2015 Yearly Forecast

 The US Stock Market

The biggest error we made last year was being bearish on the US stock market. It was our biggest error because our other significant error (being bullish on gold-related investments) was largely a consequence of our intermediate-term bearish outlook for the US stock market.

At the beginning of last year we had two scenarios in mind for the S&P500 Index (SPX), with the scenario considered the most likely involving some strength during the first 4-5 months of the year followed by a rolling over into a 2-3 year bearish trend. Under both of our scenarios the S&P500 Index would end the year with a decline of at least 10%, although the bulk of the anticipated bear market's downside would wait until 2015-2016. Given the market's high average valuation and the long duration of the cyclical bull, the decline from the bull-market peak to the ultimate bear-market trough was expected to be at least 40%.

What actually happened was that the SPX began last year at 1848 and ended the year at 2059 for an annual gain of 11%. This was a remarkably good performance considering the high starting valuation, the weak earnings growth and the gradual removal of Fed monetary support. However, with regard to future prospects it has skewed the risk/reward even further towards risk.

The old bull market is now even 'longer in the tooth', the average valuation is now even higher and the Fed's money-pumping has (temporarily) come to an end. Furthermore, unlike this time last year we now have evidence that a major top is either in place or will soon be put in place. We are referring to the downward reversal in the SPX/USB ratio (most recently discussed in the 12th January Weekly Update) and the inability of NYSE Margin Debt to exceed its February-2014 peak. On the equity-bullish side of the ledger: other important central banks have ramped up their money pumps, ZIRP continues in the US and elsewhere, and the pace of credit creation by the US commercial banking industry has accelerated over the past 12 months.

Because monetary conditions remain very easy, the sort of stock market collapse that occurred in 2008 is not a realistic possibility for 2015. A down year for the US stock market is very likely, though.

Our best guess at this time (guess is another word for forecast) is that what we had in mind for 2014 will happen in 2015. In particular, we expect the high for the year to occur within the first few months (it's possibly already in place), after which the market will gradually roll over to the downside. A choppy decline that leaves the S&P500 with a loss of around 10% by year-end 2015 is far more likely than a crash, with greater downside in store for next year if the start of a bear market is signaled this year.

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 never be breached 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 2-3 years a rational observer could no longer doubt that this is the case.

    The US Dollar

When we penned our 2014 forecast for the currency market we had no firm opinion on whether the Dollar Index would break out to the upside or the downside from the 5-point horizontal range in which it had oscillated over the preceding two years. However, we did have an opinion on what would drive the direction of the eventual breakout. Here's what we wrote:

"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."

We were right about what would drive the Dollar Index during 2014, in that dramatic strength in US equities relative to European equities (with performance measured in terms of a common currency) propelled the US$ sharply higher on the foreign exchange market during the second half of last year. This is confirmed by the following chart. However, we didn't anticipate the relative strength in US stocks and failed to react to it in a timely fashion.



We don't see any reason why the Dollar Index, which is dominated by the USD/EUR exchange rate, should stop trending with relative equity-market performance. We therefore view the shift in relative stock-market strength that occurred in early-January as a bearish omen for the Dollar Index. Furthermore, last year's relatively poor performance by European equities makes it less likely that they will underperform over the months ahead, especially considering that euro-zone monetary inflation has recently accelerated and will likely be given an additional boost when the ECB's new QE program kicks off in March. Therefore, the euro will probably have an upward bias and the Dollar Index will probably have a downward bias during the first half of this year.

That's as far ahead as we are prepared to look at this time.

   T-Bonds

Our 2015 forecast for the US Treasury market was essentially summarised in the list of "2015 surprises" included in the 7th January Interim Update. Surprises 1) and 2) covered US interest rates and the US government bond market. Here they are again, with minor changes to the wording:

1) We expect that the Fed will continue to make noises about 'normalising' monetary policy, but will end up doing almost nothing. At most, there will be a single 0.25% rate hike. One reason is the fear that economic weakness elsewhere in the world, primarily the euro-zone, will weigh on the US economy. Another reason is the absence of an obvious "price inflation" problem. A third reason is the Fed's unwavering commitment to the absurd Keynesian idea that an economy can be strengthened by punishing savers.

