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Crystal Ball Gazing

(February 26, 2012)

Please note that the following is a sample commentary and is therefore time-delayed on at least a three-week basis. To read our latest analysis and prognosis of the U.S. equity and financial markets, please subscribe to our market newsletter today. First-time subscribers are entitled to a one-month free trial period and a substantial discount for only a limited time!

Dear Subscribers and Readers,

This will be our final weekend commentary before we “sail into the sunset.” It's been a fun journey, but it is time to move on. I look forward to keeping in touch—I will continue to pen ad hoc commentaries through my personal account—you, as current subscribers, will receive the first one sometime next month. I look forward to an ongoing, personal correspondence. Please let me know if you want to opt out of this mailing list. Again, thank you for all your support over the years.

Speaking of letting go, George Friedman, CEO of Stratfor, has resigned. Aside from dealing with the fallout from its security breach last December, the latest Wikileaks' disclosure of five million emails has further damaged client confidence in the service and its business practices.

In this commentary, I will gaze into the MarketThoughts' crystal ball and make a guess on how the markets (and the broader global economy) will evolve into the end of this decade. But first, a caveat: Making money in the market is not about being “right,” but having the intuition and flexibility to change direction when one is wrong (and being egoless and not invested in the original decision). This is not college—one doesn't get rewarded for being “right.” In fact, spending a disproportionate amount of time on analyses or overthinking is a waste of time—time that could otherwise be spent with family, exercise, or to uncover new ideas. In our August 29, 2004 “Special Report” (“Three Important Questions”), we argued that one of the most important things an investor can do is to “know thyself” in terms of one's optimal investing style, savings goals, temperament, and purpose for investing. The latter could range from experiencing the thrill (akin to gambling, which I don't recommend), to pure intellectual attainment (which I don't recommend either, as investing is not about being “right”), and finally to using your capital as a vehicle to save for your future liabilities, such as buying a home, saving for retirement or for your kids/grandkids' education. That being said, I now want to discuss several potential structural trends worth considering over the next 3 to 10 years.

· The ongoing rise of Emerging Markets economies, capital, and bond/market capitalization. This is real. The Chinese possibly possesses the most capitalistic culture in the world in the pursuit of knowledge, education, material wealth, and status (this is an observation; not a judgment). In 12 to 15 years, Chinese GDP will surpass that of the US. Sure, there are significant imbalances in the Chinese economy today; the good thing is that everyone, including my neighbor's cat, knows about this imbalance. In its latest five-year plan, the Chinese leadership recognizes that Chinese consumer spending will need to not only pick up for its own sake, but for the sake of the global economy as the US consumer can no longer support China's export economy. In addition, the narrowing of the manufacturing wage gap between China and the US will lead to a significant number of manufacturing jobs relocating back to the US, as we covered in our February 12, 2012 commentary.

· Rising wages (>15% a year) and consumption in EM countries will result in dramatics shift in consumption, travel, and power dynamics over the next several years. Top-tier wineries (>$100 million) in France will be snapped up by affluent Chinese over the next several years, as the former enters a Japanese-style deflationary recession while the latter catches up. Prior to the reign of the Qianlong Emperor in the 18th century, the Chinese economy was the biggest and richest for hundreds of years. It's been more than 200 years since its relative peak, so most people still have no concept of the impacts on our everyday lives (and of course, our investments) due to a reemerging China. The most recent reference point is the rise of Japan, but the rise of China will dwarf that of Japan. In terms of wealth, financial power, and military power, the US will remain the top in the next ten years, but the center of power is definitely shifting from the West to the East. In terms of consumption patterns, we would like to point to our discussion of the economic concept of “acceleration” in our February 13, 2005 commentary (“China – Basic Background and Current Issues, Part III). As the average wage rises, consumption of higher-end goods (such as automobiles, university educations, and investment services), will rise by an exponentially higher amount. Already, we are witnessing this in university enrollments in top-tier schools such as the UC system, where local Asian-Americans are being displaced by Chinese students who have the required education and whose parents are wealthy enough to pay the ridiculously expensive overseas tuition (e.g. the UCLA MPP program enrolled more than 10 Chinese students in its 40+ program last year; versus just a few the previous year). Prices and faces at expensive ski resorts, golf resorts, Las Vegas, coastal real estate, etc., will be bid up by EM consumers at an astronomical rate.

