Outlook 2011

None of the information contained in this document or any websites or other information referenced within it constitiutes a recommendation by Pearl
Fisher Investments or the contributors to the Outlook for 2011 that any particular security,portfolio of securities,transaction, or investment strategy is suitable for any
January, 2011
PearlFisher 2011 Outlook
Index
PearlFisher 2010
What happened in 2010?

The S&P500 rose 13% in 2010, Chinas stock market fell -15% and we had the year of the flash-crash. Overall it faired better then we anticipated due to larger than expected central bank intervention (i.e. QE II) but we still had an average return of +23% mainly because of the performance we generated at the very beginning of the year in stock markets and later in the year in silver. Overall it was a fairly quiet year for stocks with low volumes and a high fear factor, which managed to end on a fairly positive note. and what do Wall Street strategists predict for 2011? The average of 11 Wall Street strategists, in a Bloomberg survey, predict an 11% gain in 2011. Read the article at the following link http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aeq5bWB6Z6GU The important thing is to realize that extensive research has shown that only once in 30 years were the average predictions correct. Usually the performance of the S&P500 is more than 5% away from the mean. The trick is to figure out whether it is significantly below or above the average prediction.
Coming trends and changes in 2011 and thereafter
1)The Post office is slowly disappearing and they wont be able to make a profit going forward since e-mail, FedEx, UPS and DHL are wiping out the minimum revenue level to keep the post offices alive. Since all we ever get is bills and junk mail nobody wants the classic postman to come anymore, but everybody is looking forward to see UPS or DHL pull up on their door whether in Europe or the US since they bring the presents or those nice packages from Amazon. (short postal services and go long fedex and UPS) 2)The landline telephone. Unless you still need a fax machine or you have a lot of local calls to make, which is a minority of todays modern society then you are double paying for something you dont need. In another 5-10 years the fax machine will probably end in a museum and they will have to offer landlines for free if they are going to continue that service at all, since they need the lines for data. If you are using the same cell service provider today as your friend or partner you can already call other people using the same service for free today. (short large old world telcos and go long pure leading cell phone provider) 3)The Check is going to disappear and even classic credit card companies will face a slow death as electronic payments are taking over. On top of that excessive fees for credit card companies may be a thing of the past as laws are about to change. In most European countries the check was already a relic of old times but even in the US it will pretty soon disappear. The cost to process checks is way too high for the financial system and electronic transfers are taking over. On top of that we will see an increasing move towards micropayments, which will change the landscape of the internet payment systems (short check processing companies and go long the Paypals (Ebay) and similar electronic payment platforms and the chip makers like Intel).
PearlFisher 2010
4)The newspaper is dead, at least in paper format. The newspaper companies of the world have gotten together and will now offer pay for services on devices like the iPad. Eventually they will probably end up charging micropayments but the newspaper companies are technologically so far behind the moon that they probably dont understand the concept yet. (short newspaper companies, go long Apple) 5)The book will disappear, well perhaps not completely but it will soon be the minority device used for reading as more and more people are discovering that you pay half price, that you can get it instantly and that you can preview before purchasing. (short old style bookstores and go long Amazon) 6)The music industry is dying, not because of illegal downloading but because of corruption and greed. The lack of innovative new music means the slow death of the music industry (go short the classic music labels, go long Starbucks which is promoting loads of young musicians) 7)Television revenues are falling continuously and the quality of the content is decreasing because of it. The young crowd is watching videos streamed from the internet or self-made films on YouTube. Services like Netflix, which let you see the newest movies and large movie libraries for a flat fee whenever it suits with no advertising are already shaping the television experience of a young generation. The old television is a thing of the past. (go short old TV channels and go long Netflix) 8)The Computer Interface (or any electronic interface) will change dramatically. I am using more and more often speech recognition software to write (or shall I say speak) this newsletter. The software is becoming affordable for everyone and more and more people are dialing their phone while in the car via voice recognition. iPads and iPhones already have touch screens and we will see more and more computers use the same technology. Gone will be the days of the mouse. On top of that the XBOX Kinect got so much attention from large manufacturers that you wont have to wait long for a much more visual interface to appear on many appliances. Just think you now already have a vacuum cleaner and a lawnmower that find their own way, so far rather randomly but still, but soon all sorts of machines including cars will find their way around by themselves (sell producers of computer mice and buy speech recognition software producers and producers of the visual part of the XBOX Kinect) 9)Drive your innovation through contests. An increasing number of firms are driving their innovation through online contests. Google (http://www.demoslam.com/) and Sprint (http://www.phonearena.com/news/Sprint-launches-4G-App-Challenge-for-developers_id13275) are just two examples of how technology companies look for new ways to use their proprietary technology. Look for an increasing number of contests and innovative ways of online advertising. (go short traditional old style advertisers and go long Google) 10) R&D is a thing from the past, E&S (Experiment and scale) is the future according to leading scientists. More and more firms outsource and open their R&D on the internet by using labs. Some are just open internally within a firm, some are opened for customers to experiment with the customer interface, new products and marketing. These labs are looking for new ways to create value and it is a cheap form of value creation. (Go long Google and companies like Facebook [too bad they are not listed])
PearlFisher 2010
11) Retirement is a thing from the past. Retirement costs (or pensions) turn out to be the single largest longterm problem for any government. The more local the government (meaning municipalities or cities in some countries) the worse it gets. No matter whether you look at local governments in Europe, Japan, the US or anywhere else, almost all of them know for sure that they will not be able to meet their long-term pension obligations in the long run. There will be several effects from the long-term government debt crisis but the most obvious one will be a continuously rising retirement age. There will probably be a number of plans you can chose from but early retirement is a relic from the past. (short municipalities and other units which have loads of pension obligations and go long producers of human spare parts like Stryker) 12) Travel and Tourism is back. Revenue in the industry is forecast to reach a new record $1.4 trillion by the end of 2011. Just think of the baby boomer generation of all industrialized nations, which has more time on their hands, coupled with Chinese, Indian, Brazilian, Russian and you name it emerging countries tourists who want to get out and use their newly found wealth to try and explore the world. This industry will continue to grow for quite some time. (go long online travel agents and travel app providers) 13) Social Shopping online is taking off. Facebook and Twitter have taken shopping to the next level. Research shows that social media users spend one and a half time as much money online then all other netizens, which do not belong to a social network. E-commerce has gone social and most people rate personal advice from friends as the strongest source of information that influences their purchase decisions. And over 50 percent of social network users reported that they follow brands and products on social networks. (unfortunately neither Facebook nor Twitter are listed) 14) Healthcare continues to be mega growth driver and will easily be the largest industry in 10 years from now. Just look at the numbers. Healthcare and social assistance already generated almost $2 trillion in revenues in 2010 (just in the US). It is incredibly resilient against economic downturns. 10 of the 20 fastest growing occupations are healthcare related, and the industry will generate about 3.2 million jobs between 2008 and 2018 in the US alone. On top of that there will be some favorable legal changes, which will come into effect by 2014 in the US. (go long the healthcare sector and no later than 2013) 15)The Pharma industry could see a scandal the size of the BP scandal in the oil industry last year. GlaxoSmithKline was recently fined $750 million to resolve manufacturing deficiencies. Apparently the situation at one of their manufacturing plants in Puerto Rico were so chaotic that medication was mixed up in the packages that were sold. As the pharma industry is trying to squeeze higher margins out of less and less new products could eventually lead to more scandals in a very greedy industry. 16) Home Improvement will be a major trend again as many homeowners who have put off fixing their homes during the financial crisis. On top of that millions of homes, which have been empty for a long time change owners now and usually many things need to be fixed in those homes. According to IBIS World home improvements are on track to top $117.6 billion in 2010 and $133.7 billion in 2011. 17) Energy Efficiency and Recycling continue to be growth industries. While a large part of the hippness factor is gone and the industry is slowly getting out of its growing pains, it is now moving on to the next stage into sustainable profitability. A large part of the industry is now moving into consulting other businesses on how to save money and the environment at the same time. And once you hear how large the numbers are you will want to start a business in that area too. The estimates of for the true cost of oil for the
PearlFisher 2010
US alone run between $1 trillion and $65 trillion a year. Yes thats a wide margin but even if you take the worst case there is enough money to go around. If you want to hear the worst case scenario then go to the following link http://www.energyandcapital.com/articles/oil-gas-crude/461 but dont come yelling at me. I dont agree with this persons view its just that I always believe that you should hear the best and the worst case scenario to get a good feel for the truth, which is usually somewhere in the middle. 18) Fitness continues to be a success story even during the recession. In the US there are now 45.3 million health club members and more than 10 million of them joined in 2009 alone. The industry continued to thrive during the recession and right now small group personal training seems to be the new growth driver. On top of that a new trend in home fitness seems to emerge which will drive the numbers for this industry even higher as many people realize that they need to start working out if they want to increase their life expectancy. 19) Globalization is here to stay! While many investors slowly started to realize it a while ago it is finally here to stay. We are speaking daily about markets like Brazil, Chile, Russia, India and even Vietnam and we are talking about more and more different assets as well. Emerging Markets are no longer emerging but are rather established now. The trend is clear and we will see and hear more and more of that going forward. 20) The Dinochicken a new trend in paleontology is emerging. If you are interested in what could soon be the first re-engineered dinosaur (scientists claim that they will have the first example in the next 5 years) then you should watch this recent CBS 60 minutes interview which will explain how they think it will be possible and youll be surprised to see what they found in 80 million year old dinosaurs http://www.cbsnews.com/video/watch/?id=7186263n&tag=contentMain;cbsCarousel 21) Data Visualization and Pattern Recognition will revolutionize the way we look at data and the way we use it. We will be able to optimize and change the ways we look at data and it will be much easier to spot all those snake oil producers and other inefficiencies in the global economy. Here is a link that will show you what I mean http://www.informationisbeautiful.net/
PearlFisher 2010
Ben Bernanke on the Economy

