Every year around this time, market strategists break out their crystal balls and economists dust off their models (which amount to the same thing) and try to predict the course of the markets and economies for the next year. Why they persist in this activity when everyone knows it is a waste of time is a mystery. Equally mystifying is why the rest of us waste our time reading their prognostications. Predicting the future is impossible and there isn’t nearly as much upside to it as one might think.

Suppose you had the ability to predict the exact change in GDP and inflation over the next year. One would assume that would be valuable information indeed and that it would allow you to make untold riches in the markets. But how valuable would this information really be? Well, if you had known in 2007 that Bush, Bernanke and Paulson would panic the entire country into believing that the failure of a few large banks meant economic Armageddon you could have made a fortune since no one expected that. But what if today you accurately predict that GDP will grow 3% next year and CPI will rise 2%. Will that make you anything? Unlikely, since that is the average forecast of economists polled by the Wall Street Journal in December. The only way to make money off of accurate forecasting is to forecast something significantly different than the consensus – and be right.

That’s why I spend a lot more time trying to figure out what the consensus is than trying to predict the future. Knowing the consensus isn’t easy either but it is a lot easier than trying to predict the unpredictable. Sentiment is something that can be discerned by listening, reading and observing. I don’t watch CNBC to get the financial or economic news. I can read the reports as well as Steve Liesman. I listen to CNBC to get the reaction to the news which is much more important than the actual news. I listen to CNBC to discover the investing consensus. You can’t avoid being part of the crowd if you don’t listen to what the crowd is saying.

What I look for are anomalies. Good news that doesn’t cause a positive market reaction. Bad news that doesn’t cause a negative market reaction.  A good example was the employment report released last Friday, which showed a drop in non-farm payrolls of 85,000 and an unemployment rate of 10%. The report was much worse than expected in almost all respects. After an initial selloff, stocks spent the rest of the day coming back and eventually closed in positive territory. It does not matter if you thought the report was awful – and I did  - the fact remains that the “market” apparently doesn’t share that view. That is an anomaly that should make you reassess your assumptions about the US economy.

So I’ve spent the last few weeks trying to determine as best I can what the expectations are for 2010. That hasn’t been easy since it seems the sheer number of New Year predictions has grown to massive proportions and the variety of opinions this year seems unusually wide. But a few themes do emerge:

1.     The US economic recovery will be muted at best and at worst is prone to a double dip recession. The markets are priced for recovery though, not a double dip. The middle of the road 3% growth expectation means that there is potential for surprise in either direction.

2.     Inflation is not a problem and interest rates will remain low. The TIPS market shows five year inflation expectations at 2.11%, but one year expectations seem to be a bit less since Treasuries of that maturity yield considerably less. This is an area where I think there is a significant chance of surprise. Despite the deflation worries of the Fed, commodity and other market indicators don’t show the same concern. Retail investors poured money into bond funds last year so a spike in interest rates and big losses in bonds can’t be far behind.

3.     The best stock markets are outside the US with emerging markets a particular favorite.Money flowed out of US stock funds and into international funds all last year. It is tempting to buck the consensus and bet on the US market, but if the US does well, it seems unlikely that foreign markets will do worse. The only way I think bucking the consensus makes sense is if it is a down year. Emerging markets are more volatile than the US in both directions so a down year would likely mean a bigger drop for foreign bourses.

4.     Commodities will continue to rise and this is an indication of economic recovery, not inflation. If oil keeps rising, at what point does it become an impediment to recovery? I don’t know but the Fed better.

5.     China is a bubble destined to pop. This has become a popular theme of late complete with videos of whole cities of empty real estate. What the bears don’t get is that the empty real estate can fill up pretty quickly when you have massive migration from rural to urban. I am worried about inflation in China - and the reaction to it - but I am still bullish on China over the long term.

6.     Commercial real estate – and real estate in general – will continue to be a problem. I don’t see how problems with CRE could possibly surprise the market with everyone so aware of the problem.  CRE could also heal very quickly if the economy is better than expected. Surprises seem more likely to the upside.

7.     Mortgage rate resets will cause many more foreclosures and many more bank losses.This is another theme that seemingly everyone is aware of and therefore represents a low probability of surprise. The losses don’t matter as much when financial industry profits are annualizing at over $350 billion as they are now.

