Yearly Forecast

  Random Thoughts

1) The monetary backdrop continues to be very different in the US today than it was in earlier post-bubble periods. This is slowing the corrective process and introducing new price distortions that will have to be 'resolved' via another devastating economic bust. When will they ever learn?

2) Economic declines will become progressively more serious and economic recoveries will become progressively weaker until there is wide recognition that the central bank is a big part of the problem as opposed to part of the solution.

3) At this time last year, we wrote: "It has become clear that the Fed's policy of throwing new money at the economy in a horribly misguided effort to generate real growth is not only going to continue in 2013, but also going to be applied more aggressively than was the case in 2012. This money-pumping could prevent widespread recognition of recessionary economic conditions for several more months, but only at a substantial long-term cost. For an economy to function efficiently, price signals must be genuine; that is, price signals must accurately reflect sustainable consumption and production trends."

The Fed is now beginning to slow the pace of its money-pumping, but the damage has been done. The seeds of the next economic bust have been sown.

4) The economic data will probably be OK during the first few months of 2014, but if commercial-bank credit growth continues at its present slow pace then by the third quarter of this year there will probably be enough stock market weakness and enough signs of economic deterioration to prompt the Fed to step away from its "tapering" plan.

5) At the beginning of 2013, we wrote: "China has huge economic problems, but these problems will come to the fore gradually over the space of a few years and won't likely be the cause of big moves in global financial markets during 2013." The same statement applies to this year.

6) At the beginning of 2013 we thought that the euro-zone's government debt disaster would return to "Page 1" during the second half of the year. It didn't. Another euro-zone banking/debt crisis is inevitable, but there are currently no signs that it is imminent. For example, the yield on 10-year Spanish government bonds is near a 5-year low and the EURO STOXX Banks Index recently made a 2-year high. We will monitor European bonds and bank shares in an effort to determine the timing of the inevitable crisis. All we can say right now is that it probably won't happen during the first half of 2014.

7) Last year we thought that unexpected weakness in the US economy was an intermediate-term threat worthy of attention, but not one of the top three risks. Unexpected weakness in the US economy is now one of the top three risks, although it is a risk that probably won't materialise until the second half of the year.

8) As 2013 got underway we considered greater instability in the Middle East to be one of the biggest intermediate-term risks facing the financial markets. We also thought that if this risk was going to materialise it was more likely to do so during the second half than the first half of the year. Our reasoning was that the US government (by far the greatest threat to world peace) would be more inclined towards aggressive military intervention in the Middle East after it became clear that the US economy had sunk into recession, something that was unlikely to happen prior to the second half of 2013. To further explain, governments tend to view external threats as useful distractions during periods of economic weakness. Additionally, in a world dominated by "Keynesian" policy-makers and political advisors, large-scale military action can be perceived as a convenient excuse for more government spending and more monetary inflation.

The threat that the pot of territorial disputes, religious hatreds, political grievances and economic problems known as the Middle East will boil over is ever-present. However, with a deal now in the works regarding Iran's nuclear program, with the start of the next US recession still lying more than 6 months into the future and with US mid-term elections scheduled for this November, the next Middle East 'boil over' of global importance is probably not going to happen in 2014.

9) Last year we wrote: "There's a new big intermediate-term risk facing the financial world as 2013 gets underway: the risk that the government bond bubble will burst. The bursting of the government bond bubble is a more pressing concern today than it was, say, 6 months ago due to the immense political pressure being put on the Bank of Japan (BOJ) to reduce the purchasing power of the Yen."

The government bond bubble probably did burst last year, but the other financial markets took the first phase of the new secular bond bear in stride. Furthermore, despite the actions taken by the BOJ to bring about higher "inflation" in Japan, the JGB market recovered from a sharp April-May sell-off to end the year with a gain. That is, the JGB yield was lower at the end of the year than at the start of the year.

Even though a secular bond bear has probably begun, for the reasons outlined in our 20th January commentary we don't perceive much intermediate-term downside risk for US Treasury bonds. In fact, we suspect that the T-Bond market will end 2014 with a gain.

