Despite the profusion of verbiage spilled about trading purely with technical skills, the best traders use such skills within a framework of fundamental analysis. Given that lesson, I like to take reflection time at the beginning of each year to establish macro themes around which I can trade.
One year is a relatively short time with regard to macroeconomic themes. Scenarios typically develop over much longer periods, building as events unfold and psychology shifts. In addition, time unfolds within a trader's imagination at a much faster pace than in reality. A trader must invoke patience and pay close attention to market signals, not only to trade at the right time but also to not trade at the right time. In other words, one's fundamental analysis may be thorough and one's conclusions accurate, yet the scenarios envisioned may not come to fruition for quite a bit longer than anticipated.
Most of the expectations outlined below have been discussed in daily posts to my market blog.
My outlook for U.S. equities in 2006 is rather grim. If collective expectations for the stock market were high in 2005, they are downright ebullient at the beginning of 2006, and it seems such hopes are already built into prices. Earnings expectations for many companies, especially in technology, are fantastical. I expect to see a series of major disappointments follow the ones already put forth by Intel and Yahoo, and the disappointments won't be limited to one quarter. This year will witness a major reality re-alignment in equities.
Away from tech, the delayed effects of slowing home equity extraction will produce a serious drag on consumption. We may not see the worst of it until 2007 when monthly mortgage payments skyrocket due to ARM adjustments. Nevertheless, consumer stocks are to be panned this year, as are the home builders themselves. Some of the homeys have enjoyed a second wind thanks to a resilient bond market and ferocious money printing during Sir Alan's final weeks. However, the housing bubble has already burst, and as its effects hit home, a major psychology shift will collapse housing share prices. Suppliers to the housing construction industry, such as Building Materials Holding Corp., will also have a painful year.
As in any bear market, there are sectors that are already under-priced and have the potential for surprise gains. Apart from commodity-related equities, the drug sector looks very attractive. Major drug shares, such as Pfizer, Schering-Plough, and Merck, have already experienced a severe bear market. Much of their risks appear to be already built into share prices, so surprises are more likely to be to the upside. These companies also offer attractive dividend yields. I was bullish on these shares a year ago, but stayed out of them for technical reasons. I believe they have now formed a long-term bottom, and I will be looking for entry points to start building a portfolio of drug shares, beginning with Pfizer and Merck.
Despite the ubiquitous use of the word "tightening" to describe the Federal Reserve's current interest rate activities, they have been doing no such thing. Money supply is still growing abundantly, as divulged by numerous intrepid writers on Safe Haven. True, FOMC activities have been pushing the Federal Funds rate higher, but the money supply cannot truly tighten until the rate is higher than where the market would set a freely floating rate. Alan Greenspan has openly revealed this lack of tightening in FOMC language, which has included the phrase "still accommodative" throughout the current rate cycle. An accommodative interest rate is one in which the FOMC is purchasing securities… printing money… to maintain.
Unless Bernanke turns out not to be the man we all think he is (see "Propensity to Print"), the current interest rate cycle will end without any tightening being done at all! An economic slowdown or some larger crisis is sure to put Mr. Bernanke to the test early in his tenure, and the dollar presses will churn like never before. I do not believe that a new asset bubble in stocks or housing will form during the next deluge of dollar devaluation. Major holders of dollars will want to get out of dollar-based assets at that time, and fast. In fact, the dollar diffusion is under way… central banks of several countries have already revealed plans to diversify reserves. I see a very bad year for the dollar.
While many players believe an impending recession in the U.S. will drive yields lower, my opinion differs. I believe that a secular change has occurred regarding bonds and that they are entering a long-term bear market. We are now witnessing exactly the opposite scenario seen in the early 1980s when traders thought yields would stay high forever. What will drive bond prices downward, even in the face of recession? Simply the desire to exit dollar-based assets. Some sort of catalyst will be needed to instigate the first wave down for bonds, but once it starts, the selling will escalate from pressure by foreign central banks, or even large U.S. holders, as bonds are tossed like hotcakes.
Despite the tremendous show PMs have put on since mid-2005, I suspect they will presently spike in a way that dwarfs the move of recent months, and the spike may fittingly coincide with the first major swoon in equities. The spike will draw in members of the public that have been watching this bull market from the sidelines. We will then see a painfully sharp correction to burn the latecomers, followed by a resumption of the bull market. Regardless of any correction, both gold and silver will hold the lower bound of their long-term trend channels and finish higher on the year.
In early 2005, while well-known fund managers were calling for $40 oil, I wrote that one of the surprises of the year would be that oil rallied far more than most people expected. I believed that oil could go as high as $60. In fact, it surpassed that mark by 20% at its 2005 peak. This year I have a bolder prediction for oil: barring major geopolitical turmoil, oil will be not be a major winner for the year. Although I am a longer-term bull on energy (I believe we will see $200 oil within this decade), I expect its price to be mitigated in the intermediate term by weakening demand as China and the U.S. enter recessions. If it turns out at year-end that I was off the mark in timing these recessions, I will cut and paste this section into my 2007 outlook because I believe these slowdowns are nearly inevitable over the next 24 months.
Overall, I expect 2006 to display much more volatility across all asset classes than we've been used to in the recent years. Speculators will have to be more nimble and investors more patient and resolved. Fortunately, when a trader expects volatility and has a fundamental framework within which to work, it can be used to an advantage.
Wishing health and prosperity to all readers….