(CBS 60 minutes from December 2010) http://www.youtube.com/watch?v=LxSv2rnBGA8&feature=related even if you have already seen it I urge you to go back and watch it a second time to get a good feel of what we are talking about. Ben Bernanke essentially is determined to re-inflate the economy so that we will not see a similarly dramatic situation as during the Great Depression. Of course that comes at a cost but the positive effects are supposed to outweigh the negative effects and he may just get right, only the future will tell. The quantitative easing approach he is taking has two main effects, for one he is providing a lot of liquidity to the system which he hopes will eventually end up with corporations so that they can improve their balance sheet and start to hire new employees and two he is inflating the economy in two ways which should help equity and commodity markets fight of the deflationary pressures, so that businesses and investors start to see more value in investing rather than hoarding cash. The two ways of inflating are for one the direct effect, which happens through more money being available in the system and two because of an indirect devaluation of the dollar, which helps to import inflation and export deflation. The risk is as some believe that once he turns that inflation engine on, that he cannot turn it off again. I personally believe that he is right that he will eventually be able to turn it off by raising interest rates since the deflationary risks are still far greater than the inflationary risks at the moment (for the US, in other countries that is completely different). The interesting thing is that all the other countries are totally dependent on the US because of it being the largest consumer market in the world but even more so because it is the largest financial market, with the largest debt market in the world. In 20 years or more that may eventually change, or lets just say be less of an issue, but right now large emerging countries like China depend on a fully functioning US debt market, in which they have invested a trillion dollars or more and a working US consumer who buys all their goods. Yes surely there are other markets as well but they cannot compensate the size of the US. Chinas economy would be brought to a grinding halt if their products would not find an end consumer in the US. The recent successful Christmas holiday shopping season in the US was important for everyone. Does that mean that the worst is over? Well we may have escaped the worst and uncle BEN will have to continue to support us for a while, but when it is all over then the US should stand back on its feet even though it will probably take 4-5 years or more to get rid on those high unemployment numbers and we will have to deal with the unwinding of the enormous government debt over the course of the next two decades, but in the end it is better than a global war which is what the Great Depression brought us in one form or another. It was the years from 1933 to 1938, which laid the foundation for dictators in so many countries like Germany and Russia and eventually led to WWII because the impoverished masses wanted change at any cost even so it drove them right into the arms of the evil empire. There are a lot of critics of Ben Bernanke and the fed these days but what they should always remember is that you first have to have a better plan, which ensures economic stability before you start pointing with your finger. I highlighted many times that there are great risks of putting on too much government debt and it is extremely important to highlight them from a risk management point of view but at the same time there may be little to no alternatives for the global central banks right now unless they intend to send the economy into a tailspin.
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The Big Picture
The table to the right is a description of a typical business cycle. Unfortunately markets almost never stick to this plan but it is important to understand the mechanics behind them and to watch for early warning signs. According to the business cycle we should now be in Stage 5 and that may be a reason why the fed continues their Quantitative Easing programs to prolong the economic recovery for as long as they can, even if it is artificially. If stocks start to peak in the next few weeks and commodities eventually do the same until March/April then it will even be hard for the fed to try to stop the economy from slowing down again.
Asset Allocation
In 2010 people changed the structure of their portfolios substantially. The percentage of stocks in the portfolios was raised above the long-term average quota of 60%, Cash was significantly lowered to around 15% well below its long-term average of 25% and bonds while initially higher started to come off in the last few weeks.
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ICI Flow of Funds

Below you can see the flow of funds over the last 3 years. During the financial crisis, which was also a system crisis as investors lost confidence in the whole monetary system, we saw investors sell massive amounts of equity and bond funds, but while bond flows recovered very quickly, equity flows stayed subdued for most of the time. The development over the last few weeks as you can see in the spreadsheet from ICI below is interesting in the fact that last week equity funds started to see their first weekly inflow from investors, following eight months of outflows, and in bonds you can observe almost exactly the opposite picture. Particularly in Municipal Bonds the outflows increased over the last few weeks, which is inline with the recent selloff we have seen in bonds.
Estimated Weekly Net New Cash Flow

Date Total Domestic Foreign Equity Equity Equity Hybrid Total Bond Taxable Municipal Bond Bond
PearlFisher 2010
Interest Rate Cycle

The interest rate cycle is one of the oldest cycles in existence and some people have written books about data on interest rates and gold coins, which go as far back as 2500 B.C. We can argue about the usefulness of that kind of research but all thats important to us now is that there is an interest rate cycle, which has a length of approximately 30 years one way or 60 years full circle. The last time interest rates turned round was in 1980 at the top of the interest rate cycle, with interest rates at around 20% during the peak in March of 1980. I will never forget when my father and some other homeowners of the time showed me their mortgage statements of those days with interest rates around 18% for those mortgages. Imagine how high your monthly bill would be and how much of your monthly expenses would suddenly get eaten up just by the interest payments alone. The reason I highlight that part early on and I would like you to think about it is because governments which pay interest rate on their debt obviously also have to spend a lot more money on those interest payments if interest rates are particularly high, which would make it even more difficult for them to balance their budget. Coming back to the interest arte cycle it seems that we are now at a point where the interest rate cycle has turned. Since bond yields recently made a higher low, which means they had their lowest low in 2008 and now in 2010 they confirmed that by creating a higher low, interest rates probably already turned in 2008. That also means that while it could go very slowly that interest rates will rise from here on going forward for approximately the next 30 years. Of course not in a straight line but the general trend is pointing that way.
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Average pre-election years

Pre-election years are usually the best performing years in the presidential election cycle as most presidents usually leave the best for last to try to help the economy before the next elections begin. The numbers prove it, the average gain of a pre-election year in the Dow Jones Industrial Average is 10.5%, next comes the election year with 5.8% on average, followed by the mid-term year with 4.0% and the postelection year with 2.0%. The following chart is the average for all pre-election years, which end on 1. Just like 2011. We took the average of the Dow Jones years 1911, 1931, 1951, 1971 and 1991. As you can see in the next chart the market rose up until February (or the Q1 earnings season announcements) and then started to slowly fall off, almost sideways so that the volatility did not rise dramatically until about September when the sell-off gained momentum before we saw a short year-end rally.
PearlFisher 2010
The next chart shows the average for all pre-election years (this includes all years going back to 1900, so for example 2007, 2003, 1999, 1995, 1991,..). Of course it presents quite a different picture as pre-election years are typically more positive since many presidential candidates try to help the economy in their last year in office to strengthen their chances for a re-election. The weakness of the number 1 years is so strong as we saw in the previous chart that it can override the positive tone of pre-election years in a negative way. In a typical pre-election year markets go up until May, then you get a summer sideways motion until September when markets sell off before the short year-end rally. It is almost the prototype of an average stock market year.
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And in the next picture you can see the performance of the S&P500 in the year 1980, which was the year that started with the peak in the silver market and highs in many other commodities. We will take a deeper look at the market in that year later on but as you can see the stock market sold off early in the year just when silver reached its peak and started to sell off, however only one month later they started to recover and did so for the rest of the year.
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Macroeconomics
The first chart below shows the market cap of the US stock market versus the US GDP. Many famous investors like Warren Buffet use it to estimate whether the stock market is under- or overvalued. This is a very long-term approach and as you can see according to this ratio stock markets are still undervalued.
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The size of the derivatives market after it has come down more than 15% is now at $583 trillion. The shrinkage is creating enormous deflationary pressures, which can be felt throughout the global financial system and we will discuss the relationship between inflationary and deflationary pressures later on.
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The US GDP typically runs on an 8.3year GDP cycle. In the next chart you can see the GDP since 1980 and how it marked significant lows about every 8.3 years. According to this cycle we should not see another recession anytime soon.
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In the next picture you can see the yield curve (spread between short and long bonds) and it is usually a good lead indicator what will happen to the GDP for the next 12 months and it is also not showing any signs of weakness, it does however show that GDP will probably go sideways for the next 12 months, which would also fit to the previous chart. In any case there is no sign of a coming recession in 2011, but the slowdown in growth rates could mean that markets are more sideways oriented this year. We will take a closer look later on.
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Capacity utilization also runs on a similar 8.3-year cycle as you can see in the 44-year chart below ad we are still at what was the lower boundary in many cycles before, even so we have a strong recovery behind us, but it will probably still take a very long time for companies and the market to work through the excess capacity.
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The Growth of the ECRI economic leading indicators is on the rise again but it is still below its long-term trading range. It does oscillate quite frequently since it is a growth rate, but so far I would assume that it gets back into its trading range which would be inline with what we are seeing on the GDP development.
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The US initial jobless claims (next chart) have also improved significantly over the last few weeks and while the US unemployment rate will remain a problem for the next 4-5 years, mostly for economic reasons but also because the US has added another 30 million people to their workforce over the last 10 years (3 million annually), the US may be in a better position than Europe in the long run when the demographic effect of a dramatically aging society is going to come to haunt Europe if they dont find a solution to their pension problem soon.
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The Chicago Purchasing Manager Index is even close to all time highs as you can see in the next chart. Unfortunately, those were often turnaround points when markets started to cool down within 2-3 months after the Chicago Purchasing Manager Index reached that level.
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Baltic Dry Index

The Baltic Dry Index in the next chart is admittedly somewhat distorted because the shipping capacities that were built up until 2008 were so large that it will be hard to judge when old capacity that has been taken out of the market is being brought back in and when we will finally reach the point when all overcapacity has been taken out of the shipping market, but in any case it is a sign that the international trade particularly with China is starting to cool off again. Certainly no indication that we will be seeing any inflation coming from this end anytime soon. Remember that the Baltic Dry measures the transport of commodities and mainly coal, iron ore and grain.
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Interesting is also as you can see in the chart below what happens when the Commodity Index runs too far away from the Baltic Dry Index. Over the last 20 years every time that happened the spread eventually closed by bringing down the commodity prices. The larger the spread gets the stronger should be the selloff in commodities in the end, which fits into our larger picture. As you can see in the next chart the gaps always closed over time and particularly if there are no signs of inflation you can wait for commodities to come down to close the gap just like in 2006 or in 1997/98.
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Inflation vs. Deflation

First of all remember inflation and deflation are local phenomenon. One country can have serious inflation, while the other experiences deflation! Of course it is in the feds best interest to keep the media talking up inflation because as we all know the rumor can become a self fulfilling prophecy and secondly if Bernanke succeeds in making Deflation the enemy number 1 then the fed has the ability to do whatever is necessary to fight deflation. Unfortunately, Quantitative Easing and low interest rates are not enough you also have to motivate your population to consume and companies to invest and merge in order to get the economic engine back in high gear and to get rid of the overcapacities quickly. Bernanke does a pretty good job in three ways. He does pump liquidity into the economy, which is step one. Then he gets companies to merge because of the low interest rates, which gets rid of the old overcapacities. And then he gets consumers to spend because they believe in rising inflation, which is step 3. On top of that we see a gradual devaluation of the dollar versus some of the leading exporter nations to the US which includes China, Taiwan, Korea, India and Australia to name a few. And all of that if Ben Bernanke is successful helps to stop the deflationary pressures in the US by importing some inflation and in return it will send some of those deflationary pressures abroad. Currency devaluation can help to import inflation! What Bernanke and so many economists are afraid of the most is the Japanese Deflation Ghost. In the next picture you can see the Nikkei over the last 40 years and what happened to Japan over the last 20 years. The Nikkei within a trading range keeps falling.
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In the next chart you can see that all the quantitative easing has not helped yet prevent the US from seeing the worst deflationary pressures in the last 50 years. I do believe that what you see in the chart was a false breakout and that we should see some inflation kicking in over the next few months but if precious metals end in a blow-off top over the next few months as well, then we wont see any raging inflation anytime soon, as a matter of fact we will be lucky as you can see in the chart below if we can get to 2% inflation in the shortterm (in 2011). In the long run inflation could go a lot higher but normally that takes time. As you can see on the left of the chart it took ten years in the late 60s and early 70s to get over 6% inflation.
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Critical is of course what the velocity of money or the money multiplier is doing. If money that is being created just sits with the banks but does not reach the consumer then inflation has no chance. In the next chart you can see the money multiplier. During the financial crisis it fell off a cliff and only now it is finally getting close to 1 again. If it keeps recovering then there is a chance that the US will come out of the deflationary pressures we can still see at the moment.
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Even if you were to calculate inflation differently (next chart), like the guys from shadowstats (www.shadowstats.com) then you still would have seen a strongly declining trend recently.
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As you can see in the next chart from shadowstats it is the contraction of M3 money supply (no longer officially reported), which is one of the main reasons why inflation has been coming down and that is inline with what we have seen in the money multiplier.
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Where is the Fed going with their approach?

Well in an ideal world the fed will inflate enough so that the economy will go into a boom ( la the 1920s or the 1990s) and then the economic boom will give the government enough taxable revenues so that they can very easily pay off the debt, but the fed is no society of ignorant economists, they understand the demographic challenges, the unemployment issue and the issues surrounding the household budget very well. We will see no large boom but there is another equation that will work to their advantage. If the fed succeeds to create enough inflation (remember that we had 4 periods in which the US reached 20% inflation in its peak at least 4 times over the last 100 years) then they can inflate the debt away. Lets take an example, if they create 6% inflation on average along with 3% real growth, you get a nominal growth rate of 9%. That means in 8 years the economy is twice the size (in dollar terms), but only about 27% bigger in inflation-adjusted terms. If you manage at the same time to reduce your deficits down to 3%, then your Debt-to-GDP ratio will be reduced by 6% a year. In eight years you could cut your Debt-to-GDP ratio in half. So where is the downside you may ask? Well, for one your currency will lose purchasing power and in the currency section later on you will see some nice charts regarding purchasing power parity, this effect will of course mostly hit your middle class and folks in the retirement age. And at the same time you will find it hard to get your deficit down to just 3%, but it is not impossible. The largest position in the US household today is military expenses and the other problem area is pensions for public officials. If you could cut military expenses then the budget would come down dramatically. The biggest problem the US is facing right now is that retired military personnel (soldiers which had to leave the US forces) make up the largest part of the unemployed, particularly those, which see themselves without any hope of finding a new job. This makes it particularly difficult to downsize the military because sadly they end up on the governments payroll again. The US government needs to do a better job to reintegrate these people into society and find work for them. Perhaps a New Deal type program for the ex-US forces personnel is needed. I am surprised that this topic is not being discussed more. The second problem and this is one that all industrialized nations are facing, as a matter of fact it is much worse in Europe than in the US is that of retirees from public service. It is the same problem that hits US companies like airlines or car manufacturers hard when they are trying to compete against international rivals from young Asian economies which dont face the large pension burden yet, and eventually governments all around the world will have to raise the retirement age for public officials by at least 2-3 years to solve this growing burden on the household budget. However, all of these problems are solvable and a successful re-inflation would get the US and many other industrialized nations back on a path of a reasonable Debt-to GDP ratio, and it would prove all of the Dr. Dooms who are making a fortune off their predictions wrong. These people still believe in the coming hyperinflation, which while it cannot be completely ruled out has a chance of less than 1% of occurring anytime soon (next 3-4 years). See the following document for more information and also the following section on the crack-up boom. Just remember that the people that caused the mass hysteria were the ones that positioned themselves extremely long in gold, silver and copper, and while there is nothing wrong with going long precious metals from an investor point of view (we invest in precious metals too when the opportunity is there), it is not wise to create a mass hysteria in my opinion. It is always important to look at all the facts and the possible solutions and only then you should draw your conclusions and as we saw already there is still more deflation than inflation visible at the moment. Document on Hyperinflation: http://www.shadowstats.com/article/hyperinflation-2010.pdf
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Crack-up Boom
So whats a Crack-up Boom? At the following link you can find all you ever want to know about Hyperinflation, Crack-up Boom and Money Supply http://mises.org/daily/4016, but in a nutshell the supporters of the Austrian School of Economics believe that the central banks will eventually go into overdrive, meaning that they will print more and more money which will lead to a point of no return. At this point inflation will start to spin out of control because governments cannot contain their spending habits and they need to print ever more money to finance their debt.
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Bonds
The turnaround in the interest rate cycle, which we described earlier, has profound effects on the bond market. As you can see in the chart below (US treasury futures) the recent top was lower than the top in 2008, indicating that in the long term the bond market has probably turned around. That has profound effects on the asset allocation as bond investors, which represent the largest market, will at least need to partially diversify their investments to generate a reasonable return.
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Muni Bonds
Municipal securities were particularly hard hit in the past two months. As you can see in the next chart they sold off dramatically over the past two months and selling pressure in municipal bonds reached a new record in December 2010 when $896 million daily in municipal securities (the most on record) were looking for buyers. The second highest on record was March 2008 when $783 million on average daily was the turnover. Investors are pulling money out of fixed income funds as the interest rate cycle in turning and going the other way for the next 30 years approximately. Some analysts are also forecasting billions of dollars in municipal defaults like Meredith Whitney (a banking analyst) for example.
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International 10-yr bond yields

In the next chart below you can see the bond yield of the 10-year German, Japanese and U.S. Treasury bonds. As you can see they move in line most of the time and they all start to climb marking the turnaround in the interest rate cycle.
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In the next picture you can see the yen and the U.S. Treasury bond, which typically have a very high correlation. Recently a large gap between the yen and the US treasury bonds opened up, which will most likely close over the next 2 to 3 months, the big question is in what direction. If the US dollar starts to gain momentum then the yen should follow the U.S. Treasuries. We will discuss the dollar in more detail later on.
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Japanese Bond Yield

