Never make predictions, especially about the future.
—Casey Stengel
By means of background, in December 2002, I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien's playbook, who originally delivered his list while chief investment strategist at Morgan Stanley then Pequot Capital Management and now at Blackstone.
“I'm astounded by people who want to ‘know’ the universe when it's hard enough to find your way around Chinatown.”
—Woody Allen
There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:
“Let's face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins.”
—UBS's top 10 surprises for 2012
It is important to note that my surprises are not intended to be predictions but rather events that have a reasonable chance of occurring despite being at odds with the consensus. I call these “possible improbable” events. In sports, betting my surprises would be called an overlay, a term commonly used when the odds on a proposition are in favor of the bettor rather than the house.
The real purpose of this endeavor is a practical one—that is, to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs on small wagers/investments.
Since the mid-1990s, Wall Street research has deteriorated in quantity and quality (due to competition for human capital at hedge funds, brokerage industry consolidation and former New York Attorney General Eliot Spitzer–initiated reforms) and remains, more than ever, maintenance-oriented, conventional, and groupthink (or groupstink, as I prefer to call it). Mainstream and consensus expectations are just that, and in most cases, they are deeply embedded into today's stock prices.
It has been said that if life were predictable, it would cease to be life, so if I succeed in making you think about (and possibly position for) outlier events, then my endeavor has been worthwhile.
Nothing is more obstinate than a fashionable consensus, and my annual exercise recognizes that over the course of time, conventional wisdom is often wrong.
As a society (and as investors), we are consistently bamboozled by appearance and consensus. Too often, we are played as suckers, as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein's weapons of mass destruction, the heroic home-run production of steroid-laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank Citigroup, the uninterrupted profit growth at Fannie Mae and Freddie Mac, housing's new paradigm (in the mid-2000s) of noncyclical growth and ever-rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign, and Larry Craig), the consistency of Bernie Madoff's investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.
“Consensus is what many people say in chorus but do not believe as individuals.”
—Abba Eban (Israeli foreign minister from 1966 to 1974)
In an excellent essay published two years ago, GMO's James Montier made note of the consistent weakness embodied in consensus forecasts. As he puts it, “economists can't forecast for toffee.”
They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else.…
If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!
—James Montier
Some of my surprises were on target last year; to be precise, about one-third of the “possible improbables” came true. In particular, the following events had a familiar ring for readers of my “2003 surprises”:
Here is my list of possible surprises for 2004:
Internet stocks prove to be one of the worst performing sectors of the market, after New York Attorney General Spitzer sues eBay and Amazon for nonpayment of state sales taxes.
Despite a widespread belief that housing activity will fall off the cliff, the rise in home prices (fueled by ever-lower mortgage rates) continues apace and begins to resemble the bubble in the Nasdaq of the late 1990s.
Many of my surprises were on target last year; to be precise, almost one-half of the “possible improbables” came true, up from only one-third of my 2003 surprises coming to fruition.
In particular, the following actual events had a familiar ring for readers of my 2004 surprises.
About a fifth of last year's predicted surprises actually happened, which was down from the prior two years—nearly one-half of our prognostications proved prescient in 2004 and about one-third in 2003.
Two of our most accurate surprises related to markets and asset classes. We posited that the Nikkei would be among the best-performing markets in the world. Several emerging markets outperformed Japan, but Japan was probably the best performer among the more liquid international indices.
We suggested that the price of gold could briefly touch $575 an ounce (it hit $540) and would be the best asset class extant. Indeed, few markets rivaled gold in 2005.
Parts of Europe sank into a recession in the second quarter.
We said Hank Greenberg would unexpectedly retire from AIG; he did, though not voluntarily.
We thought the AOL division would be sold (to either Marc Cuban or Warren Buffett); recently a 5% position was sold to Google.
We envisioned a flattening in home prices in the late summer (and a buildup in inventory of unsold homes); this has transpired.
Let's move on to my list for 2006:
This new wave of socialism and left-wing presidents contributes to a series of moves to nationalize certain industries, and supply disruptions in certain countries in South America are destabilizing, resulting in much higher commodity prices during the year (including oil, natural gas, copper, tin, and grain). The CRB Index approaches 375 (now at 326).
Fears of stagflation befall economies and markets dependent on imports of goods from South America. Crude climbs to over $80 a barrel, and the DJIA bottoms at 9,000–9,250 during the early summer (and closes the year at the 10,000 level). Gold trades above $675 an ounce sometime during the year.
A special prosecutor begins an aggressive assault on the White House that results in Vice President Richard Cheney taking the fall for the administration and resigning by midyear. The president's popularity plunges as memories of Watergate are resurrected and the Democratic Party takes a large lead in preliminary presidential polls. Condoleezza Rice is selected to replace Cheney as vice president.
As the Fed and ECB continue tightening and the Bank of Japan ends its easing, bond yields initially rise early in 2006, but in the second half of the year, the 10-year U.S. note's yield dips to 3.65% as the market's focus moves toward potential rate cuts by the Fed and a potential recession in late 2006 or early 2007.
Weakness in personal consumption is exacerbated by many external shocks, including rising commodity prices, lower home prices (leading to weakening job creation and the lost ability to extract equity), stretched affordability of the first-time and repeat homebuyer to purchase a new home, the absence of personal savings (and a safety net), rising debt-service requirements (proliferation and reset of floating-rate and interest-only loans), changes in credit-card payment requirements, and so forth.
The rise in commodity prices and the CRB Index (affected by political unrest in South and Central America and a rise in agricultural prices due to a terrorist act) bring the DJIA down to the 9,000–9,250 level in early summer, where it settles in for the balance of the year, though another sharp late-year rally brings the DJIA back to about 10,000 by year-end.
Volatility during this period rises dramatically—the S&P 500 routinely has 2% daily moves, acting more like a commodity than a stock index. Mutual fund inflows drop precipitously.
Coca-Cola is a close second (buoyed by more stock purchases by Warren Buffett), and Verizon is the third-best performing member of that index. On the downside, the popularity of the exchanges (Chicago Mercantile, International Securities Exchange, Nasdaq, Chicago Board of Trade, etc.) wanes, and the stocks lead most sectors to the downside in 2006.
The current surge in tax revenue, which produced a reduction in the federal deficit, is reversed as tax-revenue growth normalizes back toward that of nominal GDP. Contributing to an expanding deficit are the Medicare prescription drug plan, spending on unmet infrastructure needs, the Homeland Investment Act (which encouraged repatriation of foreign profits to be taxed at low rates), hurricane rebuilding efforts, a pickup in bonuses (and other nonstandard income), and the normalization of individual nonwithheld and corporate taxes (both having previously benefited from a rising stock market and an increase in the value of homes, which served to increase capital gains).
The new competitive player is taken public by Goldman Sachs and has an instant valuation in excess of $25 billion after its IPO. Google's shares briefly touch $200 a share during the year as competition among the older and the new entities intensifies.
Further hurting Google will be an attempt by the Federal Communications Commission to extend the definition of decency laws to the Internet, an adverse court ruling in the Google Book Search case, a patent issue that is brought up in the courts by content providers and a major privacy scandal involving the U.S. government.
Most importantly, a suit claims Google has become a Web monopoly and is violating U.S. antitrust law. Microsoft's Vista is more successful than expected, and MSN search experiences a surprising gain of 10 points of search share after hiring two senior Google engineers who introduce massive changes such as eliminating clutter from its home page.
A high-profile, content-rich media company will make available a free video product, hurting the launch of Google Video. Finally, Google will release far fewer services this year, disappointing investors, as the company realizes it must go through a consolidation phase in which it makes its existing services scale better.
Similar to the legendary cult movie Putney Swope, he swiftly gains control of the company's board of directors by the end of the third quarter. Toward year-end, Steve Case—in concert with Microsoft and Berkshire Hathaway—pays $18 billion for the AOL division of Time Warner.
About one-third of last year's predicted surprises actually happened, up from 20% in 2005. Nearly one-half of our prognostications proved prescient in 2004 and about one-third in 2003.
Our most accurate sprang from a variant view of prices of a broad range of commodities—specifically the prices of the CRB Index, crude oil and gold. We expected the CRB Index to approach 375 (it stood at only 326 when the surprise list was published a year ago and peaked at 368 in early summer); we expected the price of crude to rise to $80 per barrel (exactly the price crude hit in July) and suggested that gold might rise to above $675 per ounce (gold reached $740 in May 2006). Our expectation of a sharp drop in the U.S. dollar was also realized.
Later in the month, one of the largest buyouts in the history of the media and entertainment industry is made by Bain Capital and Thomas H. Lee Partners when they acquire CBS for $30 billion.
In early February, Goldman Sachs (teaming up with Warren Buffett's Berkshire Hathaway) announces that it is considering a going-private transaction. The Goldman deal is abandoned three months later, as a fractured mortgage market leads to a standstill in deal making as the capital markets (and underwriting activity) seize up.
Sales of existing and new homes take another sharp leg lower as we enter what I've dubbed “The Great Housing Depression of 2007.”
Importantly, the financial intermediaries that source mortgage financing/origination begin to feel the financial brunt of “The Great Mortgage Bubble of 2000–2006” after years of creative but nonsensical, low-documented or nondocumented lending behavior.
Reflecting the deflationary threats, one of the best-performing groups of 2006, industrial materials, morphs into the worst-performing group in 2007. With credit spreads flying open, the junk-bond market records its worst performance in over two decades and substantially underperforms almost every asset class in 2007. Technology, pinched by an abrupt demand plunge in consumer electronics, a listless response to Microsoft's Vista and a drop in business spending, ends the year with a 20% decline in value.
As the capital markets falter, institutional funds committed to real estate are also reined in, initially leading to a marked slowdown in the recent appreciation in office building values. While broadening economic weakness leads to only a slight rise in office vacancy rates, as the year progresses, vacancy rates deteriorate more noticeably. Real estate investment trust (REIT) shares get hit hard (and fall below net asset values), as the historic relationship between REIT dividend yields and the yield on the 10-year U.S. note mean regresses.
The first few virtual attacks are ignored and have no effect on the market or on the Internet. During a chaotic weeklong period after the July Fourth holiday, however, an attack renders the Internet partially ineffective, threatening to eradicate crucial information storage bases and to stop commerce and communication.
On the other side of the ledger, Newt Gingrich is an early aspirant to the Republican nomination and, surprisingly, is in a dead heat in early polls against the favorite, Sen. John McCain, with Mitt Romney and Condoleezza Rice far behind. Rudy Giuliani does not enter the race after a New York Times investigative report uncovers some questionable business dealings.
Almost half of last year's predicted surprises actually transpired, up from one-third in 2006 and from 20% in 2005. Nearly one-half of the prognostications proved prescient in 2004 and about one-third in the first year of surprises in 2003.
But it wasn't the quantity of the correctly predicted surprises that made 2007's list a remarkable success, it was the quality, as I hit on nearly every major variant theme: the severity of the housing depression, the turmoil and write-downs in the credit markets, the curtailing of private-equity deals and the reawakening of equity market volatility.
Consider just a couple of these quotes from our surprise list for 2007:
It will be hard to do it again and beat last year's surprises, but without further ado, here is my surprise list for 2008.
The Retail HOLDRs (RTH) exchange-traded fund declines from $94 to $80. Despite their apparent “value” today, retail stocks, especially women's apparel, are among the worst-performing stocks in the first half of 2008.
Nevertheless the economy fails to revive as the Fed pushes on a string.
