Archive for Strategy Lab

10 Questions (and Answers) for 2013

I’m doing a pre-emptive Q&A this week covering a  macro view of 2013.  I generally don’t believe in forecasting a full year out because I think it’s impossible, but that doesn’t mean we can’t provide some general guide posts for the year given what we currently know.  I usually update these views on a quarterly basis (more frequently through the research with specific market views) so this is probably more like a Q1 outlook with some vague 2013 commentary.  And unfortunately, because the fiscal cliff remains unresolved a lot of this is just pure speculation….But I hope this helps frame the big picture for you.

1) What Will Happen With US Fiscal Policy?

With the fiscal cliff still entirely unresolved this one remains a bit hard to decipher.  A worst case scenario of $500B+ in cuts to the 2013 budget would drive us down from 2012’s $1.1T budget to something in the $600B range.  With a private sector that is still de-leveraging and unable to run with the baton since the damage of the credit crisis has been inflicted this would obviously have very damaging effects on the economy.  Recession is a near certainty in a worst case scenario.

The more likely scenario is moderate cuts and another year of economic muddle through as the budget deficit remains large enough to offset a healing private sector.

Downside risk: The obvious risk is Washington.  A poor outcome on the fiscal cliff means an already fragile economy will be driven into recession.  I am substantially more concerned about recession in 2013 than I was in 2012 as the risk of austerity is higher.

2)  What Will Happen with US Monetary Policy?

This one looks like a no-brainer.  The Fed has been pretty clear that they’ll remain accommodative through 2015.  The recent change in communication and timing made it clear that they’ll be on hold until the unemployment rate drops below 6.5%.  Even in a best case scenario the unemployment rate likely won’t hit 6.5% until the middle of 2014 so it looks like we’re in accommodation mode for the duration of 2014.

Downside risk:  Ben Bernanke is likely to step down in 2014.  Could he become less accommodative later in the year in order to create flexibility for a smoother transition?  Or could policy take an unexpected turn due to the uncertainty that is likely to develop in the market surrounding this event?

3)  Is the US Economy Headed into a Recession?

I’ve been pretty vocal over the last 18 months since the ECRI came out with their recession call.  I said the US economy would not enter a new recession in late 2011 or 2012.  The thinking was relatively simple.  Because the US economy remained in a balance sheet recession you had to throw all the past historical data out.  None of the models applied to what we are going through.  What did apply was understanding how the US economy was de-leveraging and that meant the private sector was too weak to sustain growth on its own.  That meant we needed the public sector to pick up the slack.  You’ve probably seen this chart (or some version of it) a million times here:

What happened to the US economy was an unprecedented collapse in private investment.  Normally, the private sector alone can bring us out of a recession.  But this was no ordinary recession.  Private investment cratered over 20%.  This was beyond unusual.  It meant the private sector was flat on its back.   And more importantly it meant that the huge public deficit was supporting incomes, driving revenues, and generating an economic “flow” where there wasn’t one.

It’s kind of like the office building called the US economy was burning down and the indoor sprinkler system stopped working.  A balance sheet recession isn’t merely a contained one office fire.  It has the potential to wreck the building.  So, what was needed was an outside flow.  That arrived in the form of government spending.  It not only put the fire out, but saved the building from collapsing.

Anyhow, it’s hard to tell whether there will be a recession in 2013 due to the fiscal cliff circus, but if we get a relatively sane response then the budget deficit should remain large enough to support the private recovery in 2013.  On the other hand, in a negative cliff outcome the US economy almost certainly suffers the European fate of austerity in a BSR and enters recession.  I am going to make the insane call of assuming politicians will do the sane thing in the next few weeks and avoid a major budget catastrophe in 2013.  Therefore, I still don’t see the recession in the USA this year, but the odds are substantially higher than they were in 2012.

Downside risk:  It’s all about the cliff.

4)  Is Global Growth Going to Slow?

Global growth appears to be stabilizing.  The USA has maintained a muddle through environment, Europe has been mired in recession and Asia has stumbled a bit in late 2012.  But that third leg of the stool (Asia) appears to be turning a corner.  This has been apparent in global PMI data where the GDP weighted PMI is turning positive for the first time since early 2012.  I think global GDP should stabilize further in 2012 largely on the back of a stabilizing Chinese economy.

