Tuesday, January 27, 2015

A Five Year Forecast: Is this a Tsunami Warning?

By John Mauldin

It is the time of the year for forecasts; but rather than do an annual forecast, which is as much a guessing game as anything else (and I am bad at guessing games), I’m going to do a five year forecast to take us to the end of the decade, which I think may be useful for longer term investors. We will focus on events and trends that I think have a high probability, and I’ll state what I think the probabilities are for my forecasts to actually happen. While I could provide several dozen items, I think there are seven major trends that are going to sweep over the globe and that as an investor you need to have on your radar screen. You will need to approach these trends with caution, but they will also provide significant opportunities.

There is a book in here somewhere, but I do not intend to write one today. In fact, my New Year’s resolution is to write shorter letters in 2015. Over the last decade and a half, the letter has tended to get longer. A little more here, a little more there, and pretty soon it just gets to be a bit too much to read in one sitting. That means I need to either be more concise, break up my topics into two sessions or, if further writing is necessary, post the additional work on the website for those interested.

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So I’m writing today’s letter in that spirit. Each of the major topics we’ll be covering will show up in other letters over the next few months. I would appreciate your feedback and any links to articles and/or data points that you think I should know about regarding these topics.

But first, this is generally the most downloaded letter of the year. I want to invite new readers to become one of my 1 million closest friends by simply entering your email address here. You can follow my work throughout the year, absolutely free (and see how my prognostications are turning out). And if you’re a regular reader, why not send this to a few of your friends and suggest they join you? At the very least, Thoughts from the Frontline should make for some interesting conversations this year. Thanks. Now let’s get on with the forecasting.

Seven Significant Changes for the Next Five Years

Let’s look at what I think are six inexorable trends or waves that will each have a major impact in its own right but that when taken together will amount to a tsunami of change for the global economy.

1. Japan will continue its experiment with the most radical quantitative easing attempted by a major country in the history of the world… and the experiment is getting dangerous. The Bank of Japan is effectively exporting the island nation’s deflation to its trade competitors like Germany, China, and South Korea and inviting a currency war that could shake the world. I’ve been saying this for years now, but the story took a nasty turn on Halloween Day, when the Bank of Japan announced it was greatly expanding and changing the mix of its asset purchases. The results have been downright scary, and a major slide in the JPY/USD exchange rate is almost certain over the next five years. I give it a 90% probability. All this while the population of Japan shrinks before our very eyes.

2. Europe is headed for a crisis at least as severe as the Grexit scare was in 2012 – and for the resulting run-up in interest rates and a sovereign debt scare in the peripheral countries. After all these years of struggle, the structural flaws in the EMU’s design remain; and now major economies like Italy and France are headed for trouble. In the very near future we will finally know the answer to the question, “Is the euro a currency or an experiment?” The changes required to answer that question will be wrenching and horrifically expensive. There are no good answers, only difficult choices about who pays how much and to whom. Again, I see the deepening of the Eurozone crisis as a 90% probability.

3. China is approaching its day of reckoning as it tries to reduce its dependency on debt in its bid for growth, while creating a consumer society. The world is simply not prepared for China to experience an outright “hard landing” or recession, but I think there is a 70% probability that it will do so within the next five years.

And the probability that China will suffer either a hard landing OR a long period of Japanese style stagnation (in the event that the Chinese government is forced to absorb nonperforming loans to prevent a debt crisis) is over 95%. To be sure, it is still quite possible that the Chinese economy will be significantly larger in 2025 (ten years from now) than it is today, but realizing that potential largely depends on President Xi Jinping’s ability to accomplish an extremely difficult task: deleveraging the debt overhang that threatens the country’s MASSIVE financial system while rebalancing the national economy to a more sustainable growth model (either through either a vast expansion of China’s export market or the rapid development of “new economy” sectors like technology, services, and consumption; or both).

This will not be the end of China, which I’m quite bullish on over the very long term, but such transitions are never easy. Even given this rather stark forecast, it is still likely (in my opinion) that the Chinese economy will be 20 to 25% bigger as 2020 opens than it is today; and every other major economy in the world (including the US) would be thrilled to have such growth. At the very least, though, China’s slowdown and rebalancing is going to put pressure on commodity exporters, which are generally emerging markets plus Australia, Canada, and Norway.

4. All of the above will tend to be bullish for the dollar, which will make dollar-denominated debt in emerging market countries more difficult to pay back. And given the amount of debt that has been created in the last few years, it is likely that we’ll see a series of crises in emerging-market countries, along with an uncomfortably high level of risk of setting off an LTCM-style global financial shock.

My colleague Worth Wray spoke about this new era of volatile FX flows and growing risk of capital flight from emerging markets at my Strategic Investor Conference last May, and he has continued to remind us of those risks in recent months (“A Scary Story for Emerging Markets” and “Why the World Needs the US Economy to Struggle”).

Now that Russia has tumbled into a full-fledged currency crisis with serious signs of contagion, Worth’s prediction is already playing out, and I would assign an 80 to 90% probability that it will continue to do so, as a function of (1) the rising US dollar and a reversal in cross border capital flows, (2) falling commodity prices, or (3) both. This massive wave is going to create a lot of opportunities for courageous investors who are ready to surf when countries are cheap.

5. I do not believe that the secular bear market in the United States that I began to describe in 1999 has ended. Secular bull markets simply do not begin from valuations like those we have today. Either we began a secular bull market in 2009, or we have one more major correction in front of us.

Obviously, I think it is the latter. It has been some time since I’ve discussed the difference between secular bull and bear markets and cyclical bull and bear markets, and I will briefly touch on the topic today and go into much more detail in later letters. For US focused investors, this is of major importance. The secular bear is not something to be scared of but simply something to be played. It also offers a great deal of opportunity.

If I am right, then the next major leg down will bring on the end of the secular bear and the beginning of a very long term secular bull. We will all get to be geniuses in the 2020s and perhaps even before the last half of this decade runs out. Won’t that be fun? Let’s call the end of the secular bear a 90% probability in five years and move on.

6. Finally, the voters of the United States are going to have to make a decision about the direction they want to take the country. We can either opt for growth, which will mean a new tax and regulatory regime, or we can double down on the current direction and become Europe and Japan. I’ve traveled to both Europe and Japan, and they’re both pleasant enough places to live, but I wouldn’t want to be a citizen of either Japan or the Eurozone for the rest of this decade. (I particularly love Italy, but it is beginning to resemble a basket case, with last year’s optimistic drive for reforms seemingly stalled.)

However, I would rather live and work and invest in a high-growth country, with opportunities all around me, a country where we reduce income inequality by increasing wealth and opportunities at the lower end of the income scale instead of trying to legislate parity by increasing taxes and imposing government mandated wealth redistribution, which slows growth and squelches opportunity for everyone.

A restructuring of the US tax and regulatory regime does not mean a capitulation to the wealthy, big banks, or big business. Properly conceived and constructed, it will allow the renewal of the middle class and result in higher income for all. Sadly, it is not clear to me that either the Republican or Democratic parties are up to the task of making the difficult political decisions necessary. They each have constituencies that tend to opt for the status quo. But I see hope on both sides of the political spectrum that change is possible. The course they set will give us an idea where we will want to focus our portfolios in the decade of the ’20s. It is a 100% probability that we will have to make a decision. It is less than 50% that we will make the right one – or at least the one that I think is the right one.

7.  We have entered the Age of Transformation. We’re going to see the development of new technologies that will simply astound us – from increasingly capable robots and other applications of AI to huge breakthroughs in biotechnology.

The winners are going to be those who identified the truly transformational technologies early on in their development and invested wisely. While riskier (potentially far riskier) than most of your investments should be, a basket of new-technology stocks should be considered for the growth part of your portfolio. I see the Age of Transformation as a 100% probability.

Just for the record, I also see a continuation of the global deflationary environment and a slowing of the velocity of money until we have some type of resolution concerning sovereign debt. Central banks will continue to try to solve the “crises” I mentioned above with monetary policy, but monetary policy will simply not be enough to stem the tide. Central banks can paddle as hard as they like into the waves of change, but they cannot reverse their powerful flow.

Now, let’s look further at each of the waves that are forming into a potential tsunami.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.



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Monday, January 26, 2015

The New Normal for Crude Oil?

