This commentary originally appeared at 7:15 a.m. EST on Jan. 7 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.
"Never make predictions, especially about the future."
-- Casey Stengel
It's that time of the year again!
It was a tough task repeating the success of my surprise list for 2011 over the past year.
This is particularly true since my most important surprise (No. 4) in 2011 -- namely, that the S&P 500 would end the year at exactly the same price that it started the year (1257) -- was eerily prescient. As well, in 2011 I basically nailed that the trading range over the course of that year would be narrow (between 1150 and 1300).
As we entered 2012, most strategists expressed a relatively sanguine economic view of a self-sustaining domestic recovery and an upbeat corporate profits picture but shared the view that the S&P 500 would rise but only modestly.
By contrast, I called for a much better equity market -- one capable, in the second half of the year, of piercing the 2000 high of 1527. As it turns out, the S&P 500 breached 1480 to the upside in the fall -- or about only 3% less than the 2000 peak. (In October, I concluded that the S&P 500's fair market value was 1415, and the S&P closed the year just 10 points higher than that figure.)
Before reviewing what else went right in my surprise list for 2012 (and what went wrong), I wanted to give some historical perspective on the lessons of the past, on the role of the consensus and what I am trying to bring to the table in the construction of the surprise list.
Lessons Learned Over the Years
"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown."
-- Woody Allen
There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:
- how wrong conventional wisdom can consistently be;
- that uncertainty will persist;
- to expect the unexpected;
- that the occurrence of black swan events are growing in frequency; and
- with rapidly changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.
Consensus Is Often Wrong
"Let's face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins."
-- UBS's top 10 surprises for 2012
Let's get back to what I mean to accomplish in creating my annual surprise list.
It is important to note that my surprises are not intended to be predictions but rather events that have a reasonable chance of occurring despite being at odds with the consensus. I call these "possible improbable" events. In sports, betting my surprises would be called an "overlay," a term commonly used when the odds on a proposition are in favor of the bettor rather than the house.
The real purpose of this endeavor is a practical one -- that is, to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs on small wagers/investments.
Since the mid-1990s, Wall Street research has deteriorated in quantity and quality (due to competition for human capital at hedge funds, brokerage industry consolidation and former New York Attorney General Eliot Spitzer-initiated reforms) and remains, more than ever, maintenance-oriented, conventional and groupthink (or groupstink, as I prefer to call it). Mainstream and consensus expectations are just that, and in most cases, they are deeply embedded into today's stock prices.
It has been said that if life were predictable, it would cease to be life, so if I succeed in making you think (and possibly position) for outlier events, then my endeavor has been worthwhile.
Nothing is more obstinate than a fashionable consensus, and my annual exercise recognizes that over the course of time, conventional wisdom is often wrong.
As a society (and as investors), we are consistently bamboozled by appearance and consensus. Too often, we are played as suckers, as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein's weapons of mass destruction, the heroic home-run production of steroid-laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank Citigroup (C), the uninterrupted profit growth at Fannie Mae (FNM) and Freddie Mac (FRE), housing's new paradigm (in the mid-2000s) of noncyclical growth and ever-rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff's investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.
"Consensus is what many people say in chorus but do not believe as individuals."
-- Abba Eban (Israeli foreign minister from 1966 to 1974)
In an excellent essay published two years ago, GMO's James Montier made note of the consistent weakness embodied in consensus forecasts. As he puts it, "economists can't forecast for toffee."
They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else....
If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!
-- James Montier
By means of background and for those new to Real Money Pro, 10 years ago, I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien's playbook, who originally delivered his list while chief investment strategist at Morgan Stanley (MS) then Pequot Capital Management and now at Blackstone (BX).
Dueling Annual Surprise Lists: Kass vs. Wien
Every year I, and many others, look forward to Byron "Brontosaurus Rex" Wien's annual compilation (hat tip to "Squawk Box's" Joe Kernen for giving him the moniker).
Byron has had a remarkable (and almost uncanny) record of his surprises becoming realities ever since he started his exercise back in 1986. His picks in 2009 were particularly accurate, but his surprises for 2010-2011 were considered by some to be off the mark.
The tone of almost all Byron's 2011 surprises was diametrically opposed to my list -- namely, his list was rooted in optimism, while my list was rooted in pessimism. Where I saw slowing and sluggish economic growth, a weak housing market, a European recession by year-end and a lackluster stock market, Byron saw improving prospects. His principal surprises for the economy, interest rates, housing, the eurozone's debt crisis and the housing markets were off the mark in 2011. (Byron is an honest guy, so he would be the first to admit this.)