Downside risk:  The Chinese government fails to act in front of a still very fragile economic environment.

5)  Is the Euro Crisis Over?

The Euro crisis never ended.  As I’ve explained before, this remains a currency crisis and not a banking crisis.  The problem in Europe is that the Euro remains unworkable.  The single currency system has locked its users into a fixed exchange rate regime without a fiscal rebalancing mechanisms.  In other words, unlike the USA (which is almost perfectly analogous to Europe’s union) there is no central treasury to rebalance any imbalances.  Most people aren’t aware of the fact that the USA is actually a huge fiscal transfer union.  The wealthy states pay more into a system that redistributes funds to weaker states.  This helps eliminate the solvency concerns and trade imbalances that naturally develop in any fixed exchange rate system.

Europe has no such arrangement so the only rebalancing mechanism is through painful austerity and time.   The result is depression in many regions. Unfortunately, there hasn’t been any permanent fix to this problem.  Instead, the ECB has implemented a series of measures that help reduce the solvency risk at the national level which brings private bond buyers back to the market, but this is far from a permanent fix to the underlying economic problems in the region.  The Euro crisis remains one of the primary risks to the global economy.

Downside risk:  The big risk is civil unrest which leads to potential defections and defaults.  The citizens of Europe are unlikely to put up with depressionary economics forever.

6)  Where is US Employment Headed?

Last year I said we were making “baby steps” in the right direction on the employment front.  Understanding the balance sheet recession has been all about understanding the growth of private credit.  As the lifeblood of our monetary system private credit tends to correlate with the unemployment rate and rate of hiring.  The one positive trend we’ve seen on the employment front is the beginning of gains in private credit accumulation.  As you can see in the chart below, private credit (inverted) is beginning to turn the corner.  The process is slow and remains incredibly fragile, but it’s moving in the right direction.  I don’t think it’s unreasonable to assume that the unemployment rate will drop below 7% this year for the first time since the crisis flared up.

Downside risk:  Again, it’s all about the cliff and austerity.  Austerity would hurt private balance sheets and likely cause a freeze in credit accumulation and hiring.

7)  Will High Inflation Finally Arrive in 2013?

In 2012 I expected disinflation leading to a level where the Fed would feel comfortable intervening with QE3 around the middle of the year.  I’ve been lucky predicting inflation in recent years.  Looking forward, we’re likely to see many competing forces on the inflation front in 2013.  Oil prices are still very high, credit trends are improving, government spending remains high and yet hourly earnings are still near rock bottom.  Ultimately, I think the two primary drivers will be credit trends and hourly earnings.  Continuing weak demand for credit and virtually zero earnings power on the labor front will continue to suppress inflation.  Contrary to popular opinion, I am not a deflationist and haven’t been for many years.  So, I see positive inflation, but low inflation in 2013.

Downside risk: Or should I say “upside risk”?  It is definitely oil prices.  A repeat of something like 2008 cannot be ruled out.  Particularly with the volatility in the Middle East.

8)  Will hyperinflation finally come in 2013?

I’ve had a lot of fun over the years at the expense of the hyperinflationists.  But that was mostly in trying to create a teachable moment about the way our monetary system works (see here for more). As I’ve long predicted, hyperinflation is not a serious risk in the USA because hyperinflation is far more than a monetary phenomenon and none of the conditions that precede hyperinflationsts are present in the USA.  I would place the risk of hyperinflation in the USA in 2013 at approximately 0%.  I’d go negative if I could.

Downside risk:  None.  I honestly don’t think there is any risk of hyperinflation in 2013.

9)  Should You Buy a House in 2013?

5 years ago I was a big housing bear.  I wouldn’t say that I’ve done a 180 here, but I’ve definitely become much more constructive on housing in recent years (see here and here).  The keys in the housing market has been sizable declines in inventory, vast improvements in affordability, improving price to rent ratios and substantial price declines across the nation.  I still think we’re in the midst of a post-bubble “workout”.  Like most bubbles, it’s highly unusual for prices to bounce back quickly.  Instead, we’re likely to see a flat-lining in prices.

