A Happy 2011 And A Disillusioned Outlook For The New Year From Nic Lenoir
From Nic Lenoir of ICAP
Happy 2011! Disillusioned thoughts for the year ahead
Going into 2011, I decided to first reflect on my January 2010 strategy piece on the year ahead. I remember at the time of writing it that I made a conscious effort to temper my fervor and tried to think objectively without letting my own opinions dominate what should be one's realistic expectations. My conclusion was at the time that with liquidity withdrawal at the top of the central banks agenda, runaway asset prices were unlikely. My conviction was also that as they tried to withdraw liquidity central banks would quickly realize that it was the only thing holding the system up and therefore would adjust their agenda accordingly, resulting in a range for asset prices. I had in particular 1,014/1,236 for the S&P. At the time I did get a lot of criticism for not making a call as to whether we would end the year at the top or the bottom of that range. In retrospect I am actually thrilled with that call. Taking a step back and thinking of what realistically would happen was the best thing I could have possibly done. Certainly and for reasons I will cover in more details below I was inclined to short strength a fair part of the year, with great success in April, and less so in late October. All in all though, having recommended to cover shorts in late August and possibly getting long tactically, realizing the technical picture did not support my strong desire for a break lower, and having capitalized on sharp reversals earlier whether it is the spring debacle in equities or the move towards lower rates started around the same period, I feel it was a good year yet not a great one. My biggest mistake was not to embrace the enthusiasm ahead of QE 2.0 and get behind asset prices. Because I trade more tactically when it comes to positioning I did not hang myself and throw the year away, but I do feel I missed out and more importantly I did so because I let my personal beliefs surpersede fundamental developments. I stick however to the fact that around 1,155/1,165 we had a technical set-up very prone for a reversal, and I think it was very fair at the time to take a stab, knowing to step aside if the market pushed forward. Another belief of mine was that basic commodities would not be able to sustain large price increases as the economy was too weak to withstand inflation (not as measured by the government which is a vast fraud, but as experienced by the consumer). That proved absolutely right for crude oil which I had contended would not manage to trade in a sustained manner above $90, but I misjudged the capacity of businesses and the consumer to absorb inflation in agricultural commodities and base metals. Thankfully my bullish conviction for Lumber partly tempered my misperception. In rates I was obviously convinced rates would remain unchanged in the front-end, and while I felt the rise in the long-end was not over at the start of 2010, I had 10Y topping at 4.10, which was not too far from the highs in early April.
So with all that said there are a few things I would like to discuss: first how can we learn from the good things we did in 2010 while avoid repeating our mistakes, then I would like to explain why I will remain a bear at heart until a number of issues that we will cover are addressed, and what it all means for what we see developing in 2011.
Our mindset was perfect going into 2010: we had a view that the underlying economy was weak, and we knew that in March the Fed's QE 1.0 would end with the ECB scheduled to close long term financing facilities in June. We waited, timed the market using technical analysis which I believe remains the only way to really attempt at timing top and bottoms in market prices and sentiment, and it worked perfectly. Where we went wrong is that after getting a technical signal to buy around 1,040 and rightfully closing out short positions and recommending tactical longs, I failed to factor in the Fed's hints of QE 2.0 at the Jackson Hole conference. When big time portfolio managers go on TV claiming it's a done deal I got irritated thinking they were either taking an ill-advised all in gamble or they were corruptly privied to a certified guaranty of what was to come. It doesn't matter what I believe, I should have embraced the corruption and policies I cannot stand rather than keep too bearish a focus, which only thankfully to careful tactical considerations based on technical observations did not turn into a complete disaster. So while we did overall a good job looking for technical opportunities to express our views, I will need to be much more cynical when it comes to assessing potential government intervention in the economy. At the end of the day it very much comes back to my intimate conviction that a good bearish trade ideally has positive carry or as close to no negative carry a possible. As long as the government makes carry even remotely available to collect because the amount of money in the system is being pumped up and is so great the herd will keep piling in despite how ill-advised and criminal policies may be.