Specifically, Byron expected U.S. real GDP growth of close to 5% (real U.S. GDP over the 12-month period saw only a 1.8% growth rate), a 5% yield on the 10-year U.S. note (which stood at 2.03% by year-end 2011, but, hey, I got that one wrong, too!), a year-end S&P 500 close near 1500 (it closed at 1257), a sharp recovery in housing starts to 600,000 and a rise in the Case-Shiller Home Price Index, and a quiescent and non-market-disruptive European debt situation. He was very correct on the price of gold (where I was far off base) and on benign inflationary pressures.
In 2012 Byron batted about .500 -- more or less in line with my batting average.
He was correct in his upbeat forecast for stock prices, oil prices, the strength in corporate profits, the results of the Presidential election, a EU plan that successfully stabilized and ring-fenced the sovereign debt problem, the intensification of cyberwarfare, the strength in the U.S. housing market and that the price of gold would hit $1,800 an ounce.
His optimism on domestic economic growth proved wrong, as did his view that the Democrats would take back the House. Similar to myself, Byron expected a less dysfunction in Washington, D.C. -- the opposite occurred. He was too optimistic regarding China and other emerging stock markets, and his forecast of a 4% 10-year U.S. note yield was way off mark.
Last Wednesday Byron Wien presented his 10 surprises for 2013 (and five also-rans).
For the first time in years there is a large overlap in our surprise lists this year.
How Did Consensus Do in 2012?
As we entered 2012, consensus estimates for economic growth and stock market prices were modest, corporate profits expectations were upbeat and projections for bond prices were lower and for bond yields higher. As is typical, most estimates were grouped in an extraordinarily tight range.
Last year, I chose to use Goldman Sachs' (GS) forecasts as a proxy for the consensus.
Below were Goldman Sachs' year-ago forecasts for 2012 (with the actuals in parentheses and boldface):
- 2012 U.S. real GDP up 1.8% (+2.3%), and global GDP up 3.2% (+3.1%);
- 2012 S&P 500 operating profits of $100 a share ($100 a share);
- year-end 2012 S&P 500 price target at 1250 (1425);
- 2012 inflation of +1.7% (+2.6%); and
- 2012 closing yield on the U.S.10-year Treasury note at 2.50% (1.80%).
How Did My Surprise List for 2012 Do?
Last year's surprise list achieved about a 50% hit ratio, similar to my experience in 2011. Forty percent of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, one-third in 2006, 20% in 2005, 45% in 2004 and one-third came to pass in the first year of my surprises in 2003.
Below is a report card of my 20 surprises for 2012 (I hit on 50% of the surprises):
Surprise No. 1: The U.S. stock market breaches the 2000 high of 1527. Right.
I call this correct as:
- this was a hugely out of consensus and bullish view;
- the S&P came within 3% of 1527; and
- in September I reduced my year-end price close for the S&P 500 to 1415. (It closed at 1425.)
Surprise No. 2: The growth in the U.S. economy accelerates as the year progresses. Wrong.
Surprise No. 3: Former Presidents Bill Clinton and George Bush form a bipartisan coalition that persuades both parties to unite in addressing our fiscal imbalances. Wrong.
Surprise No. 4: Despite the grand compromise, the Republican presidential ticket gains steam as year progresses, and Romney is elected as the forty-fifth President of the United States. Wrong.
Surprise No. 5: A sloppy start in arresting the European debt crisis leads to far more forceful and successful policy. Right.
Surprise No. 6: The Fed ties monetary policy to the labor market. Right.
Surprise No. 7: Sears Holdings (SHLD) declares bankruptcy. Wrong.
Surprise No. 8: Cyberwarfare intensifies. Right.
Surprise No. 9: Financial stocks are a leading market sector. Right.
Surprise No. 10: Despite the advance in the U.S. stock market, high-beta stocks underperform, but Apple (AAPL) is a standout to the upside. Right.
Surprise No. 11: Mutual fund inflows return in force. Wrong.
Surprise No. 12: We'll see merger mania. Wrong.
Surprise No. 13: The ETF bubble explodes. Wrong.
Surprise No. 14: China has a soft landing (despite indigestion in the property market), and India has a hard landing. Right.
Surprise No. 15: Israel Attacks Iran. Wrong.
Surprise No. 16: Bank of America (BAC) is forced to raise an additional $20 billion-$25 billion, and Brian Moynihan resigns as President. Wrong.
Surprise No. 17: The CBOE Volatility Index (VIX) falls to the 10-15 level during the second half of 2012. Right.
Surprise No. 18: Facebook's (FB) IPO fizzles and breaks issue price in the first day of trading. Right.
Surprise No. 19: A second-half growth scare briefly lifts the yield on the 10-year U.S. note to over 3%. Wrong.
