Cystall Ball for 2011

Putting up a crystal ball for the future is a risky thing. Nevertheless, it is a good exercise to mull over all the various factors that will affect the market for next year, set a direction and develop a trading plan from a high level perspective.

I believe I will be 70-80% correct in my forecast. But if I am 50% right on the forecast, it will be considered an achievement taking account into the all changes and dynamism on the market. At 50%, I will make money considering the factor majority of my trades are hedged. In addition, there are risk control actions that will limit my loss when  I am wrong.

Despite the conviction I have on the directions of gold, stocks, currency, commodities or even the economy, there is no such thing as buy and hold position.  I am a trader. If fundamentals and technical change, I reverse my trades. There must be no preconceived ideas or prejudice.

My key trading strategy is to “catch and latch” to the trend. A variety of techniques are explained in the various parts of my blog. These are tools I had used successfully and will continue to deploy it on my trades.

So lets start with examining the bulls and bears argument for the market in 2011.

Bullish View

·       Current yield curve is very positive for banks. The financial sector should continue to outperform

·       Earnings momentum is strong and will probably positively drive the market for another quarter or two. There are so far no signs of slowing down

·       Corporations have plenty of cash on their balance sheet. Thus, M & A activities should continue into 2011 which is positive for the market. With the high cash level, dividend will increase and there will be more buy back of stocks.

·       One of the factors for the bullish market in 2010 is continued boom in technology sector. Internet infrastructure is undergoing a major overhaul with increased applications of media streaming, cloud computing, e-commerce  and smart phones applications. Corporation will be forced to upgrade their infrastructure. Technological companies and its users will continue to outperform. In 2011 we have seem astronomical rise in stocks like Apple, Netflix, Priceline, Amazon, VM Ware and Akamai. The excitement in the technology segment will continue.

·       While unemployment remains high, it is showing signs of improvement. The huge stimulus by the Fed is taking effort. Besides keeping interest rates low, hopefully it is driving corporation to hire.

·       US stocks will  trade higher despite the economic conditions and rising interest rates. Corporate profits will be maintained as cost-cutting measures and lack of spending allow businesses to maintain reasonable profitability. There are few other places to put capital to work. Asset inflation will cause price of fundamentally sound stocks to go up.

·       Valuation is still reasonable.  It is trading at 13.6 X forward four quarters. This is moderately cheap although it can easily go cheaper.

·       ISM index is the big surprise. It was the highest in 20 years!

.     2010 ended with consumer sales went up. How consumers manage to spend more with more mortgage default and unemployment remains a puzzle to me. However, one must not forget that 30% of the consumers are responsible for the sales. These are people that probably do well in the recent bull of the stock market. However, there are signs of strains:

• Walmart is 10% of US retail sales, has 150 million customers, and its stock it is down 6 consecutive quarters;
• Sears is the largest department store in America: "their stock is terrible"
• Best Buy had a huge earnings miss
• Toys'R'Us loss increased last quarter
• A&P filed bankruptcy
• Loehmann's filed bankruptcy
• Charming Shoppes is going to close 100 stores
• TJMaxx just liquidated AJ Right

Bearish View

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·       One of the biggest threats is that Europe will implode. It is almost inevitable that one of the countries like Ireland, Greece or Spain will default. If one of the countries decides to default, it will cause a domino of negative effects possibly causing the Euro to collapse. The situation is still very ugly. There are no signs of a good solution. So far, actions are mere band-aids. There will be continued effort of bailout through printing of money otherwise also known as quantitative easing, as they do not have the funds to support.  Undercurrent for bailout is losing steam but the need is rising.  Very visible recently is the collapse of the Ireland and Greece. Increasing there are reports of stress in Italy and Spain. In the Telegraph, there is a report of Italy's debt reaching the red alert. Keep in mind is that Italy and Spain have economies that are over 10 times the size of Ireland and Greece. Both these nations are under tremendous stress.  A bailout of Italy or Spain will spell the beginning of the end for the euro. No way can Germany support a bailout of either country.

