From Whence We Came and Where We Go. 2006 In Review & 2007 The Look Ahead: Does The Financial Bubble Get Bigger?
Happy New Year to everyone! I hope 2007 will be a memorable year for all. So, let's take a few moments and look back at 2006 and what 2007 may have in store.
2006 was again the year of the consumer, small caps, emerging markets and commodities. Funds and investors focused on these sectors were outperformers once again. Towards mid-year we started to see a measurable shift. Many commodities corrected large amounts and some actually cratered. That was expected. We'll likely see other commodities pick up the slack going forward. This does not mean we are having a twenty year bull market in copper or other commodities. It does mean we'll likely see violent swings in commodities for quite some time. Maybe even another five to ten years. But, higher highs and higher lows, the definition of a bull market, is not what we'll see out of commodities over the next decade. We've talked about that ad nauseum though.
2006 was also a year where we have been told that Asia and emerging markets have finally matured. That they have reached a level of development and sophistication where they can be trusted as a source of investment diversification. Many believe they will carry the load if the U.S. has an economic slow down. I believe there is a stronger argument to be made that there is a lack of demand for capital in the U.S. which has found its way into emerging and international markets (for many reasons) thus creating instabilities on a global scale. This situation has been exacerbated by a relative loss in value of dollar denominated assets. Or, put another way, if you are in natural resource rich Australia, Saudi Arabia, Russia or Canada, as an example, the tremendous run up in dollar denominated commodities has fueled extremely distorted and unsustainable commodity-related profits. Economic miracle or economic mirage? My thesis for this cycle's investment returns is gaining momentum as Thailand markets imploded late in the year caused by government attempts to control the destabilizing instantaneous flow of funds from "western" investors. ie, Mostly U.S. and British hedge funds. I wouldn't be surprised to see more of this in the months ahead. Especially given the parabolic moves in Russian and Chinese equities this past month. Remember, most emerging markets are like the wild west. There is little understanding of safety and risk, lack of sophisticated market controls, weak leadership, nepotism and all of the other risks I've written about. If you like emerging markets, do so for the right reasons. Do so because hot money is plowing new fields of temporary wealth with an eye towards getting out before the mess is created.
It also seems as though 2006 was the year of vacillation. Many money managers have jumped back and forth on their investment ideas and market expectations. I'm not sure how they successfully invest with so many changes of opinion. I suppose they either underperform the markets as the majority of money managers do or they are saying one thing and doing another. Of course, why would underperformance not be expected? The reason most money managers underperform are because they lack discipline. What is vacillation? A lack of discipline. The world's greatest investors are anything but lacking in discipline. Why? Because they are confident in their approach and methodology. In other words, they know what works at what time and they play to win.
I believe the most important macro topic we've discussed this past year is the "topping" or peaking of the financial industry. I can't recall the exact title of the post. I believe it was "The Finance Industry Is Peaking" and was posted in August or September. We simply have a disproportionate amount of people, capital and resources flooding into the entire financial industry food chain be it hedge funds, funds of hedge funds, investment banking, private equity, real estate agents, accountants, private trading desks, commodities, mortgages, consumer credit or the other massive dislocations. You must remember, in long wave cycles, it is the finance industry that is the last to peak. If this isn't peaking, I don't know what is. Every spare dollar, yen, euro, peso, yuan and nearly every other currency are piled into nonproductive use. As I stated before, we will eventually see excess capital destruction. I view this as an absolutely essential requirement to create a new long cycle bull market in American business and thus American equities. Unfortunately, the process is going to be painful. Ultimately, we'll see a reversion and redeployment of productive assets and intellectual capital into constructive wealth creators such as technology, green initiatives, biotechnology, health care, lean manufacturing and other productive investments.
So, what will 2007 hold? I've said it a few times and I'll say it again. Markets are extremely overvalued to overvalued. Does that mean the markets are going to fall off of a cliff the first week in January? No. Wall Street is terribly bullish about 2007. In addition there seems to be a general consensus that sentiment is too bearish and that is going to fuel a massive 20-30% rally in the S&P. I simply don't pay that much attention to sentiment. It's rather ridiculous to me. Everyone jumps on the bandwagon when the Nasdaq goes down 10% saying sentiment is awful and we are due a rally. Well, that works until it doesn't work. Tis better to measure what the markets are doing instead of what people are saying. Did sentiment help in 2000-2003 when the Nasdaq went down 80-odd percent? Certain sectors of the S&P could go down 75% to be fairly valued with other secular bear markets. Some 30%. Does that mean I am calling for a 75% correction in the S&P? Only if we are at the end of the world. But, the complacency is palpable. Anyone calling for a 10-15% correction is being laughed out of town right now. I believe we are going to see a very nasty correction starting in 2007. Originally, I wrote that I expected to see a bottom in October of 2007. That might be a bit premature but then it's also based on esoterics that only a handful of people even attempt to harness. (As I've said before, I do not invest based on estoric cycles analysis.) All I will say is forecasting the turning points of the markets is not a science. It is an art. Forecasting times of high risk is a science. We are in a time of incredibly high risk and most Wall Street professionals look like the proverbial deer in the headlights. Last time we saw that same look was in 2001 when Wall Street professionals were as bullish as they are for 2007. Take note. When Wall Street has achieved prajna, it's time to worry. Emerging markets? Brazil or India may have a low valuation comparative to the U.S. but then again, they deserve a low valuation. They have not proven their ability to create continued reform, wealth and economic prosperity over long periods of time. Their financial infrastructures are unsophisticated and their capital markets are typically a ruse. In other words, don't buy the ridiculous statements that such and such international market only has a PE of 10 so it's undervalued. That's Wall Street prattle. If the long term PE has been 10 or less, there's a reason for it. They aren't called emerging markets for nothing. Most have been emerging for the last one hundred years and many will still be emerging one hundred years from now.
Alot of people believe small caps, energy and a few other sectors are still outperforming. That is simply not true. There are multiple methods to measure outperformance and from my methods, there are no major sectors outperforming mega caps. In other words, mega caps as a class are leading all sectors. So, how does one interpret this? Well, I interpret that data point as a run for safety as I mentioned a few months ago. My long term models are unbelievably bearish on all equities and if I were a buy & hold investor, as most mutual funds, retirement funds and the sort are, I'd be running, not walking, to mega caps. That is exactly what they are doing.
Some final comments about 2007. Now, I'm not going to share any proprietary work but I will share a comment which I am quite confident will come to pass. I've said it half a dozen times but I like repeating myself. It sounds better the more I say it. Those expecting to ride "defensive" sectors through any severe correction, when one happens, will see tremendous capital destruction. Those who are investing in higher dividend paying stocks for the same reasons are likely due the same outcome. There is only one segment of equities which I consider to be value priced in comparison to all other sectors. It isn't defensive. And, while it is cheap comparatively, it's still overvalued.
My view of equities was that most investments would print May of 2006 as the high. I thought 1400 was possible on the S&P but didn't expect broader markets, technology or small caps to follow suit. That position still holds for most nearly all sectors and styles. We are basically at the same level or lower than May in nearly all equity sectors and styles. The lone dissenters are the mega cap averages which sit a handful of percentage points above the May high. We are due a correction at some point here. Some data points I follow have fallen off of a cliff in December but I discount light holiday season activity so we just have to see. Whether any future corrections turn out to print the October breakout in the S&P as a false breakout and an opportunity to short or whether it's a buying opportunity is the big question. Regardless of what happens, the upside is limited in my opinion. In other words, no Dow 30,000 any time soon.
As you can tell, I am not optimistic about the near term future of equities. The higher we go the bigger the ultimate mess is my concern. Nor am I optimistic about the global economy. Anyone who is not hedged, positioned defensively or in mega caps is playing with fire. When they get burnt is the only question. One of my favorite quotes was made famous by Hyman Minsky: "Periods of stability create instability.". In other words, it is human nature to be generally self destructive when exposed to long term prosperity. To expect anything different from the inflated asset prices we see in so many investments is to disregard human nature. That said, in all likelihood we are going to get the buying opportunity of a life time in equities at some point. You'll know that point. It is when you've vowed never to invest in equities again.
2006 was again the year of the consumer, small caps, emerging markets and commodities. Funds and investors focused on these sectors were outperformers once again. Towards mid-year we started to see a measurable shift. Many commodities corrected large amounts and some actually cratered. That was expected. We'll likely see other commodities pick up the slack going forward. This does not mean we are having a twenty year bull market in copper or other commodities. It does mean we'll likely see violent swings in commodities for quite some time. Maybe even another five to ten years. But, higher highs and higher lows, the definition of a bull market, is not what we'll see out of commodities over the next decade. We've talked about that ad nauseum though.
2006 was also a year where we have been told that Asia and emerging markets have finally matured. That they have reached a level of development and sophistication where they can be trusted as a source of investment diversification. Many believe they will carry the load if the U.S. has an economic slow down. I believe there is a stronger argument to be made that there is a lack of demand for capital in the U.S. which has found its way into emerging and international markets (for many reasons) thus creating instabilities on a global scale. This situation has been exacerbated by a relative loss in value of dollar denominated assets. Or, put another way, if you are in natural resource rich Australia, Saudi Arabia, Russia or Canada, as an example, the tremendous run up in dollar denominated commodities has fueled extremely distorted and unsustainable commodity-related profits. Economic miracle or economic mirage? My thesis for this cycle's investment returns is gaining momentum as Thailand markets imploded late in the year caused by government attempts to control the destabilizing instantaneous flow of funds from "western" investors. ie, Mostly U.S. and British hedge funds. I wouldn't be surprised to see more of this in the months ahead. Especially given the parabolic moves in Russian and Chinese equities this past month. Remember, most emerging markets are like the wild west. There is little understanding of safety and risk, lack of sophisticated market controls, weak leadership, nepotism and all of the other risks I've written about. If you like emerging markets, do so for the right reasons. Do so because hot money is plowing new fields of temporary wealth with an eye towards getting out before the mess is created.
It also seems as though 2006 was the year of vacillation. Many money managers have jumped back and forth on their investment ideas and market expectations. I'm not sure how they successfully invest with so many changes of opinion. I suppose they either underperform the markets as the majority of money managers do or they are saying one thing and doing another. Of course, why would underperformance not be expected? The reason most money managers underperform are because they lack discipline. What is vacillation? A lack of discipline. The world's greatest investors are anything but lacking in discipline. Why? Because they are confident in their approach and methodology. In other words, they know what works at what time and they play to win.
I believe the most important macro topic we've discussed this past year is the "topping" or peaking of the financial industry. I can't recall the exact title of the post. I believe it was "The Finance Industry Is Peaking" and was posted in August or September. We simply have a disproportionate amount of people, capital and resources flooding into the entire financial industry food chain be it hedge funds, funds of hedge funds, investment banking, private equity, real estate agents, accountants, private trading desks, commodities, mortgages, consumer credit or the other massive dislocations. You must remember, in long wave cycles, it is the finance industry that is the last to peak. If this isn't peaking, I don't know what is. Every spare dollar, yen, euro, peso, yuan and nearly every other currency are piled into nonproductive use. As I stated before, we will eventually see excess capital destruction. I view this as an absolutely essential requirement to create a new long cycle bull market in American business and thus American equities. Unfortunately, the process is going to be painful. Ultimately, we'll see a reversion and redeployment of productive assets and intellectual capital into constructive wealth creators such as technology, green initiatives, biotechnology, health care, lean manufacturing and other productive investments.