Surprise No. 20: Three very high-profile executives of Fortune 500 companies are forced to resign after sexual harassment allegations. Right.
What Is the Consensus for 2013?
As we enter 2013, investors and strategists are again grouped in a narrow consensus on economic growth (+2% real GDP), bond yields (higher) and year-end 2013 closing stock market price targets (on average at about 1575, a gain of 10%).
On the latter issue of stock prices, strategists are unusually tight in their year-end S&P 500 forecasts, with Bank of America, Bank of Montreal, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, KKR, JPMorgan and Oppenheimer all in the range between 1550 and 1615, representing, on average, about a 10% gain for the full year. BTIG and Barclays are at 1525. Only UBS (1425) and Morgan Stanley (1434) stand out from the crowd.
Again, let's use Goldman Sachs' principal views of expected economic growth, corporate profits, inflation, interest rates and stock market performance as a proxy for consensus.
Here are Goldman Sachs' forecasts for 2012, 2013 and 2014:
The Rationale Behind My Downbeat Surprises for 2013
- No meaningful spending or entitlement cuts will be made;
- Unsustainable and diminished value of fiscal and monetary policy;
- An aging recovery and aging stock market;
- Investment narrative shifts to the earnings cliff and to the end of profit margin expansion;
- A market that starts the year at reasonable if not high valuations relative to headwinds;
- Full-year estimated S&P 500 range of 1275-1480 with a close of 1425; and
- Fade (sell/short) early January stock market strength.
"Say what you will about Congress, but it has created jobs for people who would be unfit to work anywhere else."
Last year my surprise list had an out-of-consensus positive tone to it, but this year it is noticeably downbeat relative to generally upbeat expectations.
As contrasted to 2012, when most were dour in market view (and wrong!), the 2013 consensus is an optimistic one and now holds to the view that European economic growth is stabilizing while growth in China and in the U.S. is reaccelerating. The popular view goes on to believe that even our dysfunctional leaders in Washington will not upset the growing consensus that it is clear sailing for equities and trouble ahead for bonds.
Once again, the bullish consensus is tightly grouped with the expectation that the S&P 500 will close the year at 1550-1615 (up from 1425 at the close of 2012) and that the 10 year U.S. note yield will trade at 2.50% or higher (up from 1.80% at the close of 2012).
These consensus views might prove too optimistic on stock prices and too pessimistic on bond prices. I believe that the U.S. stock market will make its 2013 high in the first two weeks of January, be in a yearlong range of 1275-1480 and close the year at 1425 and that the 10-year U.S. note will be below 2.00% in the first six months of 2013.
Many of my more downbeat surprises for 2013 are an outgrowth of an aging economic recovery (now four years old), a maturing stock market (of a similar age!) coupled with the recognition that running trillions of dollars in deficits while maintaining zero interest rates are unsustainable policy strategies.
I am also concerned that the multiplier being applied to the tax increases agreed to last week will be greater than many expect, serving to weigh on domestic economic growth.
As well, it is also my view that the trajectory of economic growth in 2013 (and corporate profits) will also be adversely impacted by the manner in which businesses and consumers react to the tax hikes and the growing animosity and contentiousness in Washington, D.C., in the months ahead.
Indeed, I fully expect the upcoming deliberations between the revenge-lusting Republicans in the House and the equally dogmatic and partisan incumbent President and Democratic Senate to not result in any meaningful cut in spending or entitlements reform. I do, however, expect these negotiations to have a direct and distinct adverse impact on economic growth, confidence and profits.
The dependency on our economy and on business and consumer confidence to Washington's ability to compromise and deliver intelligent policy will prove, at the very least, unsettling to the markets in the year ahead. At worst, it will undermine the economic expansion.
In addition, policy alternatives are diminishing.
U.S. monetary policy is now effectively shooting blanks, and fiscal policy will now turn to be a drag on growth. Moreover, the likely reluctance and inertia by our leaders in addressing our budget will continue to turn off the individual investor class to stocks this year.
Finally, my ursine tone is also a reflection that, by most measures, the U.S. stock market is not meaningfully undervalued and that given the dynamic of the headwinds of slowing economic growth, a poor profit outlook and the developing weakness of policy are unlikely to be revalued upward in 2013 (as many strategists suggest).
Without Further Ado...
Below are my 15 surprises for 2013. This year I have reduced the surprise list from 20 to 15. As I did last year, following each surprise, I have included a specific strategy that might be employed in order for an investor to profit from the occurrence of these possible improbables.
Surprise No. 1: The U.S. economy disappoints relative to consensus expectations.
Amid contentious and hyperpartisanship of political debate, consumer and business confidence sours, adversely impacting personal spending, job growth and capital spending plans:
- U.S. real GDP growth expands by only +1.5% (or less) in 2013.
