Year End Prediction Follies

As we approach year end, we can confidently expect the number of predictions for the markets in 2011 to rise. Some of it is good harmless fun (why think of the big picture only once a year?) but most of it is based on rigorous research, hard work and solid preconceptions. Since most of the research and work is focused on supporting the preconceptions, the result is the usual range of expectations that plot along a broad spectrum from the dire to the hopelessly optimistic.

Which one should you choose? Frankly, any one you like. It does not matter because the financial markets will probably steer another wobbly course like it did this year. Fortunately, that course was generally positive in 2010. There is no guarantee that it could not be mildly negative in 2011.

Bond Vigilantes

We are not looking for any particularly dramatic outcome next year. The bond vigilantes have pushed 10 year government paper up a bit around the globe and might push interest rates up a bit further but there is no serious demand for credit. You might scratch your head and wonder how that can be. In the land that invented the modern credit card, take a look at the falling balances.

Central Banks to the Rescue?

What about all the government debt that is being issued? Well, much of that is being issued to bail out banks by buying dud assets (Irish sovereign debt, anyone?) at or near par value. There is a big accounting game going on in financial centers all around the world to make sure that the banks do not start falling like dominos. If you need to brush up on the game, I found a fun site that took me back to my days as a runner on Wall Street (back when stocks and bonds were printed on paper). I actually won $20 once as the “mark.” OK, OK, I lost it back later that week.

Confused Like Chairman Bernanke?

It is OK to be a bit perplexed but one does not expect confusion from the Chairman of the Federal Reserve, Ben Bernanke. In the space of 21 months, he appears to have executed a complete 180 on the impact of Quantitative Easing. For a man who has built his substantial academic reputation in Economics on what he identified as the central mistake of the Great Depression (failure by the Fed to provide sufficient liquidity), this is not a trivial issue.

Last week, we posted the recent 60 Minutes interview where Mr. Bernanke defended his decision to embark on a second round of Quantitative Easing (QE). The strong denial of “the myth” that QE had something to do with “printing money” was a surprising statement to say the least. I actually replayed it several times to make sure that I had not misheard. As a reader of a blog called Pragmatic Capitalism, I thought Professor Bernanke was engaging in a bit of academic “hair splitting.” Perhaps he was talking about Modern Monetary Theory (MMT). But the answer (or at least clarity) came from an unexpected source: the comedy writers at The Daily Show. In a three minute segment, Jon Stewart played a part of the recent 60 Minutes interview which showed Mr. Bernanke saying “we’re not printing money” in reference to QE2. Then he played a previous 60 Minutes interview which showed Mr. Bernanke saying “it’s much more akin to printing money” with regards to QE1 in March of 2009.

At best, Mr. Bernanke appears confused about what Quantitative Easing means to the financial system and the economy. At worst, it looks like he is trying to pull a fast one. Which is it? Unfortunately, it is a bit of both. QE was the prescription for Japan proposed by Mr. Bernanke as well as others throughout most of the 1990s. Although it has been argued that the BoJ did not execute correctly, QE failed to produce the expected results in Japan. John Hussman’s November 1st letter argues that any increase in reserves is taken away with lower velocity of money (Heading “Fed Policy and QE”, second paragraph) suggesting that it is unlikely to work anywhere. As for pulling a fast one, the truth is that the Fed has almost no leverage to restart the economy with short term interest rates near zero. With low, flattish velocity of money and bank reluctance to lend against reserves, QE2 really does just change the structure of the Federal Debt at this point.

So what does that mean for 2011?

Next year will probably be look a lot like this year: most of the predictions will be wrong and the markets will be volatile. We expect investor sentiment to swing from bullish to bearish with little pause in the middle.

At the end of 2009, investors were worried about economic growth (Global GDP will probably come in well above expectations at 5%), inflation (there is some but there is also deflation), double dip recession (US growth surprised on the upside), a hard landing in China (someday, perhaps) and currency devaluation (the US dollar actually rose slightly after a big rise and fall).

In 2011, the Global Economy will continue to grow but the average will mask large variations. Large developed economies will continue to struggle with “too big to fail” banks that face massive asset writedowns. Until the bad debts clear the system (by being written off or paid back), the financial markets will remain in flux. Emerging markets are struggling with the massive fund flows which threaten overheating in some countries and malinvestment in others. With signs of inflation, deflation, hyperinflation, sovereign credit risk and sluggish consumer demand all vying for market attention through the year, expect another roller coaster ride. The net result should be fairly pedestrian but there will be plenty of ups and downs to keep blood pressure medicine sales on track for a bumper year.

Given the decent returns and lowered blood pressure readings we have achieved with the Fund King System, we will carry on regularly rebalancing our investment universe to put our money to work in the most promising asset classes.

Seeking Alpha Portfolio

This week, the Commodities ETF (DBA) drops out of the top three which signals a switch into the Mexico ETF (EWW). Unless there are some dramatic moves on Monday, that will yield a small gain on our DBA.

What do we know about EWW? Although one could wax eloquent about the broad macro-economic shifts in the global economy and how the developing world productivity is quickly catching up to developed world standards, the story of EWW is best demonstrated by its largest holding (24%), America Movil (AMX, see all holdings on this page). One need not be a chartist to see the correlation in this chart on Yahoo Finance. America Movil is owned by Carlos Slim and has substantial mobile phone franchises throughout Latin America as well as big prepaid services in the US.

We plan to sell our 320 shares of DBA and buy around 160 shares of EWW on the Monday market close.

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