There is a lot more risk in Japanese Government Bonds. This is mostly because they have a much higher valuation (lower yield), but it is also because the JGB market is much further along in its long-term topping process.

10) Due to the downward trend in the US monetary inflation rate and the valuation-related downside potential in the US stock market, a US deflation scare is a realistic possibility for the second half of the year.

11) For speculators in commodities and commodity-related equities it will be much easier to make money on the 'long' side during 2014 than it was during 2012 and 2013. This is especially so for the year's first half (the second half could contain a deflation scare) and for speculators in gold and gold-related equities.

  The US Stock Market

At the beginning of last year we had no opinion about what the stock market would do over the ensuing 12 months. We thought that risk outweighed reward, but pointed out that this risk/reward assessment didn't translate into a forecast. It didn't even translate into a view that the market was more likely to fall than to rise. It only meant that we thought the potential cost of being wrongly bullish was greater than the potential cost of being wrongly bearish.

For better or worse, as 2014 gets underway we do have a 12-month forecast for the US stock market (S&P500 Index). At least, we have two favoured scenarios that have the same intermediate-term implication.

The first scenario is that a major peak is forming right now. Under this scenario the ultimate price high will occur this month, after which the market will gradually roll over to the downside. Weakness during the first half of the year will be relatively minor, but downward acceleration will occur during the second half of the year after it becomes clear that "QE" has failed to bring about a sustained economic recovery.

This scenario is consistent with a) the extreme optimism reflected by sentiment indicators over the past month, b) the market's high average valuation, and c) the past year's decline in the rate of money-supply growth. It is also consistent with the likelihood of economic data remaining generally supportive for at least a few more months.

The second scenario involves some 'corrective' activity during the first two months of the year followed by a final surge to the ultimate high during April-May. In addition to being consistent with the same influences as the first scenario, this scenario also meshes with the Presidential Cycle Model.

Under both of these scenarios the S&P500 Index would likely end the year with a decline of at least 10%, but the bulk of the bear market's downside would wait until 2015-2016. Given the market's high average valuation and the uncommonly long duration of the cyclical bull (the bull will be 5 years old in March), the decline from the bull-market peak to the following bear-market trough will probably be at least 40%.

Of our two scenarios, at this time we favour the second. The main reason is that although the US monetary inflation rate has trended lower over the past year, it has not yet dropped to levels that preceded the bursting of previous investment bubbles. Unfortunately, the economic underpinnings have been sufficiently damaged by price-distorting monetary policies that the next bust could begin at a higher monetary inflation rate than previous busts. We therefore can't blindly assume that everything will remain superficially fine until/unless there is a significant additional tightening of monetary conditions.

Lastly, as we've done in every yearly forecast beginning with the 2010 edition we again state our belief that the S&P500's March-2009 low will prove to be its ultimate bear-market bottom in nominal dollar terms. This is due to previous and expected-future Fed-promoted depreciation of the US$.

A floor has effectively been placed under the US 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 in the future than it was during 2007-2008. Based on the Fed's actions over the past 18 months a rational observer could no longer doubt that this is the case. After all, the Fed introduced new money-pumping schemes in late-2012 and early-2013 for no reason other than the high unemployment rate, as if counterfeiting money could possibly bring about sustainable gains in employment.

  The US Dollar

The following daily chart creates the impression that there was plenty of movement in the Dollar Index over the past two years, with large near-vertical rallies followed by sharp declines.



But when we step back and look at the much longer-term weekly chart displayed below we see that in actual fact the market was unusually quiet over the past two years. What we see is that the Dollar Index has essentially spent two years trading sideways within a 5-point range.



We expect that the Dollar Index will break out of its 5-point (79-84) range this year and move at least 5 additional points in the direction of the breakout. However, we don't have a clear-cut opinion on the most likely direction.

The performance of the Dollar Index is largely determined by the performance of the US$ relative to the euro, and at this time we see no decisive reason to favour one of these currencies over the other. Sentiment is close to neutral, as are momentum and price action. The current rates of supply change (the respective monetary inflation rates) are in the same ballpark, and the current US$/euro exchange rate is about right on a purchasing power parity basis.