By Marin Katusa, Chief Energy Investment Strategist

You may have come across the word “contango” in an oil related news report or article recently and wondered, “What’s contango?”

It isn’t the Chinese version of the tango.

Contango is a condition in a commodity market where the futures price for the commodity is higher than the current spot price. Essentially, the future price of oil is higher than what oil is worth today.


The above forward curve on oil is what contango looks like. There’s more value placed on a barrel of oil tomorrow and in the future than over a barrel today because of the increased value of storage.

I personally believe our resource portfolios are in portfolio contango—but that’s an entirely separate discussion that I’ll get to later. In today’s missive, I want to focus entirely on oil contango.

Crude oil under $50 per barrel may seem to put most of the producers out of business, but many oil and gas exploring and producing (E&P) companies are sheltered from falling prices in the form of hedges.

Often, companies will lock in a price for their future production in form of a futures commodity contract. This provides the company with price stability, as it’s sure to realize the price it locked in at some future date when it must deliver its oil.

But the market will always figure out a way to make money—and here’s one opportunity: the current oil contango leads to plenty of demand for storage of that extra oil production.


With US shale being one of the main culprits of excess crude oil production, storage of crude in US markets have risen above seasonally adjusted highs in the last year. This abundance of stored crude has pushed the current spot price of crude oil toward five year lows, as current demand is just not there to take on more crude production.

When in contango, a guaranteed result is an increase in demand for cheap storage of the commodity, in order to clip the profit between the higher commodity price in the future versus what’s being paid for the commodity at present. This is precisely what’ playing out in oil today.

Contago, Five Years Later


Looking back at the similarities of the 2009 dramatic free fall in oil prices to $35 per barrel, after a five year hiatus, crude has returned to a similar price point, and the futures market has returned to contango (green shows oil in contango).


Floating Storage Is Back in Vogue


Oil traders are now taking advantage of the contango curve through floating storage in the form of waterborne oil tankers.

This is what a big oil tanker looks like:


I’m personally reminded of contango whenever I look out my living room window:


Here’s a photo taken out my living room window—and this is non-busy part of the harbor. At times when I do my runs along the seawall, there have been up to 30 large oil tankers just sitting in the harbor. (On a side note, Olivier and I went for a run in July along the Vancouver seawall, and we counted 26 oil tankers.) All that pricey Vancouver waterfront will have an incredible view of even more oil tankers in the years to come when the pipelines are eventually built. I can only imagine what the major import harbors of China and the US look like… never mind the number of oil tankers sitting in the export nations’ harbors and the Strait of Hormuz. Multiply the above by at least 50 red circles.

As the spread between future delivery of oil and the spot price widened, traders looking to profit from the spread would purchase crude at spot prices and store it on oil tanker ships out at sea. The difference between the spread and the cost to store the crude per barrel is referred to as the arbitrage profit taken by traders. Scale is a very important factor in crude storage at sea: therefore, traders used very large crude carriers (VLCC) and Suezmax ships that hold between 1-2 million barrels of crude oil.

In the late summer of 2014, rates charged for crude tankers began to climb to yearly highs because of the lower price that spurred hoarding of crude oil. This encouraged VLCCs to lock in one year time charter rates close to and above their breakeven costs to operate the ship.

Time charter rates share similarities to the oil futures market, as ships are able to lock in a daily rate for the use of their ships over a fairly long period of time. VLCC spot rates have reached around $51,000 per day; however, these rates tend to be booked for a shorter period of around three months. These higher spot rates tend to reflect the higher cost paid to crew a VLCC currently against locking in crew and operating costs over a longer-term charter that could last a year. Crude oil is often stored on floating VLCCs for periods of six months to a year depending, on the contango spread.


Floating Storage: Economics


Many VLCCs are locking in yearlong time charter rates at or above $30,000-$33,000 per day, as that tends to be the breakeven rate to operate the vessel. If we assume that a VLCCs charge their breakeven charter rate and we include insurance, fuel, and financing costs that would be paid by the charterer, storage on most VLCCs in the 1-2 million barrel ranges are barely economic at best.

However, they’ll soon become profitable across the board once the oil futures and spot price spread widens above $6-$7 per barrel.


The red star depicts the current spread between the six-month futures contract from the futures price in February 2015. Currently companies are losing just under $0.20 per barrel storing crude for delivery in six months. However, once that $6-$7 hurdle spread is achieved, most VLCCs carrying 2 million barrels of crude will be economic to take advantage of the arbitrage in the contango futures curve.

The VLCC and ULCC Market

VLCC= Very Large Crude Carrier
ULCC=Ultra-Large Crude Carrier

VLCCs store 1.25-2 million barrels of oil for each cargo. Globally, there are 634 VLCCs with around 1.2 billion barrels of storage capacity, or over one-third of the US’s total oil production. The VLCC market is fairly fractioned, and the largest fleet of VLCCs by a publicly traded company belongs to Frontline Ltd. with 25 VLCCs. The largest private company VLCC fleet belongs to Tankers International with 37 VLCCs. In early December, Frontline and Tankers International created a joint venture to control around 10% of the VLCC market. Other smaller VLCC fleets belong to DHT with 16 VLCCS, and Navios Maritime with 8 VLCCs.


The lowest time charter breakeven costs of $24,000 per day are associated with the largest VLCC fleet from Frontline Ltd. and Tankers International. This is followed by the smaller fleets that have time charter breakeven costs of around $29,000 per day. Of course, on average the breakeven costs associated with most VLCCs is around $30,000 per day, and current time charter rates are around $33,000.


Investing in companies with VLCC fleets as the contango trade develops can generate great potential for further profits for investors. The focus of these investments would be between the publicly traded companies DHT Holdings, Frontline Ltd., and Navios Maritime.

But one must consider that investing in these companies can be very volatile because of the forward curve’s ability to quickly change. It isn’t for the faint of heart.

However, if current oil prices stay low, there will be an increase in tanker storage and thus a sustained increase in the spot price of VLCCs. However, eventually low prices cure low prices, and the market goes from contango to backwardation. It always does and always will.

Shipping companies have been burdened by unprofitable spot and charter pricing since the financial crisis, and these rates have only recently started to increase.

Warning!


As I sit here on a Saturday morning writing this missive, I want to remind all investors now betting on this play that they’re actually speculating, not investing.

There’s a lot of risk for one to think playing the tankers is a sure bet. I have a pretty large network of professional traders and resource investors, and I do not want to see the retail crowd get caught on the wrong side of the contango situation.

In the past, spot rates for the VLCCs usually decline into February and have dropped to as low as under $20,000 per day. It is entirely possible that if the day rates of VLCCs go back to 2012-2013 levels, operators will lose money.

Conclusion: this speculation on tankers is entirely dependent on the spot price and the forward curve.
The risk of this short term trade is that these companies are heavily levered, and some are just hanging on by a thread. Although this seasonal boost to spot rates has been a positive for VLCCs and other crude carriers, the levered nature of these companies could spell financial disaster or bankruptcy if spot rates return to 2012-2013 levels.


What should be stressed are the similarities to the short-lived gas rally in the winter of 2013-‘14, and the effect these prices have had on North American natural gas companies. A specific event similar to the polar vortex has occurred in the oil market, which has spurred a seasonal increase in the spot price tankers charge to move and store oil.

However, much like the North American natural gas market, the VLCC market is oversupplied; a temporary increase in spot prices that have led to increased transport and storage of oil will not be enough to lift these carriers from choppy waters ahead. Future VLCC supplies are expected to rise, with 20 net VLCCs being built and delivered in 2015 and 33 in 2016. This is much more than the 17 net VLCCs added in 2013 and 9 in 2014.

Another looming and very possible threat to these companies is the same debt threat that affected energy debt markets as global oil prices plummeted. If VLCC and other crude carriers experience a fall in spot prices, these companies’ junk debt could be downgraded to some of the lowest debt grades that border a default rating. This will increase financing costs and in turn increase the operating breakeven costs to operate these crude carrying vessels. The supply factor, high debt, and potentially short-lived seasonally high spot market could all affect the long-term appreciation of these VLCC stock prices. Investing in these companies is very risky over the long run, but a possible trade exists if storage and transport of oil continues to increase for these crude carriers.