Several high-profile housing-related bankruptcies occur in 2008, including Countrywide Financial, Beazer Homes, Hovnanian, Standard Pacific, WCI Communities, and Radian Group.
Citigroup halves its dividend, and the shares briefly trade in the mid-$20s. Asset sales and write-downs leave the bank crippled, and in late 2008 (after another capital infusion by Abu Dhabi), Citi is merged with Bank of America. Its new name is its old name: CitiBank.
Bear Stearns is acquired by HSBC in a take-under (well below today's price), as investor Joe Lewis loses nearly $350 million on his near-10% position in the brokerage firm.
Mutual fund outflows and uncertainty regarding the integrity of money market funds result in the asset-management stocks being among the worst-performing sectors in 2008. With private-equity deals at a standstill, Blackstone shares trade down close to $10 a share. Late in the year, CEO Stephen Schwarzman and his management group take the company private.
Technology disappoints, as it becomes clear by the beginning of the second quarter that “double ordering” inflated recent revenue gains as the weakening consumers' appetite for electronics founders. Rapidly growing biotech names are embraced as their price-to-earnings ratios (P/Es) grow high into the sky and they become the new big thing and market leaders. Housing-centric equities continue to deflate and mop up the rear.
Second, a major data center will fail and will be far worse than the 1988 Cornell student incident that infected about 5% of the Unix boxes on the early Internet.
Third, cybercrime explodes exponentially in 2008. Financial markets will be exposed to hackers using elaborate fraud schemes (like liquidating and sweeping online brokerage accounts and shorting stocks, then employing a denial-of-service attack against the company). Fourth, Storm Trojan reappears.
In a remarkably close election (reminiscent of the Bush/Gore battle of 2000), the Democrats grab the White House.
Our surprise list for 2008 proved to be our most successful ever, with 60% of last year's “possible improbables” proving to be materially on target. Almost half of the prior year's predicted surprises actually came to pass, up from one-third in 2006 and from 20% in 2005.
Nearly of one-half 2004's prognostications proved prescient and about one-third in the first year of our surprises for 2003.
Investing based on some of my outlier events over the past 12 months would have yielded good absolute and relative returns and would have protected investors somewhat from the market's downdraft.
My surprise list for 2008 hit on a number of themes that dominated the investment landscape this year: the extent of the weakness in worldwide economic activity, the severity of the housing downturn, the collapse of retail spending, the obliteration of the hedge fund industry, the reawakening of market volatility, the spike in oil, the cessation of private equity deals and the steady drop in large bank shares.
Without further ado, here is my list of 20 surprises for 2009. In doing so, we start the new year with the surprising story that ended the old year, the alleged Madoff Ponzi scheme.
During the next few weeks, a well-known CNBC investigative reporter documents that the Russian oligarchs, certain members of the Russian mafia and several Colombian drug cartel families have invested and laundered more than $2 billion in Madoff's strategy through offshore master feeders and through several fund of funds. There are several unsuccessful attempts made on Madoff's and/or his family's lives. With the large Russian investments in Madoff having gone sour and in light of the subsequent acts of violence against his family, U.S./Russian relations, which already were at a low point, are threatened. Madoff's lawyers disclose that he has cancer, and his trial is delayed indefinitely as he undergoes chemotherapy.
President Obama, under the aegis of Larry Summers, initiates a massive and unprecedented Marshall Plan to turn the housing market around. His plan includes several unconventional measures: Among other items is a $25,000 tax credit on all home purchases as well as a large tax credit and other subsidies to the financial intermediaries that provide the mortgage loans and commitments. This, combined with a lowering in mortgage rates (and a boom in refinancing), the bankruptcy/financial restructuring of three public homebuilders (which serves to lessen new home supply) and a flip-flop in the benefits of ownership vs. the merits of renting, trigger a second-quarter 2009 improvement in national housing activity, but the rebound is uneven. While the middle market rebounds, the high-end coastal housing markets remain moribund, as they are impacted adversely by the Wall Street layoffs and the carnage in the hedge fund industry.
President Obama's broad-ranging housing legislation incorporates tax credits and other unconventional remedies directed toward nonresidential lending and borrowing. Banks become more active in office lending (as they do in residential real estate lending), and the commercial mortgage-backed securities market never experiences anything like the weakness exhibited in the 2007 to 2008 market. Office REIT shares, similar to housing-related equities, rebound dramatically, with several doubling in the new year's first six months.
After a decidedly weak January-to-February period (and a negative first-quarter 2009 GDP reading, which is similar to fourth-quarter 2008's black hole), the massive and creative stimulus instituted by the newly elected president begins to work. Banks begin to lend more aggressively, and lower interest rates coupled with aggressive policy serve to contribute to an unexpected refinancing boom. By March, personal consumption expenditures begin to rebound slowly from an abysmal holiday and post-holiday season as energy prices remain subdued, and a shallow recovery occurs far sooner than many expect. Second-quarter corporate profits growth comfortably beats the downbeat and consensus forecasts as inflation remains tame, commodity prices are subdued, productivity rebounds, and labor costs are well under control.
Housing-related stocks (title insurance, home remodeling, mortgage servicers, and REITs) exhibit outsized and market-leading gains during the January-to-June interval. Heavily shorted retail and financial stocks also advance smartly. The year's first-half market rise of about 20% is surprisingly orderly throughout the six-month period, as volatility moves back down to pre-2008 levels, but rising domestic interest rates, still-weak European economies and a halt to China's economic growth limit the stock market's progress in the back half of the year.
The yield on the 10-year U.S. Treasury note moves steadily higher from 2.10% at year-end to over 3.50% by early fall, putting a ceiling on the first-half recovery in the U.S. stock market, which is range-bound for the remainder of the year, settling up by approximately 20% for the 12-month period ending December 31, 2009. Foreign central banks, faced with worsening domestic economies, begin to shy away from U.S. Treasury auctions and continue to diversify their reserve assets. By year-end, the U.S. dollar represents less than 60% of worldwide reserve assets, down from 2008's year-end at 62% and down from 70% only five years ago. China's 2008 economic growth proves to be greatly exaggerated as unemployment surprisingly rises in early 2009 and the rate of growth in China's real gross domestic product (GDP) moves toward zero by the second quarter. Unlike more developed countries, the absence of a social safety net turns China's fiscal economic policy inward and aggressively so. Importantly, China not only is no longer a natural buyer of U.S. Treasuries but it is forced to dip into its piggy bank of foreign reserves, adding significant upside pressure to U.S. note and bond yields.
Despite an improving domestic economy, a further erosion in the Western European and Chinese economies weighs on the world's commodities markets. Gold never reaches $1,000 an ounce and trades at $500 an ounce at some point during the year. (Gold-related shares are among 2009's worst stock market performers.) The price of crude oil briefly rallies early in the year after a step up in the violence in the Middle East but trades in a broad $25 to $65 range for all of 2009 as President Obama successfully introduces aggressive and meaningful legislation aimed at reducing our reliance on imported oil. The price of gasoline briefly breaches $1.00 a gallon sometime in the year. The U.S. dollar outperforms most of the world's currencies, as the U.S. regains its place as an economic and political powerhouse.
Despite an improving economy, large-scale capital spending projects continue to be delayed in favor of maintenance spending. Technology shares continue to lag badly, and Advanced Micro Devices files bankruptcy.
The Madoff fraud, poor hedge fund performance, and renewed controversy regarding private-equity marks (particularly among a number of high-profile colleges such as Harvard and Yale) prove to be a short-term death knell to the alternative investments industry. As well, the gating of redemption requests disaffects high net worth, pension plan, endowment and university investors to both traditional hedge funds and to private equity (which suffers from a series of questionable and subjective marking of private-equity deal pricings at several leading funds). Three of the 10 largest hedge funds close their doors as numerous hedge funds reduce their fee structures in order to retain investors. Faced with an increasingly uncertain investor base, several big hedge funds merge with like-sized competitors in a quickening hedge fund industry consolidation. By year-end, the number of hedge funds is down by well over 50%.
The mutual fund industry does not suffer the same fate as the hedge fund industry. In fact, a renaissance of interest in mutual funds (especially of a passive/indexed kind) develops. Fidelity is the largest employer of the graduating classes (May 2009) at the Wharton and Harvard Business Schools; it goes public in late 2009 in the year's largest IPO. Shares of T. Rowe Price and AllianceBernstein enjoy sharp price gains in the new year. Bill Miller retires from active fund management at Legg Mason.
The municipal bond market seizes up in the face of poor fiscal management, revenue shortfalls and rising budgets at state and local levels. Municipal bond yields spike higher. A new municipal TARP totaling $2 trillion is introduced in the year's second half.
Under the pressure of late first-quarter bankruptcies, the UAW agrees to bring compensation in line with non-U.S. competitors and exchanges a reduction in retiree health care benefits for equity in the major automobile manufacturers.
Upon his inauguration, President Obama immediately replaces SEC Commissioner Christopher Cox with Yale professor Dr. Jeffrey Sonnenfeld. The new SEC commissioner recommends that the uptick rule be reinstated and undertakes a yearlong investigation/analysis into the impact of ultra-bear ETFs on the market. Later in the year, the administration recommends that the SEC be abolished and folded into the Treasury Department. Dr. Sonnenfeld returns to Yale University.
Economies of scale and mergers of equals become the M&A mantras in 2009, and niche investment banking boutiques such as Evercore, Lazard and Greenhill flourish. Goldman Sachs and Citigroup announce a merger of equals, but Goldman maintains management control of the combined entity. Morgan Stanley acquires Blackstone. Disney purchases Carnival. Microsoft acquires Yahoo! at $5 a share.
Though continuing on CNBC, Jim Cramer announces his own reality show that will air on NBC in the fall. At the time his reality show premieres, he also writes a new book, Stay Mad for Life: How to Prosper From a Buy/Hold Investment Strategy. Dr. Nouriel Roubini continues to talk depression, but the prices of his speaking engagements are cut in half. He writes a new book, The New Depression: How Leverage's Long Tail Will Result in Bread Lines. Kudlow & Company's Larry Kudlow proclaims that it's time to harvest the “mustard seeds” of growth and, in an admission of the Democrats' growing economic successes, officially leaves the ranks of the Republican Party and returns to his Democratic roots. Yale's Dr. Robert Shiller adopts a variant and positive view on housing and the economy, joining the bullish ranks, and writes a new book, The New Financial Order: Economic Opportunity in the 21st Century.
The Web is invaded on many levels as governments, consumers and investors freak out. First, an act of cyberterrorism occurs that compromises the security of a major government or uses a denial-of-service attack against media and e-commerce sites. Second, a major data center will fail and will be far worse than the 1988 Cornell student incident that infected about 5% of the Unix boxes on the early Internet. Third, cybercrime explodes exponentially in 2009. Financial markets will be exposed to hackers using elaborate fraud schemes (such as liquidating and sweeping online brokerage accounts and shorting stocks, then employing a denial-of-service attack against the company). Fourth, Storm Trojan reappears. (Same as last year.)
Three Major League Baseball teams fail in the middle of the season and seek government bailouts in order to complete the season. The Wilpon family, victimized by Madoff, sells the New York Mets to SAC's Steve Cohen. The New York Yankees are undefeated in the 2009 season, and Madonna and A-Rod have a child together (out of wedlock).
Racked by large losses, Rupert Murdoch abandons the Fox Business Network. CNBC rehires several prior employees and expands its programming into complete weekend coverage. Two popular CNBC commentators “go mainstream” and become regulars on NBC news programs.