- There is no grand bargain, as the debt ceiling and budget issues are kicked down the road.
- The only real development in the budget debate is that a financial transaction tax is adopted in exchange for a one-year increase in Medicare eligibility.
- By midyear either Janet Yellen or Alan Blinder replaces Ben Bernanke as Fed Chairman and the administration's entire economic advisory team is turned over.
Question: How many politicians does it take to screw up our economy?
Answer: 537 (436 members of the House, 100 members of the Senate and one president)
The consensus view is that while the upcoming budget debate will likely get ugly and go down to the wire, a 10-year, $2 trillion agreement will be negotiated.
Unfortunately, the last meaningful agreement (in 2013) between the Republican and Democratic parties was the twenty-fourth-hour fiscal cliff compromise on Jan. 1, 2013.
The squabbling and enmity of the recent fiscal cliff debate poisons all future budget talks. The Obama administration is unwilling to make spending concessions anywhere that is needed to make substantive progress on our fiscal deficit. The Republicans are equally entrenched in policy view.
This subcommittee has demonstrated in hearings and comprehensive reports how various schemes have helped shift income to offshore tax havens and avoid U.S. taxes.... The resulting loss of revenue is one significant cause of the budget deficit and adds to the tax burden that ordinary Americans bear.
-- Sen. Carl Levin (D-Mich.), Senate Permanent Subcommittee on Investigations
The debate grows increasingly contentious and vitriolic. Congressional Democrats, prodded by the president, introduce the idea of a wealth tax.
A Levin-led subcommittee investigation determines and highlights that Apple (which deferred taxes on over $35 billion in offshore income between 2009-2011) and many other companies -- including Hewlett-Packard (HPQ), Google (GOOG) and Microsoft (MSFT) -- have adversely impacted the budget deficit by unfairly allocating revenue and intellectual property offshore to lower the taxes they pay in the U.S. (and have even avoided taxes in the U.S. by moving subsidiaries to Nevada). The investigation reveals that Apple was a pioneer (as early as in the mid-1980s) of an accounting technique known as the "double Irish with a Dutch sandwich," which reduces taxes by routing profits through Irish subsidiaries and the Netherlands and then on to the Caribbean. The Levin subcommittee finds that this tax avoidance technique employed by Apple has been imitated by hundreds of other international companies.
The Democrats in Congress propose a closing of such corporate tax loopholes and more strict rules regarding non-U.S. tax havens. This creates a complete impasse when Republicans react violently to it. Congressional Republicans, on the other hand, offer sizeable entitlement benefit cuts which turns off the Democrats.
During the debate it becomes clear that the risks of destabilizing outcomes are rising (e.g., a technical default on U.S. debt and a downgrade by all of the major ratings agencies), and investors panic. The S&P 500 hits a low of 1275.
The surprise is that there is no grand bargain in 2013 that brings our country closer to fiscal sustainability -- indeed, there is virtually no bargain (on tax and entitlement reforms nor in discretionary spending cuts) in the new year at all.
The debt ceiling is finally raised, though only minor spending cuts are instituted. At the last moment, the Democrats agree to a one-year increase in Medicare eligibility in exchange for an Elizabeth Warren-inspired campaign (in conjunction with Congressional Democrats) to introduce a financial transaction tax to be imposed on securities trades by year-end. (See surprise No. 4.)
After the debate comes to a close it is apparent that the ability of the administration to enact previously sought gun control laws, immigration reform and other projects is in serious jeopardy.
Foreign leaders openly discuss the waning role of our country's leadership in the world. The U.S. dollar suffers as our standing in the global economy erodes.
Meanwhile, though the fiscal drag from last week's fiscal cliff agreement appears to many to be a manageable $250 billion-$280 billion (or less than -1.0% taken off U.S. GDP), the actual multiplier of this drag is greater than most are projecting (over -1.5%). The growing tortured debate, animosity and fiscal uncertainty that follows between both parties during the January-March period chills the economy further and adversely impacts business and consumer confidence. Corporate fixed investment, hirings and industrial production suffer, and it becomes clear that there is little economic momentum in the U.S. and that, among other issues, corporate pricing power is harmed by increased competition from non-U.S.-based companies.
Most market participants begin to accept the notion that the Fed is essentially out of bullets and can no longer impact our economy at the margin and that it doesn't possess the sort of durable and effective fiscal remedies that are needed to materially address the complexity of the secular challenges facing the country (education, the jobs market, etc.).
By midyear President Obama seeks scapegoats for economic policy failure. He replaces most of his team at the Council of Economic Advisers as well as Fed Chairman Bernanke (with Alan Blinder or Janet Yellen) a full six months before Bernanke's term is officially over in January 2014.
