5 Trends That Will Define The Market In 2012

by: Nicholas Pardini

The current economic climate is very sensitive to headline risk and political developments that shift equities, commodities, bonds, and currencies one way or the other. However, in a largely unpredictable market, here are five trends that are likely to occur and that investors need to note throughout the year.

1) Volatility in the markets will favor pair traders. Despite violent swings in absolute stock prices in 2011, the relative spread between leading and lagging companies grew at a rather steady pace. Instead of trying to find just stocks to buy that will best withstand the current market, look to find to profit of the performance spread of the best and worst companies in a given industry [examples that worked well last year included Coinstar (CSTR) vs. Netflix (NFLX), Tesla (TSLA) vs. GM (GM), Ambev (ABV) vs. Diageo (DEO), Apple (AAPL) vs. Research In Motion (RIMM), Polo Ralph Lauren (RL) vs. Abercrombie & Fitch (ANF) and many others]. Pair trading also gives portfolios market neutrality. This allows investors to sleep at night when a meeting in Europe will determine an 100+ point gap up or down in the Dow Jones in the premarket. Despite, the recent pullback in the VIX, I expect volatility to climb as the European debt crisis and Chinese hard landing prospects will return to the headlines. However, this volatility will simply mask relative value that is able to be recovered through pair trades. I will not be endorsing any specific pair trades in this column, but I will be sure to write updates as I place them.

2) Concerns about China and Japan will replace Europe as the source of economic stress. European debt was the story of 2011. But as the European debt crisis eventually resolves itself, the attention will shift to concerns about Asia which have been largely ignored by the market and financial community. China's economy is decelerating as a rapid rate due to a real estate bust and declining exports from the US and EU. This has materialized through the Shanghai index's plunging to new lows and the slowdown in Chinese demand (and the resulting price decline of) commodities. Japan is also a pressing concern as demographic issues are on the verge of undermining its bond market. With the lack of wealth among Japan's small working youth population, Japanese interest rates will rise as foreigners will not accept a sub 2% returns on a ten year bond with a debt to GDP ratio of 220%. Due to the Japanese government's high level of leverage, a large increase in borrowing costs will crush the Japanese economy through either austerity or high inflation caused by monetization of its debts. The best ways for investors to play this trend is to short the Yen (FXY), Japanese government bonds (JGBS-OLD), and minimize long positions in industrial metals and basic materials companies.

3) The U.S. economy will continue to grow, while the average American's standard of living declines. Technology and globalization have allowed the marketplace to more accurately value employee productivity and lower the operating costs of businesses. Technology and trade will continue to increase economic growth, but these gains will be restricted to those who possess capital, have unique talents, or have a willingness to take entrepreneurial risk. Average workers, on the other hand, will have their relative value continue to decline as automation and outsourcing make them more inefficient and less valuable. As a result, income inequality will continue to rise and unemployment will remain high. The way investors can benefit from this trend is by buying luxury goods companies such as Coach (COH), Nordstrom's (JWN), and Tesla Motors or companies that cater to low income consumers such as Family Dollar (FDO) and Autozone (AZO). On the short side, investors can bet against companies that primarily sell to middle class customers such as Darden Restaurants (DRI).

4) Gold and silver will decouple with equities markets. Despite precious metals association as a safe haven investment, gold (GLD) and silver (SLV) have been largely been positively correlated with the equities markets since August. However, I expect this correlation to break in 2012. With the declines of the Yen and the Euro and caused by sovereign debt issues, the peg of the Swiss franc, the continuous debasement of the US dollar through quantitative easing, and record low Treasury yields, investors seeking a safe alternative to fiat currencies and low return government bonds, gold and silver will serve as viable alternatives as a store of value. Declining stock prices also will trigger a higher likelihood of additional easing from central banks across the globe, which increases buying of precious metals. On the other hand, if the economy stabilizes back to normal growth, central banks will raise interest rates and the general public's fear of an absolute economic collapse will decline. Both of those factors are strongly negative for precious metals while being neutral to positive for stocks.

5) Oil will also break positive correlation with the equities markets With oil (USO) near $100 per barrel, any additional rise in oil prices will have a severely adverse effect on the macroeconomy. Due to slowdowns in emerging economies, geopolitical risk in the Middle East will become the greatest driver for oil prices. If tensions in Iran increase, oil will continue to rise and the losses from higher gas prices, shipping costs, airline fare hikes, and expenses in manufacturing plastics will erode earnings and stock prices shortly after. Lower oil prices have the inverse effect and provide a stimulus for future earnings.

Disclosure: I am long TSLA, SLV.

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