NOTE: We have moved our head-notes to the rear, but we do regard them as providing thoughtful insights on the year ahead in the markets. Two Ecinya confidants have suggested that by the time they get through the head-notes they are unsure of what the message precisely is. Beauty is in the eye of the beholder and we love our head-notes as we see them always reminding us of basics. Head-notes (2), (3) and (4) and their accompanying explanations are warmly recommended.
OUR FORECAST EXPECTATIONS FOR 2011?
Our real focus is stock selection against the background of micro company earnings forecasts and macro market and macro economic analysis. Technical and quantitative analysis provide confirmation or divergence from these deliberations. In index terms we focus on the All Ordinaries locally (XAO) and the SP500 as our global proxy (SPX on most systems).
In our opinion 2011 will be a year of shadow and light, not unlike 2010.
The SP500 finished 2010 at 1257. Our 2011 forecast expectations for the SP500 is that it encounters resistance around 1275 to 1290, then falls to around 1200. After that it rises about 15% to around 1380 and then falls about 15% to around 1180 before rising to finish the year at about 1320 for an overall gain of about 5%.
Our market in All Ordinaries terms is languishing around 4820 at the moment. We suggest that it will over the course of the year rise to about 5400 before retracing to around 4700 and finishing the year around 5100, up 5% year-on-year.
Our hypothesis therefore is that overall the year will be essentially flat, but with sufficient volatility to allow traders and active value investors to out-perform market indices.
There is always scope for over-and under-shoot but trend, bias and momentum are the phenomena needing to be observed for risk management and asset allocation decisions.
A WORD ON FORECASTS
A forecast is a prediction and calculation related to future events. The future is difficult to predict both in relation to time and dimension. Therefore, the underlying hypothesis has to be set out so that as events unfold and time passes, the forecasts can be measured to provide confidence or provoke action.
An hypothesis is according to our Collins Dictionary "A suggested explanation for a group of facts or phenomena, either accepted as a basis for further verification or accepted as likely to be true".
The world was in recession for 2009 with world growth running at negative 0.6% according to the IMF. In 2010 their estimate is that the world will grow at 4.8% and at about 4.2% for calendar 2011.
The market recovery from March 2009 was a renunciation and recognition that the world was NOT about to end. Too many of the world’s bureaucrats failed to recognise that inappropriate fiscal and monetary policy was encouraging manipulation and exploitation of inadequate regulatory frameworks and this combination of factors would lead to an inevitable crash. Responsible persons and entities above the market were not moved to say "Stop, this has gone too far!" Current observations are that we have learned little from the last crash and previous episodes.
The 2010 year was driven by monetary and fiscal stimulus as "too big to fail" prevailed. "Too big" embraced both countries and corporations.
In 2011 we face the natural consequences of the actions that aided an economic and market recovery in 2010. The bullish hypothesis is that the emerging world (Asia and parts of South America) can take the developed world from survival to revival. Also that Ben Bernanke will succeed in stabilising the US economy to allow free enterprise to invest and borrow to create jobs. It is rather amusing that we hear the expression "jobless recovery"….. how can you have a jobless recovery?
In Europe the approach has been that austerity is the path to prosperity. The PIIGS have not gone away they are merely sleeping.
Australia went into the global financial crisis in good shape thanks to good government prior to 2007, China and commodity prices. However, over-reaction on the fiscal front to the GFC in early 2009 now leaves us more exposed, as so much of the fiscal policy resulted in waste, extravagance and fraud. Thoughtless politics got in the way of thoughtful economics.
On the American sub-prime fiasco It is interesting to reflect that home ownership which normally requires a job and the resulting income to repay a mortgage only required the existence of an aspiring home-owner and a glut of financial engineering. But then we pass this sub-prime event and the dot-com event off as ‘bubbles’ which both softens and trivialises the enormity of the travesty. It seems that too many of our global bureaucrats think that a university degree, briefcase and Armani suit plus a reading of Buffetology, business and economic history qualifies them to recognise and solve problems that impact on ordinary workers and taxpayers.
