You guys know how I’m always preaching “never mistake luck for skill” and that goes double when it comes to making predictions. The last thing I want is for you to ascribe me with powers I simply do not possess.
The other thing I’m always preaching is that if you’re taking someone’s predictions seriously, you’re doing it wrong. Predicting the future is impossible. It’s an exercise in futility. I don’t judge myself by the number of these things that come true nor should you. The point of all this is to raise interesting questions about the year ahead and to try and look at things through a slightly different lens. As an investor, being able to do that is a valuable exercise.
I also do it because it’s fun and I like to poke fun at myself. Plus, nothing builds character like getting up in front of thousands of people and failing.
You should try it sometime!
One of the things that worked out for me last year was the process I used. I sought first to identify a high-probability macro-economic backdrop. Within that, I then looked at specific areas where the consensus views didn’t quite add up or had higher probabilities of deviating from the consensus forecast.
So what are we highly likely to see in 2013? What should our backdrop be?
We’re going to do this in two parts, first the secular backdrop and then the cyclical backdrop. Then we’ll figure out where consensus is, identify exactly where it’s weakest, and use its own energy push back against it and throw it to the floor.
I like to call it Speculative Judo.
The secular backdrop for 2013 and beyond
I know I’ve been writing about it forever, but the 3%+ rate of growth we all got used to is gone. Not just gone for a little while, but gone gone. That era is behind us. This is the era of 1.5% average growth.
There are a lot of reasons for this, but one of the least discussed is population growth. It’s a lot less than it used to be. Population used to be cruising along well in excess of 1%/year. Now we’re growing at less than 0.5%/year. You might laugh at me for bringing up demographics, but demographics really matter for long-term investors. It’s simple: more bodies consuming and investing in an economy translates to more economic growth (ceteris paribus).
On a tangential note, this is another reason why I think the U.S. should explore liberalizing its immigration policy. Intelligent, sensible immigration reform could help keep the economy on track, to say nothing about the wonders of what an influx of population growth could potentially do for the housing market. I know nobody wants to be like Japan when it comes to things like deflation, an uncontrollably strong currency, and a 200%+ debt/GDP ratio. But we really don’t want to be like Japan when it comes to demographics. A top-heavy, shrinking population is one of the big reasons — maybe even the biggest — why their economy is in a perpetual funk. None of that is changing any time soon. Such is the awesome power of demographic trends.
This is nothing new, but the result of these new trends is that the stock market isn’t going to post the same kind of long-term gains it did during the 20th century, and especially the era that most of us grew up in, The Long Boom.
Sorry, guys. It’s possible the trajectory of that amazing 100-year Dow chart has changed for good. The slope will be smaller in the next century.
Another reason is that we now have a cessation of credit growth.
Consumer credit went from about 4.5% of GDP after WWII to 18.5% of GDP at the peak of the boom. We’ll probably drift around at these levels for a long time, but it seems as though we’ve found the maximum. There won’t be secular growth in credit the way there was last century. That’ll slow things down in the decades ahead.
On top of that, we no longer have that wonderfully guilty trend lower in the savings rate. For a long time we saved less and less while we spent more and more. But that topped out. Consumption stopped growing and GDP is made up mostly of consumption.
Best case, the savings rate hangs out here and doesn’t drag growth any lower than it otherwise will be. Worst case (and the more realistic case) is that the savings rate slides a bit higher as our demographic profile shifts towards an older population less interested spending and more interested in saving.
To go along with fewer bodies, less consumption on credit, and increased savings, we also have the fact that real incomes have totally flatlined.
This is a hot issue right now, especially within politics. I wonder, though, why real median incomes are supposed to grow indefinitely? How much wealthier than the rest of the world can the U.S. theoretically get? Shouldn’t the median family income stay relatively constant, slowly inching higher over time to account for inflation? Isn’t the concept of incomes rising at the rate they did unsustainable? Especially in an economy that will grow at less than half the rate it used to.
So strike rising incomes off the list of economic tailwinds we once knew and enjoyed.
Add it up, and pretty much all of these positive secular forces have disappeared, flattened out, or changed direction. These factors will vary from cycle to cycle, but this idea of the “Secular Slog” needs to be present in ever year’s macro-economic backdrop.
For investors, this means that the stock market is going to grow less. The baseline from year to year has changed. The stock market is ultimately dependent on earnings growth, so when GDP and earnings aren’t growing as much they used to for all the reasons we talked about, the average annual rate of return is going to dip below what it once was. On a side note, the effect of cylical economic swings and shorter-term changes in risk appetite will be felt more intensely.
Lower return, more volatility.
The cyclical backdrop for 2013
Now that we’ve got the secular backdrop out of the way, here are the cyclical forces I’m watching.
Below trend economic growth, especially with the fiscal drag associated with higher tax rates. Rolling back the payroll tax from 4.2% to 6.2% will generate around 50bps of fiscal drag on its own. The effect of rolling back the Bush tax cuts on high-income individuals is tougher to calculate, but we know it sure ain’t going to add to growth.
