I love this time of year when folks start releasing their forecasts, predictions and assumptions for the year ahead. The theme behind all of my predictions this year is that the “New Normal” will persist, and it will create fantastic opportunities for those who are smart, willing and able. For those of you who have been living under a rock, Bill Gross popularized the “New Normal” concept following the onset of the financial crisis explaining markets had entered a “New Normal” era characterized by deleveraging, re-regulation and lower long-term growth rates.
Before I get into my predictions, it is important to remember that not even Bill Gross can predict the future with 100% accuracy 100% of the time, and even a broken clock is right twice a day. Nonetheless, I think it’s a fun thing to do, especially when the right calls are made. Without further ado, here are my twelve predictions for 2012:
1) Hgh volatility creates continued short-term trading opportunities as the S&P 500 moves up or down more than 1% on over 100 days in 2012. For reference, the S&P 500 moved up or down more than 1% on average 105 times in each of the last four years from 2008 through 2011. In the previous four-year period (2004-2007) the average was only 41 times per year. More poignantly, it moved up or down more than 2% on a single day 183 times from 2008-2011, while this only happened 19 times from 2004-2007 (it also moved up or down more than 3% in a single day 85 times from 2008-2011, which happened only once from 2004-2007). This is an environment where short-term trading does very well. Proprietary trading firms, volatility based hedge funds, and investors who skillfully allocate a portion of their assets to short-term trading will perform the best in 2012.
Many investors have been trained (or brainwashed depending on how you look at it) to believe profitable short-term trading is impossible. However, skilled traders know very well that it is possible and that short-term trading really isn’t a four letter word. In recent years, the two best sources of short-term trading opportunities have been government/regulator meetings scheduled well in advance (think ECB meetings, European leader summits, and debt ceiling deadlines) and news headlines. Regarding news headlines, they feed off each other and often get overdone to the point where my favorite Warren Buffett quote is applicable: be fearful when others are greedy, and be greedy when others are fearful. These are the strategies that worked the best in 2011, and they will continue to work best in 2012.
2) The S&P 500 will touch 1150 and 1400 before finishing the year at 1350. My base case scenario for the year is modest gains (+3% to +4%) during the first quarter, followed by a flair up of sovereign debt and banking system concerns in the second quarter leading to steep market declines (this is when we’ll touch 1150). However significant government intervention in the U.S. and abroad (think quantitative easing and bailouts) will prop up the markets leading into the U.S. presidential election. The S&P 500 will touch its highs for the year of 1400 right around the U.S presidential election, before giving up some of those gains after the excitement of the election fades and investors realize the global debt load continues to be a monstrous drag on the worldwide economy. The S&P 500 will finish the year at 1350.
3) The Yield on the 10-year Treasury will remain below 2.25%. Everyone who said Treasuries were a bubble in 2010 that would burst in 2011 was wrong, wrong, wrong, and they will be wrong again in 2012. Treasury yields will remain low and prices will remain high throughout the year because many corporations and countries still aren’t comfortable with the risk-reward profile of other investments. There will be short-term trading opportunities in Treasuries throughout the year as prices will move in lock-step with the risk-on risk-off trade as investors wrongfully move in and out of Treasuries according to the latest news headlines.
4) Gold falls to $1,350 before resuming its upward trend and reaching nearly $2,000 by the end of 2012. Unless you’re living off canned goods in your Montana bomb-shelter, you probably think gold is a bubble. The question is when will the bubble burst. I believe we’ll see a significant pullback in gold during the first half of the year until we see wide-scale government intervention to prop up the economy (and equity markets) leading into the U.S. presidential election which will cause the value of gold to resume its upward trend.
5) Beta exposures will be more important that alpha as the correlation of stocks in the S&P 500 will remain high, above 0.75 for most of the year. I don’t think it’s any secret that the correlation of stocks has been slowly increasing in recent years due to such things as ETF trading, macroeconomic events and government intervention. However, I do believe this has caused many investors to wrongfully give up on active investing, and to miss out on lucrative opportunities that still exist in the markets today. “Seeking alpha” may continue to be a less fruitful strategy for the next few years, however “seeking beta” is a strategy that is working, and “market timing” is NOT a four letter word! Check out the following chart (hat tip to TickerSense) to help you visualize the rate at which individual stock correlations have increased:
Click to enlarge
As an aside, I believe mutual fund investing will largely continue to be an inefficient and expensive strategy for individual investors, and they’ll be better served to seek profits by gaining exposure to select market betas via exchange traded funds. It’s very challenging for a mutual fund manager to outperform the S&P 500 when the correlation of individual stocks is so high. Investors continue to recognize that it’s the beta exposure that matters, and low cost ETFs are generally a better option than mutual funds which charge much higher fees.
6) In U.S. dollar terms, stocks markets in the U.K., Brazil and the U.S. will all outperform China and euro zone region stock markets. The euro zone will continue to underperform as European leaders struggle with the region’s debt crisis which will drag heavily on the economy and the value of the euro. The U.K. will outperform because it has wisely steered clear of getting involved with the euro. The U.S. seems to be months and perhaps years ahead of Europe in resolving its own credit crisis (not to mention it has the reserve currency of the world) which will lead to outperformance in 2012. Brazil is a unique emerging markets story where the demographics will quite simply drive that market higher regardless of inflationary pressures in the region.
China will also underperform the U.K., Brazil, and the U.S. Despite the continuing expectation of millions of Chinese people moving from the countryside and into the cities to fuel enormous growth, the Chinese economy is controlled by the government; it’s not a free market and it will not prosper as free markets do. Regardless of all the hype we’ve heard in recent years, the Dow Jones has outperformed the Shanghai Stock Exchange over the last five years and it has outperformed both the Shanghai and Shenzhen Stock Exchanges over the last year. Mainland China stock markets are not widely available to the outside world, and even private equity investors have a hard time making investments without hitting government roadblocks. Free market capitalism is the best system in the world for creating prosperity. Underweighting China and the euro zone while overweighting the U.K., Brazil and the U.S. will serve investors well in 2012.
The reason economies around the world will remain incredibly challenged in 2012 is because governments around the world have made the incredible mistake of assuming they know better than the collective wisdom of the people they serve. Governments have assumed they have the ability to allocate resources better than the collective decision making of individual citizens. Mark Spitznagel recently penned an interesting analogy in an op-ed for the Wall Street Journal which compares the value of forest fires in preserving forests to the necessity of markets occasionally crashing to preserve their long-term ability to survive. What governments and regulators around the world don’t seem to recognize is that debt is supposed to default sometimes. If there is no risk of default then debt should offer zero interest. This is one of the most basic principles of investing yet our meddling governments and regulators clearly don’t understand. And the result is a prolonged period of deleveraging, re-regulation and lower long-term growth rates, which Bill Gross has eloquently described as the “New Normal.” My advice to anyone reading this article is don’t make the mistake of believing the long-term bull run we’ve seen for decades in the U.S. will continue indefinitely. The U.S. is still the best economy in the world, but recognize we’ve entered the “New Normal” and you need to be smart, willing and able to profit from it!