfully brought inflation under control and that the economy is ready for another round of stimulus. Like many other emerging markets it has enormous foreign currency reserves and is assumed to have little public debt. But there is another side.

As Premier Wen Jiabao admits, the Chinese economy is “unstable, unbalanced, uncoordinated and ultimately unsustainable”. The tightening of the blistering real estate market has lend to 900 failed land auctions in 2011, three times the number as in 2010. One third of the failed auctions occurred in November and December alone.

Failed auctions are a real problems because land sales make up 74% of the revenue base of local governments up from 10% in the late 1990s. Local governments owe the state owned banks Rmb 10.7 trillion and 53% of that has to be paid back in 2012. Another indication of a rapidly slowing economy has been imports. The growth has fallen from almost 40% in October to 13 % in December. China started 2012 with its first triple A rated bond default (theoretically temporary).

China is not the only problem. Inflation is exceptionally high in India, Turkey and Brazil. All of these once vibrant economies are beginning to slow. But perhaps the most interesting indicator has been that high end sales growth in Asia for the jeweler Tiffany has slowed from 36% to just 12%.

What will and will not be is not for us and certainly not for financial analysts to know. The success rate for predictions is less than 50%, but when it comes to making money, the best strategy is to veer away from the herd to find new and different pastures.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.