·       Another big negative is the US Budget deficit and debt. It is a problem for many years but will continue to haunt the economy. The figure is accelerating. The latest count is the debt is US$14 trillion.  It is translated to $680,000 per household. US is bankrupt. There is no way they can repay the debt.  The only foreseeable solution is for US to devalue its currency selectively without causing geopolitical chaos. That is the reason asset prices and commodity will continue to go up.

·       Probability is Bernanke and the Fed will launch QE3/4 in response to the housing and municipality crisis, as well as to ward off the potential sell-off in the financial markets. The “audit the Fed” talk heats up and this becomes Bernanke’s last stand. However, the economy is saved by the thought that it “needs to get worse before it gets better” and that the “extend and pretend” policies of 2010/early 2011 are finished. Each successive bailout will produce smaller and smaller effects until systemic risk hits all at once. The world’s central banks are in fact powerless to stop systemic risk once contagion hits.

·       There are arguments on deflation and inflation. Arguably, housing price goes down and high unemployment will keep prices down. I know when I travel, I am paying the same price or lower for airfares and hotels compared to what it was 20 years ago. But commodities, gas, and even tuition fees for colleges have gone up. My bet is on inflation.  When it comes, it will surprise the Fed chairman who is confident to control it within “15 minutes” as he claimed during the 60 minutes interview. It is too simplistic and obviously he is lying.

·       Potentially, the bubble in China housing market is worrying. It has all the signs and symptoms of US housing market in 2007.  The only difference is China has a huge surplus that could help to control the crisis when it hits. Also, they are taking pre-emptive actions by restricting credits with regular interest hikes and setting new regulations to defuse wild speculations. Nevertheless, the crisis will hit. But question is how severely it will affect China. My bet is that China will be able to contain the crisis and recover. Also, it may take a little longer for the crisis to hit. The situation is certainly better that what is happening in Europe.

       We must not forget there are many toxic assets, “market to market” collaterals at banks, assets at  Fannie and Freddie that are not recognized. These are ticking nuclear bombs for the financial sector. Foreclosure is still an issue not resolved. Housing price is still going down.  Thus despite the yield curve today, I am staying away from the financials with a 10 feet pole. I have been wrong so far. But I will be right some day..

Summary

My bold forecast is that market is over extended. There will be a correction within 10 weeks of magnitude of up to 10%. Sentiments are far too bullish. It is at the most extreme levels since 1965 and 1958. We were in a similar situation at the end of 2010. The market went into a correction lasting a few weeks.  A similar scenario may happen this year. Probability is that market will again rebound after the correction and do pretty well baring any external crisis kicking in like default of one of the countries in Europe, China housing bubble burst and one of the municipalities in US default and declare bankrupt.

Commodities will continue to do well. I will continue to be bullish for gold and silver. I will add coal, palladium, oil, and agriculture into my list. All these commodities are very over extended. But as with all bull market, it can continue for a while. But it also can undergoes a correction before it goes up. Thus, the ability to trade will give one an edge.

Many times, the market can be totally illogical for an extended period of time, I will keep in mind not to get emotional over the issues but understand that the fundamentals will catch up.  The market has gone considerably in 2010 especially from September to Dec. The Dow Jones Industrials rose 11%, a second straight year of double-digit upside. he S&P 500 rose 13%, also the second straight year and the first time recording back-to-back double-digit gains since 2003-2004. Let the “don’t worry be happy” sentiment moves on. I am certainly watching for a reversal anytime especially a quick correction before moving up again.

Although the VIX index is low now, volatility will be high again.  It is the new paradigm. There will be increased uncertainty

US$ will be down. I watched CNBC on Friday on the interview with Peter Schiff. I cannot understand how they argued that US$ will be up. It is up against the Euro but down against most major currencies It may get a bounce again if Europe crisis worsen. But, in the long term trend is down as with what is going on the past decade.

I am on the inflation camp. So I am betting interest rates will go UP.  I will continue to be bullish on TBT. I have been totally wrong on TBT in 2010. Currently, I am collared on TBT and still positive on my trade. I am betting it will give me double digit gains.