The Japanese bond yields are on the rise but as you can see in the next picture at a yield of 2% there is a major resistance line (in red).
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Currencies
The Big Mac Index is published by the Economist and is a very good way to show how far away from fair value different world currencies are. The purchasing power parity (or Big Mac Index in this case) should even out the prices of Bic Macs sold across the world. The Purchasing Power Parity (PPP) is a very long-term indicator, which points to where currencies ought to go in the future, since they should all revert back to the mean in the long run (theoretically). In the first table below you can see the price changes for a Big Mac in 2010 in the second to last column (in green and red), and in the very last column you can see the long-term valuation differences to the US dollar (in brown). For example in the Eurozone the prize for a Big Mac decreased by -6.28% last year, while the Euro is overvalued by 16% relative to the dollar in the long run.
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The next picture from the Economist you can see very clearly, which currencies are over- or undervalued relative to the dollar.
Source: The Economist
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Another way to look at it is a picture produced by UBS, which shows the working time needed to buy a big Mac.
Source: The Economist
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The Dollar
Next we will take a closer look at the dollar. The dollar against a basket of currencies is still caught in a triangle and it currently hovers around its long-term support and resistance line around 80. It could be that the dollar stays within this triangle (in red) all throughout 2011.
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And the dollar is still sitting within an even larger triangle as you can see in the next 40-year chart. Once it breaks out of this triangle I would expect strong acceleration after the initial breakout.
I eventually expect the breakout to the upside in the above chart (through the black line), but it could take at least another year or two before that happens. In the next chart below you can see the euro with the same triangle, except that here we eventually expect a breakout to the downside.
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In the next picture below, which shows the yen versus the dollar on a 40-year time frame, you can see what happens when currencies break out of long-term triangles. The yen has been on a three-year rally versus the dollar since it broke out at the beginning of 2008.
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Some currencies like the Swiss franc, which you can see in the next picture below, seems to be reaching the top of its trading range pretty soon. If the top of the trading range holds then it could be a sign that the dollar is slowly gaining strength.
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Some other currencies like the Taiwanese dollar have already broken out and are reaching for the sky (see next chart).
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Apparently currency speculators are expecting a significant increase in the growth and the inflation rate (next chart) in Taiwan, just like in the 1986 through 1988 time period, when the Taiwanese dollar also appreciated significantly (red circle) as you saw in the chart before. This is another sign that many speculators still expect a lot more inflation ahead.
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Conclusion (Currencies):
The dollar is caught in a triangle in the big picture, which may take a year or two to resolve. In the short run I expect the dollar to gain momentum but eventually it should run out of steam and stay within the large picture triangle for a while, possibly all year. However when it breaks out of that triangle it will start to accelerate aggressively no matter in which direction the breakout takes place, therefore it is important to pay attention to those upper and lower trading ranges all year. From a fundamental point of view a lot of emerging market countries have reached the point where each further cent of appreciation of their own currency against the dollar will hurt their economy because their exports become too expensive and therefore I would expect a lot more newsflow regarding emerging market government interventions going forward.
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Commodities
Crude Oil
Oil is sitting right in the middle of its major multi-year uptrend as you can see in the next chart, but while oil is still going up and could possibly reach the $100 level this year, it will be extremely difficult for oil to break above that level.
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In the next chart you can get a glimpse of why oil is most likely restricted in its upside. Since the great recession of 2008 oil (black line) is now trading inline with the S&P500 (orange line). Apparently oil is now an indicator for economic prosperity. The problem is that if as I believe stock markets will eventually be restricted in their course (we will discuss that in more detail in a later section), then it will be extremely difficult for oil to break through the $100 level. It may also be the reason why oil no longer follows its seasonality effects. The real problem is however that eventually the relationship with oil will reverse itself again as higher oil prices eat into the wallets of the consumers and that part always comes to bear no matter how bullish the outlook. The question is as always at what level the consumer and investors will care and I believe that a $100 level in oil will bring oil back into the headlines of the media.
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The countries you need to watch out the most when oil reverses its trend are those, which have the highest oil production and that is usually equal to the highest oil reserves. As you can see in the next chart they are mainly the Middle East, Russia and Canada. When the oil price comes down those markets will be affected the most.
Source: CIA Factbook
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Natural Gas
Natural Gas is unusual in the fact that it is for commodities what the home building sector is for stocks. Both reached their peaks already very early in 2005 and both are still struggling to come back, but perhaps they will do better in the next selloff phase whenever it will set in. We will keep a close eye both on natural gas and on the homebuilders as they are forming solid bottoms with higher lows which usually makes for a good long term support. You can see in the chart below that natural gas has a solid support in the red line and it has just recently bounced off that support line again.
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What you can also see in teh enxt chart is that natural gas is still widely available around the globe and since it is a very clean fuel and reserves are stsimated to last for another 100-200 years we can see the usage of gas in all sorts of areas including cars go up dramatically over the next few years.
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Sugar
Sugar broke out of its 50-year triangle in 2009 and then again in 2010. Sugar is typically a good indicator for inflation in emerging markets and it does correlate strongly with markets like Brazil and India. Since both countries have put the economic brakes on and since it is likely that these markets have passed their economic peak in this cycle sugar will probably only have a few more weeks left in the current rally.
Sugar has broken out of its long-term trading range but most of the other soft commodities are still sitting within their trading ranges waiting to possibly break out later this decade when serious inflation will finally kick in. I dont believe that it will happen before 2012/2013. In the next couple of pictures you can see the other soft commodities and how far they are still away from their resistance lines.
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Rice
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Cocoa
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Coffee
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Wheat
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Oats
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Soybeans
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Lumber
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Hogs
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Cattle
Lean Cattle are about to break out to the upside, which is inline with the increased demand for meat from emerging markets and the higher prices for cattle feed.
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Cotton
Cotton, which was one of the biggest success stories besides silver in 2011, is now also close to the top of its long term trading range. I suspect that it will run out of steam around here at least for the next few months.
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Copper
Copper has finally broken out its long term trading rang as you can see in the next chart, and since copper is usually one of the best early warning indicators for inflation we will most likely see some first signs of
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However, there is one fundamental problem as you will see in the next chart, which shows the copper inventories. The inventories are already rising again (circled in red) and they never even came back down to their normal average so that the situation is getting increasingly difficult from a fundamental point of
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Interestingly the share price of Freeport McMoran, which is probably the best known player in the copper market, I also reaching its all time high again which could turn out to be a large resistance. It also does not help as you can see in the next 15-year chart that volumes are constantly coming down ever since the high in 2008.
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Goldmines
Gold and particularly Silver have been amongst the best performers in 2011. Goldmines were also amongst the best stock market sectors in 2011 but the air is getting a lot thinner. If goldmines break through the red support line in the next chart below then there is a great danger that we will see a substantial selloff following that event.
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Silver
Silver as we rightly pointed out last year just before it happened had a tremendous performance once it broke out of its long-term triangle. As so often when that happens it started to accelerate and never looked back. I expect that this gold rush type of run will come to an end fairly soon since the necessary inflation to keep this sort of run going is just not there.
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I expect a significant sell-off once silver breaks through its uptrend (red line in next chart) to the downside, which is very similar to what is happening in goldmines, but so far it did not happen yet and as long as thats the case silver could still get close to $50 which was the old high from 1980. In 1980 silver already started to sell off in the first few days of the year until January 11th and then all of a sudden silver exploded again to the upside until January 21st, which marked the end of the bull run in silver with a price close to $50.
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The next chart is also silver and it shows you how close we are getting to the old 1980 high. Silver and Gold were key factors in the 1980 cycle to determine where one cycle ended and where another started and we will take a closer look at scenario later on.
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Gold
Gold is said to be the Reserve Currency of the World and in recent days that has been even more the case as many people are worried that Fiat money loses its value. Interestingly enough the sideways move in gold for almost 20 years from the 1980s to 2000 brought gold from its upper long-term logarithmic trading range to the bottom of that range and since 2001 gold is on its way up again. As you can see in the next chart it still has along way to go before it will come even close to the top again but then again it could very well take another 5 years before it gets there. In 1980 gold and silver took a breather in the first week of the year and many believed that it was already the coming sell-off, but actually it went up by another 40% from January 10th until January 21st, in just 11 days killing those short sellers that thought the rally was over. It was mainly the short sellers that caused it to go up by that much in a short time because they were forced to cover. When they finally had all covered the big rally was over and the gold price began to fall for good. Another example was in the mid 70s when gold was half way up on the way to its 1980 high, which of course no one knew at the time, it had a fairly strong correction in 1975 until middle of 1976, for about a year and a half, before then continuing its rally. The big question is whether we will soon see a correction like in 1980, or is it going to be more like in 1975, but in any case I do expect some sort of a correction fairly soon before the yellow metal can then start a new rally to new highs in another year and a half when more serious inflation will start to kick in.
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Silver and Gold also always had an interesting relationship and recently silver started to appreciate versus gold, but right now silver is sitting on the red resistance line in the next chart below versus gold, which it attempted to get through already two times before over the last 15 years but never managed.
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Silver versus the Dow Jones Industrial Average (next chart) looks much better and while a correction is always possible it does seem that silver should continue its outperformance versus the Dow Jones over a longer time horizon.
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Platinum (next chart) seems to have already reached its peak in 2008 it does not seem able to make a new high. That is another sign that gold and silver are benefitting more and more from the ETF market, relative to other precious metals.
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Palladium (next chart) has broken out of an 18-year trading range and is slowly getting back up to its old high, which it formed in early 2001 because it was one of the main ingredients used in auto catalysts.
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Conclusion (Commodities):
Gold and Silver are still the main drivers of the commodity family, but other commodities like copper and soft commodities are also making new all time highs. As long as silver does not fall below a spot price of $25 and gold does not fall below a price of $1265, their long-term uptrends are fully intact even though they could correct almost 10% before they get there. I think that we will see a correction this year and probably no later then by February but at the same time gold and silver could still rise in a blow off top move which could easily bring 20-40% upside in a very short time. So over the next few weeks it should not get boring in precious metals, while the rest of the year may be exactly that in a sideways move. Oil could possibly still reach the $100 level this year but at the same time its strong correlation to the S&P500 will keep the upside rather limited also because the economy would take a serious hit again if oil should ever go over $100 because the consumer has less money to spend. And lastly soft commodities have probably seen their highs for the most part for now. When true inflation starts to kick in (in the US) above 3% or higher, which I dont foresee happening until late 2012 the earliest, then I see another run up in commodities, silver and gold, but that may take a year or two to develop. One last point on commodities is that should we see by any chance a global draught or some extreme climatic change over the next few years then keep in the back of your mind that commodities, particularly soft commodities could see a price explosion because they are already trading so close to the upper resistance line of their long term logarithmic trading range.
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Stock Markets
Stock markets internationally have taken very different routes in 2010 and many journalists may say that they have finally completely decoupled. That is partially true but the main reason for a temporary decoupling is that those markets are at different points in the economic cycle as I already pointed out before. China and some of the emerging markets are already past their peak and Chinas stock market return in 2010 was -15%, while the S&P500 is still approaching its peak and it returned 12% in 2010. On the next few pages we will take a closer look where the US stock market is and where it can go. The following chart in the next picture shows the Dow Jones Industrial Average from 1907 to 1911 compared with todays Dow Jones. Some of you have sent me that chart before and just a few days before Lehman blew up I did make that analogy between the Knickerbocker Trust company (essentially a bank) in the Great Panic of 1907 and the Lehman failure. I had worked for Lehman before, the events seemed so similar and they were almost exactly 100 years apart. So I am sure hundreds if not thousands of people saw the similarities. It is interesting if you look at the next chart how the current market has followed that path and as you will see later on there are also some similarities to other theories out there.
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The other chart I have shown you before which could be a pretty good lead for 2011 is the average of all preelection years (in the presidential 4-year cycle) that end on 1 (like 2011, 1991, 1971, and so on). Here is the chart again.
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Another interesting point of view is to look at all inflationary bear markets. The Dow from 1906-1926 (yellow), 1966-1986 (light blue) and 2000today (dark blue) represent those bear markets. You can see that even in that chart it will be more difficult this year to generate a positive return.
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and finally we take a look at the analog bubble theory. The similarities between the current post-internet bubble market have been very strong with other bubbles (Nikkei of 1989, Dow Jones of 1929) in the past, which would normally indicate that the stock market should see signs of weakness sometime in Q1.
All in all most of the correlations point to weaker markets in 2011 rather than any other path but we shall examine other market indicators over the next few pages to get a more complete picture.
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Market Indicators
First of all lets look at the difference between the equity yield and the bond yield over the last 50 years below. The equity yield is 1/(P/E of the S&P500) and the bond yield is the yield of the 10-year Treasury bond. As you can see from the chart below the yield spread can sometimes reach 6% or more. The other thing to notice is that once the spread reaches those extreme points it usually reverts very aggressively back to the mean. In 2010 the spread reached over 4%. Currently it is around 3% and coming down while bonds keep declining and stocks are rising, however there is one exception, which happened in the 1970s when the spread stayed right around this level between 2% and 4% for more than 2 years.
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Fundamentals
Fundamentals are always a cornerstone in every analysis of financial markets but while it is very helpful in determining long-term differences between what financial markets are willing to pay for a specific security and where its true value is, it is useless for the short-term analysis. Unfortunately there are way too many analysts who believe that they can predict short-term outcomes by using fundamental valuation while it is a fairly useless exercise. We will concentrate on the long-term valuations, which helps us eliminate the shortterm market noise. Below you can see the S&P500 P/E ratio from Robert Schiller, which uses the average inflation-adjusted earnings from the previous 10 years. You can find these charts on Robert Schillers (Yale Dept of Economics) website or on www.multpl.com. As you can see we are now at a level of the P/E10 of around 23, which is close to the highs in previous bull markets, only during the dot.com bubble when companies were allowed to have no or negative earnings and at the beginning of the Great Depression were earnings multiples higher. From a long-term valuation standpoint the current situation is very dangerous and as we will see in a moment this picture is also supported by the dividend yield argument. Interestingly enough the treasury yield on the Black Tuesday before the Great Depression was almost exactly where it is now. I dont want to scare you but you should be aware that the global economy is still running on quite a bit of life support from the central
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The dividend yield (dividend/price) is another indicator that shows that we are well below where we should be in long-term earnings. Now to be fair even so the long-term dividend yield mean is 4.35% and the median is 4.29% it would be illusive to believe that we will ever return to the dividend yields of the 1930s, which were well over 10%, but since we are currently trading close to the all time low, it makes sense to at least foresee a time where we can get back up to a dividend yield of around 4%. That is only possible if we see a sell-off in equities over the next few years since the margins companies produce seem to be at the top of the cycle, which you can se in the next chart on S&P earnings.
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S&P500 earnings
Source: Yale Dept of Economics
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The US unemployment rate is the feds main concern at the moment and as Ben Bernanke said in an interview last month it will probably take 4-5 years before it will return to normal levels. I think that 6 percent is what he would consider normal.
Source: Yale Dept of Economics
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Sentiment
One of the better short-term indicators is sentiment and no matter how you look at it is overly bullish right now because most people believe that the fed will take care of them. The AAII investor sentiment survey (next chart) has reached euphoric levels and usually thats a pretty good indication that within 4-6 weeks after reaching those levels markets will correct (you cannot say anything about the extent of the correction and they may only go sideways but it is a serious warning sign).
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Another sentiment indicator is the Put to Call ratio, which you can see in the next chart. At 0.44 investors are hardly interested in Puts any longer. As you can see we have reached a level again where the market corrected before (see red arrows and blue vertical lines).
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Momentum
In the next picture you can see the cyclical versus the non-cyclical consumer stocks. As long as the cyclical consumer stocks keep rising versus the non-cyclical consumer stocks the market continues to have upside momentum. You can see in the red circle that the new high is higher than the previous one, which is positive.
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New highs versus new lows (next chart) are also a good momentum indicator but here we can find first warning signs as the most recent tops are starting to come down. The indicator makes lots of erratic short-term moves but the long-term cycle is usually very well visible and helps to find the medium term direction. At the moment the trend seems to be coming down.
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Hindenburg Omen
The Hindenburg Omen is another indicator, which has recently been widely discussed. I would just say that there have not been any major downturns without a Hindenburg Omen occurring beforehand, but on the other hand there have been Hindenburg Omens without a downturn occurring. So the occurrence of a Hindenburg Omen is no guarantee that you will see another downturn anytime soon but on the other hand it should be seen as a warning sign particularly if many of them occur in a short period of time. In December 2010 there were two Hindenburg Omen occurrences so that the warning sign is in effect for the next 2-3 months.
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BC Consumer Confidence Ben Bernankes actions