Despite recent concerns that the Fed will end quantitative easing, more easing lies ahead during 2013, and, in all likelihood, the amount of bond buying will be raised not ended or reduced (as suggested in the recent Fed minutes release).
A weaker-than-expected domestic economy in the first half of the year underscores the fragility of the consumer (in particular).
First-quarter 2013 real GDP is +0.5% to +1.0%, worse than consensus expectations. Second-quarter 2013 real GDP shows little improvement (but only to +1.0% to +1.5%) from the first quarter.
Overall full-year U.S. GDP disappoints relative to the consensus (and particularly relative to the Fed's forecast of +3% growth) and approximates +1.5% (or less) for all of 2013.
Strategy: Buy index puts in the first half of 2013.
Surprise No. 2: The 2013-2014 earnings cliff sinks the markets in 2013's first half.
- The investment narrative shifts from fiscal cliff concerns to earnings and margin cliff worries.
- Slowing economic growth and lower margins pressure corporate profits and S&P 500 earnings drop to $95-$97 a share, well below consensus.
- Real estate activity and home prices flatten out.
- Retail sales are conspicuously weak.
- The stock market puts in its yearly high in the first two weeks of January.
- A Tale of Two Cities: a down stock market in the first half and an advancing stock market in the second half.
- The S&P 500 range for year 2013 is 1275-1480 and closes the year flat (just as it did in 2011).
The 2012 improvement seen in the residential real estate markets moderates, as sales activity/turnover and home price appreciation flattens.
Already refinancing applications (-23%) and new mortgage applications (-15%) have taken a bad fall in the last half of December 2012. Low interest rates from 2009-2012 have done their job in reviving the U.S. housing market, and that stimulus should be seen as bringing forward home sales -- now it is up to the domestic economy to resuscitate demand.
On the latter point I am less optimistic about the foundation of growth for the U.S. economy and the financial fate of the consumer who is now just absorbing a new tax hike (see surprise No. 1). Finally, let's not lose sight that the Obamacare surcharge of 3.8% will be applied to home sales in 2013.
Retail sales suffer, as spent-up not pent-up consumers are stunned by having less money in their wallets.
In 2013 we discover that there is a limit to the consumer in the face of our dysfunctional leaders' inability to deliver a grand bargain. A payroll tax increase, higher top income tax rates and the Obamacare surcharge, coupled with disappointing capital spending and weak hirings, represent the brunt of the domestic growth shortfall relative to consensus expectations.
Surprisingly, automobile sales, benefiting from pent-up demand (much like housing last year) continue to improve slowly, to a surprisingly strong 16 million-17 million SAAR rate by year-end, and represent a standout feature of the domestic economy throughout the new year.
Wage growth is muted, interest rates remain low, and inflationary pressures are nonexistent, helping to keep profit margins from slipping too far. Nonetheless, slowing domestic economic growth and reduced final demand -- personal consumption expenditures are further hurt by the droughts and rising food prices -- weigh significantly on corporate profits.
Full-year 2012 S&P 500 earnings come in at $102 a share, while 2013 S&P profits disappoint at $95-$97 a share, well below consensus of about $106-$108 a share, top-down estimates of $107-$109 a share and bottom-up forecasts of $112-$113 a share.
Though starting out strong, the stock market in 2013 is a tale of two cities, with a weak first half and a stronger second half. The 2013 S&P 500 range is 1275-1480. The S&P 500 ends the year flat.
Beginning-of-the-year equity fund inflows, breathless optimism (of a technically inspired kind) and the initial excitement over the fiscal cliff resolution lift the S&P 500 to its yearly high in the first two weeks of January 2013. Unfortunately, the lack of intelligent, thoughtful leadership becomes ever more apparent in February-March, and ultimately the S&P 500 bottoms at about 1275 (or at 13.5x my projected S&P profit surprise) during the spring.
The VIX exceeds 25, and risk premiums remain elevated amid the increased political rancor.
While dividend payout rates are low and corporate balance sheets in strong shape -- there is less than meets the eye here as it should be noted that much of the cash hoards are positioned in non-U.S.-taxed overseas accounts -- a smaller amount of money is returned to shareholders as dividend growth and share buybacks slow down as business confidence ebbs and the economy decelerates.
Though most believe that a spending deal will be forced by the pressures of a weakening stock market and economy, there is no agreement or real addressing of the deficit forthcoming despite a slide in equities and the backdrop of falling corporate profits and weaker economic growth taking center stage.
In the second half of 2013, coincident with a slow improvement in domestic growth, the market stages a persistent recovery back toward year-end 2012 levels of 1425 (as investors get inured to the political dysfunction and grow increasingly accepting of a period of slowing secular economic growth), exactly duplicating the flat market experience of 2011.