This leads me to the conversation of why I remain so bearish at the core at a time when bullish market sentiment is exploding through the roof. I have added the capacity utilization chart since the 70s as it best highlights my view of the US economy.
There is absolutely no doubt that we have a structural job problem in America. Over the last 50 years women have entered the workforce, we have automated a lot of jobs, and exported many of them. Surely it does not require a nobel prize to understand that it can't work. And because of the state of the pension system and its inevitable failure we have now been ignoring for 25 or 30 years, people will no longer be able to retire which means the job market structurally will not see any improvement from the retirement of baby boomers. Certainly new technologies have opened new horizons and created new jobs at home, but not even close to what would be needed to counter the other factors we just mentioned. It's also worth reflecting on the fact that everyone cannot invent a new revolutionary algorithm, we need jobs for everyone and with the state of the school system it's fair to say the number of people who can actually invent something useful is going to shrink not rise. I am by no means debating women's right to work, that is a given obviously. I am however convinced that no real positive societal growth will be possible in the West without addressing entitlement programs, pension issues, the cost of production in developed economies whether it is via currency revaluation or protectionism, and a more responsible management of the world's natural resources should probably make the list too. Can we continue inflating this mercantilist world economy without an absolute collapse in the value of Western currencies? The answer is not "maybe not", it's not even close: we can't and it's obvious. Maybe we can maintain the illusion for a couple more years. The problem though is that even a 50% drop in the value of the USD will not make up for the production cost difference between the US and China, or Africa for that matter, and at that point most commodity prices will absolutely cripple the average American. Yes maybe the S&P will trade north of 2,000, but 75% of the population if not more will struggle to make ends meet by then. This evaporation of jobs can be seen in simple statistics. For example the rate of growth of the 5th percentile's income level over the last 3 decades is almost 3 times that of the median. And to be sure those who make the most are also those benefiting from asset inflation. The beauty of capitalism in my mind is that it is supposed to constantly respond to shocks presented by changes in the world and lead the economy to a new state of equilibrium. That means that when the middle class is decimated and can no longer support a strong economy asset prices should collapse and with them deflation would readjust costs and standard of living across the population to allow a new growth cycle. I fully realize this is very simple and as I write it I wonder if I am just stating the obvious, but the fact is that not one single government around the world seems to understand this. The US has obviously chosen the path to bail out rich retirees at the expense of the general population. Unfortunately we had an incredible opportunity in 2008 to rebalance the world economy and the financial system, and we did absolutely nothing but make it worse. It's a debate for another day but think that unemployment leads to a gap in taxes collected to finance the federal budget which is not made up by the resulting profits of large corporations benefiting from cheap labor as they find ever more creative ways to pay dismal tax rates. Adjust that and you could solve the deficit without worrying about taxing those who are working! Inflation is not in people's best interest in our case, deflation is. It is a myth and a complete fallacy that one is dramatically worse than the other. It's just like looking at what our history books fed us growing up in Europe, that Hitler was evil, Stalin was a relatively nasty guy who had good ideas initially, and Lenin an ideologue. I barely exaggerate believe me. The truth is that they were all evil and most certainly clinically insane. Of course deflation will hurt, but we have made many mistakes. And at this stage it will hurt less than hyperinflation and it is more in the general population's interest for sure. Truth is democracy has failed us. The only reason why the American population has not protested like people in Europe is because television, facebook and youtube has dummied it into complete apathy. There is no doubt though that it will not last eternally as voices are starting to be heard though as always too late. It is not just an American problem though. The same is true in Europe where the Euro is doomed but European politicians are hanging on to this dream of theirs like a trader to a bad position, letting it fester until the patient is no longer treatable by anything else than amputation. The Euro was born of the post world war II reconciliation efforts and politicians built on it. The humiliation having to cave in to America's lead after being rescued combined with this idea of creating a warm and loving Europe led to dreams of greatness and a Euro currency that would put Europe back on the economic map. Obviously it completely failed at a time where certain public officials in Spain have had to bring their own toilet paper to work for almost a year as funding for even some very basic necessities is missing.