Though we got our 2010 market forecasts (XAO and SP500) near enough to 100% correct, our reasoning was marginally deficient in that the scale of the required stimulus was so large. It seems that the world is currently relying on fiat money to achieve survival and revival plus global excess capacity to mitigate inflation. Additionally, we find that our own forecasts whether accurate, or inaccurate, do not provide much in the way of a basis for constructive action over the course of a year in the stock-market.
We find the forecasts of others as quite useful as we know from experience that they will be either inaccurate, or extremely inaccurate, especially those of professional economists. People who forecast a year-end number for any economic or market indicator without a low forecast as well as an intermediate high, are adding little, or nothing, to your chances of matching or beating the market indices. We re-visited today the forecasts of 9 major players who on 4 January 2010 made forecasts for the top 200 (XJO). None were correct within a 3% margin of error. The best was wrong on the high side by 9% and the worst was 17% wrong on the high side. Updated forecasts for 2010 year-end were made by another group of 14 forecasters, inclusive of the original 9, on 2 July 2010. Only 3 were correct within a 3% error margin, which means that 11 were wrong. The largest error was 10%. And that was with half of the year gone and knowledge of their propensity for error given their six month earlier forecasts and the basis for them.
We see the 2011 year as having stronger elements of revival provided that government stimulus is constructively withdrawn. Using George Soros’ word on reflexivity for a good part of the 2011 year the trend will be up and the bias will be supportive of the trend, but elements will emerge that give reason to focus on the possibility of a crash. Something more than a 10% retracement constitutes a ‘crash’ in our view.
QUICK VIEWS on calendar 2011 year-end from COMPASS (the first opinion), ECINYA (second) and SOT (third) dated 10/1/2011
- SP500…….UP/ UP/ Sideways
- XAO…………UP/ UP/ Sideways
- INTEREST RATES…. UP/ UP/ Sideways
- GOLD…. Sideways/ DOWN/ DOWN
- OIL……… UP/ UP/ UP
- $A………..Sideways DOWN/ DOWN
- $US……..Sideways/ UP/ UP
- HARD COMMODITIES…. Sideways/ Sideways/ Sideways
- SOFT COMMODITIES…….UP/ UP/ No Comment
- INFLATION…….. Sideways/ UP/ UP
Compass is an Ecinya confidant and a gifted technical analyst with a robust appreciation of economic and market fundamentals. SOT (The sage of Toukley) is a retired engineer and stockbroker with significant and actively managed portfolio positions.
BACKGROUND TO OUR HYPOTHESIS
The background to our 2011 hypothesis of our reference markets (XAO and SP500) rising to a peak of about 15% before falling over to be essentially flat, is twofold.
Firstly, is our belief that government in the developed world has now become too big having moved to around 30% of GDP and is significantly over-leveraged for the very worst of reasons – to encourage their re-election. This applies in greater measure to America, but also in significant measure to Australia. Australia’s march of folly has begun from a better base than in the USA. The second plank to our hypothesis is that the symbol economy of money and credit is wagging the real economy dog of production of goods and services. Monetary policy cannot offset the cascading effects of bad fiscal policy. Ben Bernanke is not Charles Atlas carrying the weight of the world economy upon his fiscal fiat money shoulders.
The March of Folly: Barbara Tuchman wrote "The March of Folly (from Troy to Vietnam)" in 1984. Across the pages of a big slice of history she describes various events that lead to her opening paragraph:
"A phenomenon noticeable throughout history regardless of place or period is the pursuit by governments of policies contrary to their own interests. Mankind it seems, makes a poorer performance of government than almost any other human activity".
The final paragraph in her book is clinically neutral and says: "We can only muddle on as we have done in those three or four thousand years through patches of brilliance and decline, great endeavour and shadow".
An intermediate paragraph that always captures our attention concerned the United States of America: "For two centuries, the American arrangement has always managed to right itself under pressure without discarding the system and trying another after every crisis, as have Italy, Germany, France and Spain. Under accelerating incompetence in America, this may change. Social systems can survive a good deal of folly when circumstances are historically favorable, or where bungling is cushioned by large resources or absorbed by sheer size as in the United States during its period of expansion. Today, when there are no more cushions, folly is less affordable."