And don’t forget about California. California is is the 9th largest economy in the world. Bigger than India and her 1.2 billion people. Well, California just increased the statewide sales tax (a regressive tax) and meaningfully increased state income tax rates on high-income individuals (a progressive tax). Other states are doing similar things, but California represents over 13% of US GDP. It probably won’t move the needle very much on its own, but in a world where economic growth is going to average 1.5%, every basis point matters and the general trend toward higher taxation won’t come without costs.
This is probably the first place where I can sensibly push back against the crowd. Consensus economic growth for 2013 is somewhere between 2 and 2.5%. I don’t think there’s any way it clocks in higher than 2%. I think we’ll see something closer to the 1.5% suggested by the secular backdrop.
A trend toward certainty. This is a more squishy forecast, but the basic point is that we’ve been living in an environment of abnormally high policy and economic uncertainty. This is the year where those things start to change. This will probably have a positive effect on global markets.
I do expect a bit of drama and debate in two months when these babies in Washington D.C. have to negotiate a longer-term deal and run through that inane and incredibly misunderstood exercise of raising the debt ceiling. But I’m optimistic here. I don’t think the drama approaches anywhere near what it was during the last debt ceiling debate nor will it employ the same shenanigans that the tax portion of the fiscal cliff debate used.
Part of the reason for this is that the tax portion of this debate has been figured out already. That’s what matters most to most people. While the “spending cuts” portion will be important — both politically and economically — I have a hard time imagining it’s a debate that a similarly large portion of the country cares about. I don’t expect it to move markets the way it did last time, and perhaps not even move them very much.
Steady recovery in housing. This is no longer the contrarian call that it was a year ago. But a powerful trajectory is now in place. It’ll probably last a couple of years. Pricing data is wonky in certain markets because of artificially constrained supply (I wrote about this last week), but most real estate markets around the country are pretty boring and pretty normal. Which is a good thing!
New home construction will also be a key driver of the economy. This time next year we’re all really going to be really thankful for the growth that this industry provided in 2013, ’cause there won’t be much of it in other areas of the economy.
A stabilizing Europe. Again, this isn’t the contrarian call that it was a year ago, but Europe is quietly working things out. It’ll be a long, hard, low-growth slog to be sure. But it’s not going to disintegrate the way that most (myself included) thought back in 2010 when Greeks started setting fire to themselves on the steps of Syntagma Square. There will be less opportunity for headline-risk on Europe in 2013 than there was in the last few years. But don’t worry, the market will write new headlines on which to panic over.
Are you aware at just how great a year the DAX had in 2012? What is the stock market seeing that you’re not?
A permanently slower China. Yet again, this isn’t the contrarian call that it was a year ago. But this is a long-term, globally powerful trend that is now underway. I only mention it because investors still looking here for growth are going to be disappointed.
I read a few weeks ago that the average cost of labor in China is now roughly on par with Mexico. The model that powered their rapid economic growth was “make stuff cheap and sell it to the West.” That model is changing and the new models don’t grow as fast. Don’t get me wrong, there’s plenty of opportunity to be had in a 7%+ economy, but it’s going to require more work than the average investor may be willing to put forth.
Predictions for 2013
OK, so nobody is surprised about that backdrop. Given that, where are some opportunities to take a slightly or significantly contrarian stance?
Indulge me while I suggest a few:
1. The market makes a run at its all-time high — 1561 on the S&P.
Yeah, I said it.
I know that’s a long ways up there, but I think this is the year we see it. It either busts through it and keeps on running, or makes a run toward it and poops out.
Analysts have consistently been behind the market in terms of the annual forecasts. I was wrong for two years before finally wising up last year and betting on the market. The reason is because analysts have been making what appears to be an obvious guess within a high-probability backdrop: very slow economic growth and lots of uncertainty.
The market seldom rewards “obvious” predictions. Over the long run, economic fundamentals might be the only thing that matter. But during short- and medium-term cycles, risk appetite (and noise) plays a big role in the performance of the market. A portion of what we’ve seen since 2009 is a a result of a continuous trend towards higher risk appetite.
To be fair, a large chunk of that was forced upon us. The Fed hasn’t been shy about this either. They’ve got their boot applied firmly to the neck of the bond market and they’re pushing down interest rates wherever they can and using any method available to them. They are forcing investors out of low-risk assets and in to risky assets. None of that will change in 2013.
I have complete confidence that when this whole game ends, it will end in dramatic fashion. I have no idea exactly when or how it will play out and what sort tangential effects it will have. But it will end. And it will be bloody. Mark my words. This is one of those things that “nobody sees coming” in the way that nobody saw how a collapse in real estate would tear the financial markets and global economy into fleshy little pieces.