The ABC Consumer Confidence Index has been a very good lead indicator for the level of unemployment. It seems to almost perfectly (inversely) correlate US unemployment and it usually leads the unemployment numbers by a month. I dont expect any changes soon but it will be worth watching since the fed is not very likely to change their policy by much unless we see an improvement in the unemployment numbers.
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Volatility
The way volatility is measured in equity markets is a fairly random unit. It does not react the same way when markets go up as it does when markets go down. Of course it has been chosen that way to facilitate the pricing of ptions but at the same time looking at volatility has some inherent flaws. It does however at a certain level provide us with a pretty good insight as to when equity markets have a very low risk of selling off and that is usually the case when the volatility falls below a certain level (line in light blue in the next chart).
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As you can see in the following chart below, the times when the volatility falls below the horizontal line in light blue and stays between the blue and the green line are very bullish times in stock markets as you can see in the red circled periods in the next chart below. So if the Vix falls below 16 and stays there for a few weeks then it is a pretty good indication that a prolonged bull market is here, but if that does not happen then you usually get a bounce back up, which traditionally leads to a smaller or a larger correction.
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Dow Theory
Due to lack of time I am not going onto the details of the Dow Theory on which entire books have been written and there is a lot of material out there in the internet which can explain the principals of the Dow Theory but just be aware that the Dow Transport Index plays an important role in it. Below you can see chart of the Dow Transport and how it is sitting in a narrowing triangle. Usually rising triangles are exited by falling prices, so that the Dow Theory in such a case would give a sell signal, but so far it could still go either way. We will keep a close eye on it.
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The US stock market