Portfolio Contango—An Opportunity Not Seen in Decades


If you talk to resource industry titans—the ones who’ve made hundreds of millions of dollars and been in the sector for 40 years—they’re now saying that they’ve never seen the resource share prices this bad. Brokerage firms focused on the resource sector have not just laid off most of their staffs, but many have shut their doors.

The young talent is the first group to be laid off, and there’s a serious crisis developing in the sector, as many of the smart young guns have left the sector to claim their fortunes in other sectors.
There’s blood in the streets in the resource sector.

Now if you believe that, as I do, to be successful in the resource sector one must be a contrarian to be rich, now is the time to act.

I have invested more money in the junior resource sector in the last six months than I have in the last five years. I believe we’re in contango for resource stocks, meaning that the future price of the best juniors will be worth much more than they are currently.

I have my rules in speculating, and you’ll learn from my experience—and more important, my network of the smartest and most successful resource mentors whom I have shadowed for many years.

So how can we profit from the blood in these markets? Easy.

Take on my “Katusa Challenge.” You’ll get access to every Casey Energy Report newsletter I’ve written in the last decade, and my current recommendations with specific price and timing guidance. There’s no risk to you: if you don’t like the Casey Energy Report or don’t make any money over your first three months, just cancel within that time for a full, prompt refund, no questions asked. Even if you miss the three month cutoff, cancel anytime for a prorated refund on the unused part of your subscription.

As a subscriber, you’ll receive instant access to our current issue, which details how to protect yourself from falling oil prices, plus our current top recommendations in the oil patch. Do your portfolio a favor and have me on your side to increase your chances of success. I can’t make the trade for you, but I can help you help yourself.

I’m making big bets—are you ready to step up and join me?

The article The New Normal for Oil? was originally published at caseyresearch.com



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Thursday, January 22, 2015

EFPs and The Unanticipated Consequences of Purposive Social Action

By Jared Dillian


Pretend you are a corn trader. As such, you have two choices: have a position in corn futures or own physical corn. It may seem silly to even consider owning physical corn, because corn futures are easy to trade—just click a button on your screen. But assume you have a grain elevator, and whether you own futures or physical corn is all the same to you. How do you decide which you prefer?

If one is mispriced relative to the other.

If you consider owning physical corn, you have to take into account the cost of storage and any transportation costs you may incur getting the corn to the delivery point. You also have to think of the cost of carrying that physical corn position, or the opportunity loss you incur by not investing the money in the risk-free alternative.

The thing is, there’s nothing keeping the spot and futures markets on parallel tracks, aside from the basis traders who spend their time watching when the futures get out of whack from the physical. That basis exists in just about every futures market, even in financial futures that are cash settled. In fact, that was pretty much my life when I was doing index arbitrage—trading S&P 500 futures against the underlying stocks. I was basically a fancy version of the basis trader in corn.

With stock index futures (like the S&P 500, or the NDX, or the Dow), the basis is slightly more complicated. Not only do you have to calculate the cost of carry—which is usually determined by risk free interest rates and the stock loan market for the underlying securities—but you also have to take into account the dividends that the underlying stocks pay out. Remember, futures don’t pay dividends, but stocks do. At Lehman Brothers, we had a guy whose sole job was to construct and maintain a dividend prediction model for the S&P 500.

So far, so good. However, one of the first things I learned about on the index arbitrage desk was EFP, which stands for Exchange for Physical—a corner of the market almost nobody knows about.

Basically, we could take a futures position and exchange it for a stock position at an agreed-upon basis with another bank or broker. Interdealer brokers helped arrange these EFP trades. The reason so few people know about them is probably because, historically, the EFP market has been very sleepy. The most it would usually move in a day was 15 or 20 cents in the index, or in interest rate terms, a few basis points.

Now it is moving several dollars at a time.

A Basis Gone Berserk


Back when I was doing this about ten-plus years ago, we had a balance sheet of about $8 billion, which is to say that we carried a hedged position of stocks versus S&P 500 futures (also Russell 2000 futures, NASDAQ futures, etc.).

We did this for a few reasons. One, it was profitable to do so—the basis often traded rich so that by selling futures and buying stock and holding the position until expiration, we would make money. Also, by carrying this long stock inventory, we were able to offset short positions elsewhere in the firm and reduce the firm’s cost of funds. At Lehman and most other Wall Street firms, index arbitrage was a joint venture with equity finance.

During the tech bubble in 1999, the basis got very, very rich because money was plowing into mutual funds and managers were being forced to hold futures for a period of time until they were able to pick individual stocks.

During the bear market in 2008, the basis traded very cheap, up until very recently, because inflows into equity mutual funds were weak, and index arbitrage desks were willing to accept less profit on their balance sheet positions.

But now, the basis has gone nuts.

It always goes a little nuts toward year-end because banks try to take down positions to improve the optics of their accounting ratios. If you have fewer assets, your return on assets looks better. So when banks try to get rid of stock inventory into year-end, they buy futures and sell stock, pushing up the basis.

But now it has skyrocketed, and the cause seems to be the effects of regulation.

We’ve talked about this before, in reference to corporate bonds. Banks aren’t keeping a lot of inventory anymore, because there’s no money in it. The culprits here are a combination of Dodd-Frank and Basel III. There are all kinds of unintended consequences, and the EFP market going nuts is probably the least of it.

But even that is a big one. Basically, it has introduced significant costs (about 1.5% annually) to the holder of a long futures position, which includes everyone from indexers all the way down to retail investors. These are the sorts of things that don’t get talked about in congressional hearings. Did XYZ law work? Sure it worked. But now it costs you 1.5% a year to hold S&P 500 futures and roll them, and you can’t get a bid for more than $2 million in a liquid corporate bond issue.

It’s All About Liquidity


The liquidity issue is the biggest one, and the one I harp on all the time. Pre Dodd-Frank, the major investment banks were giant pools of liquidity. You wanted to do a block trade of 20 million shares? No problem. You wanted to trade $250 million of double-old tens? It could be done.

Not anymore. Liquidity has diminished in just about every asset class, from FX to equities to rates to corporates, because compliance costs have gone up and it’s expensive to hold more capital against these positions. Someday, someone might take up the slack, like second-tier brokers or even hedge funds.
But here’s the biggest consequence of the equity finance market blowing up: High-frequency trading (HFT) firms that aren’t self-clearing now find it difficult to trade profitably and stay in business. With fewer of them around, we will finally get an answer to the question whether they add to liquidity or not.

So if you talk to an index arbitrage trader about what is going on with the EFP market, he can tell you precisely why it is screwed up. It’s an open secret on Wall Street. Introduce a regulation over here, an unintended consequence pops up over there. Then there are more regulations to deal with the unintended consequences. Regulations have added 100 times the volatility to one of the most liquid and ordinary derivatives in the world—the plain vanilla EFP.

Less liquidity, more volatility—welcome to 2015.
Jared Dillian
Jared Dillian



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Wednesday, January 14, 2015

Beyond Tesla: The Huge Profit Potential of Lithium

By Tony Sagami

One of the stocks that I get the most questions about is Tesla. I’m not sure whether investor interest is due to the gorgeous lines of the Tesla Model S, its amazing high performance engine, the high flying stock, or the energy saving nature of all electric vehicles….. but Tesla is a very popular subject.


Tesla cars don’t just look fast; they are fast! The Tesla Model S can go from 0 to 60 mph in a stunning 5.9 seconds and travel up to an impressive 319 miles on a single charge.

The Tesla Model S is shockingly modestly priced by luxury car standards. The basic model has a MSRP of $69,900, but the price tag can quickly escalate to $100,000 with optional add ons. Of course, a cheapskate like me would never pay that much for a car—even an electric car—but lots of status-conscious consumers have.


And you won’t see me buying Tesla stock either. Even though it’s well off of its 52 week high, it’s still trading for almost 80 times earnings and 29 times book value.

However, a lot of technology is incorporated into electric vehicles. The most profitable way to invest in electric vehicles is not through Tesla stock, but instead from the industry that makes batteries possible.
I’m talking about lithium, one of the most valuable natural resources of the new electronic world thanks to its unique and extremely valuable characteristics:

  • Lithium has such a low density that it floats on water and can be cut with a butter knife. And when mixed with aluminum and magnesium, it can form lightweight alloys that produce some the highest strength to weight ratios of all metals.
     
