Volatility, The Only Stable Outlook
Volatility. Many experts appear to expect a severe amount of it in 2012, which is kind of ironic since volatility implies unpredictability. Or, more directly, most experts are predicting unpredictability. Thanks for the help!
If the markets are as volatile as predicted then buy-and-hold strategies are in for a long year; talented traders and stock pickers could have a banner year; and mistakes are potentially magnified. So my goals for 2012, in this order: (1) Avoid mistakes, (2) Re-evaluate positions continuously, and (3) Pounce on opportunities.
Sagflation
In 2012 I believe my Sagflation thesis can continue to explain market dynamics. Under my Sagflation thesis, fundamental deflationary pressures impact economic activity and prices swing wildly as the efforts of the central banks and possibly fiscal policies attempt to provide stimulus. I expect this highly volatile phase to stretch through at least 2012, and possibly into 2014, before we see the early signs of how the economy can move in a new and more exciting direction. Make no mistake, I expect the next few years to provide a challenging environment to be invested in equities, but I expect the early signs of "what's next" to begin to pop-up.
In 2012 I expect debt to continue to overwhelm governments and individuals around the world, providing significant deflationary forces as governments and individuals reduce spending. Make no mistake, the recent improvements in the economy were enabled by rising consumer debt levels. These higher debt levels are a result of the Federal Reserve lowering interest rates. I expect the Federal Reserve to keep interest rates low, and even target mortgages specifically, which likely enables consumer debt to continue to rise and keep the US economy somewhat stable. Eventually this debt will come due and unless inflation accelerates materially through the expansion of the money supply the debt load likely becomes a significant burden on economic activity. I believe it unlikely central banks continue to expand the money supply due to a growing debate within the US about its effectiveness, strong push back from inflation-wary countries like Germany, and increasing uneasiness about the effects the accommodating efforts have on the middle class.
Source: St. Louis Federal Reserve - FRED Economic Data
Adding to the deflationary forces are the potential trends of falling house prices (especially in China) and stagnant wages due to relatively high unemployment. Real disposable income in the US has remained relatively flat for almost five years. The combination of falling asset prices in the form of housing coupled with stagnant income means that the economy has a difficult time growing in a healthy way. In other words, demand likely declines as consumers struggle with no growth in disposable income, coupled with potentially rising food, energy and financing expenses.
Additionally, I expect to see money sloshing around the world economy seeking healthy returns. Typical safe havens like US treasuries appear less attractive with diminishing yields and increasingly risky as their fate is tied to the whims of the Federal Reserve, as opposed to market fundamentals. Riskier commodities and equities rise and fall quickly as investors chase returns but remain nervous about the risk. The sovereign debt of many countries has become too large and inter-connected with other countries, increasing the risk profile and reducing the ability of investors to diversify. The most attractive risk-return appears, in my view, in corporate bonds. Thus pension funds, annuity companies and other investment vehicles that provide defined benefits are likely actively searching for acceptable returns. Additionally, derivatives and ETFs that allow for easy movement of money likely drive asset prices higher and lower, depending on the prevailing sentiment.
On a positive note, I expect 2012 to begin to offer the first glimpses of the "light at the end of the tunnel." It may appear distant, and even disappear at times, but the first clues of a new world order likely come into focus over the next few years. Possible shining beacons to direct us include energy production innovation, advances in optical processing, and opportunities for creative destruction of control systems based on improving communication and processing systems.
Allocation Choices
US Treasuries are a dangerous investment choice in 2012, in my view. With the Federal Reserve actively twisting pricing it is difficult to glean data points that accurately depict the fundamentals. For the reason of Fed intervention, I reiterate my view published in June 2011 that the yield on the 30-year treasury touches 2.5%. With the yield hovering around 3% I do not see an attractive risk- reward to enter into either a large long or short position. Should the yield on 30-year treasuries touch 2.5% I would consider shorting longer-term treasuries. Otherwise, I plan to steer clear of this asset class.
US equities likely swing wildly in 2012, in my view. I plan to approach this asset class with extreme caution, looking for extreme moves either up or down before entering positions. At this point I expect equities to bounce around in a range for the first half of 2012, likely between 1,100 and 1,300 for the S&P 500. Any break outside this range in the first half of the year may offer a trading opportunity, in my view. The intervention by the Fed likely helps boost equity valuations and provide some feeling of health in the economy as financing remains inexpensive. My main concern is my 1-3 year outlook for equities continues to expect the S&P 500 to drop below 700. Left to its own devices, without intervention by the Fed, I believe the market would be on its way to this bottom. Once the Federal Reserve reduces its aggressive actions, the market may head in that direction. For much of the second half of 2011 I had been fighting with myself as I tried to buy dips while in a bearish mood. Not surprisingly, my performance suffered. While being careful, I find the steel, automotive, defense, telecommunications and media segments interesting.
Instead of playing equities I plan to over-weight corporate bonds in an effort to reduce the volatility but still benefit from favorable fundamental trends in the economy and activist policies by the Federal Reserve. In order to realize an attractive yield in quality companies, I plan to invest in the upper tier of high yield bonds, or BB +/- rated bonds. Ideally, the company exhibits improving fundamentals, offering both the opportunity for a credit upgrade and appreciating price should the ratings yield curve flatten. I also plan to diversify into various sectors with more emphasis placed in automotives (due to an aging fleet or cars in the US), telecommunications, consumer staples, and media
Commodities, like equities, may prove extremely volatile in 2012. For this reason they could prove an attractive investment, if timed correctly. Precious metals have pulled back significantly from their highs, making them an attractive investment, in my view, because of the potential of further monetary easing and instability in the world during 2012. The prices of many agriculture commodities, like corn and soybeans, have also pulled back significantly that may offer an attractive investment opportunity. Finally oil continues to hold onto a fairly lofty price despite my expectation of a slowdown in economic activity. Crude oil prices may remain near $100 in the first half of 2012 since the US economy appears to have a little momentum and the Fed could offer additional stimulus measures. If crude oil goes much above $100 a barrel I may short oil.
At the start of 2012 my largest exposure at around 30% is in corporate bonds, rated just below investment grade. I have chosen to put money here in order to try and avoid some of the volatility in the equity markets yet maintain exposure to anticipated improving fundamentals within certain segments in the steel, auto, telecommunications, consumer, industrial and chemical segments. Specifically, I have invested in bonds issued by US Steel, Ford Motors, NOVA Chemicals, Great Lakes Dredge and Dock, Valassis Communications, and CSC Holdings. Each of these positions provide a yield between 5-8%. In the near future I expect to add positions in precious metals and agriculture commodities due to the dramatic pull back in many of the prices of these commodities. These positions may prove more volatile but dips in their charts combined with on-going aggressive monetary policies in many countries should turn around prices, in my view.
After an exciting 2011 I'm quite happy to add some ballast to my portfolio and maintain flexibility.
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