The worlds of leverage and old media collide in a massive flameout of previous leveraged deals. Univision and Clear Channel go bankrupt. The New York Times teeters financially.
Lower oil prices, weakening European economies and a broad overexpansion wreak havoc with the Middle East's markets and economies.
Once again, 2009 proved how wrong “groupstink” and conventional wisdom can be.
While I failed to surpass our most successful year of surprises in 2008, during which 60% of the year's “possible improbables” were on target, I still had a very successful surprise list in 2009, with approximately half of our predicted surprises actually coming to pass. In fact, over the past three years (since and including 2007), at least 50% of our surprises proved accurate, which is up from one-third in 2006 and from 20% in 2005. Nearly one-half of 2004's prognostications proved prescient, and about one-third came to pass in the first year of our surprises for 2003.
Investing based on some of my outlier events over the past 12 months would have yielded good absolute and relative returns, would have protected investors somewhat from the market's downdraft into early March, and would have helped investors navigate the market's historic recovery over the past eight months.
My surprise list for 2009 hit on a number of important themes that dominated the investment and economic landscape this year. Most important, despite the economic and credit despair that existed 12 months ago, I accurately predicted the surprise that the economy and the housing market would recover well ahead of expectations. On the negative side, I was correct in predicting cascading financial conditions for U.S. municipalities and in the forecast for an abrupt halt in the Middle East infrastructure build.
Below is a list of the accurate surprises from last year's list:
So, without further ado, here is my list of 20 surprises for 2010:
It grows clear that, owing to continued draconian cost cuts, coupled with a series of positive economic releases and a long list of company profit guidance increases in mid to late January and early February, there is a very large upside to first-quarter GDP (up 4.5%) and, even more important, to S&P profit growth (which doubles). The upside on both counts is in sharp contrast to more muted growth expectations. While corporate managers, economists and strategists raise earnings per share, full-year growth and S&P target estimates, surprisingly, the U.S. equity market fails to respond positively to the much better growth dynamic, and the S&P 500 remains tightly range-bound (between 1,050 and 1,150) into spring 2010.
An outsized first-quarter 2010 GDP (up 4.5.%) print is achieved despite a still-moribund housing market and without any meaningful improvement in the labor market (excluding the increase in census workers), as corporations continue to cut costs and show little commitment to adding permanent employees.
After dropping by over 40% from 2001 to 2008, the U.S. dollar continued to spiral lower in the last nine months of 2009. Our currency's recent strength will persist, however, surprising most market participants by continuing to rally into first quarter 2010. In fact, the U.S. dollar will be the strongest major world currency during the first three or four months of the new year.
Gold's price plummets to $900 an ounce by the beginning of second quarter 2010. Unhedged, publicly held gold companies report large losses, and the gold sector lies at the bottom of all major sector performers. Hedge fund manager John Paulson abandons his plan to bring a new dedicated gold hedge fund to market.
China, facing reported inflation approaching 5%, tightens monetary and fiscal policy in March, a month ahead of a Fed tightening of 50 basis points, which, with the benefit of hindsight, is a policy mistake.
Israel attacks Iran's nuclear facilities before midyear. An already comatose U.S. consumer falls back on its heels, retail spending plummets, and the personal savings rate approaches 10%. The first-quarter spike in domestic growth is short-lived as GDP abruptly stalls.
In the face of renewed geopolitical tensions and reduced worldwide growth expectations, stocks drop as the threat of an economic double-dip grows. Surprisingly, though, the drop in the major indices is contained, and the U.S. stock market retreats by less than 10% from year-end 2009 levels.
Goldman Sachs stock drops back to $125 to $130 a share, within $15 of the warrant exercise price that Warren Buffett received in Berkshire Hathaway's late-2008 investment in Goldman Sachs. Sick of the unrelenting compensation outcry, government jawboning, and associated populist pressures, Warren Buffett teams up with Goldman Sachs to take the investment firm private. The deal is completed by year-end.
The Goldman Sachs transaction stabilizes the markets, which are stunned by an extended Middle East conflict that continues throughout the summer and into the early fall. While a diplomatic initiative led by the United States serves to calm Mideast tensions, flat second-half U.S. GDP growth and a still high 9.5% to 10.0% unemployment rate caps the U.S. stock market's upside and leads to a very dull second half, during which share prices virtually flatline (with surprisingly limited rallies and corrections throughout the entire six-month period). For the full year, the S&P 500 exhibits a 10% decline vs. the general consensus of leading strategists for about a 10% rise in the major indices.
Utilities are the best performing sector in the U.S. stock market in 2010; gold stocks are the worst performing group, with consumer discretionary coming in as a close second.
The yield of the 10-year U.S. note drops from 4% at the end of the first quarter to under 3% by the summer and ends the year at approximately the same level (3%). Despite the current consensus that higher inflation and interest rates will weigh on the fixed-income markets, bonds surprisingly outperform stocks in 2010.
A plethora of specialized domestic and non-U.S. fixed-income exchange-traded funds are introduced throughout the year, setting the stage for a vast speculative top in bond prices, but that is a late-2011 issue.
Warren Buffett announces that he is handing over the investment reins to a Berkshire outsider and that he plans to also announce his in-house successor as chief operating officer by Berkshire Hathaway's annual shareholders meeting in 2011.
The SEC alleges, in a broad-ranging sting, the existence of extensive exchange of information that goes well beyond Galleon's Silicon Valley executive connections. Several well-known, long-only mutual funds are implicated in the sting, which reveals that they have consistently received privileged information from some of the largest public companies over the past decade.
The SEC restricts 12b-1 mutual fund fees. In response to the proposal, asset management stocks crater.
The SEC announces major short-selling bans after stocks sag in the second quarter.
Two of the most successful hedge fund managers extant announce their retirement and fund closures. One exits based on performance problems, the other based on legal problems.
Citigroup's Vikram Pandit is replaced by former Shearson Lehman Brothers Chairman Peter Cohen. Cohen replaces a number of senior Citigroup executives with Ramius Partners colleagues. Sandy Weill rejoins Citigroup as a senior consultant.
Sarah Palin announces that she has separated from her husband, leaving the Republican Party firmly in the hands of former Massachusetts Governor Mitt Romney. An improving economy in early 2010 elevates President Obama's popularity back to pre-inauguration levels, and, despite the market's second-quarter decline, the country comes together after the Middle East conflict, producing a tidal wave of populism that moves ever more dramatically in legislation and spirit. With the Democratic tsunami revived, the party wins November midterm elections by a landslide.
Tiger Woods and his wife reconcile in early 2010, and he returns earlier than expected to the PGA tour. After announcing that his wife is pregnant with their third child, both the PGA tour's and Tiger Woods' popularity rise to record levels, and the golfer signs a series of new commercial contracts that insure him a record $150 million of endorsement income in 2011.
The Steinbrenner family decides, for estate purposes, to sell the New York Yankees to a group headed by former General Electric Chairman Jack Welch.
Last year's surprise list had relatively poor results. Only about 40% of my surprises were achieved in 2010, well under the success ratio in previous years. By means of background, about 50% of my 2009 surprises were realized, 60% in 2008, 50% in 2007, one-third in 2006, one-fifth in 2005, 45% in 2004, and one-third came to pass in the first year of our surprises in 2003.
While my surprise list for 2010 hit on some of the important themes that dominated the investment and economic landscape this year, I failed to expect the announcement of further quantitative easing and did not accurately gauge investors' animal spirits that followed the proclamation of QE2.
Below are some of my meticulous surprises from last year's list:
What follows is my list of 15 Surprises for 2011—reduced from 20 surprises in previous year in order to be more on point. I have listed my surprises in four categories—economic (surprise Nos. 1–3), stock market (surprise Nos. 4–6), political (surprise Nos. 7–9) and general (surprise Nos. 10–15).
“The first thing we do, let's kill all the lawyers.”
—William Shakespeare, Henry VI, Part 2
Increased hostilities between the Republicans and Democrats become a challenge to the market and to the economic recovery next year. As the 2012 election moves closer, President Obama reverses his seemingly newly minted centrist views, as newly appointed Vice President Hillary Clinton becomes the administration's pit bull against the Republican opposition.
“The day the Fed came into being in 1913 may have been the beginning of the end, but the powers it obtained and the mischief it caused took a long time to become a serious issue and a concern for average Americans.”
—Ron Paul, End the Fed
On the other side of the pew, as chairman of the Subcommittee on Domestic Monetary Policy, Congressman Ron Paul's fervent criticism of monetary policy and the lack of transparency of the Fed leads to further friction between the parties.
“‘Refudiate,’ ‘misunderestimate,’ ‘wee-wee'd up.’ English is a living language. Shakespeare liked to coin new words, too. Got to celebrate it!'”
—Sarah Palin
Sarah Palin, who can see the 2012 presidential election from her home in Alaska, continues her barbs against the opposition party and holds a large lead to be her party's presidential candidate in early 2011, but continued verbal and nonverbal blunders and policy errors coupled with an announcement that she has separated from her husband cause Palin to announce that she will not run on the Republican ticket.
Massachusetts's Mitt Romney, Wisconsin's Paul Ryan, and South Dakota's John Thune emerge as the leading Republican presidential candidates by year-end 2011.
The resulting bickering yields little progress on deficit reduction. Nor does the rancor allow for an advancement of much-needed and focused legislation geared toward reversing the continued weak jobs market.
The yield on the 10-year U.S. note, despite a sputtering economic recovery visible by third quarter 2011, rises to over 4.25%, as the bond vigilantes take control of the markets. The rate rise serves to put a further dent in the U.S. housing market, which continues to be plagued by an avalanche of unsold home inventory into the market as the mortgage put-back issue is slowly resolved.
During the second half of the year, housing stocks crater, and the financial sector's shares erase the (sector-leading) gains made in late 2010 and early 2011.
Scarcity of water boosts agricultural prices and causes a military confrontation between China and India. The continued effect of global warming, the resumption of swifter worldwide economic growth in 2011, normal population increases and an accelerated industrialization in emerging markets (and the associated water contamination and pollution that follows) contribute importantly to more droughts and the growing scarcity of water, forcing a continued and almost geometric rise in the price of agricultural commodities (which becomes one of the most important economic and stock market themes in 2011). Increased scarcity of water and higher agricultural commodity prices (corn, wheat, beans, etc.) not only have broad economic consequences, but they become a destabilizing factor and serve as the basis for a developing powder keg in the relations between China and India.
China has about 23% of the world's population but only approximately 7% of the world's fresh water supply. Moreover, China's water resources are not distributed proportionately; the 550 million residents in the more industrialized northern area of the country are supported by only one-fifth of the fresh water and the 700 million in the southern region of China have the other 80% of the country's fresh water supply. The shared resources of water supply have been a focal point of conflict between China and India since the 1962 Indo-China War.
My big surprise is that in early 2011, tension intensifies based on a decision by the Chinese government to materially expand the plans for the diversion of the 1,800-mile long Brahmaputra River, which hugs the Chinese border before dipping into India, from the south back up to the water-deprived northern China area in an expansion of the Zangmu Dam project, original construction plans of which were announced earlier this year.
At first, trade sanctions are imposed by India against China. Later in the year, the impoverished northeastern India region is the setting for massive protests aimed at China; ultimately, groups of Indian rebels, fearful of reduced availability of fresh water and the likelihood of flooding, actually invade southern China in retaliation.
While the general consensus forecast is for a rise of about 10% to 15% for the S&P 500 in 2011, the index ends up exactly where it closes the year in 2010. A flat year is a fairly rare occurrence. Since 1900, there have been only six times when the averages recorded a year-over-year price change of less than 3% (plus or minus); 2011 will mark the seventh time.
Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
—William Shakespeare, Hamlet
With a return profile reminiscent of the sideways markets of 1953 (–0.80%), 1960 (–0.74%) and 1994 (+1.19%), the senior averages also exhibit one of the least volatile and narrowest price ranges ever. The S&P 500 never falls below 1,150 and never rises above 1,300, as the tension between the cyclical tailwind of monetary ease and the cyclical economic recovery it brings are offset by numerous nontraditional secular challenges (e.g, fiscal imbalances in the United States and Europe; a persistently high unemployment rate that fails to decline much, as structural domestic unemployment issues plague the jobs market and the continued low level of business confidence reinforced by increased animosity between the Republicans and Democrats exacerbates an already weak jobs market and retards capital-spending plans, etc.).
Despite the current unambiguous signs of an improving domestic economy, as the year progresses, the growing expectation of consistently improving economic growth and a self-sustaining recovery is adversely influenced by continued blows to confidence from Washington, D.C., serving to contribute to a more uneven path of economic growth than the bulls envision.
With traditional economic analysis again failing to accurately predict the path of economic growth (as it did in 2008–2009), behavioral economic analysis, linking psychology to the business cycle, gains popularity. Yale's Dr. Robert Shiller and former Fed Chairman Dr. Alan Greenspan write books on behavioral economics that become the No. 1 and No. 2 books on the New York Times' nonfiction bestseller list.
The sideways market of 2011 will prove to be a good year for opportunistic traders but a poor one for the buy-and-hold crowd as neither the bulls nor the bears will be rejoicing next Christmas.
(This surprise is an extension of surprise No. 3.) Several well-known multinational food companies and a host of domestic restaurant chains face margin and earnings pressures, as they are unable to pass the violent rise in agricultural costs on to the consumer. Profit guidance for 2011 is taken down by Kellogg, Kraft, General Mills, and many other exposed food companies.
Publicly traded restaurant chains such as Darden Restaurants, McDonald's, Yum! Brands, Brinker International, and Ruby Tuesday all take a hit owing to the abrupt contraction in profit margins as product demand swoons in the face of higher prices. As a consequence, food companies and restaurant chains are among the worst performers in the S&P next year.
I expect a series of populist initiatives by the current administration beginning with a frontal assault on mutual fund 12b-1 fees. The asset managers—Franklin Resources, T. Rowe Price and Waddell & Reed—are exposed.
It is generally recognized that President Obama has been seriously weakened politically, but the situation gets worse early next year. A sustained and high level of unemployment and a quiescent housing market fail to revive, forcing the administration to consider some radical changes in order to survive in the presidential election of 2012. (While such a switch is unconventional, this move can be accomplished as the 25th Amendment sets out that the majorities in both houses of Congress would have to confirm Vice President Clinton; Secretary of State Biden would only have to be confirmed by the Senate.)
The other benefits to the switcheroo:
A tearful Boehner proves too dogmatic. Within the context of a gridlock-impacted interest rate rise and slowing economy coupled with the emergence of a threat from an increasingly powerful third party (see surprise No. 9), Wisconsin's Paul Ryan replaces Boehner.
Screwflation becomes a theme that has broadening economic social and political implications. Similar to its first cousin stagflation, screwflation is an expression of a period of slow and uneven economic growth, but, in addition, it holds the existence of inflationary consequences that have an outsized impact on a specific group. The emergence of screwflation hurts just the group that authorities want to protect—namely, the middle class, a segment of the population that has already spent a decade experiencing an erosion in disposable income and a painful period (at least over the past several years) of lower stock and home prices.
Importantly, quantitative easing is designed to lower real interest rates and, at the same time, raise inflation. A lower interest rate policy hurts the savings classes—both the middle class and the elderly. And inflation in the costs of food, energy and everything else consumed (without a concomitant increase in salaries) will screw the average American who doesn't benefit from QE2.
Stagnating wages and ever-higher food and other costs energize Middle America, the chief victim of screwflation, and a new party, the American Party, emerges chiefly through a viral campaign begun on Facebook. This centrist initiative initially is endorsed by several independent Republican and Democratic congressmen, but a ratification by Senator Joe Lieberman (Connecticut) leads to several senatorial endorsements as it becomes clear that the American Party's ranks are growing rapidly. (Both the Tea Party and Sarah Palin abruptly disappear from the public dialogue.)
By the end of 2011, between 5% and 10% of all U.S. voters are believed to be members of the American Party. With its newfound popularity, the American Party asks New York City Mayor Bloomberg to become its leader. By year-end 2011, he has not yet made a decision.
The commodity experiences wild volatility in price (on five to 10 occasions, the price has a daily price change of at least $75), briefly trading under $1,050 an ounce during the year and ending the year between $1,100 and $1,200 an ounce.
By means of background, the price of gold has risen from about $250 an ounce 11 years ago to about $1,370 an ounce today—compounding at more than a 16% rate annually. As a result, investing in gold has become de rigeur for hedge-hoggers and other institutional investors—and in due course gold has become a favored investment among individual investors.
My surprise is that next year the price of gold has the potential to become the modern-day equivalent of Hans Christian Andersen's “The Emperor's New Clothes,” a short tale about two weavers who promise an emperor a new suit of clothes that are invisible to those unfit for their positions, stupid or incompetent. When the emperor parades before his subjects in his new clothes, a child cries out, “But he isn't wearing anything at all!”
With a finite supply, gold has historically been viewed as a tangible asset that increases in value during uncertain (and inflationary) times. No wonder it has become such a desirable asset class following the Great Decession and credit crisis of 2008–2009. Gold bugs remind the nonbelievers that for thousands of years, gold has been a store of value and, given the current state of the world's financial system, gold is the best house in a bad neighborhood of asset classes.
But gold, which may be the most crowded trade around, is viewed now as a commodity for all seasons—during inflation, deflation, low or high economic growth.
There is a body of thought that maintains gold holds little value, that it is only a shiny metal with limited industrial value that throws off no income or cash flow (and, as such, its value cannot be determined or analyzed with any precision based on interest rates or any other measure). Those nonbelievers compare the dizzying price of gold to the unsustainable rise in comic book prices (and other collectibles) in the early 1990s, Internet stock prices in early 2000 or home prices in 2006–2007.
Here is how Oaktree Management's Howard Marks draws a colorful parallel between gold and religion:
My view is simple and starts with the observation that gold is a lot like religion. No one can prove that God exists…or that God doesn't exist. The believer can't convince the atheist, and the atheist can't convince the believer. It's incredibly simple: Either you believe in God or you don't. Well, that's exactly the way I think it is with gold. Either you're a believer or you're not.
What we do know is that gold is valued in an auction market based on the price where buyers (“the believers”) and sellers (“the atheists”) meet.
With an inability to gauge gold's intrinsic value, wide price swings remain possible. And wide price swings are what I expect in 2011.
There are numerous catalysts that can contribute to a surprising weakness in the price of gold in the upcoming year. But most likely, a large drop in the price of gold might simply be the result in a swing in sentiment that can be induced by a number of factors—or maybe even sentiment that the emperor (and gold investors/traders) isn't wearing anything at all:
In addition, there are numerous cautionary and anecdotal signs that are reminiscent of prior unsustainable asset class cycles or bubbles:
With the company in play, News Corporation follows with a competing and higher bid. The private-equity community joins the fray. Microsoft ultimately prevails and pays $24 a share for Yahoo!.
Currently, Yahoo! is universally viewed as a dysfunctional company, and few expect that Microsoft has an interest in the company. But a deal could be profitable and advantageous (more critical mass and immediate exposure to the rapidly growing Chinese market) to Microsoft:
By means of background, on February 1, 2008, Microsoft offered $31 a share, or $45 billion, to acquire Yahoo! in an unsolicited bid that included a combination of stock and cash. At that time, Yahoo!'s shares stood at $19 a share, and Microsoft was trading at $32 a share. (Today Microsoft trades at $27 a share, and Yahoo! trades at $16 a share.)
Yahoo! rejected the bid, claiming that it “substantially undervalued” the company and was not in the interest of its shareholders. In January 2009, Carol Bartz replaced Yahoo! cofounder Jerry Yang, and six months later Microsoft and Yahoo! entered into a search joint venture.
Cybercrime likely explodes exponentially as the Web is invaded by hackers. A specific target next year will be the NYSE, and I predict an attack that causes a weeklong hiatus in trading and an abrupt slowdown in domestic business activity.
This surprise is an extension of surprise No. 13 from last year's 20 Surprises for 2010:
Insider trading charges expand. The SEC alleges, in a broad-ranging sting, the existence of an extensive exchange of information that goes well beyond Galleon's Silicon Valley executive connections. Several well-known, long-only mutual funds are implicated in the sting, which reveals that they have consistently received privileged information from some of the largest public companies over the past decade.
The next SEC target is directed at some of the world's largest tech companies, including one of the leading manufacturers of flash memory cards, one of the largest contract manufacturers and a big producer of integrated circuits. A high-profile, very senior executive in one of these companies is implicated and is forced out of his position.
With the depth of the investigations moving toward the center of some of the largest hedge and mutual funds, many of the more active traders are temporarily in “lockdown” mode as the hedge fund community's trading activity freezes up.
The region's GDP climbs by only 5% in 2011.
While I had a reasonably successful surprise list for 2011, with about half my surprises coming to fruition, the real story was that I achieved something that is almost impossible to accomplish.
My most important surprise (No. 4) was that the S&P 500 would end the year at exactly the same price that it started the year (1,257) and that the range over the course of the year would be narrow (between 1,150 and 1,300).
As explained below, both predictions were remarkably close to what actually occurred.
As we entered 2011, most strategists expressed a sanguine economic view of a self-sustaining domestic recovery and shared the view that the S&P 500 would rise by about 17% and would end the year between 1,450 and 1,500 vs. a year-end 2010 close of 1,257.
By contrast, I called for a sideways market, stating that the S&P would be exactly flat year over year. To date, that surprise has almost come true to the exact S&P point. Remarkably, at around midday last Friday, December 23, the S&P 500 was trading at 1,257—Friday's closing price was 1,265—precisely the ending price on December 31, 2010. (There are still four trading days left in the year, so technically the exercise is not yet over.)
A flat year is a much rarer occurrence than many would think. According to The Chart Store's Ron Griess, in the 82 years since 1928, when S&P data was first accumulated, the index was unchanged in only one year (1947). And in only three of the 82 years was the annual change in the S&P 500 under 1%—1947 (0.00%), 1948 (−0.65%) and 1970 (+0.10%).
In addition to the amazing accuracy of my variant S&P forecast, my forecast for the index's full-year trading range was almost as precise—in both content and from the standpoint of causality.
As I wrote, a year ago, the S&P 500 would exhibit “one of the narrowest price ranges ever.”
The surprise expected was that the S&P would never fall below 1,150 (it briefly sold at 1,090) and never rise above 1,300 (it briefly traded at 1,360), “as the tension between the cyclical tailwind of monetary ease and the cyclical economic recovery it brings are offset by numerous nontraditional secular challenges (e.g., fiscal imbalances in the United States and Europe; a persistently high unemployment rate that fails to decline much, as structural domestic unemployment issues plague the jobs market and the continued low level of business confidence reinforced by increased animosity between the Republicans and Democrats exacerbates an already weak jobs market and retards capital-spending plans, etc.).” I went on to write, “Despite the current unambiguous signs of an improving domestic economy, as the year progresses, the growing expectation of consistently improving economic growth and a self-sustaining recovery is adversely influenced by continued blows to confidence from Washington, D.C., serving to contribute to a more uneven path of economic growth than the bulls envision.”