The VIX falls back under 15 by the second half of the year.
I would emphasize that a flat year in the U.S. stock market is a much rarer occurrence than many would think. According to The Chart Store's Ron Griess, in the 84 years since 1928, when S&P data was first accumulated, the index was unchanged in only two years (1947 and 2011). In only four of the 83 years was the annual change in the S&P 500 under 1%: 1947 (0.00%), 1948 (-0.65%), 1970 (+0.10%) and 2011 (+0.0%).
Strategy: Buy index puts in the first half of 2013; short Market Vectors Retail ETF (RTH).
Surprise No. 3: A dysfunctional Washington, D.C., has profound political implications, and an influential third party (the People's Party) is formed.
- A divorced Hillary Clinton officially bows out of the 2016 Presidential contest.
- Michael Bloomberg becomes the leader of a new third party.
- Senator Elizabeth Warren emerges as the Democratic presidential frontrunner.
- Governor Scott Walker is the Republican presidential frontrunner.
Despite widespread expectations of a 1992 repeat of a Bush vs. Clinton presidential contest in 2016, the consensus is proven wrong.
Shortly after a successful recovery from a concussion and blood clot, Bill and Hillary Clinton announce that they will divorce. Soon thereafter, Hillary Clinton declares that she has no intention to run as the Democratic presidential nominee for 2016, setting the Democratic leadership in turmoil.
Alienated, saddened and disappointed by the current political alternatives and a dysfunctional Washington, D.C., a meaningful movement of Democratic and Republican moderates toward the creation of a new and independent third party, known as the People's Party, gains steam.
Although it is early in the process and despite being initially reluctant, New York Mayor Michael Bloomberg becomes the standard-bearer of the People's Party, and he announces his intention to run for president.
The People's Party is named after the short-lived political party with the same name that was established in the late 1890s during the populist movement in the U.S. Originally based among poor, white cotton farmers in the South and hard-pressed wheat farmers in the plains, it represented a radical crusading form of agrarianism that possessed a hostility toward banks, railroads and elites generally. Often it formed coalitions and was aligned with labor unions and generally was seen as anti-elitist and in opposition to established interests (in banking and railroads) and mainstream parties.
Several of the wealthiest Americans -- including Bill Gates, Warren Buffett and several well-known billionaire hedge fund managers -- commit huge amount of financial and intellectual support to Bloomberg and the People's Party.
Surprisingly, Senator Elizabeth Warren (not Joe Biden or Andrew Cuomo) is viewed as the leading Democratic presidential candidate by year-end 2013, and Wisconsin Governor Scott Walker (not Marco Rubio or Jeb Bush) becomes the frontrunner for the Republican Party's presidential nomination.
Surprise No. 4: A tax on securities transactions is instituted in exchange for an increase in Medicare eligibility -- its implementation has broadly negative ramifications for financial stocks and hedge funds.
- Financial stocks underperform and miss profit forecasts.
- The transaction tax forces a further consolidation in the hedge fund industry.
- Hedge fund fees decline.
"Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation."
-- John Maynard Keynes (when he first proposed a securities transaction tax in 1936)
In conjunction with Congressional Democrats (and in exchange for an increase in Medicare age eligibility), Senator Elizabeth Warren spearheads a successful campaign to force the House to introduce a financial transaction tax attached to all securities trades. The legislation is sold to Americans (and to the Republicans) as a way to:
- curb market volatility;
- reduce the disruptive role of high-frequency trading on the markets; and
- increase tax revenue.
The ramifications of this tax are broad -- financial stocks suffer, and the hedge fund industry retrenches, consolidates and lowers fees.
The implementation of a financial transaction tax, weak capital markets, reduced merger and acquisition activity, continued pressure on net interest margins and poor loan demand lead to well-below-consensus bank and brokerage industry profits and underperforming stocks.
In 2013's macro-driven market, correlations remain at historically high levels (see below), rendering excess return generation hard to deliver by the hedge fund community. Moreover, the implementation of a financial transaction tax pressures trading-based and high-frequency-trading hedge fund strategies to close, and nearly one third of the existing hedge funds close shop in 2013.
As pressure on returns intensifies, a large institutional manager introduces a menu of low-fee hedge funds that further accelerate hedge fund closures. Hedge fund management fees move toward 1% (or lower), and performance fees move toward 10%, as the industry begins to resemble the traditional money management industry.
Several large hedge funds lower fees and structure fees to more resemble Warren Buffett's hedge fund in the 1960s, which charged no management fee but took in 25% on performance above a 6% threshold return.
Strategy: Short Financial Select Sector SPDR (XLF) and GS.