  • Lithium tolerates heat better than any other solid element, melting at 357°F.
  • Lithium batteries offer the best weight-to-energy ratio, making lithium batteries ideal for any application where weight is an issue, such as portable electronics.
     
  • That same high energy density and low weight characteristic makes lithium batteries the best choice for electric/hybrid vehicles due to car gas mileage. A car’s biggest enemy is weight.
     
  • Lithium has a very high electrochemical potential, meaning that it has excellent energy storage capacity.
Lithium is a key mineral of the future, but there are limited ways to invest in it because unlike other commodities, there is no vehicle to invest in the physical metal.

On top of that, few options exist to invest in it because the market is dominated by only a handful of producers: Chemical & Mining Company of Chile (SQM); FMC Corp. (FMC); Rockwood Holdings (ROC); and privately held Talison Lithium.

The Chemical & Mining Company of Chile is primarily a potash fertilizer company; FMC Corp. is a diversified chemical producer with a less than 15% of its revenues from lithium; and Talison is a privately held Chinese company.

That leaves Rockwood Holdings as the purest play on lithium by a wide margin, with close to a 50% share of the global lithium market. It’s the OPEC of lithium. It’s also trading around $80 a share right now… a lot cheaper than Tesla—the car and the stock!

Of course, timing is everything, so I’m not suggesting that you rush out and invest in lithium or any of the above stocks tomorrow morning. Instead, wait for my buy signal in Just One Trade.
Tony Sagami
Tony Sagami

30 year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here.

To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.



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Tuesday, January 13, 2015

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Saturday, January 10, 2015

15 Surprises for Traders in 2015

By John Mauldin


It’s that time of year when people start thinking about New Year’s resolutions and investment planning for the future. It’s also the time of year when analysts feel more or less compelled to offer up forecasts. My friend Doug Kass turns the forecasting process on its head by offering 15 potential surprises for 2015 (plus 10 also-rans).  But he does so with a healthy measure of humility, starting out with a quote from our mutual friend James Montier (now at GMO):

(E)conomists 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!


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:
  1. How wrong conventional wisdom can consistently be.
     
  2. That uncertainty will persist.
     
  3. To expect the unexpected.
     
  4. That the occurrence of black swan events are growing in frequency.
     
  5. 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.
Quoting from a very eclectic group of names, Doug does indeed give us a few surprises to think about, and I pass his thoughts on to you as this week’s Outside the Box. (Doug publishes his regular writings in RealMoneyPro on theStreet.com.)

As a bonus, and as a thoughtful way to begin the new year, we have a letter that my good friend and co-author of my last two books Jonathan Tepper wrote to his nephews. He began penning it on a very turbulent plane ride that he was uncertain of surviving. It made him think hard about what was really important that he would want to pass on to his nephews. As the song goes, I found a few aces that I can keep in this hand. I think you will too.

His letter made me think about what I want to be passing on to my grandchildren, including the newest one, Henry Junior, who showed up less than 24 hours ago. They are going to grow up in a very different world than the one I grew up in, and I mostly think that’s a good thing. But the values that I hope can be passed on don’t change. Good character never goes out of fashion.

My associate Worth Wray came down with a very nasty bug this past weekend, so he missed his deadline for delivering his 2015 forecast to you. We’re giving him a few more days and will run it this weekend – which also of course gives me a little more time to mull over my own forecast. Taking to heart James Montier’s quote above, I’m going to forgo the usual 12-month forecast and look farther out, thinking about what major events are likely to come our way over the next five years. I actually think that approach will be for more useful for our longer term planning.

Thanks for being with me and the rest of the team at Mauldin Economics this past year; and from all of us, but especially from me, we wish you the best and most prosperous of new years.
You’re staring hard at crystal balls analyst,
John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

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15 Surprises for 2015


Doug Kass, Seabreeze Partners
Dec. 29, 2014 | 8:12 AM EST
Stock quotes in this article:
CSBUXTSLATWTRGMGLDJNKSPYQQQAAPLBAC, GOOGLFBCSCO

It’s that time of year again.
"Never make predictions, especially about the future." – Casey Stengel

By means of background and for those new to Real Money Pro, 12 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. Wien originally delivered his list while chief investment strategist at Morgan Stanley, then Pequot Capital Management and now at Blackstone. (Byron Wien's list will be out in early January and it will be fun to compare our surprises.)

It takes me about two to three weeks of thinking and writing to compile and construct my annual surprise list column. I typically start with about 30-40 surprises, which are accumulated during the months leading up to my column. In the days leading up to this publication I cull the list to come up with my final 15 surprises. (Last year I included five also ran surprises.)

I often speak to and get input from some of the wise men and women that I know in the investment and media businesses. I have always associated the moment of writing the final draft (in the weekend before publication) of my annual surprise list with a moment of lift, of joy and hopefully with the thought of unexpected investment rewards in the New Year.

This year is no different.

I set out as a primary objective for my surprise list to deliver a critical and variant view relative to consensus that can provide alpha or excess returns.  The publication of my annual surprise list is in recognition that economic and stock market histories have proven that (more often than generally thought) consensus expectations of critical economic and market variables may be off base.

History demonstrates that inflection points are relatively rare and that the crowds often outsmart the remnants. In recognition, investors, strategists, economists and money managers tend to operate and think in crowds. They are far more comfortable being a part of the herd rather than expressing – in their views and portfolio structure – a variant or extreme vision.

Confidence is the most abundant quality on Wall Street as, over time, stocks climb higher. Good markets mean happy investors and even happier investment professionals.

The factors stated above help to explain the crowded and benign consensus that every year begins with, whether measured either by economic, market or interest-rate forecasts.

But an outlier's studied view can be profitable and add alpha. Consider the course of interest rates and commodities in 2014, which differed dramatically from the consensus expectations.

To a large degree the business media perpetuates group-think. Consider the preponderance of bullish talk in the financial press. All too often the opinions of guests who failed to see the crippling 2007-09 drama are forgotten and some of the same (and previously wrong-footed) talking heads are paraded as seers in the media after continued market gains in recent years.

Memories are short (especially of a media kind). Nevertheless, if the criteria for appearances was accuracy there would have been few available guests in 2009-2010 qualified to appear on CNBC, Bloomberg and Fox News Business.

Indeed, the few bears remaining are now ridiculed openly by the business media in their limited appearances, reminding me of Mickey Mantle's quote, "You don't know how easy this game is until you enter the broadcasting booth."

Abba Eban, the Israeli foreign minister in the late 1960s and early 1970s once said that the consensus is what many people say in chorus, but do not believe as individuals.

GMO's James Moniter, in an excellent essay published several years ago, made note of the consistent weakness embodied in consensus forecasts.

As he put it:

"(E)conomists 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!"

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:
  1. How wrong conventional wisdom can consistently be.
     
  2. That uncertainty will persist.
     
  3. To expect the unexpected.
     
  4. That the occurrence of black swan events are growing in frequency.
     
  5. 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.
"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 (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 group-think (or group-stink, 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 and Freddie Mac, housing's new paradigm (in the mid-2000s) of non-cyclical 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.

My Surprises for 2014


These generally proved in line with my historic percentages.
"How'm I doin'?" –  Ed Koch, former New York City mayor

While over recent years many of my surprise lists have been eerily prescient (e.g. my 2011 surprise that the S&P 500 would end exactly flat was exactly correct), my 15 Surprises for 2014 had a success rate of about 40%, about in line with what I have achieved over the last 11 years.

As we entered 2014, most strategists expressed a constructive economic view of a self sustaining domestic recovery, held to an upbeat (though not wide-eyed) corporate profits picture and generally shared the view that the S&P 500 would rise by between 8-10%.

Those strategists proved to be correct on profit growth (but only because of several non operating factors and financial engineering), were too optimistic regarding domestic and global economic growth and recognized (unlike myself) that excessive liquidity provided by the world's central bankers would continue to lift valuations and promote attractive market gains in 2015. Not one major strategist foresaw the emerging deflationary conditions, the precipitous drop in the price of oil and the broad decline in domestic and non-U.S. interest rates.