8.     The Fed will start to execute its exit strategy sometime this year but won’t raise interest rates significantly before the election. Bernanke used his recent speech at the American Economic Association meeting to explain why the Fed wasn’t responsible for the housing bubble so it seems unlikely that he’ll surprise the market by tightening quickly, but the markets may force his hand. A big drop in the dollar or a big rise in long term interest rates would need to be addressed.

I don’t know what the market or the economy will do in 2010 and neither does anyone else, but the consensus for 3% growth and 2% inflation is so benign that it seems highly unlikely to be true. Those numbers essentially amount to the Federal Reserve targets so expecting that is tantamount to believing that Bernanke and Co. have a clue which also seems highly unlikely. The question isn’t if the Fed will be wrong, but rather how they will be wrong.

Stock market expectations reflect the economic expectations so the consensus seems to be for a moderate up year in the averages of 8-10%. I suppose that is possible but if the economic expectations turn out to be wrong, then the stock market expectations will also prove wrong. One should not assume though that upside surprises to growth would mean upside surprises for stock prices. Sentiment in the stock market has recently become more than a bit frothy with bears increasingly hard to locate. Could better than expected growth mean higher than expected interest rates and compressed valuations for stocks? It is certainly one possibility.

I don’t mean to imply that surprises to growth will necessarily be to the upside either. History does tell us that deep recessions are followed by steep recoveries, but we’ve never sampled Keynesianism on such a large scale so I’m not sure history means a whole lot in this context. In the past, a recession this deep would mean a recovery with GDP growth in the range of 5-7%. I guess that is still possible but given all the uncertainty surrounding events this year, it seems very unlikely. Health care reform has not yet been decided. Cap and trade could come back but even if it doesn’t the EPA is perfectly capable of imposing onerous regulations. And God only knows what kind of mischief Congress could stir up in an election year. Uncertainty is not one of the ingredients for a robust recovery.

Don’t waste your time trying to predict the future or depending on someone else to do it for you. Successful investing requires that you think more like Sigmund Freud than Nostradamus. Be aware of expectations and especially changes in expectations. That is what moves markets and what is important.

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Economic and Market Update

The economic reports since my last update have been generally positive. Jobless claims continue to fall slowly but as the recent employment report showed, hiring hasn’t picked up yet. Income and spending reports were solid. Factory and durable goods orders are rising. The ISM indices continue to point to growth. The one area that has been disappointing is the housing market where new home sales and pending home sales both dipped hard in November. The home buyers tax credit was extended but apparently not soon enough to keep the momentum going. That does not bode well for the housing market when the subsidy eventually expires (assuming the politicians can bring themselves to do that).

Stocks continued to work their way higher at the end of the year and the beginning of the new one. One change has been that the US market has started to outperform foreign markets. That isn’t particularly surprising since individual investors spent all of last year dumping US stocks in favor of foreign ones. I’m not sure what to expect here. Growth in foreign economies - particularly emerging markets - still seems likely to outpace the US by a wide margin. Even if US growth is better than expected I would still expect foreign economies - and markets - to benefit from a little extra US growth. I suspect US outperformance is a temporary situation, but it bears watching.

Commodities have also performed well since the last update. Gold has pulled back but the rally in commodities seems to be broadening out a bit. The GSCI is overweighted to energy and with oil and natural gas both rallying, it has done better recently. Agricultural commodities are also starting to pick up. REITs have performed much better than anyone expected and US REITs in particular have been surprisingly strong. There may be a lot of problems in commercial real estate but you couldn’t tell by looking at REIT prices.

The Treasury market has recently had some setbacks with long rates rising significantly in December. Corporate and high yield are still outperforming while foreign bonds corrected with the year end dollar strength. I suspect the dollar rally is coming to an end by the way.

Selected Charts

Long term Treasuries have taken a beating since October, but they are oversold short term.

Corporate bonds have held up better but haven’t made much progress lately. I am skeptical that prices can move much higher:

High yield has been the place to be but this market is very overbought and subject to a correction at any time:

The dollar rally knocked down foreign bonds, but I am inclined to buy the dip:

Commodities had a good month and if the end of the year dollar rally is over, seem likely to continue moving higher:

REITs have performed much better than anyone expected and expectations are still quite low:

The Euro appears poised for another move higher. With problems in the peripheral countries it doesn’t seem likely though:

Agricultural commodities have been volatile but the trend is solidly bullish:

Chile’s stock market has recently gone vertical. I like the Chilean economy but moves like this rarely end well. I may be a seller soon:

I don’t think much of the Japanese economy but Japanese small caps look attractive technically:

Volatility has fallen off a cliff. Expect a snapback: