I’ve been thinking about my forecast for this year. At the highest level I believe that market neutral is a great idea for the next 12 months. There is a good chance that the US will see a recession this year and a great chance that we will see a quarter or two between negative 2% and 0% growth. Of course a recession is an aggregate measure of the performance of the economy and many sectors can perform reasonably well while a few perform terribly, this bifurcation will be the hallmark of the recession or at best very low growth (VLG) period. Credit spread expansion is probably the low risk high reward trade of the next 12 months but I'm not planning on making the trade.
Commodities are going to perform incredibly well over the next 5 years but the next 1 year could on balance see a period where prices end the year little changed or even moderately down from here (which is significantly down from their highs, especially oil, silver, gold and copper). Throughout this forecast you can measure commodities by looking at Silver, Gold, Oil, Coal and Uranium as these are the ones that I have a position in.
You can obviously sell all these holdings but I have decided not to for two reasons. Firstly because of an event that will happen coincident with the recession/ VLG scenario. Bernake will flood the system with liquidity because he doesn’t want our hosing bust to turn out like Japan. This will be wildly bullish for commodities and the exact timing of it is very hard to predict. This will be the setup for the next big leg up in commodity bull market. Secondly selling the holdings would incur significant tax payments.
I plan on implementing this with a mixture of QQQQ (Nasdaq 100) puts and keeping my long positions. Probably on a 2:1 short for long basis as the beta of my longs is at least double that of my shorts. The danger of a market neutral strategy is both sides of the trading going against you. The worst possible scenario would be good tech performance and poor commodity performance. This is very unlikely but possible. At least on the QQQQ side I’ve used options so I can only loose the premium which was very cheap about 8% of my equity for equal net beta coverage.
The best scenario for the year would be terrible tech performance and great commodity performance; a scenario which is somewhat realistic given that the BRICS (Brazil, India, China, South Korea) economic growth will not necessarily moderate and even if it does, as long as it’s not negative then their consumption in ’07 will be greater than last years
The consensus forecast for this year is the Goldilocks forecast with moderating but still significant economic growth leading into a reacceleration in the later half of the year. While I’d loose on my puts, my commodity heavy portfolio will do excellently. The consensus never picks recessions or other turning points and I think they’ve got it wrong.
I’m looking forward to commodity prices dropping and Nasdaq dropping at the same time. I’m going to try to pick the bottom (which I will fail miserably at) and then sell the puts and buy whatever of my favourite stocks have dropped the most. I’m excited about ending the year in a much better position than I started it.
It’s worth saying that I’ve though the recession/VLG scenario was possible in late’05 mid ’06 but less likely, hence I had less downside protection. This time around the chance is more than 50/50
VLG/ Recession scenarios – 70%
- Nasdaq up, commodities down – 10%
- Nasdaq down, commodities down (standard recession VLG fare) – 50%
- Nasdaq up, commodities up (strong growth resumes by EOY) – 20%
- Nasdaq Down, commodities up (massive reflation)– 20%
Goldilocks – 30%
- Nasdaq up, commodities down -10%
- Nasdaq down, commodities down – 20% (liquidity and/ or growth reduced in BRICS)
- Nasdaq up, commodities up (standard fare in global economic synchronised boom- see last 3 years ) – 50%
- Nasdaq Down, commodities up – 20%
I make money on 3, 4, 7 & 8 (50% chance). I stand to loose on 1 & 5 (10% chance).
2 & 6 (40% chance) are the most interesting because whether I make a little money, breakeven or lose depends on how the Nasdaq compares with commodity prices. I actually think that the Nasdaq 100 has more to loose than commodity stocks because its components are more highly valued and generally technology is deflating while commodity prices are inflating.
I expect to end the year moderately up and owning more shares of my favourite commodity stocks bought at cheaper prices. I expect to outperform the major indices, I expect to see a lot of volatility (which helps my puts make money) and a year of moderate capital gains.
Let the year begin!
My 2006 forecast is here
. I'm going to review them line by line and see how I did. It's important to remember that these were all contrarian calls at the beginning of 06. The average return of my forecast was 31% if it were equal weighted and you traded the mentioned stocks and currencies. It was better again if you traded the commodities. My results for the year were substantially better because I was weighted towards the stocks, took no currency position and held larger positions in the better performers.
1. NASDAQ tanks - inverted yield curve, bull market long in the tooth, crazy valuations, presidential cycle, fed tightening all portend an economic slow down which will almost certainly drag the NASDAQ down
6.7% loss! The QQQQ finished 2005 at 40.54 and trade today at 43.24. I still believe I'm early rather than wrong.
2. Silver rises - silver demand has not been met by mine supply for decades, there is less silver in the ground than any other metal, silver is consumed by industrial processes, inflation. These have been the case for some time so I expect this to continue crawling in my direction
41% gain. Silver finished 05 at around $9 and trades at 12.65 today.
3. Oil doesn't drop - No big oil discoveries in decades, reserves have not been replaced by majors for a decade, Saudi Arabia has no more light oil, Alternative sources will come online but only at high prices. Canadian Oil Sands (COS.un COSWF) reaches a yield of 10% on today's price.
Oil ended 05 at around 62 and trades today at 58.32. COS.un is not yet yielding 10% on 05 prices. I still like COS and it's up 25% on the year from $25.18 to $30.16 but the forward yield is still only around 7-8%.
4. Lead (the metal) doesn't drop more than 10% - China, India, Brazil continue to grow at very high rates and consume lead products (cars, batteries), lead in deficit, decline of the dollar. Ivernia (IVW) does well in this environment.
20% loss on IVW. Lead did very well moving from 50c a year ago to around 80c today. IVW, however, went from $1.84 to $1.47. IVW is worth more than it was a year ago but managements execution has been so poor that I'm not adding money.
5. Uranium doesn't drop - High oil prices, increasing energy demands, Uranium is the cheapest source of energy, Uranium in deficit. STM doubles and is probably bought out (I'd rather it wasn't!)
Up 86%. STM traded at $1.9 at the end of 05 and $3.53 yesterday. Uranium rose from around $35 to around $75 over the same period. STM is even more undervalued than it was a year ago.
6. Coal doesn't drop as much as the experts expect - Coal is the second cheapest source of energy, coal is required to produce steel, over production of steel requires more coal (steel can drop and coal increases), supply constraints due to infrastructure, Australia is closest to China and India, developing technologies like hydrogen and coal gasification support coal demand. Felix resources up.
A rise of 86%. FLX traded at 2.27 a year ago and $4.23 right now. Exact coal prices are difficult to come by but prices were the same to down 5% according to my research. Finishing at around $55USD.
7. The drop in the NASDAQ scares the market and everything drops for a while and then commodity stocks revive without a revival in the NASDAQ.
Well NASDAQ hasn't fallen so this is out the window.
8. US Rates peak for this cycle and fall from that peak, USD falls against Canadian dollar, USD falls against AUD.
Rates may well have peaked but didn't fall. USD has fallen against AUD moving from around .74 to nearly 80c a rise of 8%. USD has stayed about constant with the CAD after a decent fall during the year and then a rise back to late 05 levels.