It is always helpful to step back for a moment and to take a look at the big picture. In the next chart you find almost 100 years of the S&P500 on a logarithmic scale and what you can very easily see is that the S&P over all this time always traded along some very clear trading boundaries (the lower boundary in green and the upper boundary in light blue). Only in prosperous economic times like during the roaring 1920s and during the dot.com bubble in the 1990s was the S&P500 able to cross through the red median line and stay above it for several years. Those were periods of excessive growth, low unemployment and extremely high consumer and investor sentiment. None of these factors are there right now. The only thing that can be said is that Bernanke keeps the hopes alive and that the we may be entering the next bubble, since every time we crossed this line to the upside markets ended up crashing back down below a few years later down the line.
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Another way to look at it is to take the last two highs, which formed a double top and check how long that resistance line (see red line next chart) could keep the market from going up before the uptrend (lower black line) intersects with it. And the answer is until the year 2020. Thats how long the market could be trading range bound before the strong long-term uptrend comes along.
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Sothebys
Another indicator that has been very helpful in the past was Sothebys. The leading art broker is always a good indicator for times when people have a lot of extra liquidity which they can spend on art, and since they all usually have extra liquidity at the same time they bid up the art to silly prices, which makes Sothebys a fortune in brokerage fees. As you can see by the arrows in the next chart Sothebys always peaks just before the big bubbles break. The first one was the Nikkei bubble (red arrow), the second one the dot.com bubble (green arrow) and the third one the Financial/Mortgage bubble (blue arrow). The question is whats the most recent one (black arrow) - Is it the Central Bank Quantitative Easing Bubble? We shall see
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Earnings Season
The next earnings season is just around the corner and with the stock market nothing but up since the last earnings season it will be important to pay special attention to earnings expectations particularly since the P/E ratios are far from cheap. In the next table below you can see the earnings growth expectations for the S&P500 for the next quarters. You can easily spot the trend in the white line in the box below the numbers. The quarterly earnings that are about to be announced next are the ones shown with the yellow dotted line. As you can see the trend is going down. At the same time analysts have upgraded the target prices of 109 out 500 companies already so far and that is of course coming form hundreds of analysts so that we know that the estimates are pretty bullish. I find this particularly curious since when the Nike earnings were announced just before Christmas, which beat bottom and top line by the way, the stock sold off by more than 5%. I wonder whether the market could be in for a surprise since expectations seem to run ahead of reality, but in a few weeks we will know for sure.
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Standard Deviation
The next chart shows you the S&P500 once again and as you can see we are trading at the upper end of the Bollinger bands. It is possible to trade along those areas for quite some time but usually you get at least minor corrections when you hit these resistance lines as you can also see in the next chart.
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International Markets
The economic cycle on an international level seems to be at different stages. While the BRIC nations (Brazil, Russia, India and China) and the raw material producers like Australia and Chile seem to already have reached and passed their economic peak the old industrial nations in Europe and the US with their zero interest rate
Europe
European stock markets as a whole have been lagging behind most international markets mainly because some of the European markets got hit because of concerns over the government debt crisis. It could take another month or two before the index (Euro Stoxx 50) will break out of this triangle but when it does I expect an accelerated move. If it is to the upside then a level of 3000 would be the next resistance, if it is to the downside then 2500 should be the next support.
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Germany
The German stock market (DAX) on the other hand has broken out and is on the way back up to its all time high, while the Euro Stoxx 50 cant even begin to dream to get back up to its old all time high the DAX is on the way to get there soon. The German economy is in great shape and seems to be the benefactor from the recent Euro weakness. Some predictions go so far that they predict full employment in Germany soon, but should global markets come under cyclical pressures then even the German market will face a correction but in nay event it should fare better than the rest of Europe.
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Brazil
In the next chart you can see the Brazilian stock market index, which has broken down out of a triangle after it had reached a triple top. The recent measures by the Brazilian government to fight inflation seem to be working and now also show in the stock market decline. Brazil is also one of those nations, which has already passed the peak in the current economic cycle.
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Chile
Chiles stock market (next chart), which has been one of the best performers in 2010, still continues its bull run but yesterdays currency intervention by the Chilean central bank show that the recent appreciation in Chiles Peso is starting to hurt the economy. However, as long as the green uptrend in the next chart is not broken, the bullish uptrend is valid.
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Mexico
When you look at the Mexican stock market you got to ask yourself why any Mexican still tries to cross the border to the USA, the Mexican stock market seems in overdrive and since it indirectly benefits from the actions of the US fed there seems to be no end in sight. As you can see in the next chart it has broken out to the upside.
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Shanghai
China just increased its interest rate for the second time since mid-October and more moves may follow. The benchmark one-year lending rate was raised by 25 basis points to 5.81 percent and the deposit rate will climb to 2.75 percent. China reported 5.1 percent inflation for November, which is the highest in 28 months, and it seems determined to curb inflation since the raise came just before the end of the year which makes it much more effective as all banks typically adjust their long-term and medium-term lending rates at the beginning of the year. Would they have raised rates in January then the impact might not have been felt for months. There is a potential that the Chinese stock market (next chart) breaks down again just like last year when it returned -
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India
Indias stock market (next chart) has probably been one of the most bullish cases of all with enormous swings after the global financial crisis, which you can see in the next chart. Currently we are facing a double top and an extremely wide gap (red arrow) far below current levels. Not every gap gets filled but it is something to watch out for, and since India is showing a dramatic rise in inflation it will be a big battle between the central bank, which is trying to fight inflation and market forces on the other hand trying to push prices of commodities higher. India is one of the frontiers where the inflation in food prices will be felt the most, because the extremely large population which is still living just above the minimum living standards depends on stable food prices to survive and make a living.
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The next chart also shows the Indian stock market but over the last 31 years. The stock market keeps climbing along the red trend line, except when the market accelerates too quickly away from that line it tends to go sideways for a couple of years until it starts a new rally. In two more charts we take a look at exactly when that happens.
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The next chart shows Indias inflation during past market tops, which are shown by the red lines.
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The next chart then shows what happened after the inflation peaked. Every time over the last 30 years when we saw a peak in inflation the Indian stock market sold off for a few weeks and then it went into a sideways motion for a few years.
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Turkey
Turkey is for Germany what Mexico is for the USA. Both Mexico and Turkey used to offer extremely cheap labor and therefore a lot of companies outsourced part of their production facilities to these countries. For this reason both Mexico and Turkey have been big success stories and as opposed to other emerging markets these two markets will probably keep going until the US in the case of Mexico or Germany in the case of Turkey will start to lose momentum. They could of course also act as lead indicators, so that if Turkey breaks through its support then it will probably not take long before the German stock market will also show some weakness.
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Greece
The Greek stock market and their government debt situation have been in the news for a large part of last year, but as the real problem is still not solved Greece is increasingly coming under fire again. As you can see in the next chart the Greek stock market is once again close to falling off a cliff. If it falls below the red line then there is no telling where it will end.
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Financials
As I mentioned many times before there is no successful bull market without financials at least moving along. In the next chart you can see financials and after what was almost a full year in sideways motion they are now breaking out to the upside. We will keep a close eye on the development over the next few weeks, as it should give us some good clues about the overall market direction.
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Homebuilders
Homebuilders and the entire housing sector have been the problem child of the last 5 years, even so the media did not get a sense of the situation until the whole mortgage bubble blew up in 2008. In the chart below you can see how homebuilders peaked in 2005 and came down ever since.
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The next chart shows you even more how the homebuilding sector built a perfect head and shoulder formation all throughout the last decade. Now the sector is moving along its long-term support line. It is possible that homebuilders will be the first sector that will truly have come out of its bubble and that it will become somewhat of a safe heaven in the next downturn whenever that may be, since it is completely bombed out.
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Comments on a few selected stocks

In the chart below you can see Apple, everybodys darling for the last seven years. I purposely wanted to show you this logarithmic chart to give you an idea that the stock is trading at its long-term upper trading range (red line). The stock will probably slow down considerably and I would not be surprised if the upside is very limited from here. Why is that fundamentally true? Because Apple is now 20% larger by market cap than Microsoft and just in a big picture view everything positive about Apple is priced in. Now dont get me wrong I love the brand Apple and I am writing this Outlook on a Mac but even the best story eventually hits a ceiling. Just make sure you keep that in mind, but should it break out anyway then it can theoretically still get to around $450 where the green line sits, but that would signal a blow-off top and a sharp downturn afterwards would be highly likely as during the 1983 and 1987 moves when Apple reached the outer trendline (in green) before as you can see on the left of the chart.
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BHP Billiton (next chart) is a mining company and an early indicator for raw materials. If they cannot make a new high above the green line then raw materials could be in trouble
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HTC Corp (Taiwan) is a developer and manufacturer of mobile handheld devices (next chart), like mobile phones, based on Windows Mobile, Android and Brew Mobile Platform operating systems. The stock was a ten bagger from 2004 to 2005 and it is still heading for the sky.
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The Washington Post (next chart) is one of those old day newspapers, which may find it difficult to survive in todays day and age unless it can find a way to jump on the electronic media bandwagon quickly.
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Barnes and Nobles (next chart) is one of those old day book retailers. I still love those bookstores but at the same time I order most of my books from Amazon but it is more time efficient and I can find much quicker what I need. It will also be hard for them to survive in the long run.
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Ebay (next chart) is one of the most fascinating stories in the sense that their hottest story today is no longer their online auction business but their two assets PayPal and Skype hold the key to the future. At least one of the two should be a success story in the long run and then the stock would breakout of its trading range, but stockholders may have to be patient as these businesses will initially need more cash before they start to generate a decent return.
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Netflix (next chart) is part of the new TV experience. While the old television is slowly dying the new streaming and flat fee movie rental services, without the advertising and all those nonsense programs, are taking over.
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Nike shares (next chart) fell almost 6% after their earnings released on December 21st, 2010, beat the bottom and top line by a mile, only because the future projected order growth was less than expected. This has some potential implications on the upcoming earnings season. If companies particularly in the retail space dont beat earnings by a mile then those stocks might get hammered. We shall see, but I would be cautious going into next quarters earnings season.
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Scenario Analysis
Here are three possible scenarios, which I have seen discussed, but at the same time those are not the only ones. I just wanted to make you aware of different scenarios (or risks) without going into too much detail. I will then present my own scenario at the very end: 1)Crack-up boom or just a raging bull market The situation throughout the year would be ever faster rising equity markets coupled with rising gold, silver and commodity prices. Eventually central banks would start raising interest rates but too late to stop the running train, which would eventually spin out of control and the end result would be over the top inflation at rates well over 20%. 2)The Government Debt Problems spin out of control, causing a bond default in a major market The bond yields in countries like Spain, Italy, France, the UK or even Japan would start to rise to a point where 30% or more of those countries annual budget payments would solely go towards paying for the interest on all the debt. We have already seen the case in countries like Greece and what happens then is that the enormous household cuts lead to excessive deflationary pressures which lead to a strong market selloff across all asset classes except for gold and silver. 3)Markets are without direction, volumes keep coming down Due to the high valuations in many markets and because most emerging markets start to raise interest rates and use other measures to fight inflationary pressures, many markets stay without any clear direction for the largest part of the year. Volumes, which were already weak in 2010, continue to keep coming down. However, no matter what the scenario, over the next couple of weeks I would simply follow the existing trends (see the red trend lines in the next two charts). If they are not broken then the trend should continue. The next chart is the S&P500 and as you can see the index is still pretty far away from the trend line, so that the bull market is fully intact.
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The next chart is silver which is also still in an uptrend, to be fair a much steeper one than the S&P500, but it is getting dangerously close to the support line, which in this case is the 50-day moving average (purple). There is a second support, which is the green support line at the $25 level but should that be broken then the 10-year uptrend in silver will be over.
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The Silver Corner of 1979/1980

