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2013 Forecast, Part 1

We are splitting our Yearly Forecast for 2013 into two parts, with Part 1 included in today's report and Part 2 included in the coming Weekly Update. Random Thoughts, the Stock Market and the US Dollar are covered in Part 1 (below). Bonds, Gold, Gold Stocks and Industrial Commodities will be covered in Part 2.

Random Thoughts

1) 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.

2) 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.

3) 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.

4) The above three points are copied from our 2012 Yearly Forecast. 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.

5) At the beginning of last year we wrote that there was nowhere near as much scope for a negative surprise out of China in 2012 as there had been in 2011, because China's central planners had begun to loosen the monetary reins and because China's economic problems had come to be more widely recognised. In a nutshell, we thought that China-related risk had fallen. This assessment appears to have been close to the mark, or at least wasn't disproved by events.

Our thinking is unchanged. 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.

6) At the beginning of last year we thought that the euro-zone's government debt problem was still a sizeable risk, but that its potential to wreak global havoc had been substantially reduced by virtue of the fact that it had been a "Page 1" story for many months. This assessment was largely validated by events, as the news out of Europe continued to get worse over the first seven months of 2012 and yet the euro didn't collapse and severe stock market weakness was restricted to the small number of euro-zone countries at the centre of the debt crisis.

'Everyone' is now confident that the worst is over for the euro-zone's financially-challenged governments and banks. Paradoxically, this means that the risk is now much greater. The cause of all the gnashing of teeth that occurred during the second half of 2011 and the first half of 2012 hasn't disappeared, it has only been temporarily put aside. The bailouts will continue, with Spain's government probably requesting an aid package during the first quarter of this year and Greece's government confessing that it is once again in need of help. Spain will get a bailout and the markets will breathe a sigh of relief, but by the third quarter of this year it should be apparent that France's government is in danger of defaulting on its debt. After all, the finances of France's government looked precarious even before a socialist president came to power and began to enact policies that are sure to drive many of the country's most productive people and highest tax-payers elsewhere.

We expect that the euro-zone's government debt disaster will return to "Page 1" during the second half of 2013.

7) Due to a mismatch between expectations and reality, we thought that last year's biggest issue for the financial markets would turn out to be weakness in the US economy (most people were expecting the US economy to "muddle through" and most equity analysts were anticipating good earnings growth during 2012). We were wrong. Even though the US economy was lacklustre and the rate of US corporate earnings growth dropped to almost zero, the popular "muddle through" view proved to be closer to the mark.

Unexpected weakness in the US economy is still an intermediate-term threat worthy of attention, but it is no longer one of our top three risks. The three biggest risks are the likelihood of the euro-zone's government debt predicament returning to centre stage (Point 6 above) and the issues outlined in Points 8 and 9 below.

8) Going into 2012 we thought that the second biggest intermediate-term risk facing the markets involved the potential for greater instability in the Middle East. We didn't think that there would be open military conflict between Iran and the US or between Iran and Israel, but we were concerned that escalating tension between these countries could have a big effect on the markets. We were also concerned that the political situations in Egypt and Syria would become more turbulent, and that there was an outside -- but not insignificant -- chance of Saudi Arabia getting caught up in the 'revolutionary wave'.

This risk partly materialised, in that the political situations in Egypt and Syria certainly became more turbulent (Syria's instability degenerated into civil war, and Egypt's population, having thrown out their long-serving dictator in 2011, began to experience 'revolter's remorse' as the democratically-elected replacement showed signs of being equally bad). However, the financial markets ignored the troubles in Syria and Egypt, and the possibility of military conflict between Iran and US/Israel never became a big issue.

As 2013 begins, the potential for greater political and geopolitical instability in the Middle East remains one of the biggest intermediate-term risks facing the financial markets. This risk is more likely to materialise during the second half than the first half of the year, the reason being that the US government will be more inclined towards aggressive military action after it becomes clear that the US economy is in recession. Governments tend to view external threats as useful distractions during periods of economic weakness. Also, a real or imagined urgent need for military action provides an excuse for more government spending and more inflation.

9) 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. We don't know yet if the BOJ will actually take the actions required to reduce the Yen's purchasing power at the rate demanded by Japan's new government, but if it does then bond yields will be pushed a lot higher in Japan and the yields on other 'safe haven' government bonds will likely follow.