So, what will 2007 hold? I've said it a few times and I'll say it again. Markets are extremely overvalued to overvalued. Does that mean the markets are going to fall off of a cliff the first week in January? No. Wall Street is terribly bullish about 2007. In addition there seems to be a general consensus that sentiment is too bearish and that is going to fuel a massive 20-30% rally in the S&P. I simply don't pay that much attention to sentiment. It's rather ridiculous to me. Everyone jumps on the bandwagon when the Nasdaq goes down 10% saying sentiment is awful and we are due a rally. Well, that works until it doesn't work. Tis better to measure what the markets are doing instead of what people are saying. Did sentiment help in 2000-2003 when the Nasdaq went down 80-odd percent? Certain sectors of the S&P could go down 75% to be fairly valued with other secular bear markets. Some 30%. Does that mean I am calling for a 75% correction in the S&P? Only if we are at the end of the world. But, the complacency is palpable. Anyone calling for a 10-15% correction is being laughed out of town right now. I believe we are going to see a very nasty correction starting in 2007. Originally, I wrote that I expected to see a bottom in October of 2007. That might be a bit premature but then it's also based on esoterics that only a handful of people even attempt to harness. (As I've said before, I do not invest based on estoric cycles analysis.) All I will say is forecasting the turning points of the markets is not a science. It is an art. Forecasting times of high risk is a science. We are in a time of incredibly high risk and most Wall Street professionals look like the proverbial deer in the headlights. Last time we saw that same look was in 2001 when Wall Street professionals were as bullish as they are for 2007. Take note. When Wall Street has achieved prajna, it's time to worry. Emerging markets? Brazil or India may have a low valuation comparative to the U.S. but then again, they deserve a low valuation. They have not proven their ability to create continued reform, wealth and economic prosperity over long periods of time. Their financial infrastructures are unsophisticated and their capital markets are typically a ruse. In other words, don't buy the ridiculous statements that such and such international market only has a PE of 10 so it's undervalued. That's Wall Street prattle. If the long term PE has been 10 or less, there's a reason for it. They aren't called emerging markets for nothing. Most have been emerging for the last one hundred years and many will still be emerging one hundred years from now.
Alot of people believe small caps, energy and a few other sectors are still outperforming. That is simply not true. There are multiple methods to measure outperformance and from my methods, there are no major sectors outperforming mega caps. In other words, mega caps as a class are leading all sectors. So, how does one interpret this? Well, I interpret that data point as a run for safety as I mentioned a few months ago. My long term models are unbelievably bearish on all equities and if I were a buy & hold investor, as most mutual funds, retirement funds and the sort are, I'd be running, not walking, to mega caps. That is exactly what they are doing.
Some final comments about 2007. Now, I'm not going to share any proprietary work but I will share a comment which I am quite confident will come to pass. I've said it half a dozen times but I like repeating myself. It sounds better the more I say it. Those expecting to ride "defensive" sectors through any severe correction, when one happens, will see tremendous capital destruction. Those who are investing in higher dividend paying stocks for the same reasons are likely due the same outcome. There is only one segment of equities which I consider to be value priced in comparison to all other sectors. It isn't defensive. And, while it is cheap comparatively, it's still overvalued.
My view of equities was that most investments would print May of 2006 as the high. I thought 1400 was possible on the S&P but didn't expect broader markets, technology or small caps to follow suit. That position still holds for most nearly all sectors and styles. We are basically at the same level or lower than May in nearly all equity sectors and styles. The lone dissenters are the mega cap averages which sit a handful of percentage points above the May high. We are due a correction at some point here. Some data points I follow have fallen off of a cliff in December but I discount light holiday season activity so we just have to see. Whether any future corrections turn out to print the October breakout in the S&P as a false breakout and an opportunity to short or whether it's a buying opportunity is the big question. Regardless of what happens, the upside is limited in my opinion. In other words, no Dow 30,000 any time soon.
As you can tell, I am not optimistic about the near term future of equities. The higher we go the bigger the ultimate mess is my concern. Nor am I optimistic about the global economy. Anyone who is not hedged, positioned defensively or in mega caps is playing with fire. When they get burnt is the only question. One of my favorite quotes was made famous by Hyman Minsky: "Periods of stability create instability.". In other words, it is human nature to be generally self destructive when exposed to long term prosperity. To expect anything different from the inflated asset prices we see in so many investments is to disregard human nature. That said, in all likelihood we are going to get the buying opportunity of a life time in equities at some point. You'll know that point. It is when you've vowed never to invest in equities again.
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