Wednesday, December 28, 2011

Don't be surprised if -

Sears Holdings declares bankruptcy. In a possible spectacular fall, Sears Holdings shares could be halted this spring at, say, $18, as as vendors turn away from the retailer, owing to a continued and more pronounced deterioration in cash flow (already down $800 million 2011 over 2010), earnings and sales. With funding and vendor support evaporating, as paper-thin earnings before interest and taxes margins turn negative and cash flow is insufficient to fund inventory growth. The number three in the industry has little value -- especially after store improvements were deferred over the past several years. A major hedge fund and a large REIT join forces in taking over the company. Ten to fifteen percent of Sears' 4,000 Kmart and specialty stores are closed. More than 35,000 of the company's 317,000 full-time workers are laid off. As a major anchor tenant in many of the nation's shopping centers and with no logical store replacement, the REIT industry's shares suffer through the balance of the year, and the major market indices suffer their only meaningful correction of the year.

"Never make predictions, especially about the future."

-- Casey Stengel

"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown."

-- Woody Allen

There are five core lessons I have learned over the course of my years -

1. how wrong conventional wisdom can consistently be;
2. that uncertainty will persist;
3. to expect the unexpected;
4. that the occurrence of Black Swan events are growing in frequency; and
5. with rapidly changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

As a society (and as investors), we are consistently bamboozled by appearance and consensus. Too often, we are played as suckers, as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein's weapons of mass destruction, the heroic home-run production of steroid-laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank C, the uninterrupted profit growth at FNM and FRE, housing's new paradigm (in the mid-2000s) of noncyclical growth and ever-rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff's investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.

"Consensus is what many people say in chorus but do not believe as individuals."

-- Abba Eban (Israeli foreign minister from 1966 to 1974)

In an excellent essay published a year ago, GMO's James Montier made note of the consistent weakness embodied in consensus forecasts. As he puts it, "economists can't forecast for toffee."

They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else.... If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!

-- James Montier

"Those who cannot remember the past are condemned to repeat it."

-- George Santayana

Here are Goldman Sachs' forecasts for 2012:

* 2012 U.S. real GDP up 1.8%, and global GDP up 3.2%;
* 2012 S&P 500 operating profits of $100 a share;
* year-end 2012 S&P 500 price target at 1250;
* 2012 inflation of +1.7%; and
* 2012 closing yield on the U.S.10-year Treasury note at 2.50%.

"More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other to total extinction. Let us pray we have the wisdom to choose correctly."

-- Woody Allen

Don't be surprised if -

The U.S. stock market approaches its all-time high in 2012. The beginning of the New Year brings a stable and range-bound market. A confluence of events, however, allows for the S&P 500 to eclipse the 2000 high of 1527.46 during the second half of the year. The rally occurs as a powerful reallocation trade out of bonds and into stocks provides the fuel for the upside breakout. The market rip occurs in a relatively narrow time frame as the S&P 500 records two consecutive months of double-digit returns in summer/early-fall 2012.

Strategy: Buy out-of-the-money SPDR S&P 500 ETF Trust (SPY) calls.

Don't be surprised if -

The growth in the U.S. economy accelerates as the year progresses, particularly in the late summer/early fall. The U.S. economy muddles through in early 2012 through the summer, but, with business, investor and consumer confidence surging in the fall, real GDP accelerates to over 3% in the second half. Unemployment falls very slightly more than consensus, but the slack in the labor market continues to constrain wage growth. Domestic automobile industry sales soar well above expectations, benefiting from pent-up demand and an aging U.S. fleet. Inflation, at least in how it is falsely counted by our government, is contained but begins to be worrisome (and serves as a market headwind) in late 2012. Corporations' top-line growth is better than expected, and wage increases are contained. Operating margins rise modestly as sales growth lifts productivity and capacity utilization rates. Operating leverage surprises to the upside as 2012 S&P profits exceed $105 a share.

A noteworthy surprise could be that the residential real estate market shows surprising strength. The U.S. housing market becomes much bifurcated (in a market of regional haves and have-nots), as areas of the country not impacted adversely by the large shadow inventory of unsold homes enjoy a strong recovery in activity and in pricing. The Washington, D.C., to Boston, Mass., corridor experiences the most vibrant regional growth, while Phoenix, Las Vegas and areas of California remain weak. The New York City market begins to develop a bubbly speculative tone. Florida is the only area of the country that has had large supply imbalances since 2007 that experiences a meaningful recovery, which is led by an unusually strong Miami market.

