Yearly Forecast

  Random Thoughts

  *There are similarities between the current situation in the US, the US of the 1930s and post-bubble Japan, but the monetary backdrop is very different in the US today than it was in the earlier post-bubble periods. The most obvious effect of the monetary difference is that the prices of most goods and services have continued to rise in the US since the bursting of the private-sector credit bubble in 2007.

  *The less obvious effects of the current period's much higher rate of monetary inflation include the slowing of the corrective process and the introduction of additional price distortions and inefficiencies.

  *The US eventually recovered from the bursting of the 1920s bubble despite the many idiotic policies implemented by the Hoover and Roosevelt administrations, but the US will not be able to recover from the bursting of the more recent credit bubble if the Fed continues to engineer a high rate of monetary inflation. If current Fed policies continue for at least a few more years, the US economy will end up in a far worse state than it has ever been before.

  *Our view continues to be that a global economic depression of the inflationary kind began in 2007.

  *At the beginning of last year we thought that the potential for China's real estate bubble to burst was the biggest risk facing the stock and commodity markets, and that tighter Chinese monetary policy prompted by rising food prices was the most likely catalyst for the bursting of the bubble. As we write today, it looks like China's real estate bubble has burst and that Chinese officialdom has begun to ease monetary conditions despite the country's inflation problem. Also, there is a lot less optimism about China's prospects now than there was at this time last year. The upshot is that there is nowhere near as much scope for a negative surprise out of China in 2012 as there was in 2011, which means that China-related risk has fallen.

  *At the beginning of last year we thought that the euro-zone government debt problem was the second biggest risk facing the stock and commodity markets. This is still a sizeable risk, but its potential to wreak havoc has been substantially reduced by virtue of the fact that it has been a "Page 1" story for the past several months.

  *We perceive this year's biggest risk to be 'unexpected' weakness in the US economy. Reliable leading indicators tell us that the US economy will probably get a lot weaker over the coming few quarters, but most people are still expecting the economy to "muddle through" and most equity analysts are still anticipating good earnings growth in 2012. The risk relates to a mismatch between expectations and reality.

  *This year's second biggest risk is that there will be much greater instability in the Middle East. We doubt that there will be open military conflict between Iran and the US or between Iran and Israel, but fear of such conflict could have a big effect on the markets. Also, the political situations in Egypt and Syria are likely to become more turbulent, and there is an outside -- but not insignificant -- chance that Saudi Arabia will get caught up in the 'revolutionary wave'.

The potential financial consequences of this risk could be mitigated via the purchase of long-dated oil call options. Ideally, the options would be accumulated during periods of weakness in the oil market.

  *Going into 2011 we thought that money-making would be far more difficult over the year ahead than it had been over the preceding two years, and that our primary focus should therefore be on 'playing defense'. As 2012 gets underway we think it is still appropriate to maintain a defensive posture, meaning that we continue to advocate an above-average cash position.

  The US Stock Market

Our 2011 Yearly Forecast included the following statement:

"Our best guess at this time is that the stock market will be 'choppy' during the first half of this year, with a sizable downward correction occurring within the first two months. A lengthy decline is expected to begin during the third quarter of the year."

This guess turned out to be roughly correct, although it is not yet known if the decline that began during the third quarter of 2011 will turn out to be "lengthy". At this stage there is a possibility that it was nothing more than a sharp 3-month correction within a cyclical bull market, but our favoured scenario is that it was the first leg of a new cyclical bear market. Our favoured scenario requires that the market do no better than test its 2011 peak before commencing a downward trend that eventually pushes it well below last year's low.

We expect the market to hold up fairly well during the first few months of this year and then roll over into a major downward trend. To be more specific, we expect that the stock market will be supported over the first few months of the year by loose monetary policy and the fact that two of the most obvious threats (Europe's debt predicament and China's slowdown) have already been discounted. However, spreading realisation that the US economy is in recession will probably cause a major downward trend to begin after the aforementioned period of relative stability has run its course.

Lastly, we reiterate our view that the March-2009 low will prove to be the ultimate bear-market bottom in nominal dollar terms. This is due to the Fed-promoted depreciation of the US$. Furthermore, a floor has effectively been placed under the stock market's dollar-denominated price by the virtual certainty that the Fed will be a lot quicker to crank up the money pumps in reaction to stock market weakness during 2012-2014 than it was during 2007-2008.

  The US Dollar

In our 2011 Yearly Forecast we said that the US dollar's downside risk was low (the Dollar Index was trading at around 78 at the time) and speculated that the Dollar Index would trade up to near the top of its 3-year range (88-90) before the year was out. This was based on our opinion that the US$ would be boosted by stock market weakness and the re-kindling of European debt-default fears.

It turned out that we were too bullish on the dollar. The dollar was boosted by stock market weakness and the re-kindling of European debt-default fears, but the Dollar Index was able to get no higher than 81.