Many readers of this annual column assume that my surprise list will have a bearish bent (to be sure that is the case for 2015). But I have not always expressed a negative outlook in my surprise list. Two years ago my 2012 surprise list had an out-of-consensus positive tone to it, but 2013's list was noticeably downbeat relative to the general expectations. I specifically called for a stock market top in early 2013, which couldn't have been further from last year's reality, as January proved to be the market's nadir. The S&P closed at its high on the last day of the year and exhibited its largest yearly advance since 1997. (I steadily increased my fair market value calculation throughout the year and, at last count, I concluded that the S&P 500's fair market value was about 1645.)

As I said, in 2014 my success rate was at about 40% (which included five also-ran predictions).
This contrasted with my 15 surprises for 2013, which had the poorest success rate since 2005's list (20%).
By comparison, my 2012 surprise list achieved about a 50% hit ratio, similar to my experience in 2011.

About 40% of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, 33% in 2006, 20% in 2005, 45% in 2004 and 33% came to pass in the first year of my surprises in 2003.

Below is a report card of my 15 surprises for 2014 (and the five also-ran  surprises).

Surprise No. 1: Slowing global economic growth. RIGHT

Surprise No. 2: Corporate profits disappoint. HALF RIGHT (as financial engineering buoyed EPS).

Surprise No. 3: Stock prices and P/E multiples decline. WRONG

Surprise No. 4: Bonds outperform stocks. Closed-end municipal bond funds are among the best asset classes, achieving a total return of +15%. VERY RIGHT

Surprise No. 5: A number of major surprises affect individual stocks and sectors. (Starbucks (SBUX) falls, 3D printing stocks halve in price, General Motors (GM) drops by 20% in 2014). MORE WRONG THAN RIGHT

Surprise No. 6: Volkswagen AG acquires Tesla Motors (TSLA). WRONG

Surprise No. 7: Twitter's (TWTR) shares fall by 70% as a disruptive competitor appears. MORE RIGHT THAN WRONG

Surprise No. 8:  Buffett names successor. WRONG

Surprise No. 9: Bitcoin becomes a roller coaster. RIGHT

Surprise No. 10: The Republican Party gains control of the Senate and maintains control of the House. Obama becomes a lame duck President incapable of launching policy initiatives. RIGHT

Surprise No. 11: Secretary Hillary Clinton bows out as a presidential candidate. WRONG

Surprise No. 12: Social unrest and riots appear in the U.S. RIGHT

Surprise No. 13: Africa becomes a new hotbed of turmoil and South Africa precipitates an emerging debt crisis. HALF RIGHT

Surprise No. 14: The next big thing? A marijuana IPO rises by more than 400% on its first day of trading. WRONG

Surprise No. 15: An escalation of friction between China and Japan hints at war-like behavior between the two countries. WRONG

Also-Ran Surprises: Crude oil trades under $75 a barrel (short crude and energy stocks) RIGHT, VIX trades under 10 (short VIX) RIGHT, gold trades under $1,000 (Short GLD) DIRECTIONALLY RIGHT.

What Was the Consensus for 2014 and What Is the Consensus for 2015?


"The only thing people are worried about is that no one is worried about anything ... That isn't a real worry." – Adam Parker, chief U.S. strategist at Morgan Stanley

"In ambiguous situations, it's a good bet that the crowd will generally stick together – and be wrong." – Doug Sherman and William Hendricks

As mentioned earlier, we entered 2014 there was a generally upbeat outlook for global economic and profit growth, as well as upbeat prospects for the U.S. stock market. Projections for bond yields were universally for higher yields throughout the year and the same could be said for the general expectation of rising oil prices.  As is typical, most sell-side projections for earnings, the economy, bond yields and stock prices were grouped in an extraordinarily tight range.
  • Both U.S. and global economic growth disappointed the consensus (despite a strong third quarter 2014 U.S. GDP number).
     
  • S&P earnings were a slight beat, but only because of more aggressive than anticipated share repurchase programs, lower depreciation and interest expenses and a decline in effective tax rates.
     
  • Bond yields declined unexpectedly. The 10-year yield dropped to about 2.2% from 3.05%.
     
  • Deflationary forces were also a surprise, most notably no one projected that oil prices would fall to under $60 s barrel and that the Bloomberg Commodity Index would hit a five-year low in December, 2014.
     
  • Stock prices ended the year about 5% above beginning of the year consensus forecasts.
Virtually all strategists are now self-confident bulls, as gloom and doom forecasts have all but disappeared. After another year with no reactions of 10% or more, any future setbacks are being viewed by the consensus as bumps in the road and as opportunities to buy because (after the correction(s)) we will be up, up and away."

After missing the 25% rise in valuations in 2013 (and a further expansion in P/E ratios in 2014), the consensus now assumes that valuations will expand slightly again in 2015. (Note: The average P/E ratio has increased by about 2% per year over the last 25 years.)

The domestic economy has forward momentum (as witnessed by +5% Real GDP growth in 3Q 2014), so the extrapolation of heady growth is now in full force by the consensus.

In terms of the markets, the consensus remains of the view that liquidity (albeit, at a slowing rate) will overcome complacency and valuations again as it did last year, but my surprises incorporate the notion that the extremes that exist today (in price and bullish sentiment) put the markets in a different and less secure starting point in 2015.

"We expect the growth recovery to broaden as global growth picks up to 3.4% in 2015 from 3% in 2014. Inflation is likely to remain low, in part due to declines in commodity prices, and as a result monetary policy should remain easy. We think this backdrop supports a pro-risk asset allocation." – Goldman Sachs, Global Opportunity Asset Locator (December 2014)

As we enter 2015, investors and strategists are again grouped in a narrow consensus and expect a sweet spot of global economic corporate profit growth that will translate to higher stock prices.

The consensus is for U.S. economic growth of +2.5% to +3.25% real GDP, bond yields to be 50-75 basis points higher than year-end 2014 and closing 2015 stock market price targets to be up by about 8-10% (on average). Indeed, most strategists suggest (in sharp contrast to their views 12 months ago) that the big surprise for 2015 will be that there is upside to consensus economic growth and stock market price targets.
Here were Goldman Sach's views for 2014 made 12 months ago (with actual in parentheses). As can be seen, the brokerage's growth forecasts for the real economy (as was the entire sell side) were too optimistic, while price targets for the S&P were not ambitious enough:
  • U.S. real GDP was estimated at +3.1% for 2014. ( +2.4%A)
     
  • Global real GDP was estimated at+3.6% for 2014. (+3.0%A)
     
  • S&P 500 EPS $116 top-down estimate and $119 bottom-up estimate for 2014 ($119/shareA)
     
  • Year-end S&P 2014 S&P 500 price target was estimated for 2014 at 1900 (2080A)
     
  • Inflation/headline CPI +1.5% for 2014. (+1.1%A)
     
  • U.S 10-year Treasury yield 3.25% for year-end 2014. (2.20%A)
Again, let's use Goldman Sachs' principal 2015s views of expected economic growth, corporate profits, inflation, interest rates and stock market performance as a proxy for the consensus for the coming year. This year the brokerage, like most, is following the bullish trend and is more optimistic on the market relative to its uninspiring expectations last year.
  • 2015/2016 U.S. real GDP +3.1%, +3.0%
     
  • 2015/2016 global real GDP +3.6%, +3.9%
     
  • 2015 S&P 500 operating per share profits $122/share
     
  • Year-end 2015 S&P 500 price target 2100
     
  • 2015/2016 Consumer Prices +1.0%, +2.4%
     
  • 2015 closing yield on the U.S. 10 year Treasury note 3%


The Rationale Behind My Downbeat Surprises for 2015


There are numerous reasons for my downbeat theme this year. In no order of importance: corporate profit margins remain elevated, the rate of domestic economic growth is decelerating (despite five years of QE and ZIRP), a quarter of the world is experiencing minimum growth in GDP, optimism and complacency are elevated, signs of malinvestment are appearing, valuations (P/E ratios) rose again after a 25% expansion in 2013 (compared to only +2% annual growth since the late-1980s. As well, so many gauges of valuations are stretched (market cap/GDP, the Shiller P/E ratio and many others).

Above all, I expect the theme of the U.S. as an oasis of prosperity will be tested in 2015-16 as contagion might be a bi**h.

Moreover, given the large array of potentially adverse economic, geopolitical and other outcomes, the markets have grown complacent after a trebling in prices over the last five years.

Finally, my downbeat surprises this year recognize, that as we enter 2015, we should not lose sight of the notion that if pessimism is the friend of the rational buyer, optimism is the enemy of the rational buyer.