Surprise No. 5: Under political, economic and stock market pressure, Obama begins to move back toward the center, but it is too late.
By midyear (after failed budget deficit debate) it will be clear to the president that his legacy is in serious jeopardy.
In response, Obama takes a surprising move to the center. His administration's team is turned upside down, and the president, in search of economic growth and a more vibrant jobs market, will approve legislation to allow fracking on federal lands. In addition, he completely turns around on his previous Keystone Pipeline stance and green lights the project.
Several previously somnolent regional bank stock prices positioned in areas of potential fracking activity revel in the administration's move. For example, Northwest Bancshares (NWBI), a bank holding company right smack in the middle of Pennsylvania's fracking sites, rises by 25%.
The move fractures the Democratic Party and emboldens the Republicans. For both the president and the Republicans, it is too little and too late, as the approval ratings of both plummet to all-time lows and the aforementioned third party (led by Bloomberg) gains popularity (see surprise No. 3).
By year-end the People's Party is estimated to have as much as 20% of the national vote.
Strategy: Buy NWBI.
Surprise No. 6: Despite a growing concern that interest rates will rise, the yield on the 10-year U.S. note remains range-bound.
The big up move in yields that I have (long) expected and that has now become consensus is delayed by at least another six months.
The yield on the 10-year U.S. note stays in a relatively tight range of between 1.5% and 2.0% in 2013, as slowing global growth remains the bond market's dominant influence.
Surprise No. 7: There will be four market influencing black swan events in 2013.
As I have observed, there is a growing frequency of black swans around the world, and 2013 will be no exception -- climate change and technological disruptions play a significant role on the financial markets this year:
- Another major drought lies ahead. Droughts in the U.S., Brazil and Russia have a knock-off impact on much higher commodity and food prices, experiencing a greater-than-5% rise in 2013. A 5%-plus rise in food prices further adversely impacts the consumer's purchasing power.
- A coronal mass ejection. The sun emits solar flares (or coronal mass ejections) that penetrate the Earth's atmosphere and initially wipe out most GPS systems, disrupt numerous communications systems, electronic devices and power grids all over the world. Electricity is lost in several regions of the world for weeks. A mini panic ensues, as concerns about broader damage emerge.
- More flash crashes. A series of mini flash crashes occur in the first six months of the year. One such flash causes a major bank to lose close to $2 billion. In part to raise revenue and in part to curb market volatility and to halt the proliferation of high-frequency trading, a securities transaction tax is instituted by year-end.
- A cyberattack. The U.S. experiences a major cyberattack on the power grid or other key infrastructure target. The source of the attack is not detected. Cybersecurity stocks soar, while the overall market experiences a 3%-4% drop.
Surprise No. 8: Apple's share price and earnings continue to disappoint in the first half of 2013.
- A consistently low share price for Apple persists in the first half as earnings estimates are steadily reduced, owing to lower production rates.
- Tech stocks (in general) and Apple's stock (in particular) sell off after Senator Levin's subcommittee finds that companies have avoided huge amounts of U.S. taxes in offshore tax havens.
- Two important product releases lead to an improving share price for Apple in the second half.
Last year, I wrote that Apple would be a positive surprise in 2012, though I turned negative on the company's fundamentals and share price in late September.
This year I have a negative surprise in store for Apple -- at least for the first half of the year.
The aforementioned Senator Levin subcommittee investigations on offshore tax havens (see surprise No. 1) highlight Apple's tax avoidance strategies. The share price drops below $500 a share in first quarter 2013, as investors begin to recognize that it is likely that Apple's future earnings will be taxed at a much higher rate than in the past.
Meanwhile, Apple's core operating profits disappoint due to a more competitive landscape, lessening demand for iPads and iPhones and emerging margin pressures. Apple's earnings estimates (and price targets) are cut, and full-year 2013 results fall short of $40 a share.
Microsoft's Surface sales start off poorly but gain traction by the end of 2013. Google Nexus, Amazon (AMZN) Kindle, Surface and Samsung all sell at lower price points throughout the year, as price competition emerges in the tablet market.
Apple's consensus 2014 profit estimates move toward an expected year-over-year decline. The stock spends most of 2013 below $550 a share, but, in the last half of the year, two revolutionary product additions lift the share price to over $600 by year-end. (Samsung's stock performance continues to outpace that of Apple in all of 2013.)
In the third quarter Apple announces three new products in 2013: iTV, iMed and iHomes.
iTV is a yawner, but the latter two are revolutionary product additions.
With iMed, Apple enters the medical information market, providing a platform for the medical field to keep, store and transfer records in real time. This expands the use of iPads exponentially.