· Most likely, the Euro Zone will enter into a Japanese-style recession over the next decade as it struggles with reforms, but more glaringly, as its population ages and declines. Japan will continue to lose influence on the world stage, especially given its lack of competitiveness (not learning English is certainly a big hindrance) in 21st century industries such as biotech, robotics (the belief that Japan leads in robotics is a myth—the center of robotic knowledge is at MIT), solar cells, biofuels, software, quantum computing, providing university educations (university education is now a major US export), and sadly, even the latest television technology. Even Sony and Nintendo have a strong competitor in Microsoft's Xbox in gaming consoles. On a more macro scale—as is evident—the center of power in global, post WWII institutions such as the World Bank, the IMF, and the BIS is now gradually shifting to the EM countries.

· The bull market in gold, silver, and crude oil is ongoing. I cannot predict the ultimate peak price; but I would not be surprised if gold surpasses US$5,000, silver $150, and crude oil $200 before the bull market exhausts itself. The aggressive, coordinated central bank easing around the world almost guarantees an inflationary problem next year, if not later this year as the US economy recovers. In addition, the rise of the EM consumer will result in more jewelry sales, and of course more investments in precious metals and the like. In five years, I would not be surprised if the Chinese financial markets develop similar investment vehicles such as the GLD or SLV so Chinese retail investors could easily speculate on gold and silver prices. The ultimate peak price for crude oil will depend on the rate of commercialization of more efficient solar panels and second-generation biofuels. I believe that the commercialization of second-generation biofuels (such as low-cost cellulosic ethanol) will happen by the 2014 to 2015 timeframe. If that happens, crude oil will likely peak at only $200 a barrel; but if it doesn't happen by that time, then crude oil could conceivably hit $250 to $300 a barrel. Note that I sincerely believe at some point, Schumpeterian growth will kick in to “solve” the world's energy problems. I fully expect the US to gain “energy independence” by the end of this decade through the commercialization of second-gen biofuels and more efficient solar panels; but not before we're forced to invest more heavily in R&D because of higher oil prices.

· Natural gas—namely UNG—is still in a bear market as storage is at record highs while production remains near all-time highs. Because of significant contango in the Henry Hub NYMEX contract, the spot price will need to rise nearly 50% over the next 12 months for the UNG ETF to maintain its price. Over the next 6 to 12 months, I would not be surprised if UNG hits the $12 to $15 range. At some point, there will be enough production cuts to enable a bull market in natural gas again, but it will have to be aided by either a hurricane shut-in in the Gulf or a colder-than-expected winter.

· Starting in the 2015 to 2020 timeframe, as the world gains more “discretionary” income and wealth through cheaper energy (due to the commercialization of second-generation biofuels and more efficient solar cells), more funds would be freed up for investments and spending. As I mentioned, financial markets in EM countries will gain more depth and liquidity as domestic investors multiply (much like what happened in the US in the 1950s to early 1960s as equity ownership multiplied). With increasing global liquidity, I expect a significant amount of capital will flow to the poorer “Frontier countries,” including Vietnam, Bangladesh, Ghana, Kenya, Trinidad & Tobago, Bulgaria, Ukraine, and Croatia. This scenario isn't far-fetched, as many “Frontier countries” are already embracing economic liberalization policies; while the days of African dictatorships are fading away.

· The “other frontier,” space, will be up for exploration as countries and economies seek new “aspiring” goals, such as that of the 1950s to 1960s Space Race. Private, commercial spaceflights will be common; and costs will decrease dramatically. On a larger scale, I expect China to go to the moon before the US does; and perhaps even before 2020. This will be added by new, lighter nanomaterials that will be commercialized over the next several years, aided by the exponential increase in supercomputing power. Speaking of computing, I do not expect the quantum computer to be commercialized before this decade is out; however, quantum computing research efforts will accelerate over the next few years as we desperately try to find ways to circumvent Moore's Law.

· DNA sequencing is now down to $1,000 a pop, but questions have now arisen as to the efficacy of such results. There are still too many mysteries behind the human brain, the human body, and the DNA for specialized treatments. Highly efficient customized/target treatments aided by DNA sequencing may still be likely, but I do not anticipate any major breakthroughs in this area for at least the next five years.

