Outlook for the U.S. stock markets and interest rates
1999 Stock Outlook: Review and Update
Outlook for Ex-Soviet Equities
Outlook for Small- and Microcap Sectors
Outlook for Initial Public Offerings
Outlook for Global Stock Markets
Outlook for the U.S. Stock Market and Interest Rates
Last year, Taipan predicted that 1998 would be a year to "sell the rallies."
If our outlook is accurate, then 1999 will be a year to both "sell the rallies" and "buy the dips".
Crystal ball unclouded
Twelve months ago, in the last Taipan Forecast Issue, I predicted a surprise "Hyperbull" market that would propel the Dow to approximately 9,400 by mid-1998.3 The Hyperbull, I argued, was driven by the radical decline in long-term interest rates that resulted from the Asian economic crisis.
Of course, this call was controversial at a time when everyone professed to be bearish. But still, the Dow topped at 9,367 in August...
I also predicted that the U.S. market would suffer a decline of up to 40% from the mid-year peak. And I remember it well: This bearish call raised rabid objections from bullish mainstream investors.
In my view, the bear market would driven by the disequilibrium between escalating price/earnings ratios and global deflationary pressures. While the Dow managed to escape with a 20% decline, the Russell 2000 fell almost 40% from its peak...(My colleague and fellow Taipan editor Brian Hicks will tell you about that a little later in this issue.)
Market shake-out
Now that weak hands have been cleared from the market, and over-leveraged hedge funds have been taken to the cleaners, the preconditions exist to support a massive rally in U.S. stocks.
This rally may have already begun. But after the rally, destabilizing forces will appear that will (for a time) bring back the bear market.
Taipan's Forecast for 1999:
I predict that the year 1999 will be a frustrating year for investors: There will be big sucker rallies and violent, sharp corrections that will crush both bears and bulls.
Taipan predicts the birth of a directionless range trading market over the next six months. The money will be made by "trading the market."
Easy money
To fight the global deflationary spiral, central banks around the world are creating liquidity. The Federal Reserve Bank has been leading the way by cutting rates. Central banks from Europe to Japan are slashing rates like there is no tomorrow.
Aside from lowering
the cost of borrowing, the gray men at the major central banks
have both hands on the cranks of the printing presses. Money
supply is expanding in the United States, Japan, and most European
countries. Global money supply is booming, as reflected in OECD
M1 figures. (See Figure 1.)
Loose monetary conditions are necessary to destroy the global deflationary spiral. The Asian crisis of 1997 ignited a deflationary spiral in commodities. When commodity prices are plummeting, pricing power in general tends to be weak. In an environment of weak pricing power, it's difficult to sustain profit margins. That, in turn, is pure poison for earnings.
(In fact, earnings in the United States are actually falling. Wall Street analysts talk about the deceleration of earnings growth. But earnings are not decelerating -- they're actually declining. Trailing earnings for the Dow are down 4.3% over last year. Earnings for the S&P 500 are also down.)
When earnings are weak, companies usually scale back capital expenditures. Less capital expenditure means fewer orders for machines, fewer orders for computers.
That, in turn, means fewer jobs...This vicious circle weakens both wholesale demand for commodities and consumer demand for retail goods, which in turn hurts commodity prices...
Like the Hindi serpent that swallows its own tail, this process reinforces itself, becoming a negative feedback loop. That's why central banks needed to use every weapon in their arsenal to offset deflation.
Liquid lunch
In a true "liquidity trap" (like the one Japan has been stuck in for the last couple of years), loosening monetary conditions does not work.
The bears believe that the United States is mired in a liquidity trap, just like Japan. But it just doesn't jibe with the current market action. If the United States were monetarily dysfunctional, the Dow would not trade at record highs...
The problem: There is usually a time delay between monetary stimulus and its effects on the real economy. The time lag takes at least nine months. That means the United States and other major economies should experience a radical acceleration in growth over the summer of 1999.
During the twilight zone between monetary easing and its effects on the real economy, the left-wing governments in the United States and in Europe will be tempted to try fiscal stimulus. I'm talking fat, pork-belly legislation...