Despite the many calls for recovery this year, I still don’t see a big recovery in housing.  That said, I also don’t see great downside in prices.  We’ve already had a massive decline in real house prices so I think we’re most likely to see moderate gains at best in 2013.  If you’re looking to buy a home in 2013 and you’re looking to live in that house then I think the downside risk are fairly limited.

Downside risk:  I hate to be a broken record, but the risk here is in the fiscal cliff and the potential that incomes from government spending decline substantially which puts downside pressure on the economy.

10)  What Will Happen to Corporate Profits in 2013?

Last year I predicted that corporate profits were likely to come under pressure for the first time since 2009.  As Q3 operating earnings come in at just 1% I think that has become a reality.  There are a lot of moving parts here, but the likelihood of slow corporate profit growth is likely to continue into 2013.  Revenues are slowing into the low single digits, corporate profit margins are high and profits have soared on the back of the large budget deficit.  I think the risk to all of this is to the downside.  I am much more concerned about a profits recession in 2013 than an economic recession.

Downside risk:  Again, understanding the Kalecki equation shows us that corporate profits have benefited enormously from the large budget deficit.  If the fiscal cliff results in a substantial decline in the budget in 2013 we should expect a profits recession.

Credit Suisse: 6 Reasons to be Bullish

In the face of increasing uncertainty and economic weakness we can always count on one of the big banks to find the bullish case (via Business Insider):

“We are positive on equities as:

1) economic lead indicators, although beginning to soften, are consistent with reasonable GDP growth forecasts;

2) dovish central banks and synchronized QE are the end game;

3) rising global excess liquidity is consistent with a c10% re-rating;

4) valuations relative to bonds are still attractive;

5) equities remain the hedge if, as we expect, long-term inflation expectations rise;

6) positioning is still cautious.”


David Kostin, chief U.S. equity strategist at Goldman Sachs has bucked the bullish trend in the first few months of the year after having been bullish for a long time.  Kostin vocally called for S&P 1,250 despite the persistent rally in the first 4 month of the year (see here).  Kostin now says the S&P is likely to end the year down slightly at 1250 (4.2% lower than today).  He broke his reasoning down based on three big trends:

1.  Stagnating US economy.

2.  Multiples are likely to stagnate

3.  Earnings growth is slowing.

Kostin says the S&P is likely to earn $100 this year and that margins are likely to contract.  I think his positioning is totally rational given my own outlook for earnings and the very low upside potential and substantial downside risks heading into the latter portion of the year (see here for more on that).

Kostin also outlined Goldman’s hedge fund monitor and the stocks most aggressively accumulated and most owned by hedge funds.  Goldman’s hedge fund VIP basket recently added the following names:

Barrick Gold (ABX)

Berkshire (BRK)

Calpine (CPN)

Devon (DVN)


Capital One (COF)

Salesforce (CRM)

Ebay (EBAY)


Ford (F)

Hertz (HTZ)

Rock Tenn (RKT)

Equinix (EQX)

Hess (HES)

Illumina (ILMN)

WellPoint (WLP)

The names most DROPPED by hedge funds are:



McDonalds (MCD)

Amazon (AMZN)

WalMart (WMT)

Exxon (XOM)

The 5 names most owned by hedge funds are:

Apple (AAPL)

Express Scripts (ESRX)

Google (GOOG)

Microsoft (MSFT)

Qualcomm (QCOM)

You can see the full Kostin interview at CNBC.


By Walter Kurtz, Sober Look

Hedge funds have been known to move stock prices, sometimes dramatically raising volatility of specific shares. Here are two latest trends on hedge funds’ equity holdings that may have some impact on equity volatility going forward.

1. Investment allocation in small-, mid-, and large-cap stocks for an average fund is about a third for each of these categories. So one would think that by taking the full hedge fund universe, it would be equally weighted across the three capitalization groups. But that is far from reality. Small hedge funds like small-cap stocks and large ones prefer large-cap stocks. It means that as the large funds become even bigger, the overall percentage of large cap stocks within the hedge fund universe should rise (simply because large hedge funds control a bigger portion of the total hedge fund assets). That has indeed been the case, with small caps representing only 17% of the overall hedge fund equity AUM.

Source: GS

2. Hedge funds run highly concentrated portfolios. The latest numbers from Goldman indicate that top 10 positions make up some 64% of hedge fund equity portfolios. That compares to 34% for large-cap mutual funds. Such concentrations indicate that hedge fund overall performance is driven by just a few stocks.

