2006: Year-Ahead Outlook

The End of This Lethargy is Near – by Don Hays

Reprinted with permission

Summary:      Here we are once again.  This will be my 38th December looking at all the factors and attempting to foretell the future for financial instruments. Oh how many different moods I’ve been in on these annual ventures.  The greatest contrast of all these annual occasions will be the difference between my current feelings and how I felt as I was preparing these comments in December 1999. At that juncture there was not one Strategist listed in the Business Week tabulation that approached my bearishness.  And this year, there is not one that approaches my bullishness.  It is going to be fun, after the last two years of spending most of the time putting a damper on any super-bull’s prognostication to start roaring again with bullish enthusiasm. We are expecting one more squall, and then clear skies ahead. We are projecting the ……oh me, please don’t make fun of me…..but we are projecting the S&P 500 to move up over 30% in these next 12 months. We are projecting that the price of oil will fall to $42 a barrel, and that the yield on the 10-year bond will continue to remain close to current levels…or lower, as the fed funds rate is actually cut.  We are projecting that commodity prices will stabilize a little lower than today’s level, and that the currencies of the major countries are currently settling into a range where they will remain for years to come.  We are projecting a glorious coming out in the recognition of the massive “build-out” phase of the Technology Revolution in which every country of the world will either become Democratic and Capitalistic or they will be cut off from the world.

Okay, if you are still sitting up, and not roaring with laughter, let me follow up on the details.

We expect today’s strong economic news to fade as we start the year, in almost the same exact fashion as occurred in the first six months of 1995, and that to produce a sharp decline in stocks during the first few weeks of the new year somewhere in the 5-10% range.  The S&P 500 could drop back to—or slightly under—the April low.

We expect the price of oil to drop under that $56 shoulder in the next 3-4 weeks, setting the stage for a drop in the first half of 2006 to $42 a barrel.  With that pressure removed on inflation, we expect the popular inflation gauges to drop to the lower half of Chairman Bernanke’s 1-2% inflation band, and the Federal Reserve to start pumping in monetary liquidity for the first time in three years.

We expect commodity prices, bond yields, and currencies (of all major countries) to stabilize into at least a 3-year and maybe a multi-decade band with the U.S. Federal Reserve becoming the monetary leader for the world.     

That is as un-hedged as we can be. Hopefully you know where we stand on the broad front. Will we be exactly right on all these areas?  I would be flabbergasted if we were, but I hope long-term readers will remember with good thoughts how many times we have been right on a lot of factors not readily accepted by the herd over many decades.  This is definitely not a new story for us. It is only a continuing theme as we have cited numerous historical “rhymes” that give valuable clues.

But on the big secular theme, there are NO historical rhymes.  This has NEVER happened before. The excitement of the last 23 year bull market (actually it goes back to the last 31 years) has been nothing more than a foreword of what we are about to experience. We’ve all tried to describe this mighty bull market based on our experience, but that experience is based on a faulty model of conditions forged in the Industrial Revolution.  For most of us, it is even worse than that, in that our “experience” is based on the last 40 years in which even that Industrial Revolution was in decay.  The closest correlation we have in history is the “build-out” phase of the Industrial Revolution occurred prior to most of our experience base, in that itstarted in 1932 and extended to 1965-66 when General Motors was the totally accepted most important company in the world. Oh me, how much better picture could we get than the woes of this fallen hero in today’s market.

But that prior rhyme does not do justice to this new “build-out” phase.  The great economic miracle of that prior revolution was led by industrial companies largely dependent on the strength of theU.S.consumer.  This was a fairly steady ½% annual growth of new potential consumers.  This new revolution is going to be magnified by an amazing unleashing of over 2 billion new consumers as they are allowed to join in the new world of Democracy and Capitalism, and rewarded by their own abilities and ingenuity. Labor Unions and political systems that rewarded all workers the same regardless of their abilities are losing their place.

This is not all Nirvana, and we hope to do our part to describe and attend to those trouble spots. But even though Democracy is not perfect, it is better than any other form of government that has ever existed.

That’s the secular, now let me get into the nitty gritty. 

The secular is very important and exciting, but I’m convinced that for most of us, the cyclical nature of financial forecasting is the most important.  In many ways, it is worse to be perfectly right on the secular, but way off on the cyclical, than vice versa.  Being too early…or late…..can be totally devastating. That is why we always abide by the best cyclical gauge of forecasting we’ve ever found, which is our asset allocation matrix that uses a myriad of varying combinations of psychology, monetary and relative valuation conditions to describe the potential risk and reward for stocks, bonds and cash.

We’re not going to describe the dozens of important parameters that are involved in this process this morning, but I would like to show you the graphs of some of them that need a little improvement before we expect this big lift-off for the upcoming year.

I’m not going to go into a description of each of these indicators—in the interest or time and space—but you can see that the red line, a cumulative measure of the Dow’s action only in the last one hour of trading, has just dropped to a lower low, while the emotional buyer blue line has continued to rise. This is not a deal-breaker, but an indication that typically tells us the market is not ready to roar big time just yet.

This call to put ratio, which again is a measure of sentiment by opening option trades on the ISEE, is a measure of the public option trader that is renown for always being wrong at extremes. You can see that for the third time in the last 24 months, it has now crossed the first solid red line that indicates an extreme of optimism.  Those previous times, maybe not just a coincidence, occurred as the new year was approaching.  Now let’s look at what has happened in each of the Januarys for the last five years.