But we’re not there yet. Not in 2013. I think there’s a really good chance that this year resembles 2007 in the sense that this is the year where the ground beneath us starts to shift but nobody’s really aware of it yet. I just don’t think any of that will happen until the market makes an honest run and at — cue the Price is Right voice — a “neeew all time hiiigh!”
2. Bond Market Blah
Bonds have been in a bull market forever. It’s over. OFFICIALLY! Everyone on the planet believes this.
There’s still a little juice left to be squeezed.
It pains me to make predictions about bonds and interest rates because NO MATTER WHAT I can never seem to get them right. Plus, this is a fairly boring forecast in its own right.
I made a forecast about the stock market, so to be fair, I’ll make one about bonds. Heck, let’s make it a rather crazy one.
The all time low in the 10-year yield is 1.40%. I think this year we make a new all-time low.
It’s possible this won’t look so crazy a year from now. A new low in interest rates isn’t as far away as you’d think. The momentum in bonds has been so negative during the last couple of months and it seems like everybody in the world is now getting officially bearish on bonds in 2013 if they weren’t already. All it’ll take is a little more weakness in the economy — which is a legitimate risk in the first half of the year — and some whispers about some creative new Fed stimulus, and rates could plummet. Investors could get back on board.
Make no mistake, there is a ton of risk in the bond market right now. It’s just as likely that rates skyrocket and this is the year where bond investors open up their quarterly account statements and experience the slow, awful realization that you can lose a lot of money in bonds, even Treasuries. If you’ve got a shiny 10yr Treasury yielding 1.9% and rates go to 2.9% this year, you will lose 7.5% of your principal. If rates go to 3.9% that’s a 15% loss on your risk free Treasuries. Ouch. Sure, you’ll get all your money back in 2023. But in 2013 you’re going to have a capital loss, my friend.
Anyway, I just want to get a formal bond prediction on here so I can ask the following question:
What do you buy in a world where you can’t buy Treasuries because the risk/reward is atrocious?
Think about that for a moment.
Now you can see how it’s possible to get both an all time high in the stock market as investors desperate for yield are forced to buy, and an all time low in interest rates as the Fed continues its aggression and the bond market continues to defy logic and sensibility while we do everything imaginable to keep recession at bay.
Seriously, though. What do you buy when your short-term risk involves volatility of 5-15% and your long-term upside is 1.9%. I know bonds have been a simply remarkable investment for the last 30 years and made legends out of guys like Gary Shilling and Bill Gross.
But what happens when our bond market turns into this:
If you’re invested in bonds, this is a situation where you may want to start brushing up on the difference between risk and volatility. Volatility serves as a proxy for risk in much of the financial world, because it’s easy to quantify, but it isn’t technically the same thing as risk, and depending on who you talk to, it may be a radically different concept altogether. Make sure you understand this. Go read some Taleb. Position your portfolio accordingly.
Also, if you’re a newbie bond investor, now is the time to get down with the concept of duration. (Hint: you probably want it to be short right now.)
When it’s all said and done, The Yield Vigilantes should keep it all from falling apart. I think those guys push rates to a new all time low and it’s not as bad a year in Treasuries as the rest of the world seems to think.
Heck, why can’t the 10yr get to 1%? You’re not still worried about inflation, are you?
3. Real Estate Rocks
Hey, the good thing about low rates is that they don’t interfere with the real estate recovery!
(The Fed is explicitly aware of and communicative about this as well.)
Simply betting on real estate isn’t contrarian enough anymore. All the smart people are on board with this. And now, with the data of 2012, it’s time for all the Uber-Bears to come out of their caves. It’s OK. We won’t bite you, Uber-Bears. (ÜberBären?)
Here’s my crazy real estate forecast for 2013:
1 million+ housing starts.
I think that this chart not only gets to 1 million, but averages that for the year.
When you look at that chart, it doesn’t seem like such a stretch. But it’s 20-25% growth over last year. And, Wall Street consensus is somewhere around 900,000.
I guess I simply am making this forecast in this way to point out, again, that Wall Street is lagging the trend. They’re taking the present and projecting it into the future. They made the same mistake in 2012 and wound up behind the curve.
I’m still bullish on real estate. Prices aren’t as attractive as they once were and while they are almost certainly artificially high in some unique locales (like mine), they aren’t necessarily too high on a national level. To put a finer point on my bullishness, I’m bullish in the sense that this is going to be the glue that holds the economy together in 2013. I’m bullish in the sense that the we’re at a point where we need to start building more houses to satisfy current and future demand and that’s going to keep the economy afloat, or at least keep it from totally disintegrating.
And if you are afraid of inflation, I think real estate is — by far — the safest way to hedge against that. Much safer than shorting bonds and much safer than gold.
OK, so those are some rather non-conventional forecasts on the three major asset classes. Next week I owe you one about gold and then a hodge podge of other interesting, random predictions.
I’m sure at least one will make you say, “this guy is completely insane and completely wrong.” But I also think that at least one will make you say, “this guy is crazy like a fox. I like it!”
So stay tuned.