It will most likely be relative stock market performance that determines whether the Dollar Index breaks upward from its 2-year range and makes its way to the 90s or breaks downward from its 2-year range and makes its way to the low-70s. European equities currently offer better value, on average, than US equities, which gives them more intermediate-term upside potential at a time when monetary inflation rates are roughly the same in the US and Europe. On the other hand, there's a greater intermediate-term risk of another debt/banking crisis in Europe than in the US, and despite their relative expensiveness US equities would probably hold up better than their European counterparts during a global equity bear market.

This leads us to the vague conclusion that a) European equities are likely to be strong relative to US equities, leading to strength in the euro and weakness in the Dollar Index, during periods when most major stock markets are strong or at least stable, and b) European equities are likely to be weak relative to US equities, leading to weakness in the euro and strength in the Dollar Index, during periods when most major stock markets are trending downward.

Taking into account the 2014 stock market outlook described above, one realistic scenario entails moderate strength in the euro (and weakness in the Dollar Index) during the first half of the year followed by the opposite during the second half of the year.

Also worth noting is that due to the extent to which these currencies are 'oversold', if most major stock markets are strong or at least stable for several more months then we are likely to get tradable bear-market rebounds in the Australian and Canadian dollars during the first half of the year.

  T-Bonds

Although we believe that 30-year T-Bonds and 10-year T-Notes are now about 18 months into a new secular bear market, we don't expect them to have a bad year in 2014. In fact, our best guess at this time is that T-Bond and T-Note futures will end the year slightly above where they began it. Here are our reasons:

1. The T-Bond is coming off an 'oversold' momentum extreme on both a short-term and an intermediate-term basis.

2. Speculators have a large net-short position in T-Notes.

3. Inflation expectations probably won't rise by much in 2014.

4. Stock market weakness will prompt a flight to the perceived safety of Treasuries during the second half of the year.

5. The performance of the US Treasury market during the 1940s-1950s and the performance of the Japanese Government Bond market since 2003 suggest that the end of the 1980s-2000s secular bull market in US government bonds will be followed by several years of horizontal range-trading. This means that even if the T-Bond falls far enough at some point over the next three months to provide the confirmation of a secular trend reversal mentioned above, there probably won't be much follow-through to the downside.

A strong multi-month rebound could entice us into establishing a bearish T-Bond position, but we view the bond market more as an indicator than as a market to be traded.

  Gold

To arrive at our 2014 forecast for the gold mining sector [see below] we first made the reasonable assumption that the cyclical bear market had either ended or would end following a quick spike to a new low in the near future. To get an idea of what to reasonably expect over the next 12 months we then looked at how the gold-mining indices performed following the three most comparable lows of the past 50 years. Our conclusion, based on the historical record, was that there would probably be a strong first half and a choppy second half.

To arrive at our 2014 forecast for the gold market we are going to begin with the same assumption. This is reasonable, because: a) while the fundamental backdrop is not yet bullish, it is no longer bearish, b) we expect the fundamentals to become increasingly gold-bullish over the course of the year, and c) sentiment indicators suggest that a very gold-bearish scenario has been discounted by market participants, thus paving the way for any surprises to be of the bullish kind.

As we did with the gold-mining sector, for a clue as to what we can realistically expect from the bullion market over the year ahead we'll take a look at weekly charts showing what happened following the comparable lows of the past 50 years. Unfortunately, our historical sample size is only two (over the past 50 years there were only two cyclical gold bear markets that have much in common with the 2011-2013 bear market). This is partly because the gold price was fixed until 1971.

The first of our two weekly charts shows gold's performance during the 1970s, our assumption being that gold's current position is similar to its position near the September-1976 bottom.

Unlike the gold-mining sector, which gained about 50% during the 6 months immediately following the 1976 bottom and then didn't make much progress for more than two years, gold bullion trended steadily upward from its 1976 bottom.