While big government spending is always over time a waste of taxpayer money, it does tend to have an immediate impact on the real economy: Growth picks up. Anyone can borrow a big chunk of money and live well -- until it's time to pay the bill. With treasury rates at record lows and the budget in a nominal surplus, what better time for the government to borrow?
At least, that's the argument that you will increasingly hear Congress use. And a similar process will occur in Europe.
Giving the old one-two
Massive stimulus in the United States and Europe will put the world economy back on track to rapid growth in the spring of 1999. The effects of monetary stimulus will kick in during the summer. The one-two combo of fiscal and monetary stimulus will result in a rapid re-acceleration of global GDP. (See Figure 2.)
Taipan's Forecast for 1999:
The combination of loose monetary and fiscal conditions will trigger a surprise resurgence in global economic activity. Taipan predicts a robust 3.5% growth rate for US GDP and a 4.5% growth rate for global GDP.
Robust consumer demand in the Western economies will fuel an export-led recovery in Asia. The re-synchronization of global growth will support radically higher commodity prices. Inflation will return from the dead as manufacturers pass on price hikes to credit-rich consumers. Taipan forecasts a 4% annual gain in CPI.
Back to reality
Inevitably, there will be a price to pay for global reflation: higher interest rates.
While the consensus is for falling rates triggered by deflation, I expect a resurgence of inflation to trigger rising rates. In my view, the dramatic plunge in long-term rates was nothing more than a safe-haven bubble in which investors paid an irrational price for the mere perception of safety.
As soon as the inevitable impact of monetary and fiscal easing manifests itself in headline economic figures, the U.S. bond market is toast. Long-term rates could go back up as high as 6%. Long-term rates will most likely rise well before mainstream investors catch on to the new economic reality.
At the same time, robust consumer demand in the United States for Asian exports will widen the trade gap. Historically, widening trade deficits have coincided with rising rates.
Trade deficits need to be financed
Since domestic U.S. savings are negative (last September's rate was -0.2%), foreign capital will be needed to finance the trade deficit. And in the absence of a "safe-haven panic" bubble, foreign investors will require a higher return on capital...
A rising trade deficit and falling bond prices are a surefire recipe for a falling dollar. Paradoxically, a falling U.S. dollar tends to increase the nominal price of commodities -- since commodities are priced in dollars. Rising commodity prices will strengthen the domestic economies of commodity producers, reinforcing a growing global environment in which higher commodity prices can be supported.
Taipan's Forecast for 1999:
Taipan predicts that the yen will rise to 100 against the dollar by late spring. At the same time, rising commodity prices will trigger a 10% jump in the CRB index by the summer.
Rising commodity prices and a falling dollar will force the 30-year Treasury bond yield as high as 6% by mid-1998.
Don't fear the reaper
The initial response of the equity market to inflation will be unequivocally bullish: Since the market is afraid of deflation, not inflation, then any signs of robust growth will be interpreted positively.
This inflationary rally may already have begun.
Rebounding commodity prices, coincident with robust consumer demand, will expand profit margins across the board. Since the consensus is for flat or even shrinking profit margins, this is a significant positive surprise. Profit margin expansion will offset 1998's fall in corporate earnings.
I expect headline earnings for the S&P 500 to grow by 10%-15%. The market most likely will mistake one inflationary gain in margins for a structural improvement in corporate profitability and reward companies with ludicrously high price/earnings ratios. Since book values will also rise in an inflationary environment, return on equity (ROE) will actually shrink, continuing the bearish trend that began last year.
Taipan's Forecast for 1999:
Rising rates will subvert the inflation-driven bull market by second quarter. After the rally to new highs, the market will revert to 1998 lows. The bear market will be led by liquidity-driven bull market higher flyers.
Taipan predicts that the Dow will trade in a broad range, with 9,700 as the approximate ceiling and 7,000 as the approximate floor.
The market will be subject to massive sucker rallies and violent shake-outs. The money will be made by "trading the market," or buying the dips and selling the rallies. The calendar year 1999 will terminate with a dull, listless market -- setting up the scenes for the mother of all bull markets in the new millennium.
3. I know what you think: There ain't a single editor alive who didn't "accurately forecast" the crash of 1987...or the bull of 1998. But look it up, in "Outlook for the U.S. Stock Market and Interest Rates," Taipan, December 1997; p. 13.