Although we were too optimistic on the US$, our currency market outlook proved to be closer to the mark than most members of the "gold community". Most gold bulls were -- as usual -- expecting the US$ to tank, an expectation that was unrealistic considering the dollar's fiat-currency competition. It should always be remembered that the USD/EUR exchange rate comprises almost 60% of the Dollar Index, which means that a bearish view on the Dollar Index equates to a bullish view on the euro.

The euro stands a good chance of rebounding strongly against the US$ during the first half of this year by virtue of the fact that sentiment is currently more anti-euro than it has ever been. This anti-euro sentiment is reflected by a massive speculative net-short position in euro futures. On a longer-term basis, however, it makes no sense to be bullish on the euro's exchange rate -- and, by definition, bearish on the Dollar Index -- because there's at least a 50% probability that the euro won't even exist three years from now. Three years from now the purchasing power of the US$ will almost certainly be a lot less than it is today, but the US$ will still exist and still be the world's most important fiat currency.

So, for 2012 we are anticipating a multi-month euro rebound, either beginning near the current level or after a capitulation (a final blow-off decline) that pushes the euro down to around 1.20. At this stage there's no point thinking beyond the likely euro rebound. Instead, we'll wait for the market to work off the massive euro net-short position and then consider whether or not a major new euro decline (US$ advance) is likely.

The main commodity currencies (the A$ and the C$) will continue to be strongly influenced by the stock market. If the stock does roughly what we think it will do then the commodity currencies are likely to be stable over the first few months of the year and very weak during the second half of the year.

The only other currency we'll comment on is the Yen. At some point over the next three years the Yen is likely to become very weak in response to huge-scale monetisation of Japanese Government debt, but right now the supply of Yen is growing at a much slower pace than the supply of dollars and the Fed is making sure that the US$ has no interest rate advantage over the Yen. Therefore, over the months ahead the Yen will probably experience nothing more bearish than a routine correction to its up-trend. Furthermore, the Yen could benefit from stock market weakness during the second half of the year.

  T-Bonds

In last year's Forecast we wrote that we would be anticipating considerable weakness in the T-Bond market (rising bond yields) during the first half of the year if not for the fact that T-Bond futures were at the sort of 'oversold' extreme that over the past decade had always been followed by at least 6 months of T-Bond strength. We went on to write:

"Our best guess at this time is that 2011 will turn out to be a flat year for the T-Bond. The bond market's downside should be mitigated over the first half of the year by the fact that it began the year at an 'oversold' extreme, and T-Bonds should benefit from stock market weakness during the second half of the year."

This forecast wasn't a long way off the mark given that T-Bonds were flat during the first half and boosted during the second half by the combination of stock market weakness and fears of sovereign debt default in Europe, but as usual we were too bearish on this market.

Our 2012 forecast is similar in that we again expect T-Bonds to be stronger in the second half than in the first half. The difference is that whereas the T-Bond market began 2011 at an 'oversold' extreme, it has begun 2012 in a moderately 'overbought' position. This means that there should be a sizeable downward correction in the T-Bond price during this year's first half, provided that -- as per our current view -- the stock market holds together for at least a few more months.

One additional point worth taking into account is that current T-Bond sentiment is NOT what would generally be seen near the top of a long-term bull market. We note, in particular, that sentiment surveys and the Commitments of Traders data do not reveal much optimism about the T-Bond market's prospects. We also note that the public (the "dumb money") has minimal exposure to T-Bonds. Consequently, our current "big picture" T-Bond view -- that the long-term bull market ended in December of 2008 -- is probably wrong. 

Despite its obvious (from our perspective) over-valuation, this market stands a good chance of making at least one more substantial up-move prior to the start of a long-term bearish trend. We have therefore upgraded our intermediate-term T-Bond outlook from "bearish" to "neutral".

  Gold

Here's a summary of the 12-month outlook for gold described in our 2011 Yearly Forecast:

1) In US$ terms, gold will be either flat or down by a small percentage.

2) In euro terms it will be another good year for gold in response to concerns about sovereign debt default.

3) Gold will perform better than silver.

4) Relative to the industrial metals and oil, gold will end the year with substantial gains due to global economic weakness.

Gold ended up doing better than expected in US$ terms and roughly as expected in euro terms. Despite a plunge in the gold/silver ratio during the first four months of the year, our expectation that gold would outperform silver in 2011 proved to be correct in the end. Gold did what we expected it would do relative to industrial metals (it outperformed them by a wide margin), but rather than experiencing a substantial gain the gold/oil ratio was roughly flat on the year thanks to unexpected strength in the oil market during September-December.

Interestingly, our current 12-month outlook is not materially different from what our 12-month outlook was at this time last year. In particular, we suspect that over the course of 2012 gold will be a) roughly flat in US$ terms (up a few percent or down a few percent), b) up strongly (more than 10%) in euro terms, and c) higher relative to silver and the base metals. The odds favour it gaining ground against oil, but oil is 2012's biggest wildcard due to the elevated risk of large-scale military conflict in the Middle East.