My 15 Surprises for 2015


At last, here are my 15 surprises for 2015 (with a strategy that might be employed in order for an investor to profit from the occurrence of these possible improbables).

Surprise No.1 – Faith in central bankers is tested (stocks sink and gold soars).

"Investment bubbles and high animal spirits do not materialize out of thin air.  They need extremely favorable economic fundamentals together with free and easy, cheap credit and they need it for at least two or three years. Importantly, they also need serial pleasant surprises in such critical variables as global GNP growth." – Jeremy Grantham

"The highly abnormal is becoming uncomfortably normal. Central banks and markets have been pushing benchmark sovereign yields to extraordinary lows – unimaginable just a few years back. Three-year government bond yields are well below zero in Germany, around zero in Japan and below 1 per cent in the United States. Moreover, estimates of term premia are pointing south again, with some evolving firmly in negative territory. And as all this is happening, global growth – in inflation-adjusted terms – is close to historical averages. There is something vaguely troubling when the unthinkable becomes routine." – Claudio Borio

European QE Backfires: The ECB initiates a sovereign QE in January 2015, but it is modest in scale (relative to expectations) as Germany won't permit a more aggressive strategy. Markets are disappointed with the small size of the ECB's initiative and European banks choose to hold their bonds instead of selling. ECB balance sheet still can't get to 3 trillion euros and the euro actually rallies sharply. Bottom line, QE fails to work (economic growth doesn't accelerate and inflationary expectations don't lift).

Draghi Is Exposed: Mario Draghi is exposed for what he really is: the big kid of which everyone is scared. For some time, no one wanted to fight him (or fade sovereign debt bonds, which would be contra to his policy). But, after the meek January QE, the response changes. He is now seen as the bully who never throws a punch and who always has gotten his way. But at the time of the January QE a medium sized kid (and a market participant) teases him and Draghi warns him again to stop it. The kid keeps teasing. Draghi the bully takes a swing, it turns out he can't fight and the medium-sized kid whips his butt. From then on, the big kid is feared no more. For some time Draghi has said he will do "whatever it takes," but he never really had to do anything. When he finally gets going and has to act rather than talk, he will expose himself as only a bully and as a weak big kid. Mario Draghi gets fed up with the Germans and returns to Italy (where he was governor of the Bank of Italy between 2006-2011) and becomes the country's president.

Shinzo Abe and Haruhiko Kuroda Resign: Kuroda, an advocate of looser monetary policy, stays on at the Bank of Japan (for most of the year), but the yen enters freefall to 140 vs. the dollar and wage growth lags badly. Japanese people have had enough and, by year end, Prime Minister Shinzo Abe and Haruhiko Kuroda are forced to resign.

The Fed Is Trapped: The Federal Reserve surprises the markets and hikes the federal funds rate in April 2015. A modest 25-basis-point rise in rates causes such global market turmoil that it is the only hike made all year. The Federal Reserve is now viewed by market participants as completely trapped, as an ah-ha-moment arrives in which there is limited policy flexibility to cope with a steepening downturn in the business cycle in late 2015/early 2016. Stated simply, the bull market in confidence in the Federal Reserve comes to an abrupt halt.

Malinvestment Becomes the It-Word in 2015: Steeped in denial of past mistakes and bathing in the buoyancy of liquidity and the elevation of stock prices in 2014, market participants come to the realization that the world's central bankers in general, and the Fed in particular, once again has taken us down an all too familiar and dangerous path that previously set the stage for The Great Decession of 2007-09. It becomes clear that the consequences of unprecedented monetary easing and the repression of interest rates has only invited unproductive investment and speculative carry trades. The impact of a lengthy period of depressed interest rates uncork malinvestment that has percolated and detonates among differing asset classes as the year progresses. Already seen in the deterioration and heightened volatility in commodities (the price of crude, copper, etc.), in widening spreads in the energy high yield (with yields up to 10% today, compared with only 5% a few months ago) and with the average yield on the SPDR Barclays High Yield Bond ETF (JNK) up to 7% (from a low of 5% earlier in 2014), the consequences of financial engineering (zero-interest-rate policy and quantitative easing) and lack of attention to burgeoning country debt loads and central bankers' balance sheets, in addition to inertia on the fiscal front result in rising volatility in the currency markets. Malinvestment in countries like Brazil (where consumer debt has risen by 8x and export accounts have quintupled over the last eight years on the strength of a peaking export boom, in oil and iron ore, so dependent on the China infrastructure story that has now ended) translate into a deepening economic crisis in Latin America and in other emerging markets.

Then, EU sovereign debt yields, suppressed so long by Draghi's jawboning, begin to rise. Slowly at first and then more rapidly, EU bond prices fall, putting intense pressure on the entire European banking system. (In his greatest score, George Soros makes $2.5 billion shorting German Bunds). The contagion spreads to other region's financial institutions. Shortly after, social media and high valuation stocks get routed and, ultimately, so does the world's stock markets.

As a result of the influences above, the VIX rises above 30. The price of gold soars to $1,800-$2000 and the precious metal is the best-performing asset class for all of 2015. Strategy: Buy GLD and VIX, Short SPY/QQQ and German Bunds

Surprise No. 2 – The U.S. stock market falters in 2015.

"In a theater, it happened that a fire started offstage. The clown came out to tell the audience. They thought it was a joke and applauded. He told them again and they became more hilarious. This is the way, I suppose, that the world will be destroyed – amid the universal hilarity of wits and wags who think it is all a joke." – Soren Kierkegaard.

Market High Seen in January, Low Seen in December (at Year End): The U.S. stock market experiences a 10%+ loss for the full year. (Note: Not one single strategist in Barron's Survey is calling for a lower stock market in 2015. Projected gains by the sell side are between +6-16%, with a median market gain forecast at +11%). The S&P Index makes its yearly high in the first quarter and closes 2015 at its yearly low as signs of a deepening global economic slowdown intensify in the June-December period.

While earnings expectations disappoint, the real source of the market decline in 2015 is a contraction in valuations (price-earnings multiples) after several years of robust gains. Investors begin to recognize that low interest rates, massive corporate buybacks, the suppression of wages, phony stock option accounting and other factors artificially goosed reported earnings and that earnings power and organic earnings are less than previously thought. So, 2015 is a year in which the relevant ways of measuring overvaluation (market cap/GDP currently at 1.25 vs. 0.70 mean) and the Shiller CAPE ratio (currently at 27x vs. 17x mean) become, well, relevant.

With few having the intestinal fortitude to maintain skepticism and short positions into the unrelenting bull market of 2013-14, there is none of the customary support of short sellers to cover positions and soften the market decline, when it occurs.

Stocks begin to drop in the first half, well before the real economy tapers, underscoring the notion (often forgotten) that the stock market is not the economy.

But by mid-year it becomes clear that U.S. economic growth is unable to thrive without the Fed's support.
Year-over-year profits for the S&P decline modestly in the second half of 2015. Domestic Real GDP growth falls to under +1.5% in the third and fourth quarters.

By year end the market begins to focus on The Recession of 2016-17, which looms ahead in the not so distant future. Strategy: Short SPY

Surprise No. 3 – The drop in oil prices fails to help the economy.

"In its November 14, 2014 Daily Observations ("The Implications of $75 Oil for the US Economy"), the highly respected hedge fund Bridgewater Associates, LP confirmed that lower oil prices will have a negative impact on the economy. After an initial transitory positive impact on GDP, Bridgewater explains that lower oil investment and production will lead to a drag on real growth of 0.5% of GDP. The firm noted that over the past few years, oil production and investment have been adding about 0.5% to nominal GDP growth but that if oil levels out at $75 per barrel, this would shift to something like -0.7% over the next year, creating a material hit to income growth of 1-1.5%." – Mike Lewitt, The Credit Strategist

Despite the near universal view that lower oil prices will benefit the economy, the reverse turns out to be the case in 2015 as the economy as a whole may not have more money – it might have less money.

Continued higher costs for food, rent, insurance, education, etc. eat up the benefit of lower oil prices. Some of the savings from lower oil is saved by the consumer who is frightened by slowing domestic growth, a slowdown in job creation and a deceleration in the rate of growth in wages and salaries.

And the unfavorable drain on oil related capital spending and lower employment levels serve to further drain the benefits of lower gasoline and heating oil prices.