Last year's surprise list achieved about a 50% success ratio. Forty percent of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, one-third in 2006, 20% in 2005, 45% in 2004, and one-third came to pass in the first year of my surprises in 2003.
My surprise list for 2011 hit on some of the important themes that dominated the investment and economic landscape this year. Below is a list of some of my accurate surprises from last year's list.
Where did my surprises for 2011 go wrong?
My new surprises for 2012 represent a fundamental turn toward optimism and a marked departure from the pessimism expressed in my recent surprise list history.
For the last few years, since the financial and economic crisis of 2008–2009, caution, restraint and the word “no” have characterized and dominated the economic, social and political backdrop. In 2012, however, our surprise list moves toward an inflection point in which bolder steps, expansiveness and the word “yes” begin to dominate the political, economic and stock market stages.
This new, brighter and more positive narrative is the essence and the common thread contained in my surprise list for 2012. (And this year, following each surprise, I am introducing a specific strategy that might be employed in order for an investor to profit from the occurrence of these possible improbables.)
The beginning of the New Year brings a stable and range-bound market. A confluence of events, however, allows for the S&P 500 to eclipse the 2000 high of 1,527.46 during the second half of the year. The rally occurs as a powerful reallocation trade out of bonds and into stocks provides the fuel for the upside breakout. The market rip occurs in a relatively narrow time frame as the S&P 500 records two consecutive months of double-digit returns in summer/early-fall 2012.
Strategy: Buy out-of-the-money SPDR S&P 500 ETF (SPY) calls.
The U.S. economy muddles through in early 2012, but, with business, investor and consumer confidence surging in the fall, real GDP accelerates to over 3% in the second half. Unemployment falls slightly more than consensus, but the slack in the labor market continues to constrain wage growth. Domestic automobile industry sales soar well above expectations, benefiting from pent-up demand and an aging U.S. fleet. Inflation is contained but begins to be worrisome (and serves as a market headwind) in late 2012. Corporations' top-line growth is better than expected, and wage increases are contained. Operating margins rise modestly as sales growth lifts productivity and capacity utilization rates. Operating leverage surprises to the upside, as 2012 S&P profits exceed $105 a share.
A noteworthy surprise is that the residential real estate market shows surprising strength. The U.S. housing market becomes much bifurcated (in a market of regional haves and have-nots), as areas of the country not impacted adversely by the large shadow inventory of unsold homes enjoy a strong recovery in activity and in pricing. The Washington, D.C., to Boston, Massachusetts, corridor experiences the most vibrant regional growth, while Phoenix, Las Vegas, and areas of California remain weak. The New York City market begins to develop a bubbly speculative tone. Florida is the only area of the country that has had large supply imbalances since 2007 that experiences a meaningful recovery, which is led by an unusually strong Miami market.
Strategy: Buy Home Depot, Lowe's, building materials and homebuilders, and buy auto stocks such as Ford and General Motors.
The Clinton-Bush initiative, also known as “Simpson-Bowles on steroids,” gains overwhelming popular support, and despite strenuous initial opposition, it forces the Democrats and Republicans (months before the November elections) to move toward a grand compromise on fiscal discipline and pro-growth fiscal policy. Interest rates remain subdued, growth prospects become elevated and a feel-good atmosphere begins to permeate our economy in a return of confidence and in our capital markets engendered by the Clinton-Bush initiative.
The Clinton-Bush initiative includes seven basic core policies that are accepted by both political parties.
Strategy: See No. 1 surprise strategy. Sell volatility.
The U.S. moved to the left politically in the Democratic tsunami in 2008 and to the right politically as the Republican Party gained control of Congress in 2010; the 2012 election is the tiebreaker. The result of the tiebreaker is that Mitt Romney and Marco Rubio squeak by Barack Obama and Joseph Biden in the November 2012 election. All the five swing battleground states (Florida, Indiana, Missouri, North Carolina, and Ohio) go Republican. The Romney-Rubio ticket also wins the states of New Hampshire and Virginia, previously won by Obama in 2008, and the Republicans prevail (270 electoral votes to 268 votes) in one of the closest elections of all time.
Strategy: See No. 3 surprise strategy.
The EU remains intact after a brief scare in early 2012 caused by Greece's dissatisfaction (and countrywide riots) with imposed austerity measures. The eurozone experiences only a mild recession, as the ECB introduces large-scale quantitative-easing measures that exceed those introduced by the Fed during our financial crisis in 2008–2009.
Strategy: Buy European shares. Buy iShares MSCI Germany Index Fund (EWG) and iShares MSCI France Index Fund (EWQ).
In order to encourage corporations to invest and to build up consumer and business confidence, the Fed changes its mandate and promises not to tighten monetary policy until the unemployment rate moves below 6.5%, slightly above the level at which wage pressures might emerge (the nonaccelerating inflation rate of unemployment).
Strategy: Buy high-quality municipal bonds or the iShares S&P National AMT–Free Municipal Bond Fund (MUB).
In a spectacular fall, Sears Holdings shares are halted at $18 a share during the early spring, as vendors turn away from the retailer, owing to a continued and more pronounced deterioration in cash flow (already down $800 million 2011 over 2010), earnings and sales. With funding and vendor support evaporating, as paper-thin earnings before interest and taxes margins turn negative and cash flow is insufficient to fund inventory growth. The shares reopen at $0.70 after the company declares bankruptcy and its intention to restructure, as we learn, once again, that being No. 3 in an industry has little value—especially after store improvements were deferred over the past several years. A major hedge fund and a large REIT join forces in taking over the company. Ten percent to 15% of Sears' 4,000 Kmart and specialty stores are closed. More than 35,000 of the company's 317,000 full-time workers are laid off. As a major anchor tenant in many of the nation's shopping centers and with no logical store replacement, the REIT industry's shares suffer through the balance of the year, and the major market indices suffer their only meaningful correction of the year. Target and Wal-Mart's shares eventually soar in the second half of 2012.
Strategy: Buy out-of-the-money Sears Holdings puts, go long Target and Wal-Mart, and short the iShares Dow Jones U.S. Real Estate Index Fund (IYR).
Our country's State Department's defenses are hacked into and compromised by unknown assailants based outside of the United States. Our armed forces are placed on Defcon Three alert.
Strategy: None.
After five years of underperformance, the financial stocks rebound dramatically and outperform the markets, as loan demand recovers, multiple takeovers permeate the financial intermediary scene and domestic institutions enjoy market share gains at the expense of flailing European institutions. With profit expectations low, three years of cost cutting and some revenue upside surprises (from an improving capital markets, a pronounced rise in M&A activity and better loan demand) contribute to better-than-expected industry profits.
Strategy: Buy JPMorgan Chase, Citigroup, and the Financial Select Sector SPDR (XLF).
Though counterintuitive within the framework of a new bull-market leg, the market's low fliers (low multiple, slower growth) become market high fliers, as their P/E ratios expand.
With the exception of Apple, the high fliers—Priceline, Baidu, Google, Amazon and the like—disappoint. Apple's share price rises above $550, however, based on continued above-consensus volume growth in the iPhone and iPad. Profit forecasts for 2012 rise to $45 a share (up 60%). In the second quarter, Apple pays a $20-a-share special cash dividend, introduces a regular $1.25-a-share quarterly dividend and splits its shares 10–1. Apple becomes the AT&T of a previous investing generation, a stock now owned by this generation's widows and orphans.
Strategy: Long Apple (common and calls).
With confidence renewed, domestic equity inflows begin to pour into equity mutual funds by midyear and approach a $100 billion seasonally adjusted annual rate by fourth quarter 2012. The share prices of T. Rowe Price and Franklin Resources double.
Strategy: Long Legg Mason, T. Rowe Price and Franklin Resources.
Cheap money, low valuations and rising confidence are the troika of factors that contribute to 2012 becoming one of the biggest years ever for mergers and takeovers. Canadian companies are particularly active in acquiring U.S. assets. Canada's Manulife acquires life insurer Lincoln National, two large banks join a bidding war for E*Trade, and International Flavors & Fragrances and Kellogg are both acquired by non-U.S. entities. Finally, a Canadian bank acquires SunTrust.
Strategy: Long E*Trade, Lincoln National, International Flavors & Fragrances, Kellogg and SunTrust.
There are currently about 1,400 ETFs. During 2012, numerous ETFs fail to track and one-third of the current ETFs are forced to close. There are several flash crashes of ETFs listed on the exchanges. The ETF landscape is littered by investor litigation as investor losses mount. New stringent maintenance rules and new offering restrictions are imposed upon the ETF business. The formation of leveraged ETFs is materially restricted by the SEC.
Strategy: Avoid all but the largest ETFs.
India becomes the emerging-market concern. With India's trade not a driver to GDP growth, its currency in free-fall, pressure to keep interest rates high by its central bank and signs of a contraction in October industrial output, India's GDP falls to mid-single-digit levels.
Strategy: Long iShares FTSE/Xinhua China 25 Index Fund (FXI); short WisdomTree India Earnings Fund ETF (EPI) and iPath MSCI India Index ETN (INP).
The greatest headwind to the world's equity markets is geopolitical not economic. Israel attacks Iran in the spring, but, at the outset, the United States stays out of the conflict. Iran closes the Strait of Hormuz, and oil prices spike to $125 a barrel.
Strategy: Buy Schlumberger, ExxonMobil and other oil production and exploration stocks.
Some of the possible improbables that I came up with while compiling my “15 Surprises for 2012” were not quite ready for prime time, but they can certainly serve as an addendum to that list.
It was a tough task repeating the success of my surprise list for 2011 over the past year.
This is particularly true since my most important surprise (No. 4) in 2011—namely, that the S&P 500 would end the year at exactly the same price that it started the year (1,257)—was eerily prescient. As well, in 2011, I basically nailed that the trading range over the course of that year would be narrow (between 1,150 and 1,300).
As we entered 2012, most strategists expressed a relatively sanguine economic view of a self-sustaining domestic recovery and an upbeat corporate profits picture but shared the view that the S&P 500 would rise but only modestly.
By contrast, I called for a much better equity market—one capable, in the second half of the year, of piercing the 2000 high of 1,527. As it turns out, the S&P 500 breached 1,480 to the upside in the fall—or about only 3% less than the 2000 peak.
Last year's surprise list achieved about a 50% hit ratio, similar to my experience in 2011. Forty percent of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, one-third in 2006, 20% in 2005, 45% in 2004, and one-third came to pass in the first year of my surprises in 2003.
Following is a report card of my 20 surprises for 2012 (I hit on 50% of the surprises).
I call this correct as:
Last year my surprise list had an out-of-consensus positive tone to it, but this year it is noticeably downbeat relative to generally upbeat expectations.
As contrasted to 2012, when most were dour in market view (and wrong), the 2013 consensus is an optimistic one and now holds to the view that European economic growth is stabilizing while growth in China and in the United States is reaccelerating. The popular view goes on to believe that even our dysfunctional leaders in Washington will not upset the growing consensus that it is clear sailing for equities and trouble ahead for bonds.
Once again, the bullish consensus is tightly grouped with the expectation that the S&P 500 will close the year at 1,550 to 1,615 (up from 1,425 at the close of 2012) and that the 10-year U.S. note yield will trade at 2.50% or higher (up from 1.80% at the close of 2012).