If our current stock market outlook proves to be close to the mark then gold will probably under-perform silver and the base metals during the first 3-5 months of the year and handily outperform the other metals thereafter. The reason is that gold is one of the most counter-cyclical of investments. Relative to other commodities (including silver), gold tends to perform poorly when economic confidence is rising and/or when the stock market is one of the main beneficiaries of monetary inflation (that is, when the stock market's average P/E ratio is in an upward trend). By the same token, it tends to perform well when economic confidence is on the decline and/or the broad stock market is not among the main beneficiaries of excess money creation.

Our only other comment is that the next upward legs (in US$ terms) in the long-term gold and silver bull markets probably won't begin until at least the final quarter of this year. The main reason for this belief is the extent to which the silver market became 'overbought' and 'overbullish' last April. After a commodity market's sentiment and price action reach the sorts of extremes that occurred in the silver market last April it usually takes at least 18 months for the conditions to be right for the start of a new major upward trend. This doesn't mean that we expect gold and silver to make new correction lows this year. Our favoured scenario is that the ultimate correction lows were put in place last month and that a multi-quarter period of base-building is now underway.

  Gold Stocks

With regard to the gold sector of the stock market, our 2011 Yearly Forecast was way off the mark. This was what we wrote in January of last year:

"Following the unusually steady rise of 2009-2010, we expect that the gold-stock indices will experience more of a 'rollercoaster ride' during 2011. They will probably end the year with gains, but as was the case in 2010 by far the best gains are likely to occur within the ranks of the juniors."

The 'rollercoaster ride' comment was correct, but the gold-stock indices ended the year with losses of around 10%. Moreover, the junior end of the sector was very weak on a relative and absolute basis.

Although we didn't forecast last year's lacklustre performance by the gold sector, the performance wasn't out of line with the historical pattern. As noted in our 30th November 2011 discussion about the Barrons Gold Mining Index (BGMI):

"After the 60s-70s bull market reached the top of a major upward leg (the points labeled 1 and 2 on our BGMI chart), more than 5 years elapsed before there was a decisive break to a new all-time high. If the current market does something similar then there won't be a decisive break into new all-time-high territory prior to the second quarter of 2013. The point, here, is that the gold sector's seeming inability over the past 12 months to embark on a powerful new upward trend is consistent with what happened during the previous long-term bull market."



As also noted in our 30th November commentary:

"...we shouldn't blindly assume that the current long-term bull market will continue to track the earlier long-term bull market. Real-time analysis is required at each step along the way, because the current market could end up doing better or worse than the earlier one in response to contemporary fundamental developments. We are simply trying to show that the frustration being experienced by today's holders of gold stocks was most likely also experienced by holders of gold stocks at a similar stage of the 60s-70s bull market. In fact, the level of frustration could have been higher back then because this time around the BGMI was quicker to recoup the losses incurred during its first major correction."

Real-time analysis will continue to be the primary influence on our expectations, but it makes sense to also keep the 60s-70s pattern in mind. The fact is that despite the important fundamental differences between today's situation and the situation four decades ago, on a 'big picture' basis the current bull market in gold stocks is unfolding in similar fashion to the earlier one.

Perhaps the best way to view the current situation is to accept that while the bull market's next major upward leg could soon begin, there's a realistic chance -- based on the historical pattern -- that it won't begin until next year. Be prepared, then, for the POSSIBILITY that the gold-stock indices will spend this year within a range bounded by last year's high and low (640 and 480 for the HUI).

Due to the extent to which gold stocks were 'oversold' late last month, the gold sector is likely to have an upward bias over first few months of this year. This is especially so for the juniors, many of which ended last year at very depressed valuations.

    Industrial Commodities

Based on where the two have traded relative to each other over the past several years, oil is now expensive compared to the Industrial Metals Index (GYX). This suggests that if industrial demand were to decline in response to a global economic contraction, which, in our opinion, is a distinct possibility, then the oil price would fall a lot further than the prices of most industrial metals.

However, the downside risk associated with oil's relatively high valuation must be weighed against the following:

1. As evidenced by the chart displayed below, oil has been trending higher relative to the GYX since 1998. This suggests the possibility that oil will become a lot more expensive relative to industrial metals over the years ahead.

2. The risk of a major disruption to global oil supply.



For 2012, our expectation is that oil and the industrial metals will be firm over the first few months and weak during the second half of the year. This is on the proviso that the Middle East doesn't become a lot less stable than it already is. However, the risk of the Middle East becoming a lot less stable is uncomfortably high.

A Middle-East event of sufficient magnitude to materially reduce the global supply of oil would naturally lead to a large rise in the oil price. It would also, we think, lead to substantial weakness in the industrial metals as speculators quickly factored in the effects on global growth of a much higher oil price.