Updated as at 24th December 2014
Just when we thought the climate had cleared the scenario ahead, once again it has polarised, again presenting two clearly different scenarios. The question is whether we are, like the Titanic, about to experience the final plunge or will our economic boat remain afloat for a few more months or years to come? This article does not attempt to make trading or investment recommendations. Let’s look at both scenarios in two parts …..
The recovery from the GFC is the last gasp of the fiat money boom that has been in effect since Nixon left the gold standard. This was the last restraint on politicians and their ability to borrow and spend forever. Economic growth since the late sixties has been largely sponsored by credit that has left the liberal democratic economies bloated with debt, regulation and fiat money. To see how this pans out graphically, refer to the accompanying chart. The recovery since 2009 has been boosted by massive cash injections (read printing) of money into industrialised economies boosting asset prices (read inflationary) as Keynesian orthodoxy suggests boosting asset prices will eventually lead to a follow through in consumer spending. Industrial nation governments have been doing their best to boost spending in the finest tradition of neo-Keynesian economics. The printing however is having the harmful effect of dislocating markets and the traditional matrix of pricing set by markets is breaking down – most clearly illustrated by the worrying disconnect between Wall St (stock market prices) and Main St (economic activity, employment). There is divergence between assets such as stocks, real estate and commodities indicating we are at or near the top of the business cycle. Commodity markets are off their 2012 highs and yet, in spite of that, stock markets continue to climb a wall of worries and this gives rise to our market predictions.
To step back further, we are witnessing in our lifetime the completion of large scale cycles of human endeavour and activity with the attendant dislocation and reallocation of social, economic and political activity and resources. An understanding of the broad brush strokes economically, socially and politically may serve to enhance your perspective on what emerges next. The scale of forces at work in societies and economies is so huge that the current drama is taking decades to unfold. This is the topping and completion process of an economic cycle that has been going on for over 200 hundred years. By the time this top and the ensuing drama is finished, it may well have spanned generations of people. On a historical note, we are witnessing the completion of the growth phase of the industrial revolution that began around 1783-5. To be clear about the term ensuing drama, let’s be clear we are talking about the emergence of a new ‘dark age’ for society. These cycles affect all industrialized nations including China which joined the industrial revolution much later. Given the length of time involved we anticipate this having a generational impact and may not be completed for decades to come.
The phase 2000 to 2009 which included the dotcom bubble collapse, the post 9/11 recovery and Iraq War followed by the subprime mortgage debacle were all part of a major degree of correction occurring in the late stages of the Industrial Revolution Cycle that began around 1785. We had concluded that the logical outcome of the economic peak in 2007 and the following financial crisis (GFC), that a major downturn with attendant declines in asset values and income levels was underway and that this process would continue into 2016 and possibly as late as 2024. The tenacious strength of the recovery since the GFC surprised us but also revealed alternative cyclic viewpoints. The ‘animal spirits’ that drove bull markets and buoyed economic activity from the 80’s to 2000 along with the animal spirits of the politicians and central bankers whose hubris has now reached giddying heights illustrates the scope of the long term cycles discussed and gives rise to our predictions that a major cycle is currently making its top.
Part I: The Bull Argument
2014 saw only mild pullbacks in line with our recommendation in US stock markets and a slowly improving economic climate for the US. In August/September there was a clear switch in confidence as people began to realise the recovery was not going away. Economic data has generally been steadily improving and brought the boost in confidence. This has brought us back to the tipping point. On one hand we have a potential inflationary scenario ameliorated by falling oil prices – a bull market scenario lasting into 2015 and possibly extending for the next three years. This is our main scenario and we see this trend set to continue after a deeper consolidation. In fact most of 2015 may see stock markets undergoing corrections as the large moves of 2012-2014 have left the market vulnerable and overbought. Most sentiment indicators are at extreme readings. Any corrections that occur should be held by the levels recommended by our previous updates 14720, 15340 (DJIA) and 1738, 1814 (SP500). If however 11,250 (DJIA), 1219 (SP500) is breached any bull market potential is eliminated. Take precautions on any subsequent rallies. Once the correction/consolidation phase has been completed in late 2015 we expect the last leg of our inflationary/bullish scenario to play out resulting in some spectacular moves in stock markets upwards. Given that central banks are willing to engage in any amount of quantitative easing (QE) any economic deterioration will quickly be met by further printing. It is possibly that we may have continuing asset price inflation whilst economies continue to struggle bringing back the spectre of stagflation – the combination of inflation and high unemployment and poor economic growth.
Our scenario suggests that blue chip, quality performing stocks and real estate will continue to climb after dipping in 2015, even as incomes decline and other asset values fall or move sideways. Stocks and properties are seen as the main ways to hedge against inflation. Translating that into index levels implies, for example seeing the DJIA advancing to new highs from late 2015 onwards, to in excess of 20,000 whilst the S&P500 reaches towards 2200-2500. Given the QE printing stimulus to asset prices over the last few years, such a move could be characterized by a final exponential rise followed by a collapse of these two indexes any time from late 2015- 2018. Of course we must also be aware of the possibility due to the growing fragility of global economies that we see stock markets and real estate prices advance weakly before failing.
The late 2014 crude oil price declines are potentially very bullish for stock markets and economies alike. We view the oil price decline as part of a major move by oil to our long term target of US$12 per barrel. (See our Financial Markets page). It also means the death of the Peak Oil scenario. It may be the one factor that ameliorates the inflation scenario that has quietly been building over the last five years. In economic history this present phase may well be a replication of 1921-29 also known as the “Roaring Twenties”. This culminated of course in the exponential rise of stocks followed by the Crash of 1929 and we are suggesting that the circumstances are building for a repeat performance. The scale and scope however of the coming crash, will dwarf the events of 1929-33. At the cusp of 2014/15 we would pinpoint 1923/24 as the mirror of this current time. A steadily improving economy, low inflation, rising stock and real estate markets; all giving way to boom times for the next few months to 3 years. In 1921 crude oil prices fell sharply as well, setting up the low consumer price inflation that characterized the 20’s.
Such a 1929 style top in the next few years would mark the completion of the entire Industrial Revolution upward phase of this long term cycle and indicate we are entering into a prolonged period of economic, social and political stagnation and upheaval. Whilst these highs are being made the discrepancy between Wall Street and Main Street will be acutely emphasized with further deterioration of the economic, social and political fabric of industrialized nations. This may well be accompanied by dramatic movements in interest rates, commodities, currencies, gold and silver. You can also anticipate the emerging market economies to suffer as more cash gets sucked back into leading economies – the US, UK, Germany and Japan at the expense of peripheral economies. Anticipate the US dollar to continue to strengthen with attendant corrections along the way.
Using the stock market as a barometer or benchmark of prosperity is a recent development by the US Federal Reserve and illustrates how far we have travelled from liberal style economics to justify the level of intervention by government and the Fed. The severity, speed and relentlessness of the events following will shock. For this scenario to unfold there still needs to be a consolidation of stock markets during 2015 before the final advance continues. Social mood in the US and other leading economies will be ebullient just as they were in 1928-29. We believe however that the time scale to complete the End Game is small, measured, at most, by a few years, before the next major sell off phase.
Part II: The Bear Argument follows……