Strategy: Buy HD, LOW, building materials and homebuilders, and buy auto stocks such as F and GM.

What we desperately need -

1. A broad infrastructure program focused on a massive build-out and improvement of the U.S. infrastructure base -- the restoration of our country's highways, bridges and buildings and an extensive internet bandwidth expansion.
2. The annual increase in government spending is limited to the change in the CPI. It's a start.
3. A comprehensive jobs plan including new training programs -- all veterans are made eligible to tuition subsidies to vocational schools and colleges.
4. A Marshall Plan for housing, highlighted by a nationwide refinancing proposal adopted for all mortgagees (regardless of loan-to-values).
5. Mean test entitlements, freeze entitlement payouts and gradually increase the Social Security retirement age to 70 years old.

Strategy: Sell volatility.

Don't be surprised if -

A sloppy start in arresting the European debt crisis leads to far more forceful and successful policy. The EU remains intact after a brief scare in early 2012 caused by Greece's dissatisfaction (and countrywide riots) with imposed austerity measures. The eurozone experiences only a mild recession, as the ECB introduces large-scale quantitative-easing measures that exceed those introduced by the Fed during our financial crisis in 2008-2009.

Strategy: Buy European shares. Buy iShares MSCI Germany Index Fund (EWG) and iShares MSCI France Index Fund (EWQ).

Don't be surprised if -

The Fed ties monetary policy to the labor market. In order to encourage corporations to invest and to build up consumer and business confidence, the Fed changes its mandate and promises not to tighten monetary policy until the unemployment rate moves below 6.5%, slightly above the level at which wage pressures might emerge (the Non- Accelerating Inflation Rate of Unemployment).

Strategy: Buy high-quality municipal bonds or the iShares S&P National AMT - Free Municipal Bond Fund (MUB).

Don't be surprised if -

Cyberwarfare intensifies. Our country's State Department's defenses may be hacked into and compromised by unknown assailants based outside of the U.S. Our armed forces are place on Defcon Three alert.

Don't be surprised if -

Financial stocks are a leading market sector. After five years of underperformance, the financial stocks may finally rebound dramatically and outperform the markets, as loan demand recovers, multiple takeovers permeate the financial intermediary scene and domestic institutions enjoy market share gains at the expense of flailing European institutions. With profit expectations low, three years of cost-cutting and some revenue upside surprises (from an improving capital markets, a pronounced rise in M&A activity and better loan demand) contribute to better-than-expected industry profits.

Strategy: Buy JPM, C and XLF

Don't be surprised if AAPL pays a $20-a-share special cash dividend in the 2nd quarter, introduces a regular $1.25-a-share quarterly dividend and splits its shares 10-1. Apple becomes the T of a previous investing generation, a stock now owned by this generation's widows and orphans.

Strategy: Long Apple (common and calls).

Don't be surprised if -

We see merger mania. Cheap money, low valuations and rising confidence are the troika of factors that contribute to 2012 becoming one of the biggest years ever for mergers and takeovers. Canadian companies are particularly active in acquiring U.S. assets. Canada's Manulife (MFC) acquires life insurer LNC, two large banks join a bidding war for ETFC, and IFF and K are both acquired by non-U.S. entities. Finally, a Canadian bank acquires STI.

Don't be surprised if -

The ETF bubble explodes. There are currently about 1,400 ETFs. During 2012, numerous ETFs fail to track and one-third of the current ETFs are forced to close. There are several flash crashes of ETFs listed on the exchanges. The ETF landscape is littered by investor litigation as investor losses mount. New stringent maintenance rules and new offering restrictions are imposed upon the ETF business. The formation of leveraged ETFs is materially restricted by the SEC.

Don't be surprised if -

Israel Attacks Iran. The greatest headwind to the world's equity markets is geopolitical, not economic. Israel attacks Iran in the spring, but, at the outset, the U.S. stays out of the conflict. Iran closes the Strait of Hormuz, and oil prices spike to $125 a barrel.