From Ms Tuchman’s text immediately above the striking and agreeable words to us are "accelerating incompetence" and "when there are no more cushions folly is less affordable." ‘Folly’ in the Austrian school of economics is reflected in their focus on misallocation of resources. Economics teaches us that relative to wants and needs, resources are always scarce. ‘Cushions’ to us means things like balanced free enterprise with governments playing a role that guarantees or strives for integrity and transparency. However, as governments have become more opaque and less honest in their dealings with voters and taxpayers, the private sector has followed suit (especially large businesses) and become less opaque and less transparent itself for reasons of short-term profit maximisation and for survival.
Real reform is off the agenda until truth becomes politically fashionable and effective again. In the meantime we can rely on market trends being up for most of the year and the bias tending towards optimism. The Ninth Zurich axiom of Max Gunther says "Optimism means expecting the best, but confidence means knowing how you will handle the worst. Never make a move if you are merely optimistic".
ACCORDINGLY ECINYA’S AIMS FOR 2011 ARE –
- Preserve capital.
- Lock in some of the gains from 2010 early in 2011.
- Be more committed to fewer stocks over the course of the year knowing that stock selection is almost always vital. A few stocks that have the potential to surprise will be bought from time to time.
- Be prepared to move quickly and aggressively into cash from time to time.
- Pick some recovery stocks (e.g. media, building materials are possibilities, banks, some retailers later in the year perhaps)
- Pick some takeovers (Crane has been a good beginning, though we got the bidder wrong)
- Double digit returns.
- Out-perform the All Ordinaries by more than 400 basis points.
- Have a good dividend flow.
WHAT DO YOU NEED TO DO TO ACHIEVE OUT-PERFORMANCE?
We have long believed that out-performance can best be achieved by an investor learning to trade a reasonable proportion of his stake over the course of the year. The ‘buy and hold’ strategy is risky. The ‘buy and sell’ strategy is less risky. Our preferred approach is the ‘buy and trade-around-the edges’ of an investment portfolio which can be rewarding and can be fun. Occasional speculation is OK but do not confuse speculation with investment. Our speculative positions are generally confined to a few mining and bio-techs but we prefer possible recovery stocks that appear to be over-sold, and identifying possible takeover targets.
EXECUTIVE SUMMARY OF THE CONCERNS SURROUNDING OUR 2011 HYPOTHESIS
Australian Concerns –
- The current Queensland floods.
- Fiscal policy out of control and will get worse before it gets better,and may not get better at all in the life of the Gillard-Rudd-Greens coalition.
- China might slow down just enough to give us a dose of economic castor oil.
- Interest rates may stay uncomfortably high.
- Tax reform is off the agenda, pretend reform is on the agenda.
- Economic growth may be uninspiring below 3% in real terms.
- Policy positions on water management, electricity, climate change, national broadband, refugees, and welfare generally seem hopelessly inept.
- Lack of attention to small business.
- Political donations need to be banned and instead go into an electoral bank to be distributed on a formula basis. Too many cronies in the political ranks.
- The federal parliamentary term should be extended to 4 years with a minimum term of 42 months to give time for policy to work and/ or be fine-tuned.
- Liberal Party provoking Labor into bad policy e.g. the recent bank bashing exercise lacked perspective and balance.
American concerns –
- Crony capitalism has not dissipated under Mr Obama. Goldman Sachs, Bank of America, Citibank, and JP Morgan appear to be part of government providing personnel, market and donor support
- The Federal Reserve is outwardly non-independent promising to ‘print money’ as long as it takes. We hope that behind closed doors they are somewhat more independent.
- Trends in the US domestic deficit and current account deficit. America can afford its deficits but not an acceleration in the current trend.
- Lack of employment policies though this may be remedied by a successful implementation of the Dodd-Hagel Infrastructure Bank Act.
- Lack of effective savings plans e.g.compulsory superannuation Aussie style.
- House prices still in decline.
- Smaller commercial banks still being closed down.
- House prices still falling.
- Large state and local government budget gaps. California appearS to be insolvent.
