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Market Outlook 2007 - Thoughts of a Professional Investor January 2, 2007 Many highly successful traders exercise their 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. 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. 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 wrong time. Most of the expectations outlined below have been discussed in daily posts to my market blog. Stocks Last year's prognostication began with the sentence, "My outlook for U.S. equities in 2006 is rather grim." Obviously, the impetuous rally of the latter half of the year proved the outlook wrong, though in mid-July it was looking mighty insightful. The reasons for my grim view, however, have not retracted, but rather grown stronger. Collective expectations for equity returns have become more ebullient. Bulls feel bulletproof after surviving the early summer tumble, and earnings expectations, especially in tech, continue to escalate despite incontrovertible proof that the demand side is weakening rapidly while inventories grow. I also cited the decay in the housing arena as a drag on the overall market and suggested that housing stocks and their suppliers, such as Building Materials Holding Corp., would have painful years. Housing shares did, indeed, tumble (BMHC fell 30% in 2006), though the effects of their decline have yet to be felt on a broader scale. That said, the rally from the July lows appears very much like a speculative blow-off phase for the greater cycle that began off the 2002-03 lows. I will not only reiterate, but amplify, my grim outlook for equities going forward. The U.S. economy is slipping into recession. In fact, if one uses more realistic figures for inflation than what the government publishes, we have already experienced recession in real terms. The effect of overzealous lending in the housing market is beginning to be felt in the sub-prime arena and will make a greater mark in 2007. More subtle indicators include the facts that Dow dog, GM, which lead the market higher by doubling off its early-year low, appears to have completed its counter-trend rally. Also, odd-lot short sales, a useful indicator of how unsophisticated investors are positioned, are at a 13-month low. Finally, Nasdaq indices have failed to better their November highs while the S&P 500 and Dow have set new highs. In recent years, weakness has tended to develop in the Nasdaq prior to broader market declines. Therefore, I anticipate that an inflection point could be imminent. The Dollar The dollar, by falling substantially, behaved as anticipated in 2006. As measured by the U.S. Dollar Index, the greenback lost about 8% of its purchasing power. So much for inflation running at only 3%! That the dollar lost ground despite the frenetic pace of U.S. bond and equity purchases by foreigners is a testament to its underlying weakness. Given that Chairman Bernanke halted rate hikes mid-year and will frantically cut them once the effects of the unwinding in housing becomes more ubiquitously recognized, the dollar is likely to continue its downward trend in 2007. I would not be surprised to see fresh all-time lows for our currency. Bonds Bond prices began 2006 in anticipated fashion... by falling sharply... then staged a surprise rally in the latter half of the year, much like equities. Also like equities, I believe this rally represents a blow-off phase and that a change in trend is impending. In fact, my outlook for bonds is identical to that of last year, so I will simply reiterate the view: "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." Precious Metals Precious metals performed fabulously in 2006. Gold's price increased 25% for the year, despite retreating sharply from a parabolic move that ended in spring. Many pundits assert that this parabolic move represented a bubble in gold's price and that its bull market is finished. I could not disagree more. First, the term "bubble" has been grossly over-used since the tech heyday. It seems any time an asset experiences a rapid price increase, people start shouting, "Bubble!" However, for price increases to truly be deemed a mania, the market must contain the necessary condition of broad-based participation, drawing in traders with little or no previous experience in the asset class who suddenly deem themselves experts. Tech in 2000 and housing in 2005 certainly qualify, but gold in 2006 does not. I do believe that precious metals will experience a mania phase, but that the event is years down the road with prices several times higher. As for the coming year, the road may be tricky. While one should expect precious metals to continue appreciating as the dollar slumps, there are headwinds. A recession could exert downward pressure on commodity prices. The damage should be mostly concentrated in industrial commodities, but there is a correlation between industrial and monetary commodities. Therefore, positive performance in gold and silver will ultimately depend heavily on weakness in the dollar. Perhaps traders with heavy PM exposure could hedge those positions with shorts in various industrial metals. Also, precious metals have experienced six straight years of price appreciation. Even the strongest of bull markets have down years, and I do not expect the current bull market in commodities to be an exception. Nevertheless, my outlook remains positive for precious metals in 2007. Energy Last year's prognostication for oil stated that the black stuff would not be a major winner for the year because the emergence of recession would mitigate demand. The view was spot-on. Oil closed the year barely $2 higher than where it began. During the first half of the year, however, oil surged more than 30%, largely due to speculation over the hurricane season. When it became apparent that no major hurricane would threaten the Gulf, the speculative premium unwound rapidly. Oil now sits at a critical crossroad. On one hand, its price is sitting just above the support of its bull market trend line. On the other, the rapid emergence of recessionary conditions should continue to mitigate industrial demand. A big battle is shaping up, and oil is likely to witness a sharp price adjustment in whichever direction it breaks. Therefore, the most prudent strategy for trading oil may be to construct option strangles going several months out. As was the case in 2006, geopolitical turmoil is a wildcard for oil. There is no doubt that tensions between Israel and Iran are intensifying and the odds of a strike on Persian soil are rising. A triple-digit price per barrel would almost surely result. The volatility spike I anticipated in 2006 did not occur. The VIX is trading at all-time lows, providing for very inexpensive options premiums, relatively speaking. Contrary to popular belief, this condition will not last. Risk cannot be under-priced indefinitely because an outlier event will eventually provide a catalyst for rapid change and risk adjustment. Whether or not such an event occurs in 2007 is unknowable, but given the extreme levels of risk absorption, caution is warranted. Wishing a healthy and prosperous New Year to all…

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