The potential for a large decline in government bonds is not only linked to the goings-on in Japan. Clearly, the Fed and the ECB are taking actions that will eventually lead to much higher inflation expectations and bond yields regardless of whether or not the BOJ joins the inflation party. The big unknown is -- and has always been -- the timing.

10) We think that 2013's best profit-creating opportunity will be provided by -- dare we say it -- the gold mining sector.

11) Going into both 2011 and 2012 we thought that money-making would be far more challenging over the year ahead than it had been during 2009-2010, and that our primary focus should therefore be on 'playing defense'. Unfortunately, as 2013 gets underway we still think it is appropriate to maintain a moderately defensive posture, meaning that we continue to advocate an above-average cash position.

The Stock Market

As is our wont, we were too bearish on the stock market in 2012. At least, our concerns weren't validated by the price action. We expected the market to hold up fairly well during the first few months of the year and then roll over into a major downward trend, with spreading recognition of a US recession being a primary driver of the downward trend. The first half of 2012 went according to plan, but the global stock market fared much better during the second half than we thought it would. The deviation from our 'plan' began in late July, not coincidentally around the time of ECB chief Mario Draghi's promise that the ECB would "do whatever it takes". We under-estimated the importance of the ECB's July-2012 shift.



Although this is the time of year when it is traditional for a newsletter writer to express an opinion on what will likely happen over the year ahead, right now we simply have no opinion on what the stock market will do during 2013 and see no point in pretending otherwise. The market is 'overbought' on a short-term basis, but sentiment is neutral and the 'overbought' condition could be eliminated by a routine consolidation. We think that the risk/reward balance is skewed towards risk in the short and intermediate terms, but a perception that risk is markedly higher than potential reward doesn't necessarily translate into a forecast. It doesn't even necessarily translate into a view that the market is more likely to rise than fall. To use an analogy, we would reasonably expect to win a round of Russian roulette, but it wouldn't make sense for us to play because the cost of losing would be too great. We view the current stock market situation in a similar way. Due to how the risk/reward is skewed, the cost of being wrongly bullish would be far greater than the cost of being wrongly bearish.

Lastly, as we've done in every yearly forecast beginning with the 2010 edition we reiterate our view 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 the Fed-promoted depreciation of the US$. Another consideration noted in previous yearly forecasts is that 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 four months a rational observer could no longer doubt that this is the case. After all, the Fed is now introducing new money-pumping schemes for no reason other than the high unemployment rate, as if counterfeiting money could possibly bring about sustainable gains in employment.

The US Dollar

Most gold bulls are constantly expecting the US$ to tank, but this expectation is 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. Based on various considerations including interest-rate differentials, monetary-inflation differentials and sentiment, there are times when it makes sense to be bullish on the US$ relative to the euro and times when it makes sense to be bearish.

Here is how we stated our 2012 forecast for the euro and, consequently, the Dollar Index (the Dollar Index effectively being the reciprocal of the euro):

"...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."

It took longer than expected for the euro to rebound and for the euro net-short position to be worked off, but it eventually happened. As things now stand, the euro has rebounded for about 5 months and speculators have shifted from being massively net-short euro futures to being approximately flat.



Once a sentiment swing from an optimistic or pessimistic extreme gets underway in the financial markets it usually doesn't end until the opposite extreme is reached. Given that sentiment in the currency market has shifted from an anti-euro extreme to neutral, this probably means that the euro will gain some additional ground before making an intermediate-term peak (a peak that holds for more than a few months). Our best guess at this stage is that the euro will peak at somewhere between 135 and 140 during the first half of this year and then roll over into a major multi-quarter decline driven by the resumption of the euro-zone's government debt crisis.

We now turn our attention to the most interesting currency of the moment: the Yen.

In our 2012 forecast we wrote:

"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."

The Yen has become very weak over the past few months in response to the ANTICIPATION of huge-scale monetisation of Japanese Government debt. At this stage it isn't known if the anticipated monetisation will begin in the near future, although there's a high probability of it beginning within the coming two years. It's the logical (from a political perspective) next step along the road to debt default.