- Energy prices still a problem.
- Paranoia over China leading to poor dialogue and lack of constructive communication.
- QE2? Where does it end?
- Need for structural reforms in taxation, probably a national sales tax.
- Continuing debate and lack of consensus and viability in health-care.
- Wall Street appears to have learned nothing from sub-prime and dot-com fiascos.
- Congressional grid-lock giving the impression that America is ungovernable.
European concerns –
- Germany appears to be the only European country with an established work ethic.
- Portugal, Italy, Ireland, Greece and Spain struggling on high sovereign debt loads.
- European response to austerity seems to be riots, looting and burning…. hellishly unproductive.
- The Euro seems to be a constraint when countries cannot devalue their way to recovery.
- Euro area growth projected by the IMF to move from negative 4.1% in 2009 to positive 1.5-1.7% in 2011, a muted recovery.
Asian concerns –
- China inflation and consequent policy tightening.
- China to decide how it wants to become a fully fledged member of the global community.
- Over-simplification to regard China as a country of economic geniuses. That mistake was made when Japan was growing exponentially.
- Japan still in the doldrums after several decades.
- India inflationary concerns.
Technical concerns/ watch-list –
- SP500 seems over-bought.
- Baltic Dry index, a reasonable proxy for world trade, is weak possibly indicating that China trade is weakening.
- The Shanghai A index is wilting.
- Chinese industrial production slowing.
Geo-political concerns/ watch-list –
- North Korea
- Afghanistan
- Pakistan
- The Middle east – Iraq, Iran, Israel, Palestine, Yemen.
MACRO EMBELLISHMENT OF THE CORE MESSAGES ABOVE
Nothing but the good news would embrace much of the following:
- Earnings rebound, interest rates are set at appropriate levels – not too high, not too low, confidence returns.
- Wall Street recognises that it has moved away from its prime function which is to raise, distribute and allocate capital to achieve economic progress. This means that banks have to as Paul Volcker says become ‘more boring’. Trading operations have to be stripped out.
- China seeks to become an adult member of the international community in word and deed. For our part that would involve something like changing the title of the Chinese Communist Party to something akin to ‘The China Central People’s Party’. reducing the size of their armed forces and denouncing extremism in strident terms on economic grounds, not religious grounds. Recognition of Tibet is an inconsequential issue at this stage of China’s development. People are better off working hard, educating themselves and being honest citizens than going to church.
- President Obama succeeds on several fronts but particularly in relation to the economy. This means progress on tackling the exponential rise in the domestic deficit, reining in Congressional spending by cutting programmes and expanding spending on national infrastructure. We are hopeful that recent changes to White House personnel are positives, particularly the new chairman of the National Economic Council.
- The Chinese and Asian consumer becomes a driver of the global economy.
- Austerity works for Europe and expansion then takes place on a timely basis. Austerity does not need to over-shoot.
- Fiat money works for everyone.
Ecinya’s major worry list considered to be of most relevance to the outlook for our market:
- Australian fiscal policy on a trend basis is veering toward being out of control and will be exacerbated by the National Broadband roll-out plus the flow-on and fall-out from policy errors in the various ‘revolutions’ of 2010 (pink batts, building education, asylum seekers, flu pandemic). Monetary policy has had to adjust for poor fiscal policy placing pressure on the non-mining states of New South Wales and Victoria. If the Gillard-Rudd-Greens government were a stock it would be on our avoid list. The Liberal coalition would be held on an underweight basis, but we would be inclined to move to market-weight if Mr Hockey were elevated to Kevin Andrews portfolio of Families, Housing and Human services where his talents could shine. Malcolm Turnbull could then move to Treasurer with special responsibility for National Broadband and Paul Fletcher could move into Communications and Broadband.
- Ecinya is not yet convinced that leveraging the public sector to de-leverage the private sector is sound economics. Debt is more disciplined in private hands (exclude major Wall Street bankers from this observation), and generally reckless in public hands.
- China slows more than is currently envisaged. The Chinese do not have a monopoly on economic wisdom or good economic behaviours. Ecinya well remembers when Japan was the miracle economy, a model for the developed world, when they benefited from a lazy and profligate America, American money and American know-how.