If the post-1976 bottom is a valid roadmap then the gold price will move up to around $1600 during 2014 and test its 2011 peak by mid-2015.



Our second weekly chart shows gold's performance from the beginning of 2000 through to the end of 2004. It therefore covers the final year or so of a bear market and approximately the first four years of a bull market. In this case we are assuming that gold's current position is similar to its position in early-2001.

If the post-2001 bottom is a valid roadmap then the gold price will peak in the $1400s during 2014 and perform very well during 2015. A test of the 2011 peak would occur in late-2015 or early-2016.



Based on the small historical sample size, which is all we have to go on, you should ignore the predictions that gold will zoom straight back to its 2011 top. This is particularly so considering that gold's true fundamentals are mixed at this time (no longer bearish, but not yet bullish). Gold is likely to provide a good return in 2014, but even if a major bottom is in place the gold price is unlikely to trade significantly above $1600 and could have trouble getting beyond the $1400s.

  Gold Stocks

The assumption that underlies our 2014 forecast for the gold mining sector is that the cyclical bear market has either ended or will end following a quick spike to a new low in the near future. This is a big assumption, but it's a reasonable one considering that the 2011-2013 decline was a) equal in magnitude to the largest decline and longer than the longest decline of the 1960s-1970s secular bull market, and b) almost equal in magnitude to and a lot longer than the first major decline of the 1980-2000 secular bear market. Also of importance, the Fed has been busily laying the groundwork for another devastating economic bust that will no doubt be met by another flood of new money.

With this assumption as our premise, for a clue as to what we can realistically expect from the gold-mining sector over the year ahead we'll take a look at weekly charts showing what happened following the three cyclical gold-stock bear markets of the past 50 years that have the most in common with the 2011-2013 bear market.

Our first chart shows the final 12 months of the 1968-1970 cyclical bear market and the ensuing 4 years, using the Barrons Gold Mining Index (BGMI) as the sector proxy. The red line on the chart is the 200-week MA.

Notice that the BGMI rebounded by about 50% to its 200-week MA during the first 6 months of its new bull market, but that after this initial surge it essentially traded sideways for more than two years before commencing a huge rally. In fact, a huge rally didn't get underway until about 3 years after the bear-market bottom.



Our second chart shows the final 8 months of the 1974-1976 cyclical bear market and the ensuing 4-and-a-bit years, again using the BGMI as the sector proxy.

In this case there was also a 50% surge within the first 6 months of the new bull market, but due to having experienced a steeper decline it took the BGMI about 2 years to return to its 200-week MA. Furthermore, as was the case during the first half of the 1970s a huge rally didn't get underway until about 3 years after the bear-market bottom.



Our third chart shows the final year of the late-1990s cyclical bear market and the ensuing 4 years, this time using the HUI as the sector proxy. The blue line on the chart is the 200-week MA.

In this case the initial rebound was stronger (100% instead of 50%), but the overall pattern during the first 12 months of the new bull market was similar. Specifically, there was a rally lasting about 6 months followed by 6 months of sideways trading. Note: The cyclical bull market that began in 2000 was considerably stronger during its first few years than the cyclical bull markets that began in 1970 and 1976, probably because it was the first cyclical bull market in a new secular bull market.



With regard to the gold sector's performance during 2014, the message from the historical record is that there will probably be a strong first half and a choppy second half. The message about the longer-term outlook is that it could be three years (early-2017) before the market takes off to the upside, but there is no point looking that far ahead.

With regard to price targets, the historical cases discussed above suggest that the HUI will trade at least 50% above its bear-market bottom at some point during the year (most likely before mid-year). Also, in two of the cases the upside during the first year of the bull market was limited by the 200-week MA and in the other case the price high during the first year was well below the 200-week MA. This suggests to us that the 200-week MA could reasonably be viewed as defining the MAXIMUM upside potential for the HUI during 2014. As illustrated by the following weekly chart, the 200-week MA is presently at 440 and trending downward.

Further to the above, our guess is that the HUI's 2014 high will be at least 300 and could be as much as 400.