Source: GS


Combining 1 and 2 above tells us that certain large-cap stocks could experience dramatic moves, as hedge funds change positions in these names. Large concentrations and significant holdings could result in some outsize volatility.


Here we go again.  It’s all about Europe.  And now we’re all in wait and see mode on Greece and whether they’ll default and defect and possibly trigger the Lehman 2.0 scenario that so many have been worried about for years now.  In many ways this market has a 2008 feel to it.  I wouldn’t say it’s quite the same because the global economy had been on a 5 year credit binge just waiting for a negative catalyst that came in the form of house price declines.  Today’s environment is a little different.  Back then we were Mike Tyson walking around sticking our chin out and taunting the idea of recession and a knock out punch.  Today, we’re Mike Tyson fumbling around looking for his mouthpiece after the Buster Douglas knockout blow.   We’re barely on one knee.   So kick us over if you want – we won’t fall very far.  In the case of some European nations we’re not even talking about being on one knee.  Spain and Greece for instance, are flat on their backs, barely breathing.  They didn’t get hit by Buster Douglas.  They were hit by a Mack truck that kicked it in reverse and came back to run them over just for good measure. So my decoupling call for Europe is still on.  I just don’t see how they pull out of this tailspin without some sort of unified action….The USA is recovering, but still weak.

I still don’t think the USA is on the verge of a renewed recession, but I know the risks are rising.  My worst fear is that all this chatter of a “fiscal cliff” is paralyzing corporate America to the point where business investment is going to come to a halt from its current crawl.  The one really positive sign in recent quarters has been the continued recovery in business investment paired with the government budget deficit.  This is all part of the balance sheet recession healing process.  But we’re at serious risk of this process coming to a stop.  And recent rhetoric out of Congress regarding the debt ceiling isn’t helping matters.  So I admit that the risks of recession are certainly rising, but the data isn’t there yet to convince me that my long-standing “no recession” call needs to be changed.

As for the markets – it’s a mess out there.  Messier than I thought they’d be.  And that’s coming from a guy who was building a short position all the way up to SP 1420.   But I was a buyer in small bits on Thursday.  My indicators aren’t raging bullish, but I do think we’re beginning to see some fear levels and market action that is generally consistent with a market that is a bit overdone on the downside.  We’re seeing lots of extremes in different markets with the Euro tanking, Treasuries spiking and equities getting bludgeoned in a matter of weeks.  The bears are betting on a worst case scenario and if Europe stays true to their actions of the last few years the bears will once again find themselves on the wrong side of the trade resulting in a rip your face off style move against them.  I wouldn’t get wildly bullish here because the worst case scenario is certainly not off the table.  But from a risk management perspective I certainly feel better about owning equities 8% cheaper than they were just a few weeks ago….


Jeff Gundlach just wrapped up another conference call and he made some good (and bad) insights.  Here are the key takeaways:

  • He says Greece is likely to leave the Euro as the situation continues to spiral out of control.
  • Spanish equities are a decent risk-on asset if you have to choose something in Europe.  But he’s not sure if you’ll make money….
  • He seems to be joining the Kyle Bass team with regards to Japan’s debt situation….
  • Germany is near a recession.
  • The long natural gas, short Apple trade has performed well so far….
  • QE3 is more likely after recent economic data.
  • Keep an eye on the week of June 18th where we have a big Fed meeting, another European leader’s conference and implementation of the Volcker Rule.
  • The Fed won’t raise rates unless CPI gets very high.  He says those who think we’re reliving the 70’s are wrong.  “It’s not gonna happen”.
  • He says housing in the USA has not bottomed even though it’s becoming fashionable to call the bottom now.  Housing will “bumble along”.
  • There’s not a great deal of downside in 10 year yields….
  • Gold is a reasonable thing to own here….


By Robert Balan, Sr. Market Strategist, Diapason Commodities

There has been a lot of debate about the end of the “Commodity Supercycle” in recent days. The subject came up along market speculations that a hard landing will take place in China, and that the “miracle” is “over. The premise here is that if the infrastructure development of China is over, then surely the so-called “Commodity Supercycle” is over.