2) We expect US Treasury yields to defy the majority view by ending the year flat-to-lower. More specifically, we expect the 30-year T-Bond yield to be roughly unchanged over the course of the year, but that yields will decline in the middle and at the short end of the curve. Of all the Treasury securities, the 5-year T-Note should experience the largest decline in yield as traders belatedly realise that the Fed will not be taking any significant steps towards 'policy normalisation' during 2015 or 2016.

In addition to the absence of an obvious "price inflation" problem, there are two current reasons and one potential reason to expect flat-to-lower Treasury yields (flat-to-higher Treasury prices) over the course of this year. The current reasons are sentiment (surveys and the COT data indicate that bullish sentiment is not yet close to an extreme) and the good value offered by US Treasury securities relative to the value on offer in Europe and Japan. The potential reason is stock market weakness, in that a lengthy downward trend in the stock market would likely boost the demand for Treasury debt. This is a "potential" reason because a lengthy downward trend in the stock market is not a sure thing.

The reason to expect Treasury securities with 5-10 year durations to do better than 30-year T-Bonds is the extent to which the T-Bond out-performed over the past 12 months and is now stretched to the upside. The following two weekly charts illustrate what we mean.

The first chart shows that the 30-year T-Bond has reached the top of the moving-average (MA) envelope that limited the powerful rallies of 2008 and 2011, and that the T-Bond's weekly RSI is now at its highest level in more than 10 years. The second chart shows that the 10-year T-Note is only slightly 'overbought'.

   Gold

Here's the conclusion of our 2014 gold forecast:

"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."

We were wrong about gold providing a good return in 2014, at least relative to the US$. In US$ terms gold was flat in 2014, although it did provide a good return in terms of every other currency.

In 2014 gold performed roughly as expected in US$ terms during the first half of the year, but then fell to a new bear-market low during the second half. The problems for the US$ gold price during the second half of 2014 were the perceived strength of the US economy (linked to the continuing upward trend in the S&P500 Index), the flattening of the US yield-curve (related to the perceived US economic strength), and the Dollar Index's upside breakout from a long-term basing pattern.

The gold market has come to ignore the strength in the Dollar Index, because the US dollar's rise on the foreign exchange market has come to be seen as more of a reflection of declining confidence in the ECB and weakening global growth than a reflection of improving US$ fundamentals. However, there is no evidence, yet, that the S&P500 has peaked. Also, the US yield-curve hasn't yet signaled a trend reversal from flattening to steepening, and despite the problems in the 'oil patch' the general belief is that the US economy will make real progress this year.

There is never a good time to make a 12-month forecast, since forecasting is for the birds. But right now is a particularly bad time to make a gold forecast, the reason being that changes in other markets are needed to turn the gold market higher on a sustained basis and the needed changes may or may not be about to happen. Of primary importance, a sustained turn to the upside in gold almost certainly requires a sustained turn to the downside in US equities. Some long-term indicators are warning that such a change is in the works, but the S&P500's price action hasn't yet signaled anything of the sort. The first sign would be a daily S&P500 close below 1970.

If the S&P500 is in the process of rolling over to the downside on a long-term basis then it's highly probable that gold bottomed last November and will generate the sort of performance in 2015 that we originally expected to happen in 2014. That is, gold will probably work its way higher over the course of this year with a top most likely occurring in the $1400s and with an outside chance of making it as high as $1600. The most plausible alternative is that the S&P500 will make some additional headway over the next few months and gold will drop to test its 2014 bottom during the second quarter of this year prior to a long-term reversal.

   Gold Stocks

Gold-mining stocks will normally outperform gold bullion by a wide margin during the first 2 years of a new cyclical gold bull market. This is due to the fact that the cost of mining gold follows the gold price with a lag of 1-2 years. Due to this and depending on the length of the preceding gold bear market, the cost of mining gold will probably be in a downward trend at the start of a new cyclical bull market in gold bullion and will probably continue to fall during the first 1-2 years of a new bull market in gold bullion. A rising trend in the gold price combined with depressed stock valuations and falling production costs equals substantial profit-margin expansion and large gains in stock prices. Consequently, if gold made its ultimate bottom last November then the HUI should achieve a large percentage gain over the next 18 months in both nominal price terms and relative to gold bullion.