These consensus views might prove too optimistic on stock prices and too pessimistic on bond prices. I believe that the U.S. stock market will make its 2013 high in the first two weeks of January, be in a yearlong range of 1,275 to 1,480 and close the year at 1,425 and that the 10-year U.S. note will be below 2% in the first six months of 2013.
Many of my more downbeat surprises for 2013 are an outgrowth of an aging economic recovery (now four years old), a maturing stock market (of a similar age) coupled with the recognition that running trillions of dollars in deficits while maintaining zero interest rates are unsustainable policy strategies.
I am also concerned that the multiplier being applied to the tax increases agreed to last week will be greater than many expect, serving to weigh on domestic economic growth.
As well, it is also my view that the trajectory of economic growth in 2013 (and corporate profits) will also be adversely impacted by the manner in which businesses and consumers react to the tax hikes and the growing animosity and contentiousness in Washington, D.C., in the months ahead.
Indeed, I fully expect the upcoming deliberations between the revenge-lusting Republicans in the House and the equally dogmatic and partisan incumbent president and Democratic Senate to not result in any meaningful cut in spending or entitlements reform. I do, however, expect these negotiations to have a direct and distinct adverse impact on economic growth, confidence and profits.
The dependency on our economy and on business and consumer confidence to Washington's ability to compromise and deliver intelligent policy will prove, at the very least, unsettling to the markets in the year ahead. At worst, it will undermine the economic expansion.
In addition, policy alternatives are diminishing.
U.S. monetary policy is now effectively shooting blanks, and fiscal policy will now turn out to be a drag on growth. Moreover, the likely reluctance and inertia by our leaders in addressing our budget will continue to turn off the individual investor class to stocks this year.
Finally, my ursine tone is also a reflection that, by most measures, the U.S. stock market is not meaningfully undervalued and that given the dynamic of the headwinds of slowing economic growth, a poor profit outlook and the developing weakness of policy are unlikely to be revalued upward in 2013 (as many strategists suggest).
Following are my 15 surprises for 2013. This year I have reduced the surprise list from 20 to 15. As I did last year, following each surprise, I have included a specific strategy that might be utilized in order for an investor to profit from the occurrence of these possible improbables.
Amid contentious and hyperpartisanship of political debate, consumer and business confidence sours, adversely impacting personal spending, job growth and capital spending plans:
By midyear either Janet Yellen or Alan Blinder will replace Ben Bernanke as Fed Chairman, and the administration's entire economic advisory team will be turned over.
Question: How many politicians does it take to screw up our economy?
Answer: 537 (436 members of the House, 100 members of the Senate and one president).
The consensus view is that while the upcoming budget debate will likely get ugly and go down to the wire, a 10-year, $2 trillion agreement will be negotiated.
Unfortunately, the last meaningful agreement between the Republican and Democratic parties was the twenty-fourth-hour fiscal cliff compromise on January 1, 2013.
The squabbling and enmity of the recent fiscal cliff debate poisons all future budget talks. The Obama administration is unwilling to make spending concessions anywhere that is needed to make substantive progress on our fiscal deficit. The Republicans are equally entrenched in policy view.
“This subcommittee has demonstrated in hearings and comprehensive reports how various schemes have helped shift income to offshore tax havens and avoid U.S. taxes.…The resulting loss of revenue is one significant cause of the budget deficit and adds to the tax burden that ordinary Americans bear.”
—Sen. Carl Levin (D-Mich.), Senate Permanent Subcommittee on Investigations
The debate grows increasingly contentious and vitriolic. Congressional Democrats, prodded by the president, introduce the idea of a wealth tax.
A Levin-led subcommittee investigation determines and highlights that Apple (which deferred taxes on over $35 billion in offshore income between 2009 and 2011) and many other companies—including Hewlett-Packard, Google, and Microsoft—have adversely impacted the budget deficit by unfairly allocating revenue and intellectual property offshore to lower the taxes they pay in the United States (and have even avoided taxes in the United States by moving subsidiaries to Nevada). The investigation reveals that Apple was a pioneer (as early as in the mid-1980s) of an accounting technique known as the “double Irish with a Dutch sandwich,” which reduces taxes by routing profits through Irish subsidiaries and the Netherlands and then on to the Caribbean. The Levin subcommittee finds that this tax avoidance technique employed by Apple has been imitated by hundreds of other international companies.
The Democrats in Congress propose a closing of such corporate tax loopholes and more strict rules regarding non-U.S. tax havens. This creates a complete impasse when Republicans react violently to it. Congressional Republicans, on the other hand, offer sizable entitlement benefit cuts, which turn off the Democrats.
During the debate it becomes clear that the risks of destabilizing outcomes are rising (e.g., a technical default on U.S. debt and a downgrade by all of the major ratings agencies), and investors panic. The S&P 500 hits a low of 1,275.
The surprise is that there is no grand bargain in 2013 that brings our country closer to fiscal sustainability—indeed, there is virtually no bargain (on tax and entitlement reforms nor in discretionary spending cuts) in the new year at all.
The debt ceiling is finally raised, though only minor spending cuts are instituted. At the last moment, the Democrats agree to a one-year increase in Medicare eligibility in exchange for an Elizabeth Warren–inspired campaign (in conjunction with Congressional Democrats) to introduce a financial transaction tax to be imposed on securities trades by year-end. (See surprise No. 4.)
After the debate comes to a close it is apparent that the ability of the administration to enact previously sought gun control laws, immigration reform and other projects is in serious jeopardy.
Foreign leaders openly discuss the waning role of our country's leadership in the world. The U.S. dollar suffers as our standing in the global economy erodes.
Meanwhile, though the fiscal drag from last week's fiscal cliff agreement appears to many to be a manageable $250 billion-$280 billion (or less than 1.0% taken off U.S. GDP), the actual multiplier of this drag is greater than most are projecting (over 1.5%). The growing tortured debate, animosity, and fiscal uncertainty between both parties during the January–March period chill the economy further and adversely impact business and consumer confidence. Corporate fixed investment, hirings, and industrial production suffer, and it becomes clear that there is little economic momentum in the United States and that, among other issues, corporate pricing power is harmed by increased competition from non-U.S.-based companies.
Most market participants begin to accept the notion that the Fed is essentially out of bullets and can no longer impact our economy at the margin and that it doesn't possess the sort of durable and effective fiscal remedies that are needed to materially address the complexity of the secular challenges facing the country (education, the jobs market, etc.).
By midyear President Obama seeks scapegoats for economic policy failure. He replaces most of his team at the Council of Economic Advisers as well as Fed Chairman Bernanke (with Alan Blinder or Janet Yellen) a full six months before Bernanke's term is officially over in January 2014.
Despite recent concerns that the Fed will end quantitative easing, more easing lies ahead during 2013, and, in all likelihood, the amount of bond buying will be raised not ended or reduced (as suggested in the recent Fed minutes release).
A weaker-than-expected domestic economy in the first half of the year underscores the fragility of the consumer (in particular).
First-quarter 2013 real GDP is 0.5% to 1.0%, worse than consensus expectations. Second-quarter 2013 real GDP shows little improvement (but only to 1.0% to 1.5%) from the first quarter.
Overall full-year U.S. GDP disappoints relative to the consensus (and particularly relative to the Fed's forecast of 3% growth) and approximates 1.5% (or less) for all of 2013.
Strategy: Buy index puts in the first half of 2013.
The 2012 improvement seen in the residential real estate markets moderates, as sales activity/turnover and home price appreciation flattens.
Already refinancing applications (down 23%) and new mortgage applications (down 15%) have taken a bad fall in the last half of December 2012. Low interest rates from 2009 to 2012 have done their job in reviving the U.S. housing market, and that stimulus should be seen as bringing forward home sales—now it is up to the domestic economy to resuscitate demand.
On the latter point I am less optimistic about the foundation of growth for the U.S. economy and the financial fate of the consumer who is now just absorbing a new tax hike (see surprise No. 1). Finally, let's not lose sight that the Obamacare surcharge of 3.8% will be applied to home sales in 2013.
Retail sales suffer, as spent-up not pent-up consumers are stunned by having less money in their wallets.
In 2013 we discover that there is a limit to the consumer in the face of our dysfunctional leaders' inability to deliver a grand bargain. A payroll tax increase, higher top income tax rates and the Obamacare surcharge, coupled with disappointing capital spending and weak hirings, represent the brunt of the domestic growth shortfall relative to consensus expectations.
Surprisingly, automobile sales, benefiting from pent-up demand (much like housing last year) continue to improve slowly, to a surprisingly strong 16 million-17 million SAAR rate by year-end, and represent a standout feature of the domestic economy throughout the new year.
Wage growth is muted, interest rates remain low, and inflationary pressures are nonexistent, helping to keep profit margins from slipping too far. Nonetheless, slowing domestic economic growth and reduced final demand—personal consumption expenditures are further hurt by the droughts and rising food prices—weigh significantly on corporate profits.
Full-year 2012 S&P 500 earnings come in at $102 a share, while 2013 S&P profits disappoint at $95-$97 a share, well below consensus of about $106-$108 a share, top-down estimates of $107-$109 a share and bottom-up forecasts of $112-$113 a share.
Though starting out strong, the stock market in 2013 is a tale of two cities, with a weak first half and a stronger second half. The 2013 S&P 500 range is 1,275 to 1,480. The S&P 500 ends the year flat.
Beginning-of-the-year equity fund inflows, breathless optimism (of a technically inspired kind) and the initial excitement over the fiscal cliff resolution lift the S&P 500 to its yearly high in the first two weeks of January 2013. Unfortunately, the lack of intelligent, thoughtful leadership becomes ever more apparent in February–March, and ultimately the S&P 500 bottoms at about 1,275 (or at 13.5× my projected S&P profit surprise) during the spring.
The VIX exceeds 25, and risk premiums remain elevated amid the increased political rancor.
While dividend payout rates are low and corporate balance sheets in strong shape—there is less than meets the eye here, as it should be noted that much of the cash hoards are positioned in non-U.S.-taxed overseas accounts—a smaller amount of money is returned to shareholders, as dividend growth and share buybacks slow down while business confidence ebbs and the economy decelerates.
Though most believe that a spending deal will be forced by the pressures of a weakening stock market and economy, there is no agreement or real addressing of the deficit forthcoming despite a slide in equities and the backdrop of falling corporate profits and weaker economic growth taking center stage.
In the second half of 2013, coincident with a slow improvement in domestic growth, the market stages a persistent recovery back toward year-end 2012 levels of 1,425 (as investors get inured to the political dysfunction and grow increasingly accepting of a period of slowing secular economic growth), exactly duplicating the flat market experience of 2011.
The VIX falls back under 15 by the second half of the year.
I would emphasize that a flat year in the U.S. stock market is a much rarer occurrence than many would think. According to The Chart Store's Ron Griess, in the 84 years since 1928, when S&P data was first accumulated, the index was unchanged in only two years (1947 and 2011). In only four of the 83 years was the annual change in the S&P 500 under 1%: 1947 (0.00%), 1948 (−0.65%), 1970 (+0.10%), and 2011 (+0.0%).
Strategy: Buy index puts in the first half of 2013; short Market Vectors Retail ETF (RTH).
Despite widespread expectations of a 1992 repeat of a Bush vs. Clinton presidential contest in 2016, the consensus is proven wrong.