Lets go back to the silver chart. Silver has the potential to continue rising at exponential levels, which we saw the last time during the 1979-1980 timeframe. In the next chart (below) you can see what happened during that timeframe. Silver and the dollar are in black, the treasury yield (10-year) in green and the S&P500 in orange. Silver peaks where I included that red vertical line. Silver peaked on January 18th, 1980 (red vertical line). Following silver the S&P500 peaked three weeks later and the bond yield (inverse of bond prices) five weeks after silver peaked. Some of those peaks were only intermediary highs but they did lead to some significant short-term corrections. Usually markets wont act exactly the same but possibly in a similar fashion when silver prices finally peak. The next few weeks are critical and silver, copper, sugar and oil prices could end their rallies with a final blow-off top.
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The following charts show a possible outcome of the described scenario for each individual asset class:
The dollar would break out above its flag and it would keep rising until it would eventually reach the upper trading range again (red lines) where it would probably turn around.
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Bond yields as you can see in the next chart would first continue to rise and then eventually after the peak in commodities start to come down.
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Stocks as you can see in the Fibonacci level chart would get up to the next level and then start to sell off for a while before they would start to rise again.
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Interesting is also what fundamentals looked like at the time. The unemployment rate rose significantly after the silver peak in 1980 (red vertical line) and only started to fall three years later. This could mean that this time the unemployment rate will stay very high for the next 4-5 years, which is also inline with what Bernanke is saying.
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In the next chart you can see capacity utilization and it dropped off significantly after the silver peak of 1980 (red vertical line). This could mean that capacity utilization will stay low for a long time relative to past cycles while the industry is getting rid of the overcapacities that were built up during the economic boom years. You can see in the chart that we are now only at the level of the bottoms of previous recessions even though we have had a sharp recovery in capacity utilization.
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In the next chart you can see home sales and while they dropped sharply just before the silver peak (red vertical line) they then gradually recovered soon after the event. This also makes sense today. Housing is already so weak and oversold that it can hardly become any worse.
And even though I dont show it here there was one significant difference between then (at the beginning of 1980) and today. The P/E ratio of the S&P500 was below 10 in 1980, which is different from today since it is much higher now. Why do I show this whole comparison? Because if the silver price keeps rising and possibly at exponential levels and if some people really corner the copper market then we may see a similar spike just like during the 1980 peak. This peak could come fairly fast and possibly as soon as by the end of February.
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Conclusion (Equities)
The stock markets around the world are in different stages of their economic cycle. The emerging markets and BRIC countries are much further along then the old industrialized nations, which leads to different scenarios and most likely different outcomes for the year. The government debt crisis is the most concerning topic which we will discuss over the next pages and depending on how different government tackle their debt it will lead to different outcomes which will also affect the equity markets. Two examples are Greece and the US. Greece which of course being the tiny nation it is today (in economic terms) was forced as part of the bailout to start saving its way out of the crisis causing extreme deflation, which brings stock market down aggressively, just like it did in Japan over the last 20 years. The US on the other hand is printing money and so far it at least succeeded in keeping the market form falling over. The risk is of course that everyone does feel very comfortable with the fed holding their hand and that in itself poses the risk of overconfidence in the current rally. Normally you need a last blow-off top move or in other words a last acceleration of the rally before you get a sell-off which is what I still expect. So in general I would expect a rally throughout January and then at some point a counter reaction should lead to a small correction, but unless the fed is forced to change its course of action, which could really only be because inflation rates would rise too quickly (something I dont expect for the next few months), I dont expect stock markets to sell off aggressively this year. As a matter of fact if we should see a nice but not to strong correction (around 10-15% in magnitude) in the first half of the year, then I would think that stock markets could start another rally from there, because of the fact that central banks keep pumping liquidity into the global economy.
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Government Debt
The following charts can be found on Moodys Analytics Dismal Scientist http://www.economy.com/dismal/default.aspx?edition=2
Deficits
(usually short-term but a warning sign)
This chart is a pretty good overview over who had to borrow the most last year.
Moodys Analytics Dismal Scientist: http://www.economy.com/dismal/default.aspx?edition=2
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Debt (mostly long-term)

This chart shows the long-term obligations and the picture changes quite dramatically (there is no information on the grey areas).
High Risk countries are: Greece, Italy, Belgium, Japan and Iceland
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Risk of a debt default

These countries are the ones that apparently have the highest debt default risk for a variety of reasons, which besides their debt also includes their demographics and plenty of other variables.
The most interesting story here is that some countries like Russia for example, which basically defaulted on its debt as recent as 1998 is now one of the best ranked countries in the world by comparison. And that Japan, France, Spain, Portugal, Italy and the UK are considered the riskiest besides Greece and Iceland by Moodys Analytics, which shows that the recent government debt crisis has hit many old-fashioned industrial countries. A large part of the problem are the enormous pension payments for retired government employees of course, which is a much larger problem in industrialized nations and the only way out may be to restructure the pension debt by either paying those retired government employees less or by forcing them to work a lot longer.
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GDP per Capita

The GDP is the revenue side of the equation and therefore the higher your GDP the easier it is to pay back the debt over time.
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While the charts above were from Moodys and the CIA factbook these next ones are from McKinsey Global institute, available on the internet. Their analysis confirms the points made by the Moodys analysis. Here also Japan, the UK, Spain, France and Italy stick out.
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...but what is also interesting according to the next chart is that while Japan is by far the worst off as far as the government debt goes, the UK has the worst-in-shape financial institutions.
Source: McKinsey Global Institute
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Having seen the charts above it is however important to put it into perspective with what the UK managed to do in the past. Below is a chart of the two previous periods in which the UK managed to pay back debt of similar or even higher proportions than today.
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and the next chart puts the US and UK public debt into a historical perspective.
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The next chart shows the debt yields of the European countries in comparison to Germany. The black line at the bottom is Germany and then above that are France, Spain, Greece, and so on. The top line (in green) is Portugal, which is apparently the new target of the bond vigilantes as its yield keeps rising fastest.
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The next chart shows the total US government debt. Pay attention to how fast it is rising lately. It went from almost flat until 2000, to a steady rise until 2007 and then it went into overdrive going almost straight up
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Another way to look at government debt, which I have used in our newsletters many times before is to look at the bond insurance, and that is nothing else but Credit Default Swaps (CDS). Below I show you a few so you can get a sense how they have been developing over the last 5 years. The higher CDS prices are the more expensive the insurance, which normally means the more risky the investment. Here is the CDS for the US and while it has been climbing along the green line below it is still at a relatively low level around 40 (the average of 71 countries is at 197.7)
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Japans CDS is next and as you can see it currently trades around 70. Japans rate of incline for the price of CDS is steeper than that for the US, which is probably the case because they have the highest debt to GDP ratio and the risk is constantly rising, but so far they are not at critical levels yet (chart below).
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Even worse are the CDS of France. They seem to be making new highs recently and we will have to keep a close eye on the development (chart below).
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Belgiums price for CDS has already broken out and it is now at a level of 200 while not too long ago it was still close to zero. Belgiums risk of default is rising, but so far it is still at the average of all 71 countries for which CDS are quoted (chart below)
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Italys Credit Default Swap is also rising and at a similar level as that of Belgium (chart below).
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Next we look at Spain. At a price level of around 330 and the rate at which it is climbing Spain could be one of the next European nations in trouble soon (next chart).
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And even worse off is Portugal and Ireland. The most interesting part is that Ireland, which already received bailout, is trading at the same level with Portugal, see the chart below. That could mean that Portugal is only a few weeks away from bailout itself.
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And as a comparison lastly here is the CDS of Greece in the chart below, which is at a level of around 960.
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Conclusion (Government Debt):

