How has another year come and gone so quickly? It seems like someone hit the fast forward button. And once again, all too soon, it is time for me to demonstrate my masochistic nature and write a forecast issue. Rather than going into details on every topic, I will try and stick to the big picture and leave the fine points for later letters.
Each year as I do this forecast, I look for a theme. What will be the driving factor which will set the stage for the economy? In 2001 it was the coming recession; in 2002 it was a weak recovery and the beginning of the Muddle Through Economy; in 2003 it was Surprise and Transition. In 2004 it was the Silver Lining Economy; in 2005 it was the See-Saw Economy. Last year it was The Gripping Hand, as Bernanke had the economy in his interest rate gripping hand. Who knew in January 2006 how far he would go?
This year the theme is The Goldilocks Recession. As outlined in the past few months, I think the US will have a mild recession or slowdown in 2007. That premise leads to a lot of other follow-on forecasts. Why the theme? Remember that after finding things were just right, Goldilocks ended running out of the house when the bears came home. And I think the housing bear will finally come home in 2007.
And as I do each year, we start by reviewing last year's forecast. Prior to last year, I had been on kind of a roll in my forecast issues. Never perfect of course, but all in all I have been lucky. I wrote as a preface last year:
"As I look at the coming year, I think it is likely I will not be as successful in my accuracy. There are a lot of potential variables which could cause any number of my predictions to be wrong. But chief of my concerns is Fed policy. When will they stop raising rates? In my mind, I see Ben Bernanke playing Clint Eastwood, doing the Dirty Harry role, looking into the face of the housing market and saying, 'Do you feel lucky punk? Well, do you?' As we will see, this is the wild card upon which the economy will turn." As it turns out, I did not do all that badly. I wrote at length why I though the Fed would go further hiking rates than the consensus at that time and I was right.
However, I thought that raising rates more than most economists thought, plus a slowing economy, would put a damper on the stock market and I was really wrong in calling for a down year in the stock market. I also thought inflation would peak earlier than it has, but that is my bias, as I think that global deflationary forces will eventually be the order of the day.
On the plus side, I got the currency markets right. I was mildly bearish on the dollar as well as seeing a small rise in the Chinese Renminbi. I was bullish on gold and energy. I did not think we would go into a recession in 2006, but that consumer spending would slow down by the end of 2006. I predicted a return of the Muddle Through Economy by the end of the year, which we certainly saw. Growth in the last half of the year will be below the 2% range, which qualifies for Muddle Through. I was positive on global growth and China in particular, even with many calling for a hard landing in China. I also called for a correction in copper, which we surely got this year.
Past performance is not indicative of future results. In golf, you drive for show and you putt for dough. Forecasts are for show. I can guarantee I will get a few things wrong. Maybe a lot of them. Count on it. Its how we invest, and what either confirms or changes those forecasts as time plays out that is the key. If the facts change, so will my views. However, a forecast stays forever in the archives, good or bad. Let's see if we can get a few right this year.
Caveat: If I am wrong about the housing market retreat causing a recession, this forecast is going to be really wrong.
And speaking of the accuracy of forecasts, a note from reader Nathan Lewis called to my attention an interesting historical event. Let's get in the Way Back Machine and go to the 70s. The Dow had topped out in late 1965 - early 1996, and then began an almost 30% bear market drop to the spring of 1970. But wait, from that bottom the Dow took off. In January of 1973, the Dow topped out around 1050, or 5% above its previous high. Writes Nathan:
"On January 1, 1973, Barron's published its famous Roundtable interviews with big-name professional investors. The title was 'Not a Bear Among Them.' (By the way, the Fed Funds Rate, as of the end of December 1972, was -- 5.33%! You can't make this stuff up.)" Of course, the Dow then proceeded to drop 40%.
And yes, this year's Roundtable had not a bear in the room. Let's see. A 5% rise from previous highs? No bears in the Roundtable? You drive for show. Let me note that this issue probably gets forwarded more than any other weekly letter I write. Now, let's get into the forecast.
The Goldilocks Recession Economic forecasts this year tend to fall into three camps. The very large majority which sees a mild slowdown (not a recession!) with the Fed cutting rates in response and then renewed growth. They look back to the middle 90's where there was indeed a slowdown but not a recession, and the market continued to climb. Goldilocks, indeed.
There are a few which see the roots of a serious recession based upon a collapse in housing prices and a manufacturing slump.
And then there is the lonely middle where I reside, which sees a mild recession (at least by historical standards). It's like the line from the one hit wonder by Stealers Wheel from 1973:
"Clowns to the left of me, jokers to the right of me, stuck in the middle with you. And I'm wondering what it is I should do."
Why just a mild recession? Because basically the bulls are right about 70-80% of the economy. Things are doing just fine, thank you. The service sector is rocking along with the latest ISM number for the service sector at 57.1%, which is quite healthy. By some estimates, the service sector is up to 80% of the economy.
The Goldilocks Recession