We think the Yen is positioned similarly today to how the euro was positioned at its low points during the first seven months of 2012. Almost everyone is bearish for reasons that everyone is well aware of. According to Market Vane's sentiment survey, only 19% of traders were bullish on the Yen at the low point over the past week. By comparison, 24% of traders were bullish on the euro when it was bottoming in late-July of last year. It's possible that the currency-trading community will become a little more anti-Yen before we get a meaningful swing in the opposite direction, but there doesn't seem to be scope for Yen sentiment to get a lot worse.

Primarily for sentiment reasons, we expect that a substantial multi-month Yen rebound will begin by April. It should also be noted that long-term fundamentals still favour the Yen over both the US$ and the euro, but that will change if the BOJ begins to increase the Yen supply at a much faster pace.

Moving along, we expect that the main commodity currencies (the A$ and the C$) will be strongly influenced by the stock market during 2013 just as they were during each of the past several years. To be a little more specific, the A$ and the C$ will be in rising trends when the global stock market is strong and falling trends when the global stock market is weak.

The Stock Market

The following chart-comparison of the S&P500 Index and the stock price of Apple (AAPL) is puzzling. Until September of this year, the strong upward trend in Apple's stock price appeared to be a major contributor to the rising trend in the broad stock market. Therefore, it would have been reasonable to expect that a 25% decline in the price of Apple shares, with no important negative company-specific news to explain it, would be accompanied by significant weakness in the broad market. However, the chart shows that over the past four months the S&P500 has essentially traded sideways while AAPL has lost 25% of its value. This is strange, especially considering that AAPL's valuation is attractive based on what it earned over the past 12 months and what it is expected to earn over the next 12 months.

It usually isn't difficult to come up with a plausible-sounding explanation for market action after the fact, but in this case we didn't expect such a divergence and we can't explain it now that it has happened.



Most stock indices are 'overbought' and close to important resistance. Also, the VIX is at an unusually low level. This probably means that the indices will trade 5%-10% below current levels within the next couple of months, even if they maintain an upward bias for 2-3 more weeks.

That being said, sentiment surveys do not reveal rampant optimism. Actually, on a scale of zero to ten, with zero representing abject pessimism and ten representing manic optimism, we would put current stock market sentiment at six. This opens up the possibility that a routine 5%-10% correction would clear the way for another 2-3 month rally.

Gold and the Dollar

Gold

Basel III Progress

In three commentaries last November-December we discussed the potential impact of the new "Basel III" banking regulations on the gold market. Our conclusion: "Despite the breathless commentary of some pundits, at this stage it doesn't look like Basel III will be a watershed event for the gold market. Moreover, there is still doubt as to exactly what Basel III will entail, which parts of Basel III will be implemented by the banking regulators of different countries, and the implementation schedule."

There was a new Basel-related development early this week. The Basel Committee announced that the first ever global liquidity standards would be less onerous than expected and not be fully enforced until 2019, four years later than expected. Of particular relevance, the list of assets taken into account when calculating a bank's "liquidity coverage ratio" has been expanded to include some equities and mortgage-backed securities, but not gold. Refer to the FT article posted HERE for more information.

This latest development effectively underlines two points. First, gold will not be directly affected by Basel III. Second, the world's major central banks, commercial banks, banking regulators and governments are in bed together.

Current Market Situation

The gold market drifted uneventfully over the first three days of this week, leaving gold's price at the end of the US trading session on Wednesday 9th January within $1 of its price at the end of last week.

Gold Stocks

There probably aren't many gold-stock bulls left. Being a contrarian investor works well over the long term, but it often results in discomfort. That's why many investors claim to be contrarians, but very few actually are.

The HUI has tested its December intra-day low of 420 on each of the past two trading days. Until now it has managed to hold above this level on a daily closing basis, but it will obviously take only a small increase in selling pressure or a small reduction in buying pressure to bring about a daily close below 420. If the HUI were to close below 420 then the chart-based objective would be major support at 375-385.



GDXJ and GLDX, ETFs that represent the junior end of the gold sector, have recently traded more positively than the HUI. For example, whereas the HUI is testing its December-2012 intra-day low and just achieved its lowest daily close since early August of 2012, the following chart shows that GDXJ ended Wednesday's session a few percent above its December low. However, a daily close below 420 by the HUI will take us out of the GDXJ trade we initiated in the latest Weekly Update, regardless of whether or not GDXJ remains above equivalent support. This is being done to ensure that if there is a loss it will be small.

Update on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html