Of course, that's a big "if". Preliminary signs have emerged that the US$ gold price did indeed make its ultimate bottom last November (the non-US$ gold price having almost certainly bottomed way back in December of 2013), but we have been disappointed before. Last year, to be specific.

A long-term (that is, multi-year) bullish trend in gold mining stocks (as represented by the HUI) naturally requires a long-term bullish trend in gold bullion, which probably requires a long-term bearish trend in the US stock market (as represented by the S&P500 Index). A transition from a long-term bearish to a long-term bullish trend in the HUI and an associated transition from a long-term bullish to a long-term bearish trend in the S&P500 Index is our favoured possibility at this time.



There is, however, another realistic possibility that would lead to substantial gains in gold mining stocks this year, but would not involve a long-term trend shift. Specifically, a further 6-12 month extension of the cyclical bull market in US equities would likely coincide with a very profitable 6-12 month rally in the gold-mining sector if the extension of the old bull market encompassed a rotation into commodity-oriented and other basic-material stocks. This would be similar to what happened during the final quarter of 1986 and the first three quarters of 1987.

   Industrial Commodities

Oil

As everyone knows, the oil price crashed during the second half of last year. This crash was due to a number of bearish forces coming together at the one time. First, oil was expensive relative to commodities in general. Second, oil's supply/demand fundamentals were price-bearish as the result of slowing economic activity and rising US supply. Third, the US$ was getting stronger. Fourth, there was broad-based weakness in the commodity markets. And fifth, the supply/demand situation became even more bearish when Saudi Arabia decided not to reduce supply in response to the falling price.

As a consequence of the price crash, over the past two months the oil market not only became extremely 'oversold' in US$ terms, with oil's weekly RSI hitting its lowest level since 1986 and Market Vane's bullish percentage for oil achieving the lowest reading we've ever seen in any market (9%), it also became extremely cheap relative to other commodities. In particular, oil dropped to a 15-year low relative to copper, to a multi-decade low relative to gold, and to within a few percent of a 15-year low relative to the Continuous Commodity Index. Oil's long-term position relative to gold is illustrated by the following monthly chart. Also, relative to the S&P500 Index the oil price fell to its lowest level since 2002.

This sets the stage for oil to outperform over the next 12 months.



We expect that oil will soon turn upward on a sustained basis relative to industrial metals such as copper, but that in US$ terms and relative to gold a sustained up-turn won't get underway until the second half of this year. In US$ terms, we expect that during the first half of the year the oil price will build a base, with the likely pattern involving a rebound during the first quarter followed by a second-quarter test of the January bottom.

By the way, our inflation-adjusted (IA) calculations suggest maximum downside risk during the first half of this year to the mid-to-high-$30s, which is the current-dollar equivalent of the major price bottom in 1986. We do not expect that oil will get this cheap, but that level of weakness cannot yet be ruled out. If oil does get that cheap it will be one of the best buys of the past 50 years.

One reason to believe that it's too early to start speculating on a SUSTAINED turn to the upside is that although Market Vane's bullish percentage for oil recently hit an extraordinarily low level and almost everyone seems to be bearish on oil, which is exactly what would be expected near a major price bottom, speculators in oil futures haven't yet capitulated. Incredibly, speculators (as a group) have maintained a sizable net-long position in NYMEX oil futures over the past four months.

A second reason is that although there has been a large decline in the quantity of US drilling rigs over the past three months, US oil production hasn't yet begun to decline. Instead, what's happening is that heavily-indebted US oil producers are trying to extract oil from their existing wells as quickly as possible to generate the cash-flow needed to meet their monthly expenses. That is, they are trying to make up for the large fall in the per-barrel price by producing more barrels.

Industrial Metals

We expect that copper and the Industrial Metals Index (GYX) will commence new cyclical bull markets from price bottoms during the first half of this year. This forecast assumes that gold bottomed last November (gold is the leader) and that central banks will continue to react to economic weakness by increasing the money supply.

Even if we are right about new bull markets getting underway within the next few months, the ultimate price lows could be well below current levels. In particular, we perceive downside risk in the copper price to the low-US$2 area, which is where the inflation-adjusted copper price would roughly match its 2008 low. $2.00-$2.10 for copper would likely equate to about 250 for GYX.