We’ve just shown the S&P 500 in the above graph.  Actually the NASDAQ Composite that I consider a better gauge of future stock performance has experienced an even more destructive January performance. The historical review reveals that the period from a few days before Thanksgiving to four days into the new year have the most strong seasonal days of the year of any other time, with the last two days of the year capping it off. But that gradually deteriorates in the first four trading days of the new year, and on January 9th, 2006 the stock market loses that seasonal strong tendency.

It is not JUST psychology and seasonality. This year we are almost exactly copying the schedule that Greenspan followed in that 1994-95 era when he was choking the economy so rigidly. Take a look at the close correlation between money supply growth in that era as compared to today’s.

For a week or two, we had hoped that he had learned his lesson in 1994-95 when he choked the economic patient to its knees. But no, we should have guessed.  You can’t teach an old dog new tricks, so here he is again.  Now, take a look at the economic statistics then….and now. As you know, the 3rd quarter GDP has just been revised for its third revision to show a 4.1% growth in real GDP.  Here’s the data from 1994-95.


This is not the only close correlation to that prior rhyme.  I’ve shown you this graph many times, but the unemployment insurance claims, which I consider to be one of the best coincident indicators is also almost an exact replay then and now.

So I’m using all these “rhymes” to formulate my excuse for the January trouble I expect for the market. I am expecting a much weaker economic back-drop as we get into the first quarter of the year. And guess what that would do to today’s speculation on energy futures? Now remember, the best statistics around are telling us that for the last two years there has been much more supply of oil than the demand.  The C.E.O. of Exxon Mobil has certainly been very vocal on confirming that.  Here’s that table.

But the price of oil has continued to remain very high.  How could that be? Well, we believe this graph tells who the culprit is that has been keeping the price of oil (and gold as well in our opinion) high.

Oil future contracts have seen an asymptotic rise in the number of futures contracts coming from the financial industry. As we described in a previous market letter, we are seeing the same exact phenomena being played out in the price of gold, as over 70% of the new demand for gold has come from the new gold ETF. But are these speculative forces based on realism—on supply and demand—or on the emotions of the herd.  You know where we stand on that.  Now let’s look at a very intriguing chart pattern emerging in the price of oil.

If, and remember it hasn’t happened yet, but if the price of oil drops under that shoulder level of 56, it will be the culmination of a head-and-shoulders topping formation.  Of course, I expect that to happen based on all the above, and chart theory would then project a drop to $42 a barrel, about where we would expect it to trade….or lower.

So what if…this occurs during the first three months of the year.  It would impact energy company earnings fairly dramatically, and it would start those huge new energy financial future contracts running for cover. Since so much of the trading dollars is in this zone, it would impact stocks very negatively…for the short run.

But just like in 1995, it will not take the Federal Reserve long to change their stripes. I’m sure there are still many members of the Federal Reserve body of governors and Presidents that are not willing to give the new Chairman Bernanke the same degree of respect for his theories as they did Greenspan, but when you see the price of oil drop, and the inflation gauges that are already very docile ex food and energy, start to plunge commensurate with the slower economy and the declining price of oil, I would then expect Bernanke’s genius to replace Greenspan’s ability to sell his thoughts—very quickly. From that point on, theU.S.and the world will be put on a monetary speed governor based on a 1-2% inflation band.

So now, for the first time since 1997, it appears that the currencies of the world are falling into place—back to normal.

I expect this band to continue as well, as all the countries of the world will actually try to keep their currency no stronger than theU.S.currency.  They will need all in their power to keep their products competitive to the huge new hoard of international consumers.  Here’s the Swiss franc against the dollar as well.

You can see that this widely traded currency has also just now come into that prior trading box that existed before the massive currency crisis of 1997, that produced the big push of the emerging world into the new world.

So, if we are tied into that 1994-95 rhyme in so many other ways, how did the stock market react in 1995 when the long boring consolidation ended?

It moved up over 30%. But does this make sense today?  If anything I could make an even stronger case for today’s market as you can see as you review the historical record versus today’s relative valuation of the S&P 500.  We think the Alligator is about to close its big powerful jaws.

With inflation pressures subsiding, we believe the yield of the 10-year T-Note in the above graph is not about to move up very much if any.  In fact, it will probably decline. So the jaws will close by the top part of my depiction coming down.  What will bring it down? I would guess that yes, for the first six months of the year the 12-month forward earnings will drop some, but not all that much, and before the year is over they will once again be headed up. So the only way to close those jaws under these conditions is for the S&P to move up. We expect before this year is over that the massive relative under-valuation of the S&P 500 will be nudging back into fair value.

Corporations now have $2.5 trillion of cash.  The public investor now has $5.6 trillion of cash. A little optimism will go a long way to start that cash moving toward growth vehicles, and of course you know stocks are the number one vehicle to take advantage of economic growth.

Our bottom line is that we are on the cusp of the recognition by the herd of the most exciting economic miracle in history, and as that recognition starts to seep into the thought process, those of us that are already positioned are going to be rewarded very richly.

That is our story my friends. We’ve all been very patient for these last 23 months.  By following our top-down approach, we’ve already seen our assets appreciate very substantially even while the broad market has been stuck in a sideways consolidation, but the really exciting times lie ahead.eprinted with permission

Merry Christmas