- A bubble developing in both hard and soft commodities led again by the villains and scallywags of Wall Street searching for a new bubble to exploit after the demise of dot-com, commercial and residential real estate bubbles.
- The US economy making little or no constructive structural changes in electoral reform, tax reform, employment, the domestic and current account deficits. A good first step would be stop blaming China.
- Europe may be ‘the calm before the storm’. The Euro currency was always a bad idea.
- North Korea, Iran, Yemen, Pakistan are all areas of potential conflict.
- Municipal governments and authorities generally around the world having too much debt and too little income, but particularly in America
- A Major Wall Street institutional failure not yet in evidence. Bank of America is probably on the list.
- American accounting standards always a cause for concern.
- The US Presidential election cycle for 2012 which begins in the fourth quarter of 2011. Because of crony capitalism America may well be ungovernable.
OUR HEAD NOTES FOR THIS ISSUE (moved to rear as requested by two of our confidants)
(1) Adam Smith, at least, lived to have high hopes for the new country. He thought it was normal for human beings to want to live in a prosperous society, but that it was also normal for them to live in a broadly just society. Their desire for self-improvement was in many ways mysterious, but in the end it was inherently social, rooted not only in the love of acquiring but in the love of haggling, bargaining, interacting – the whole work of building worlds out of wishes. What then moved men to make markets was ultimately their love of pleasure and happiness, and who Smith wondered, could live happily in a society where all the wealth had been confiscated and kept in a few hands? He believed not that markets make men free but that free men move towards markets. This difference is small but decisive; it is most of what we mean by humanism.
AFR 29/12/2010 – Adam Gepnik of The New Yorker writing on Nicholas Phillipson’s "Adam Smith: An Enlightened Life."
(2) The principal contribution that monetary policy can make to economic well-being is to maintain low and stable inflation. I think it is true to say that if you wished to forecast the path of the Australian economy, and you were able to have fore-knowledge of only one economic variable, the one you would choose is the path of the world economy. That is not to say that we have no influence over our own destiny – we can make the situation better or worse than it would otherwise be – but we cannot escape the influence of the world business cycle and the other factors that feed off it.
Ian Macfarlane, Governor of the Reserve Bank, 14/6/ 2005.
(3) All countries which accumulate debt and habitually run big current account deficits are vulnerable. And for many centuries societies have been susceptible to irrational booms, South Sea Bubbles, tulip bulb booms, and dot com busts. But no central bank can offset the cascading effects of bad government policy.
Peter Walsh former Labor Party Finance Minister, Financial Review 10/12/2003.
(4) The propensity of Congress to create benefits for constituents without specifying the means by which they are to be funded has led to deficit spending in every fiscal year since 1970, with the exception of the surpluses of 1998 to 2001 generated by the stock-market boom. The shifting of real resources required to perform such functions has imparted a bias toward inflation. In the political arena, the pressure to make low-interest-rate credit available and to use fiscal measures to boost employment and avoid the unpleasantness of downward adjustment in nominal wages and prices has become nearly impossible to resist. The American people have tolerated the inflation bias as an acceptable cost of the modern welfare state.
Alan Greenspan in "The Age of Turbulence", September 2007.
(5) Treasury was at its most influential during the term of the Hawke government, but I give credit for that to our greatest ever treasurer, Paul Keating, a man with a deep understanding of how to obtain and use political power, and who needed a purpose to fight for. Treasury supplied that purpose, affecting his conversion to economic rationalism. Treasury’s highest institutional objective has long been to dominate the economic advice going to the government, and no secretary has been more successful in this than Ken Henry, thanks to the arrival of the deeply insecure Rudd government, which sought to hide behind the authority of the supposedly independent Treasury.
Ross Gittins, The Sydney Morning Herald, 27/12/ 2010.