· We know that US stocks are relatively cheap based on P/B and P/E ratios; however, corporate profit margins have also been near record highs due to outsourcing to EM countries and record high levels of productivity. The $64 trillion question is: Can this be sustained?  Probably not. As we argued, US manufacturing is likely to experience a Renaissance over the next few years, leading to higher wage pressures in states such as Alabama, Tennessee, and South Carolina. At the same time, rising wages in EM countries mean that outsourcing will no longer have much of an impact (outsourcing to the Chinese interior doesn't help much given the cost of transportation from the interior to the coastal cities) on the bottom line. Just as important, consumer trust in US corporations is now at multi-decade lows; while some workers (such as myself in a previous life) have now gotten so sick of the corporate environment and are now quitting their jobs to start their own businesses. With the advent of 3-D printing and cheap design software, it will not be difficult for a stay-at-home that aims to produce several hundred custom-designed t-shirts to compete with the local Gap Stores in a few years (today, the stay-at-home mom is inhibited by volume, i.e. she either needs to manufacture over 10,000 shirts to produce in China; or face many times the production cost if she produces locally but in small batches). The “destruction” of mom-and-pop stores began with the popularity of A&P in early 20th century—culminating with the rise of Wal-Mart and other “big box” stores in the latter half. Will the evolution of manufacturing technology—coupled with cheaper, renewable power—lead to the rise of mom-and-pop stores again (only this time the mom-and-pops are armed with an iPad, cool design apps, and ultra-fast internet connections hooked to a cheap power source)? Crazier things have happened.

Let us now discuss the most recent action in the U.S. stock market using the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from July 2008 to the present:

For the week ending February 24, 2012, the Dow Industrials rose 33.08 points, while the Dow Transports declined 100.38 points. For the second straight week, the Dow Transports has failed to confirm the new highs in the Dow Industrials. This is a concern, at least in the short-run. Given short-term overbought conditions, we are looking for a correction over the next several weeks. That said, with the Fed committed to an extremely dovish policy (near-zero Fed Funds until 2014), the latest cut in the required reserves ratios in the Chinese banking system, and the surprised easing by the Bank of Japan, the Dow Industrials should surpass the 13,000 level decisively over the next several months. We remain bullish on US and US financial stocks for 2012.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The four-week moving average of these sentiment indicators decreased slightly from 24.9% to 24.7% for the week ending February 24, 2012.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 2001 to the present:

Since hitting a multi-year low of -11.3% in early October, the four-week MA has spiked by a stunning 36.0%. The four-week MA is now hovering at its most overbought level since late February 2011. As such, we are looking for a correction over the next several weeks. That said, with the European Sovereign Debt Crisis on the backburner—and combined with cheap US$ swap lines, a dovish Fed, the resilience of the US economy, and Chinese and Japanese easing—we still expect a decent rally in US stocks and US financial stocks over the next several months.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it is such a useful sentiment indicator.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

Ever since breaking 100 in mid-December, the 20 DMA had consistently risen until five weeks ago. Over the last five weeks, the 20 DMA underwent a significant correction, declining from 123.9 to 98.6. In fact, it is now significantly lower than its 50 DMA. This pullback was much needed as this indicator was getting very overbought in the short-run. That said, our other sentiment indicators remain overbought on a short-term basis—hence, we believe the market is highly vulnerable to a correction over the next few weeks. Over the next several months, though, we remain bullish on US stocks and US financial stocks.

Conclusion: As we wind up MarketThoughts.com, I thought it'd be wise (and cool) to outline my thoughts and predictions to the end of this decade. Human history is characterized by discontinuities—such as the fall of civilizations, dynasties, discoveries (e.g. agriculture, printing press, crude oil, electricity, nuclear energy, etc.), wars, and natural disasters. Capitalist societies, with their constant changes, are actually more continuous. Problems and discontent are more transparent, and thus are recognized quicker and “fixed” assuming economic power is widespread. Even then, changes are difficult to predict, even by industry Titans who are very intimate with their industries. The above illustrations cover all the major trends I haven't covered recently, and please email me if any of you would like to engage in an ongoing dialogue. I am always humbled by this work; and I wish all of you future success and happiness.

Signing off,

Henry To, CFA, CAIA

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