Could this meme be correct? We disagree with those notions on five counts: (1) We do NOT believe that China is in for a hard landing (we expect higher growth in Q2 2012), and (2) even if China’s growth ratchets down from “boiling” to “simmering” that does not necessarily mean an end to the upward trend in commodity prices as other emerging countries and even OECD economies would soon take up the “slack” from Chinese demand moderation;

(3) a China paradigm shift from investment to consumption does not necessarily derail the commodity gravy train — it just rearranges the order and the number of the train cars; (4) the Fed’s reaction function almost guarantees that rates will stay low too long again, and will likely re-ignite inflationary pressures in a 1970 context; and (5) the “commodity supercycle” being discussed is not really a “Supercycle”, but only a “boom” in a longer, larger, higher-amplitude period of economic activity (the “Long Wave” or “Kondratief (K) Wave”) which could top out in sometime in 2022-2026.

Read the full report attached below:






By Charles Rotblut, CFA, AAII

“Sell in May and go away” is strategy that some investors and traders are likely contemplating right now. The adage is based on the historically weaker performance of stocks during the May through October time period. Adherents shift from stocks to cash at the beginning of May and then invest back into stocks at the start of November.

Historical performance shows there are best and worst six-month periods for stocks. Jeff Hirsch at the Stock Trader’s Almanac calculates that the Dow Jones industrial average has an average return of just 0.3% during the worst six-month period (May through October) since 1950. Conversely, during the best six months (November through April), the Dow has an average gain of 7.5%. Sam Stovall at S&P Capital IQ says the S&P 500 has risen by a mere 1.2% during the average worst six-month period, while rising 6.9% during the average best six-month period. (Sam’s numbers go back to 1945.)

Certainly, last year made selling at the end of the April seem like a prudent decision. From the end of April 2011 to the end of October 2011, the Dow lost 6.7%. Using the October 4, 2011, intraday low as the endpoint, the drop worsened to 19.1%.

As we reach the end of April this year, the problems in Europe that caused last summer’s weakness (e.g., Greece’s sovereign debt) have not gone away. Plus, Spanish bond yields have recently risen, French president Nicolas Sarkozy is in a closely contested run-off, the Dutch coalition government has collapsed and Britain’s economy is contracting. In Asia, China’s economy has shown signs of slowing, and Standard & Poor’s just lowered its outlook for India. In the U.S., many politicians remain more interested in bickering and getting quoted than agreeing on long-term solutions.

Even with these legitimate concerns, things could still go right or, at least, conditions could hold up well enough to support stock prices. Europe could simply muddle along, as opposed to worsen. China’s economy may slow less than forecast. Gasoline prices in the U.S. may have peaked (fingers crossed). The U.S. economy may maintain its uncomfortably slow, but ongoing, recovery. (The Federal Reserve boosted its 2012 GDP growth projections yesterday.) Plus, low valuations could limit any downside to stocks. (The S&P 500 is trading with a forward-looking price-earnings ratio of 12.9.)

You also need to consider the downside of selling stocks. Yields on six-month Treasuries are 0.14% and says money market accounts are yielding 0.46%. Your broker will charge you commissions for selling stocks, and if you sell shares in a taxable account, the IRS will bill you too. Then there is the question of when you will get back into stocks. Were you buying during last August’s or October’s lows, or were you selling? What about at the start of last November?

My cracked crystal ball cannot predict how much or how little downward volatility we will see over the next six months. Given how strong the first quarter’s rally was, a summer pause in the markets would not be surprising, but a pause is far milder than a correction. Then again, if global (or domestic) economic conditions surprise to the upside, summer flowers may not be the only thing blossoming. What I can say is that you will be taking a risk either way, but over the long term, stocks reward those who take prudent risks.

A middle-ground strategy is to see if your portfolio allocation is still close to your targets at the start of May and the end of October. If your allocations are more than five percentage points off target, rebalance. For example, if your strategy calls for a 60% allocation to stocks and stocks currently account for 66% of your portfolio, reduce your stock allocations back to 60% and shift the proceeds into the asset class that is currently underweight (e.g., bonds). This allows you take advantage of the best and worst six-month periods by selling high and buying low, while still adhering to your long-term investment plan. (If you are unsure as to how you should be allocating your portfolio, our Asset Allocation Models may help.)

Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors and editor of the AAII Journal.