Also introduced is the iHomes program, an iTunes-like software to control all electrical (and some non-electrical, like plumbing) elements in a home remotely. The software receives rave reviews from The Wall Street Journal's Walt Mossberg, after which Apple announces it will not license the software for use on Android devices. (Google shares drop 60 points on the announcement.)
Strategy: Avoid Apple in the first half of year; buy Apple and short Google in the second half of the year.
Surprise No. 9: The big market winners and losers of 2013.
- The winners: Ford (F) and Altisource Asset Management (AAMC).
- The losers: XLF, Morgan Stanley, Citigroup, Goldman Sachs, JPMorgan Chase (JPM) and asset managers.
Over the past few years (2010-2012), Altisource Portfolio Solutions (ASPS) was my stock of the year. The shares of Altisource Portfolio Solutions, which traded at around $15 a share in late 2009, rose to nearly $130 a share several months ago.
So, what is the next Altisource Portfolio Solutions, and what will be the stock of the year for 2013?
My answer is that we don't have to go far from Altisource Portfolio Solutions. The stock of the year will be the recent spinoff of Altisource Portfolio Solutions, Altisource Asset Management. With a sharp trajectory of earnings growth (resembling that of Altisource Portfolio Solutions in 2010-2012), I expect Altisource Asset Management will trade over $150 a share sometime this year.
Last year's surprise large-cap stock was Bank of America, which, after dropping by over 50% in 2011, climbed by over 100% in 2012.
My surprise large-cap pick for 2013 is Ford.
Trading at $13.50 a share, I expect Ford's share price to rise to above $17.50 a share in 2013 based on a combination of surprisingly strong domestic automobile industry sales (in excess of 16 million SAAR) and a revaluation (upward) in the company's P/E ratio.
After an initial burst to the upside, overowned financial stocks are the big losers in 2013, as the financial transaction tax, weak capital markets, still-low interest rates and tepid merger-and-acquisition activity weigh on the sector.
Strategy: Long AAMC and F.
Surprise No. 10: Takeover activity slows to a standstill.
Though interest rates are low and there is an abundance of excess cash on corporations' balance sheets, economic uncertainty meaningfully curtails merger-and-acquisition activity in 2013.
There is one large exception: Oracle (ORCL) takes over Hewlett-Packard (at only a modest premium). Mark Hurd returns to become Hewlett-Packard's CEO. Hewlett-Packard's current CEO Meg Whitman rejoins Kleiner Perkins.
Strategy: Avoid investment and brokerage stocks.
Surprise No. 11: A comprehensive New York Times expose reveals that all Chinese economic data has been fabricated.
Strategy: Short iShares FTSE/Xinhua China 25 Index Fund (FXI).
Surprise No. 12: There is no reallocation out of bonds and into stocks in 2013.
Despite a growing consensus that the reallocation trade is imminent and will reverse the trends of money moving out of stocks and into bonds (in place since 2007), outflows from domestic equity funds and inflows into bond funds continue throughout the year. In support, I would note that, according to AMG, bond/equity fund flows started 2013 just the way they ended last year, with large outflows totaling -$3.5 billion coming out of domestic equity funds and with inflows into fixed income.
Surprise No. 13: Signs of life are found on Mars.
There are signs of life on Mars but not in Washington, D.C.!
The Curiosity rover conducts a chemical test in early 2013 that uncovers complex carbon based compounds in Martian soil.
Surprise No. 14: Procter & Gamble splits apart into three separate companies and Avon Products is courted.
Another activist hedge fund investor joins Bill Ackman's Pershing Square and acquires a large position in Procter & Gamble (PG). Under pressure from an expanding shareholder group, Procter & Gamble decides to split into three separate entities. The shares rise by $7-$10 a share on the announcement.
As was the case of Procter & Gamble, several activist investors pressure Avon Products (AVP) to consider being acquired.
Strategy: Long PG and AVP and out-of-the-money calls.
Surprise No. 15: There are numerous surprises in entertainment and in sports.
- Move over Taylor Swift, as "The Voice's" Cassadee Pope wins more Grammys than any new entertainer in history.
- The New York Yankees, seen as too old and too slow, shock the world and win the 2013 World Series.
- The Oklahoma Thunder win the NBA Championship.
- The Seattle Seahawks win the 2013 Super Bowl.
- Alabama trounces Notre Dame by 28 points in tonight's BCS Championship game, but Notre Dame's men's basketball team reaches the Final Four.
- Tiger Woods wins a major and comes close to a second win. He marries a famous entertainer.
- Three-year-old thoroughbred Violence wins the Kentucky Derby.
- I finish in first place at the World Series of Poker in November and win $8.2 million.
I discussed some of my list on CNBC's "Fast Money" yesterday with Melissa Lee and the gang.