(6) Labor should just stop meddling with the markets: History shows Julia Gillard and Kevin Rudd always can be trusted to do the wrong thing……..Gillard, god bless her, is less inclined to write a treatise on economics during her holidays, but it would be hard to find someone less qualified to understand markets than a union lawyer who was a member of the Socialist Forum for the best part of her adult life. With Australia’s economic growth figures for the September Quarter on a precipice at 0.2 per cent, Gillard wants to introduce a tax on mining, the one thing that kept Australia out of recession these past few years, and then get to work on a carbon price….. and legislate against exit fees in home loans, a measure that non-banks assure us will make them less competitive. The truth is that the Gillard government has the same chronic problem that crippled the Rudd government: neither incarnation seems to have the faintest clue about markets. Watching them blunder through each fresh initiative leaves you with a feeling of helplessness reminiscent of being an audience member at a kid’s puppet show.
Gavin Atkins, www,asiancorrespondents.com, The Australian 28/12/2010.
(7) Investors have nothing to fear but the lack of fear itself. The debt situation in Europe is deteriorating. Inflation threatens to derail emerging market economies and the US faces a time bomb with its own sizable debt. Yet in the face of all these hazards the stock-market is hitting two-year highs and investors are feeling more bullish than they have in years. UBS strategist Jeffrey Palma said: "Given some of the uncertainties in the world, it seems pretty tough to believe that we can hold sustained levels of low volatility through the next year."
Ben Levisohn, The Wall Street Journal 27/12/ 2010.
OUR QUOTES EXPLAINED (90% of the message is in the head-notes).
(1) Adam Smith is most famous as author of "Wealth of Nations" and his thesis that the ‘invisible hand’ of enlightened self-interest pursued by men of integrity would promote pervasive prosperity. Ayn Rand appears to have built her philosophy of ‘Objectivism’ on Mr Smith’s various writings.
(2) Australia needs to regularly remind itself that it is about 1% of the global economy and act accordingly. Though we participate above our weight there is a recurring tendency for our political leaders to exaggerate our place in the world and pursue policies that are against the national interest and to squander the proceeds of our resources boom
(3) The Hawke-Keating-Walsh Labor trio got the balance about right and the first term, and a bit of the second term, of the Hawke government advanced Australian prosperity enormously, overcoming much of the malaise and regression under the Whitlam and Fraser administrations. Mr Walsh from retirement has branded Mr Rudd an ‘economic illiterate’ and there is currently no reason to suppose that Ms Gillard is significantly different than her predecessor.
(4) Alan Greenspan’s memoirs are something of a mea culpa as he was a terrible central banker who failed to realise that bubbles were being created in the American banking system and too often pursued monetary policies to favour the White House President who had appointed him. He has come to realise that America has become indulgent and profligate, borrowing and printing money to pay for recurring expenditures including defence, war and welfare.
(5) Ecinya cannot entirely endorse Mr Gittins’ remarks on Ken Henry but we were interested to reflect on his use of the phrase "deeply insecure Rudd government", an observation which we wholeheartedly agree with. Mr Rudd seems destined to live and travel with his insecurities. However, at this point in time we can also find elements of ‘insecurity’ in both the Liberal alternative (a crazy paid parental leave scheme that missed shadow cabinet scrutiny, Mr Hockey remaining in the Treasury portfolio), and the incumbent Gillard-Rudd-Greens coalition where insecurity is evident in excessive debt loads, waste and extravagance. The Hawke-Keating-Walsh- Howard-Costello budget bonanza has gone. Mr Henry should have refused to undertake his Tax Policy Review without inclusion of the GST and to have protested the government response to the bulk of his recommendations.
(6) Ms Gillard, Mr Swan et al are no students of Adam Smith nor, closer to home, of the past success of the Hawke-Keating-Walsh-Howard-Costello years. Government is now running at close to 30% of the national economy, instead of a more manageable and balanced 20-22% forcing the Reserve Bank into tightening when it should be able to think about reducing interest rates. Fiscal policy waste could have been channelled into sustainable tax reform.
(7) Wishful thinking is the enemy of hard work, and despite the fact that we have begun a happy new year, the torment and strife that characterised much of 2009 and 2010 is still with us. Necessary progress on recognition of problems and implementation of sustainable solutions is still somewhat elusive.