Shortly after a successful recovery from a concussion and blood clot, Bill and Hillary Clinton announce that they will divorce. Soon thereafter, Hillary Clinton declares that she has no intention to run as the Democratic presidential nominee for 2016, setting the Democratic leadership in turmoil.
Alienated, saddened and disappointed by the current political alternatives and a dysfunctional Washington, D.C., a meaningful movement of Democratic and Republican moderates toward the creation of a new and independent third party, known as the People's Party, gains steam.
Although it is early in the process and despite being initially reluctant, New York Mayor Michael Bloomberg becomes the standard-bearer of the People's Party, and he announces his intention to run for president.
The People's Party is named after the short-lived political party with the same name that was established in the late 1890s during the populist movement in the United States. Originally based among poor, white cotton farmers in the South and hard-pressed wheat farmers in the plains, it represented a radical crusading form of agrarianism that possessed a hostility toward banks, railroads and elites generally. Often it formed coalitions and was aligned with labor unions and generally was seen as anti-elitist and in opposition to established interests (in banking and railroads) and mainstream parties.
Several of the wealthiest Americans—including Bill Gates, Warren Buffett, and several well-known billionaire hedge fund managers—commit huge amount of financial and intellectual support to Bloomberg and the People's Party.
Surprisingly, Senator Elizabeth Warren (not Joe Biden or Andrew Cuomo) is viewed as the leading Democratic presidential candidate by year-end 2013, and Wisconsin Governor Scott Walker (not Marco Rubio or Jeb Bush) becomes the frontrunner for the Republican Party's presidential nomination.
Strategy: None.
“Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation.”
—John Maynard Keynes (when he first proposed a securities transaction tax in 1936)
In conjunction with Congressional Democrats (and in exchange for an increase in Medicare age eligibility), Senator Elizabeth Warren spearheads a successful campaign to force the House to introduce a financial transaction tax attached to all securities trades. The legislation is sold to Americans (and to the Republicans) as a way to:
The ramifications of this tax are broad—financial stocks suffer, and the hedge fund industry retrenches, consolidates and lowers fees.
The implementation of a financial transaction tax, weak capital markets, reduced merger and acquisition activity, continued pressure on net interest margins and poor loan demand lead to well-below-consensus bank and brokerage industry profits and underperforming stocks.
In 2013's macro-driven market, correlations remain at historically high levels, rendering excess return generation hard to deliver by the hedge fund community. Moreover, the implementation of a financial transaction tax pressures trading-based and high-frequency-trading hedge fund strategies to close, and nearly one third of the existing hedge funds close shop in 2013.
As pressure on returns intensifies, a large institutional manager introduces a menu of low-fee hedge funds that further accelerate hedge fund closures. Hedge fund management fees move toward 1% (or lower), and performance fees move toward 10%, as the industry begins to resemble the traditional money management industry.
Several large hedge funds lower fees and structure fees to more resemble Warren Buffett's hedge fund in the 1960s, which charged no management fee but took in 25% on performance above a 6% threshold return.
Strategy: Short Financial Select Sector SPDR (XLF) and Goldman Sachs.
By midyear (after failed budget deficit debate) it will be clear to the president that his legacy is in serious jeopardy.
In response, Obama takes a surprising move to the center. His administration's team is turned upside down, and the president, in search of economic growth and a more vibrant jobs market, will approve legislation to allow fracking on federal lands. In addition, he completely turns around on his previous Keystone Pipeline stance and green lights the project.
Several previously somnolent regional bank stock prices positioned in areas of potential fracking activity revel in the administration's move. For example, Northwest Bancshares, a bank holding company right smack in the middle of Pennsylvania's fracking sites, rises by 25%.
The move fractures the Democratic Party and emboldens the Republicans. For both the president and the Republicans, it is too little and too late, as the approval ratings of both plummet to all-time lows and the aforementioned third party (led by Bloomberg) gains popularity (see surprise No. 3).
By year-end the People's Party is estimated to have as much as 20% of the national vote.
Strategy: Buy Northwest Bancshares.
The big up move in yields that I have long expected and that has now become consensus is delayed by at least another six months.
The yield on the 10-year U.S. note stays in a relatively tight range of between 1.5% and 2% in 2013, as slowing global growth remains the bond market's dominant influence.
Strategy: Buy bonds on weakness via iShares Barclays 20+ Year Treasury Bond Fund (TLT); short bonds on strength via ProShares UltraShort 20+ Year Treasury (TBT).
As I have observed, there is a growing frequency of black swans around the world, and 2013 will be no exception—climate change and technological disruptions play a significant role on the financial markets this year:
Strategy: Buy Sourcefire and Palo Alto Networks.
Last year, I wrote that Apple would be a positive surprise in 2012, though I turned negative on the company's fundamentals and share price in late September.
This year I have a negative surprise in store for Apple—at least for the first half of the year.
The aforementioned Senator Levin subcommittee investigations on offshore tax havens (see surprise No. 1) highlight Apple's tax-avoidance strategies. The share price drops below $500 a share in first quarter 2013, as investors begin to recognize that it is likely that Apple's future earnings will be taxed at a much higher rate than in the past.
Meanwhile, Apple's core operating profits disappoint due to a more competitive landscape, lessening demand for iPads and iPhones and emerging margin pressures. Apple's earnings estimates (and price targets) are cut, and full-year 2013 results fall short of $40 a share.
Microsoft's Surface sales start off poorly but gain traction by the end of 2013. Google Nexus, Amazon Kindle, Surface, and Samsung all sell at lower price points throughout the year, as price competition emerges in the tablet market.
Apple's consensus 2014 profit estimates move toward an expected year-over-year decline. The stock spends most of 2013 below $550 a share, but, in the last half of the year, two revolutionary product additions lift the share price to over $600 by year-end. (Samsung's stock performance continues to outpace that of Apple in all of 2013.)
In the third quarter Apple announces three new products in 2013: iTV, iMed, and iHomes.
iTV is a yawner, but the latter two are revolutionary product additions.
With iMed, Apple enters the medical information market, providing a platform for the medical field to keep, store and transfer records in real time. This expands the use of iPads exponentially.
Also introduced is the iHomes program, an iTunes-like software to control all electrical (and some non-electrical, like plumbing) elements in a home remotely. The software receives rave reviews from the Wall Street Journal's Walt Mossberg, after which Apple announces it will not license the software for use on Android devices. (Google shares drop 60 points on the announcement.)
Strategy: Avoid Apple in the first half of year; buy Apple and short Google in the second half of the year.
Over the past few years (2010–2012), Altisource Portfolio Solutions was my stock of the year. The shares of Altisource Portfolio Solutions, which traded at around $15 a share in late 2009, rose to nearly $130 a share several months ago.
So, what is the next Altisource Portfolio Solutions, and what will be the stock of the year for 2013?
My answer is that we don't have to go far from Altisource Portfolio Solutions. The stock of the year will be the recent spinoff of Altisource Portfolio Solutions, Altisource Asset Management. With a sharp trajectory of earnings growth (resembling that of Altisource Portfolio Solutions in 2010–2012), I expect Altisource Asset Management will trade over $150 a share sometime this year.
Last year's surprise large-cap stock was Bank of America, which, after dropping by over 50% in 2011, climbed by over 100% in 2012.
My surprise large-cap pick for 2013 is Ford.
Trading at $13.50 a share, I expect Ford's share price to rise to above $17.50 a share in 2013 based on a combination of surprisingly strong domestic automobile industry sales (in excess of 16 million SAAR) and a revaluation (upward) in the company's P/E ratio.
After an initial burst to the upside, overowned financial stocks (XLF, Morgan Stanley, Citigroup, Goldman Sachs, JPMorgan Chase and asset managers) are the big losers in 2013, as the financial transaction tax, weak capital markets, still-low interest rates and tepid merger and acquisition activity weigh on the sector.
Strategy: Long Altisource Asset Management and Ford.
Though interest rates are low and there is an abundance of excess cash on corporations' balance sheets, economic uncertainty meaningfully curtails merger and acquisition activity in 2013.
There is one large exception: Oracle takes over Hewlett-Packard (at only a modest premium). Mark Hurd returns to become Hewlett-Packard's CEO. Hewlett-Packard's current CEO Meg Whitman rejoins Kleiner Perkins.
Strategy: Avoid investment and brokerage stocks.
Strategy: Short iShares FTSE/Xinhua China 25 Index Fund (FXI).
Despite a growing consensus that the reallocation trade is imminent and will reverse the trends of money moving out of stocks and into bonds (in place since 2007), outflows from domestic equity funds and inflows into bond funds continue throughout the year. In support, I would note that, according to AMG, bond/equity fund flows started 2013 just the way they ended last year, with large outflows totaling −$3.5 billion coming out of domestic equity funds and with inflows into fixed income.
Strategy: Short T. Rowe Price and Franklin Resources.
There are signs of life on Mars but not in Washington, D.C.
The Curiosity rover conducts a chemical test in early 2013 that uncovers complex carbon-based compounds in Martian soil.
Strategy: None.
Another activist hedge fund investor joins Bill Ackman's Pershing Square and acquires a large position in Procter & Gamble. Under pressure from an expanding shareholder group, Procter & Gamble decides to split into three separate entities. The shares rise by $7 to $10 a share on the announcement.
As was the case of Procter & Gamble, several activist investors pressure Avon Products to consider being acquired.
Strategy: Long Procter & Gamble and Avon Products and out-of-the-money calls.
Strategy: None.
It takes me about three weeks of thinking and writing to compile and construct my annual surprise list column. I typically start with about 40 surprises, which are accumulated during the months leading up to my column. In the days leading up to this publication, I cull the list to come up with my final 15 surprises. (This year I include five also-ran surprises).
I often speak to the wise men and women in the investment and media businesses who give me some ideas. (This year I wanted to specifically thank Steve Einhorn and Lee Cooperman at Omega Advisors and The Lindsey Group's Peter Boockvar for their input.)
I have always associated the moment of writing the final draft (in the weekend before publication) of my annual surprise list with a moment of lift, of joy and hopefully with the thought of unexpected investment rewards in the New Year (e.g., Altisource Asset Management, my stock of the decade for 2013, spiked up by 1,200% during the year). This year is no different.
Above all, the publication of my annual surprise list is recognition that economic and stock market histories have proven that (more often than not) consensus expectations are off base.
“How'm I doin'?”
—Ed Koch, former New York City mayor
While over recent years many of my surprise lists have been eerily prescient (e.g., my 2011 surprise that the S&P 500 would end exactly flat was exactly correct), my “15 Surprises for 2013” failed to achieve the successes of the past few years.
In fact, my surprises were way off the mark last year. I needed a lifeline, a call to a friend or a do over.
As we entered 2013, most strategists expressed a cautious but constructive economic view of a self-sustaining domestic recovery, held to an upbeat (though not wide-eyed) corporate profits picture and generally shared the view that the S&P 500 would rise by between 8% and 10%. (A year ago the median S&P forecast for year-end 2013 was only 1,550, according to Bloomberg; the closing price in 2013 was 1,848.)
Those strategists proved to be correct on profit growth (but only because of several nonoperating factors), were too optimistic regarding domestic and global economic growth and, most importantly (as I did), grossly underestimated the animal spirits that resulted in a well-above-historic increase in P/E ratios that buoyed stock prices to their largest annual gain since the mid-1990s.
Many readers of this annual column assume that my surprise list will have a bearish bent. But I have not always expressed a negative outlook in my surprise list. For example, two years ago, my 2012 surprise list had an out-of-consensus positive tone to it, but 2013's list was noticeably downbeat relative to the general expectations. I specifically called for a stock market top in early 2013, which couldn't have been further from last year's reality, as January proved to be the market's nadir. The S&P closed at its high on the last day of the year and exhibited its largest yearly advance since 1997. (I steadily increased my fair market value calculation throughout the year, and, at last count, I concluded that the S&P 500's fair market value was approximately 1,645.)
My 15 surprises for 2013 had the poorest success rate since 2005's list (20%).
By comparison, my 2012 surprise list achieved about a 50% hit ratio, similar to my experience in 2011. Forty percent of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, one-third in 2006, 20% in 2005, 45% in 2004, and one-third came to pass in the first year of my surprises in 2003.
Below is a report card of my 15 surprises for 2013 (I hit on only about 20% of the surprises):
There are numerous reasons for my downbeat theme this year. Below are a few (in no order of importance):
As I did last year, following each surprise, I have included a specific strategy that might be employed in order for an investor to profit from the occurrence of these “possible improbables.”
Following are my 15 surprises for 2014 (and five also-rans that didn't make the list).
At the core of this year's surprise list is that the U.S. economy disappoints (with domestic real GDP growing at 1.75% or less, half the expected rate offered by the consensus) relative to consensus expectations. Many (e.g., Harvard's Martin Feldstein) are worried about the economy overheating, but global growth also fails to meet forecasts (and is only 2.5% against consensus forecasts of 3.6%-plus).
The case for slowing growth is not necessarily quartered and dependent on rising interest rates. Rather, central to my surprise is a spent-up not pent-up consumer whose fragility may be exposed and an uptick in economic inequality, as trickle-down policy grows increasingly ineffective.
The recent rise in unemployment claims, higher gas prices, slowing population growth, the higher costs of health care, slowing retail sales and a pause in domestic automobile and housing activity likely presage that slowing growth is in store for 2014.
U.S. real GDP growth is under 2%, and worldwide growth is under 3%, making the difference between anemic growth and recession increasingly one of semantics. (Note: The U.S. stock market has a forward P/E ratio of nearly 17× with a 2% real GDP growth rate, while China has a forward P/E ratio of about 7.5× with a 7% real GDP growth rate.)
The Fed's tapering will be put on hold in response to slowing growth, and some within the Fed, including Whirlybird Janet Yellen, argue for increased levels of quantitative easing. Half the Fed members are reluctant to add “more cowbell,” however, so there is no additional QE and the new Fed Chair's more aggressive monetary policy views are repudiated.
Pressure is placed on both parties in Washington, D.C., to introduce more radical and aggressive fiscal policies in order to stimulate domestic economic growth by year-end.
Major droughts in the United States, Brazil, and Russia have a knock-off impact on much higher commodity and food prices, experiencing a greater-than-5% rise in 2014 (negatively impacting the consumer's purchasing power).
The drought brings on stagflation concerns. Other supply disruptions fuel some cost-push commodity price inflation even though economic growth is weak relative to expectations.
The risk of an exogenous shock expands, and further downgrades of global growth could put the United States and Europe in a deflationary headlock, finding both regions in a light liquidity trap.
Even though interest rates grind a bit higher in early 2014, the rise is mild, and the yield on the 10-year U.S. note spends most of the year between 2.5% and 3%.
Surprisingly (with a stable rate picture), the housing market is further disrupted. Mortgage rate and home price sensitivity are underestimated, as double-digit home price increases in 2013 dwarf modest rises in incomes. As a result, affordability suffers, and real buyers are priced out of the market. Traffic and orders drop off as the year proceeds. The accumulation of homes to rent by new-era buyers (hedge funds, private equity, etc.) precipitates further weakness in the U.S. housing market—indigestion in the rental markets develops, as there is an inability to absorb the units. By the second half of 2014, year-over-year home prices turn mildly negative.
A new homebuyer tax credit is considered in late 2014 in order to stimulate residential real estate markets.
Refinancings evaporate, serving to put pressure on household cash flow and personal consumption expenditures. The unemployment rate remains sticky (hanging around 7%), and consumer confidence falls.
The expected recovery in capital spending fails to materialize in 2014.
Companies slow down their share repurchase programs (which buoyed EPS last year), balking at higher stock prices and recognizing that the economics of debt offerings to fund repurchases are less compelling from a return-on-investment standpoint than they were in 2013.
Strategy: Buy index puts, sell index calls, or purchase inverse ETFs.
Slower global economic growth impedes corporate profit growth. (See previous section, “The Rationale behind My Downbeat 2014 Expectations,” for more reasons.)
As we approach earnings season, I estimate that 2013 S&P earnings approximate $108.50 a share.
For 2014, the consensus estimates that the S&P 500 will achieve profits of about $116 to $120 a share. (Recently, those projections have been skewing higher and seem to be moving to closer to $120 a share.) My base case estimate is for $112 a share, a gain of under 5% (year over year), which is, again, below consensus.
Slowing sales, a contraction in margins, the reduced influence/benefit from aggressive monetary policy and political uncertainties are some of the reasons why my baseline earnings expectation is for below-consensus 2014 S&P 500 profits.
Strategy: Buy index puts, sell index calls, or purchase inverse ETFs.
While the S&P 500 closed 2013 at its yearly high, equities will close 2014 at their yearly low.
Stocks trade in a relatively narrow range over the next six months but fall in the second half, ending the year at their low, with a decline of between 5% and 15%.
Valuations decline in 2014. Last year's animal spirits subside as P/E multiples, which increased by nearly 25% in 2013, fall by about 15% in 2014.
Strategy: Buy index puts, sell index calls, or purchase inverse ETFs.
Bonds outperform stocks in 2014.
Against the backdrop of a decline of between 5% and 15% in the U.S. stock market, the return on long-dated, taxable U.S. bonds is close to 10%.
Interest rates decline from 2013's year-end levels. The yield on the 10-year U.S. note ends the year between 2.5% and 3%.
Closed-end municipal bond funds are among the best asset classes during the year, achieving a total return of about 15% in 2014.
Strategy: Buy iShares 20+ Year Treasury Bond ETF (TLT), PowerShares Build America Bond Portfolio (BAB), BlackRock Municipal Target Term Trust (BTT), Eaton Vance Municipal Income Term Trust (ETX), BlackRock Investment Quality Municipal Trust (BKN), Nuveen Select Quality Municipal Fund (NQS), Nuveen Premium Income Municipal Fund II (NPM), Nuveen Dividend Advantage Municipal Fund (NAD), Nuveen Municipal Market Opportunity Fund (NMO), Nuveen Municipal Advantage Fund (NMA), Invesco Pennsylvania Value Municipal Income Trust (VPV), Invesco California Value Municipal Income Trust (VCV), Nuveen Quality Income Municipal Fund (NQU), Nuveen Premium Income Municipal Fund (NPI) and Nuveen New York AMT-Free Municipal Income Fund (NRK).
Strategy: Buy Citigroup/short Bank of America pair trade, short Starbucks, short 3D Systems, short Apple calls, buy Amazon common and calls, buy Goldman Sachs, buy Altisource Asset Management, buy Monitise, short GM, buy Consumer Staples Select Sector SPDR (XLP), short Consumer Discretionary Select Sector SPDR (XLY) and Market Vectors Retail ETF (RTH), and short PowerShares QQQ (QQQ).
Strategy: Buy Tesla Motors common and calls.
Strategy: Short Twitter common and buy TWTR puts.
Against all of his previous protestations, Berkshire Hathaway's Warren Buffett announces the name of his successor.
Strategy: None.
Bitcoin scores acceptance as a virtual currency from Amazon and eBay in early 2014 and climbs to over $7,500 in value by midyear.
The Winklevoss twins make nearly $350 million on paper from their investment in bitcoin.
Just at the time that bitcoin begins gaining legitimacy as a currency, improprieties in the calculation of the supply of bitcoins are found. A fraudulent double-spend attack wreaks havoc and significantly disrupts the bitcoin market. At the same time, a selfish miner (who does not release solutions to solved cryptopuzzles and minds a branch in secret) successfully attacks the bitcoin system and gains control of over 55% of the total network hashing power.
The value of bitcoin falls by nearly 70% in a two-week period and closes back under $1,000 by year-end.
Several momentum-based hedge funds that got long fail spectacularly.
Strategy: Buy and then short bitcoins.
As a result, President Obama becomes a lame duck president who is unable to launch any new policy initiatives.
The S&P 500 soars to over 2,100.
Strategy: Buy everything.
Revelations made by a New York Times investigative reporter precede an announcement that Bill and Hillary Clinton plan to divorce. Shortly thereafter Hillary Clinton officially bows out of the 2016 presidential contest. Elizabeth Warren emerges as a Democratic presidential frontrunner (a 2013 surprise).
Strategy: None.
Riots break out in select major cities as inequality and the screwflation of the middle class gain center stage.
Middle-class income, purchasing power and discretionary incomes continue to stagnate. Zero interest rates, quantitative easing, trickle-down economics and a higher stock market fail to solve the structural decline in labor's share of the economy.
Local municipalities raise costs and reduce their levels of services. With property values topping out, pension/health care costs rising and economic growth slowing, the decline in government services accelerates—and so does taxation. As an example, the U.S. Postal Service reduces home delivery (in favor of more post office boxes and less frequent daily service). Local “junk fees” on parking tickets, permits, recreational entrance, etc. are instituted. As well, fees for trash pickup are raised dramatically and, in certain cases, trash pickup is eliminated.
Pressured politicians introduce a national wealth tax (also a 2013 surprise) that is authorized by Congress late in the year.
Strategy: None.
Politics and economics form a potentially toxic cocktail.
Africa triggers an emerging-market crisis and becomes a flashpoint of geopolitical risk and political turmoil as the region's untapped oil wealth is recognized.
Not long ago, South Africa was meant to be the “S” in the BRICS, alongside fast-growing Brazil, Russia, India and China. The rand, however, is in steep decline, and the nation has growing budget and trade deficits and slowing growth, so it can hardly claim membership in that club right now.
At some point in 2014, the ratings agencies will downgrade South Africa, foreign money will flee, and the country will be in a full-blown financial crisis that will trigger a wider selloff in the emerging markets and could highlight problems at emerging-market central banks (which are already suffering from slowing economic growth, an acceleration in inflation, etc.).
Potentially changing regimes due to national elections in Brazil, India, Indonesia and Turkey cause those countries to join South Africa in the emerging markets' bumpy ride, which is further impacted by U.S. dollar strength caused by the Fed's tapering.
If the crisis intensifies and expands beyond South Africa, a contagion into the developed banks could raise additional concerns and pull down money center bank shares.
Strategy: Short iShares MSCI South Africa ETF (EZA), iShares MSCI Emerging Markets ETF (EEM) and Financial Select Sector SPDR (XLF).
Marijuana is legalized in many more states, and the largest (to date) marijuana grower/retailer goes public in a Goldman Sachs-led IPO that soars by 400% in the first day of trading.
Numerous copycat marijuana related IPOs follow.
Strategy: None.
Global trade and stocks suffer.
Strategy: Short iShares China Large-Cap ETF (FXI) and SPDR S&P 500 ETF Trust (SPY).
Strategy: None.
A quiescent period of Middle East peace, more U.S. energy discoveries (and an increased pace of energy independence) and slowing global economic growth adversely impact energy prices.
Strategy: Short crude oil and energy stocks.
Strategy: Short VIX.
Strategy: Short SPDR Gold Trust (GLD) and gold miner shares.
He is only human.
Strategy: None.