Recently I have tried to read more about Chinese policies to understand better what the new superpower is up to and how it maintains 10% growth no matter what. Beyond some of the stones I turned, I found that just like their European or US counterparts Chinese politicians are afraid of tackling their inflation issues and are trying to dance around rate hikes coming up with so far highly inefficient measures instead. The fear of a recession, of admitting to their people the economy can go down, has scared them into ill-advised populist policies just like anywhere else. This is why I think democracy has failed us. The bubble may carry on, and I will do my very best to identify ways to invest smartly to capitalize on trends but ALWAYS keeping in mind the fact that it will end in tears, very very badly, and never keeping my eyes away from the exit signs.
My main disillusion is summarized in looking at the attached document which is the official forecast for the US straight out of Washington dated January 2009. We have had a higher deficit in 2009 that was forecasted by over $200Bn, which until recently was half of the worst deficit ever recorded hence not a small margin of erro. 2010's deficit was almost twice what was forecasted at the start of 2009, and 2011 looks like it could be closer to 3 times what was expected in 2009. How can one look at that and possibly think that Washington, whether it is democrats or republicans, is getting anything right? It is the same type of misses we saw in Greece, Ireland, or any other government on its way to default. How long will we make adjustment to forecasts to justify today's expenses. Our future is being abused in the worst ways possible.
So with all that said, I would like to close the circle and close the discussion with what I think is possible for 2011. I will not commit to any target levels as politicians will as always adjust their policies on the fly to try to prevent the inevitable, just like they did in 2010. However, I will always do my best to make sense of what is at hand and try to devise what the near future has in stores for us. Only when the government bubble explodes will fundamentals and economic analysis make sense again.
1) I think risk in Europe is grossly underpriced still. I have discussed at length how EURCHF pointed towards troubling signs in the equity markets there. Actually a few minutes ago a friend drew my attention to the fact Swiss equities are taking a beating today. There is nothing surprising about this in fact I was analyzing it last week. Expect markets to catch up in the divergence between FX (EURCHF) and European equities early in the year. Until we either get Euro bonds (a disaster in my opinion for all the reasons discussed previously), unsterilized debt monetization, default by certain European governments leading to a break up in the Eurozone, or an outright break up of the union without defaults, the situation will not get better and remain a recurring theme. If the economy surprises us enough to the upside EURCHF will reverse course, and if not stocks will fill the gap in perception to the downside.
2) The Fed will not hike rates, and neither will the ECB. There is always a risk of June 2008 in people's mind with the ECB hiking in the face of a depression, but that would be a mere one off just like it was then as right now without constant liquidity supply the system would collapse, and commodity inflation absorbs the liquidity being enacted making it a vicious circle. The one-off scenario is highly unlikely.
3) China will not succesfully slow down inflation and it will have to be an exogenous shock for their Ponzi scheme to take one on the chin properly economically speaking.
4) The Fed will try to extend QE 2.0 or start a new program, and there will be a very heated debate. Markets will panic and the government will cave in (get ready for the end of the scheduled QE 2.0).
5) The worst thing that could happen for the long term is if recent changes in mutual fund flows are confirmed and the US retail consumer is sucked back into the ponzi scheme
6) Until the DXY remains above the 60-day moving average and/or 78.00, and it threatens to engage in a major bull move, we will not see a convincing ramp up in equity markets which are completely overstretched to start 2011 and will need at least a 7% or 8% correction before having a shot at a next convincing bull leg
7) Municipalities will start defaulting at an increasing pace but the major states will not file in 2011 so the market is likely to keep on ignoring it
On this note, I wish you and your families a very happy 2011. Thank you all for your support and your business in 2010. Any feedback as always is greatly appreciated as I am only here as long as you care and I can serve your best interests.
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