We already saw government debt become an increasingly big problem for financial markets last year when Greece and Ireland became default candidates and needed to be bailed out. The bond vigilantes have focused on the easiest target they could find, which were small European nations that were suffering from a strong currency, which left them without any real option to escape their troubles through a currency devaluation for example. It is highly likely that the bond vigilantes will once again focus on other European nations like Portugal or Spain, since they are easier targets than Japan or the US for example. We showed before that from Japan, over Europe to the US there are not many industrialized nations that can be excluded. There are several reasons why that is the case. What these nations have in common is maturing economies, which are only growing slowly. They have large well developed bond markets, which gave them access to foreign capital in the first place and they have a lot more pension obligations than younger economies. It was all fine as long as global interest rates were falling but now that the interest rate cycle is turning around many of them will get in trouble unless they start to reduce their spending soon. One other thing is important! If those nations have their own currency they can at least try to reflate by devaluating their currency which is what a lot of nations used to do for decades, but if they are caught like Greece, Ireland or Portugal in a currency union like the Euro, then they lack that opportunity which makes them ideal targets for those vigilantes.
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A Special Case - Japan:

In the next chart below you can see the Japanese Yen (orange) and the Japanese stock market (black) and the Yield of the 10-year Japanese government bond (black) over the last 22 years. Since the bond yield and the stock market almost move fully correlated it is not that important to distinguish them. What you can see is that when the market turned at the top in 1990 all three of them turned in neat order. First the Nikkei turned, then the Yen and lastly the Japanese government bond yield. Now 21 years later it seems that we may be at a turning point again. We know that Japan has suffered from serious deflationary effects over the last 20 years and depending on how the US model of the recent recovery goes Japan may try to finally follow that model and reflate their economy. Of course the problem is that they already have way too much debt but a second method would be to try to devalue their currency, which would be politically unpopular because of a largely aging population but due to a lack of alternatives that may be the easiest way out. But no matter what the solution due to the extreme correlation between the currency, stock market and bond yield, which is unique to Japan, there is an increased likelihood that any measure that will lead to a bond sell off or a devaluation of the currency will cause a stock market rally.
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Opposites win (most of the time)!

Here is some food for thought in the end when your head may feel dizzy from all the data. In 9 out of 10 years one simple approach worked extremely well to achieve above average returns and that is shorting everybodys darling and going long what is completely out of fashion. For 2011 that would mean, shorting silver and going long the home building sector. We shall see at the end of the year if the approach continues to produce above average returns.
Portfolio
There will be a few changes as far as our portfolio recommendations go going forward since we will start our own fund this year. Legally we can no longer give any specific recommendations unless you are a client of ours. We will continue to provide the big picture and we can highlight sectors or countries, which we would go long or short but we can no longer give specific recommendations to the broad audience. If you are an existing client of ours then you will continue to get our picks and recommendations in a separate mail specifically addressed to you.
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Summary of Facts
Short-term Negative:
- sentiment has reached euphoric levels, which means that we will eventually need to see a correction in stock markets even if it is just a small one (timeframe is up to 2 months from now) - The Put/Call ratio is at extreme levels just like the sentiment, which means that a sideways market or a correction could come soon - New highs versus new lows are starting to come down which is normally a sign for a slowdown in market momentum - Cisco had a profit warning, there may be more to come from other companies in the Q1 earnings season - Nike exceeded bottom and topline expectations and came only inline with their 11% growth forecast and the stock lost 7%, which shows that the market has extremely high expectations. If companies cannot exceed those expectations then their stocks will sell off. - Good macro news like the most recent jobless claims and the Chicago purchasing manager numbers had no positive impact - The market volume has been going down throughout 2010. Lower volumes increase the risk of a correction. - There is still no sign of inflation in the official numbers and even Ben Bernanke warns of deflation - There were recently two Hindenburg Omen occurrences, which raise some warning flags - gold, silver, copper and soft commodity markets seem to be overheating - many emerging markets are overheated and countries like India, Taiwan, Australia and China are raising their interest rate, while their currencies are appreciating significantly versus the dollar. That should lead to a significant cooling down of these economies in the coming months.
Positive:
- the stock market and the commodity market trend is positive - commodity markets are in a bull market trend - macro numbers and indicators show no signs of a potential recession looming ahead for next year - the housing market seems to be building a bottom
Long-term Positive
- We avoided another great depression - The general trend for stocks and commodities is positive
Negative
- the high government debt levels will continue to be a major problem - for bonds negative is that the interest rate cycle has turned (for the next 30 years bonds will be a significantly less attractive investment) - the analog bubble theory suggests weakness ahead for the next two years, before markets will then eventually start rising aggressively in 2013 because of inflation
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Conclusion:
The recent recovery in stock and commodity markets is largely based on the believe that we will see outrageous levels of inflation in the US and while there is a debate over when that inflation will kick in it is highly likely that, because of the steep acceleration that commodity markets and to some extent stock markets have recently seen, speculators who have driven up these markets will not wait more than a month or two for that inflation to kick in before they will take their bets off the table. So if there is a blow off top in commodities in the next 4-6 weeks then I would assume that we will see a pretty strong sell-off on the back of that. That does not have to be the end of the commodity story for this decade but it would then take at least a year or two for new momentum to come back into that asset class. Only if we would see commodities and stocks cool off moderately from here right away, could I see a case whereby stocks and commodities would continue to rise throughout the year. The other big influence on markets today is exercised by hedge funds, which bet against governments. The same hedge funds, which used to pick on small companies that had overleveraged balance sheets and very volatile earnings (making a nice living doing that!), have now found a whole new target of a lot larger size. Those targets are government bonds of nations with very overleveraged balance sheets. Its the same game except this time its a hundred times larger and the stakes are higher. So far they have targeted European nations, which are easy targets because of the structure of the EU and because these nations still have individual bond markets, rather than having one large Euro Bond market. So as long as these nations present themselves as easy targets I suspect that we will see more attacks of that kind by the bond vigilantes. And I would not rule out that some day when they are done with the smaller European nations they could start to attack the bond and currency market of a country like Japan, which is the global leader in the debt to GDP ratio. So for this year I would expect the inflation rate to bottom in the first quarter and then to rise in the second quarter (the base effect alone will be strong enough to push it up), but in the third or fourth quarter the inflation rate should peak again. For stocks I believe that we will see the top in the first or early second quarter, much will depend on next quarters earnings and how high the analysts set their earnings forecasts (I am sure expectations will be high!). Commodities should see their high in the first quarter (just look at the Baltic Dry Index vs. Commodities chart again the gap is huge!) and sometime between January 11th and February 21st (thats where the 1980 commodity peak and the pre-election year chart peak) a blow-off top rally could happen. It could be triggered by another government debt issue, but I would expect it to be over within 2-3 weeks after going straight up and generating between 20 and 40% in some commodities, since most governments will probably react quickly to the threat. That would be similar to what happened in 1980 (for different reasons) and it would probably be the biggest rise for the year. Bond yields should peak sometime in the second quarter but because of the rising inflation numbers in Q3 yields will probably not come down far, so that they will move more or less sideways in the second half. However, be aware that you should sell your long bonds (government or corporate). The rising interest rates and the danger because of government debt defaults make them way too risky going forward. Similarly if you are looking to lock in long-term mortgage rates you should do it now if you have not already done so, looking ahead over the next 30 years they are still a bargain right now.
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About Us
Oliver Juergens and Vince Rowe founded the PearlFisher Newsletter over 6 years ago as companion material to their regular weekly radio shows. Both currently are Registered Representatives at Taylor Stephens Advisors (see below) based in Dallas, Texas. Oliver has a dual major in economics and mathematics from Claremont McKenna / Harvey Mudd University and has worked at some of the largest financial institutions. (Lehman, Deutsche Bank, UBS). His experience delivers a unique perspective not normally afforded the individual investor in the weekly newsletters and in this yearly Outlook. Vince has been a professional trader since 1995 and created the largest classroom-based trading school in Texas for individual traders. Having helped thousands with bespoke personal trading plans and 17 years experience as a trader in a multitude of asset classes, he brings to the newsletter a disciplined approach to the financial products recommended in the weekly newsletter.
Taylor Stephens Advisor

Taylor Stephens Financial Advisors has combined over 150 years of investment management experience throughout our market areas to bring you the highest quality services available today. Taylor Stephens Financial Advisors, founded by Bill Brinson some 42 years ago, work with clients to determine unique goals, tolerance for risk and specific preferences. Clients then work with our team of qualified specialists in the areas of investments, trusts, administration, private banking, and insurance to develop a strategy that will work for their specific situation. Taylor Stephens' unique combination of personal service and state-of-the-art technology provide clients with the highest level of client service in the industry. If you have questions or comments on the services of Taylor Stephens or the PearlFisher newsletter please email info@pfiii.com or call 214-253-2381.
Contacts
Oliver Juergens e-mail address: pearlfisher@me.com Telephone number: 214-253-2381 Please feel free to recommend this newsletter to any of your friends. You can sign up for free at
Disclaimer:
None of the information contained in this newsletter or any websites or other information referenced within it constitutes a recommendation by Pearl Fisher Investments or the contributors to the newsletter that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person.
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Outlook 2011

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Outlook 2011

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PearlFisher 2011 Outlook

PearlFisher 2011 Outlook

What happened in 2010?

Coming trends and changes in 2011 and thereafter

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PearlFisher 2011 Outlook

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Ben Bernanke on the Economy

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The Big Picture

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ICI Flow of Funds

Estimated Weekly Net New Cash Flow

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Interest Rate Cycle

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Average pre-election years

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Baltic Dry Index

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Inflation vs. Deflation

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Where is the Fed going with their approach?

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International 10-yr bond yields

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Japanese Bond Yield

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Source: The Economist

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Source: The Economist

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