In The Financial Times, recently, Martin Wolf wrote: "(A) $40 fall in the price of oil represents a shift of roughly $1.3 trillion (close to 2 per cent of world gross output) from producers to consumers annually. This is significant. Since, on balance, consumers are also more likely to spend quickly than producers, this should generate a modest boost to world demand."

But Wolf, and the many other observers, as Mike Lewitt again reminds us, "fail to explain how the $1.3 trillion that has been deducted from the global economy is able to shift from one group to another. "

Surprise No. 4: The mother of all flash crashes.

"America is the 'arch criminal' and 'unchangeable principal enemy' of North Korea." (Dec. 22, 2014)
"America is a 'toothless wolf' and 'the empire of devils."" (March 27, 2010)
"North Korean missiles will reduce Washington, D.C. to 'ashes.'" (August 19, 2014)
"America is a 'group of Satan' bent on destroying Korean religion." (April 22, 2013)
"American 'ideological and cultural poisoning' is undermining socialism around the world." (July 16, 2014)

– Selected quotes from North Korea's state-controlled media

Hackers attack the NYSE and Nasdaq computer apparatus and systems by introducing a flood of fictitious sell orders that result in a flash crash that dwarfs anything ever seen in history.

In the space of one hour the S&P Index falls by more than 5%.

The identity of the attacker goes unknown for several days and it turns out to be North Korea.  Strategy: Buy VIX, Short SPY/QQQ

Surprise No. 5: The great three-decade bull market in bonds is over in 2015.

"Take then thy bond thou thy pound of flesh..." – Portia, The Merchant of Venice
Last year not one strategist saw lower interest rates (though that was my No. 1 Surprise last year). This year, not one strategist expects a spike in interest rates.

In the first half of 2015, European yields and U.S. yields start to converge, in that European yields begin to jump to where the U.S. 10-year yield resides. The failure of Draghi's policy (see Surprise No. 1) will result in an acceleration in the European debt yields rising and in a decay in debt prices. That will mark the end of the great three-decade bond bull market in the U.S. and it will occur as global growth eases. Strategy: None

Surprise No.6 – China devalues its currency by more than 3% vs. the U.S. dollar.

"It's not like I'm anti-China. I just think it's ridiculous that we allow them to do what they're doing to this country, with the manipulation of the currency, that you write about and understand, and all of the other things that they do." – Donald Trump

For years, China has essentially pegged it's currency to the U.S. dollar. (liberalization meant that a narrow trading range is permitted). With the huge run in the U.S. Dollar, China's currency has appreciated compared with other Asian currencies. As a result, China has lost its manufacturing edge and its trade surplus has all but disappeared. Whether it's a permitted day-to-day weakening, changing the peg from the dollar to a basket of currencies or whether there is an overnight surprise devaluation, China's currency will weaken materially in 2015. Strategy: None

Surprise No. 7 – Apple (AAPL) becomes the first $1 trillion company.

"There's an old Wayne Gretzky quote that I love. 'I skate to where the puck is going to be, not where it has been.' And we've always tried to do that at Apple. Since the very, very beginning. And we always will." – Steve Jobs

Apple's next generation iPhone is seen to likely outsell its latest phone iteration as Re/Code uncovers (and reveals) some amazing and unique new features/applications that are planned for the next generation phone.
I don't know what features it will have or how it will improve design or performance. But I think there is now a near-consensus that it won't and that the next product upgrade cycle is a while away.

So, I predict Apple 2016 estimates rise significantly (to $10/share) and, despite a weak market backdrop, Apple becomes the first $1 trillion dollar market-cap company and the best-performing large-cap in 2015.
Apple becomes the only one-decision stock during the stock market swoon during the last half of 2015. It is a must own. Strategy: Buy APPL

Surprise No. 8 – Legislation is introduced that allows for repatriation for foreign cash.

"The only difference between death and taxes is that death doesn't get worse every time Congress meets." – Will Rogers
As signs of domestic economic growth fade in the second half of 2015, Congress and the Administration agree on a broad program to repatriate foreign cash at a low tax rate.
The deal briefly rallies the U.S. stock market, but equities soon succumb to a slowing domestic economy and diminishing corporate profit growth.   Strategy: None

Surprise No. 9 – Energy goes from the worst-performing group in 2014 to the best-performing group in the first half of 2015 and then falls back later in the year.

"Oil vey!" – Kass Daily Diary term
Energy stocks are on a roller coaster in 2015.

As the price of crude oil rises steadily (towards $65 a barrel) in early 2015, the energy sector (which was among the worst in 2014) becomes the best market group in the first half of the year. Slowing global economic growth during the last half of the year leads to profit-taking in the energy sector as the price of crude oil closes the year at under $50 and at its lowest price in 2015.

In a surprise move, the president signs approval for the Keystone Pipeline in the second half of the year.
Strategy: Buy oil stocks in first six months of the year, sell/short mid-year.

Surprise No. 10 – More chaos in the Democratic Party.

"Mothers all want their sons to grow up to be president, but they don't want them to become politicians in the process." – John F. Kennedy

Sen. Elizabeth Warren pushes Secretary Hillary Clinton so far to the left that she loses independent voters, though she easily gains the Democratic nomination for president.  Former President George H.W. Bush passes away during the first half of the year and Governor Jeb Bush immediately declares his candidacy. By the end of 2015, Jeb Bush is well ahead in the polls and is a big favorite to win the presidency in 2016.
Strategy: None

Surprise No. 11 – Food inflation accelerates after Russia halts wheat exports.

"As life's pleasures go, food is second only to sex. Except for salami and eggs. Now that's better than sex, but only if the salami is thickly sliced." – Alan King

Russian turmoil continues and Putin decides to halt exports of wheat again to keep as much homeland as possible, resulting in a price spike in wheat, but also corn and soybeans. This price rise, on top of U.S. food inflation that is already running higher, offsets the consumer benefit of still-relatively-low gasoline and heating oil prices. Strategy: None

Surprise No. 12 – Home prices fall in the second half of 2015.

"I told my mother-in-law that my house was her house and she said, 'Get the hell off my property.'" – Joan Rivers

Under the weight of reduced home affordability, still low household formation gains and continued pressure on real incomes, home prices fall in 2015. Builders lose pricing power. Strategy: Short homebuilders.

Surprise No. 13 – Individual and sector market surprises.

"Those who are easily shocked should be shocked more often." – Mae West
  • Bank Stocks Fall – Though bank stocks have been recent market leaders, the weight of a flattening yield curve, still-tepid loan demand and an implosion in the European banking system make the sector among the worst market performers. Moreover, a major cyber attack against Bank of America (BAC) that actually destroys a percentage of customer records further diminishes enthusiasm for the group.
     
  • Twitter Feeding – Carl Icahn, calling it his "new Netflix," discloses a 9.9% position in Twitter. This stimulates a bidding war between Google (GOOGL) and Facebook (FB) to acquire the company. Google wins the battle and pays $60 a share for Twitter.
     
  • Volatility Rising – The VIX rises to over 30 in the second half of the year.
     
  • Google Institutes a Share Buyback and Shaves Capital Spending – After a lackluster performance in 2014, Google's management reverses course on its previously outsized capital spending program on non-core businesses and becomes more shareholder friendly. The company dials back spending and institutes a stock buyback program.
     
  • Corporate Inefficiency in Large-Cap Technology Targets Activist Investors –- Two hedge funds establish a filing position in Cisco (CSCO) and force Chairman John Chambers out. The new CEO announces a large special dividend and a massive stock buyback and a cutback to the employees' too-generous stock option plan. More than 10% of the workforce is laid off and Cisco's shares soar. Several other tech companies are targeted.
Strategy: Long AAPL TWTR, CSCO, VIX, GOOGL and short banks


Surprise No. 14 – Berkshire Hathaway (BRK.A) makes its largest acquisition in history.
"When I was 15 years old, I read an articls about Ivan Boesky, the well-known takeover trader – turned out years later it was all on inside information! But before that came to light, he was very successful, very flamboyant. And I thought, 'This is what I want to do.' So I'm 15 years old, I decide I'm going to Wall Street." –  Karen Finerman

During the depths of the market's swoon in the later part of the year, Warren Buffett scoops up his largest acquisition ever. The $55+ billion acquisition is not in his customary comfort zone (a consumer goods company), but rather the deal is for a company in the energy, retail or construction/equipment areas. Strategy: None

Surprise No. 15 – A derivative blowup precipitates an abrupt market drop.

"I view derivatives as time bombs, both for the parties that deal in them and the economic system." – Warren Buffett

The $300 trillion holdings of derivatives by the U.S. banking industry has been all but forgotten. The four largest U.S. banks account for $240 trillion of that total, dwarfing their combined $750 billion in statutory capital! This sort of exposure in which notional derivatives are more than 300x the banks' net worth, is, as my friend The Credit Strategist's Mike Lewitt has written, "would be laughable if the consequences of a financial accident were not so potentially catastrophic."

To make matters worse, the passage of the $1.1 trillion spending bill passed this month (written by lobbyists and voted on by bought-and-paid-for legislators who probably neither read nor understood the complex spending bill) has kept taxpayers on the hook –through the FDIC – for those derivatives (what Warren Buffett previously called "financial weapons of mass destruction.")

On any measure, the sheer size of these derivative portfolios pose potential risk to the world's financial stability. What we have learned from the past cycle is how opaque the exposure really is and how stupid and avaricious our bankers really are when allowed to venture into territories of leverage.

Whether it is energy derivatives or some other asset class, a derivative blowup in 2015 will serve to preserve the wise words of Benjamin Disraeli (who served twice as Great Britain's Prime Minister) that "what we have learned from history is that we haven't learned from history." It will also harm our markets, once again. Strategy: Short SPY

10 Also-Ran Suprises for 2015


By DOUG KASS
Dec. 26, 2014 | 7:32 AM EST
Stock quotes in this article: BABASHLDIBMBRK.AMONIF
  • On Monday I will deliver my 15 Surprises for 2015.  I think it is my most interesting list in years.
Here are my 10 also-ran Surprises for 2015 that I had considered but didn't make the top 15.
  1. China's Real GDP growth falls below 5% in 2015 as economic growth decelerates markedly in the second half of the year.
     
  2. An accounting "discrepancy" is found at Alibaba (BABA). The shares plummet and the hedge fund community feels the pain.
     
  3. Under pressure from suppliers and a falling stock price, Ron Johnson is installed as CEO ofSears Holdings (SHLD).
     
  4. George Soros makes $2.5 billion by shorting German Bunds.
     
  5. The price of crude oil drops below $40 a barrel in the second half of 2015.
     
  6. The consumer price index turns negative (year over year).
     
  7. IBM (IBM) whiffs and the share price drops below $125 a share. Berkshire Hathaway(BRK.A) suffers a near-$4 billion loss (on paper). At Buffett's suggestion, senior management is replaced.
     
  8. Warren Buffett announces his successor.
     
  9. Uber goes public at a $50 billion capitalization. The share price never exceeds the IPO price in 2015.
     
  10. Monitise's (MONIF) subscription adds far outpace expectations this year. (The shares double in price).

Letter to My Nephews


By Jonathan Tepper
December 29, 2014 in Uncategorized

You can learn a lot from books, but many things can only be learned the hard way by living, suffering and enjoying life. A year and a half ago, I was in a plane with very bad turbulence, and I worried that if the plane went down, many of the lessons I’ve learned in life would end up at the bottom of the ocean.  I wrote a letter to my nephews for them to read when they were older.  I hope they’ll find it useful.
—————–
Dear nephews,
I’m writing this on a plane. The reason I started writing this was that I feared the plane might go down, and if it went down, all the lessons I’ve learned in life would disappear with me. By writing this, I hope to pass on the few lessons I’ve learned.

The most important lesson is that the vast majority of things you worry about will not bother you the next day. A year later you will not even be able to remember them if you try. When you grow older, you will not worry about what grades you got. You won’t worry about games you lost.   You won’t worry about what other people thought about you. Most of the things you worry about will never happen. Even if the worst things that you worry about happen, life will still go on. Learn to enjoy every day, and try to enjoy it as if it is your last. It has taken me a long time to understand this, and I wish I had understood it sooner.

Happiness is not a destination but a journey. You will never be smart enough, rich enough, have a pretty enough girlfriend, boyfriend, husband or wife, or win enough prizes and awards. Whatever it is you want, there is always something better. Enjoy the journey of learning, working, and living. If you enjoy the journey, you’ll probably achieve a lot more than if you focused on goals.

Money can provide security, but once you have security, more money cannot buy you more happiness. If you show me someone who thinks money can buy happiness, I’ll show you someone who has never had a lot of money.

Things don’t make you happy, but memories will always stay with you. Whatever it is that you buy, you will soon get used to it. It will make you happy for a short while, but it will not make you happy forever.

Experiences and memories can make you happy forever. I can’t even remember most of the toys I’ve had in my life, but I still think of my times with Timothy and your Grandmom with great happiness and fondness. I remember walking Timothy to school and how happy we were. I remember hugging your Gradmom when I came home for a weekend. Those memories will never go away. The happiest memories of my friends are my travels and dinners with them, not the things I’ve bought for myself. You’ll remember dinners and travels with friends and family more than any shiny things you’ll ever have.

Your family is the most important thing you have in life. Friends, boyfriends, girlfriends and co-workers come and go, but the only thing that you can always count on is your family. (If you find a friend who is always there for you, you’re extremely lucky. They exist, but they’re very rare.) One day, you will have your own family. You must love them and look after them. You will understand one day that just as your grandparents die, your parents will as well. Strive to be a good son and daughter. One day, you will be like your parents. Your parents are not perfect, and you will not be either. But you can be loving and be a good son and daughter. One day you can be a good parent.

Never stop learning, and always be ready to teach yourself things you don’t know. The only things you will remember are things you care about. You will forget about all the rest. You must teach yourself and care about what you learn. No one can teach you everything you need to know at school or university. You will also forget most of what you study, and that is fine. As Jacques Barzun said, “Civilization is all that remains after you have forgot all that you specifically set out to remember.”

Never live someone else’s life. Find your gifts and the things that give you pleasure, develop those gifts, and pursue them.   Do what makes you happy and be great at it. You have skills and gifts that no one will ever have or see again. If you’re a businessman, build businesses. If you’re a writer, write. If you’re a scientist, discover. If you do what you love and love what you do, you will work very hard, but you will enjoy every day.

One of the things that most influenced me was something Steve Jobs once said:
When you grow up, you tend to get told that the world is the way it is and your life is just to live your life inside the world, try not to bash into the walls too much, try to have a nice family life, have fun, save a little money.

That’s a very limited life. Life can be much broader once you discover one simple fact, and that is that everything around you that you call life was made up by people that were no smarter than you. And you can change it, you can influence it, you can build your own things that other people can use. Once you learn that, you’ll never be the same again.

And the minute that you understand that you can poke life and actually something will, you know if you push in, something will pop out the other side, that you can change it, you can mold it. That’s maybe the most important thing. It’s to shake off this erroneous notion that life is there and you’re just going live in it, versus embrace it, change it, improve it, make your mark upon it.

I think that’s very important and however you learn that, once you learn it, you’ll want to change life and make it better, cause it’s kind of messed up, in a lot of ways. Once you learn that, you’ll never be the same again.

I hope that you will find what you love and you will change the world.

Life is full of struggle, and many bad things will happen to you. This is one thing that I can guarantee you. Most of my friends died of AIDS, and your uncle Timothy died in a car accident and your Grandmother committed suicide after suffering from a very bad brain tumor. These things happened and cannot be changed. Many people suffer great tragedies and live full and happy lives. Remember the people you love and mourn them. Accept that terrible things happen, and try to live as if each day is your last with those you love. There is nothing else you can do.

The best way to avoid anxiety, stress and unhappiness is to avoid internal contradiction. Don’t think that one thing is right and do the opposite. Listen to your conscience and obey it. Be a good person and live according to your convictions. You cannot answer for other people, but you can always answer for yourself.

As long as you live according to your most basic beliefs, you will not have regrets or guilt. You will be able to die happily knowing that you looked after the poor and needy, that you were loving to those around you, and that you failed often but did your best. You will not lose a night of sleep if you always try to do your best. I love you very much.
Much love,
Uncle Jonathan

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The article Outside the Box: 15 Surprises for 2015 was originally published at mauldineconomics.com.


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