What to expect in 2011?


As the first 5 days of January go, so goes January!  As January goes, so goes the year!  That's the theory, anyway.  US stocks gained 1.2% in the first week of the new year, on top of the 6.7% gained last month.  That's a year's return in 6 weeks, which makes us think "too far, too fast."  International markets generally gained in the first week of 2011 (0.1% in China to3.1% in Japan.)  However, Bombay cratered 3.8% on the week.  US investors are net sellers of bond funds and net buyers of stock funds in recent weeks, which could carry US stocks into "over-valued" territory, at least for the short term.  Fortunately, we're not focused on the short term - we're more interested in what might happen over the next 1-5 years because we believe investors with shorter time frames shouldn't be in stocks at all.  Here's what we're considering right now

US employment situation

Every month we ask ourselves, "Is this the month that employers finally start hiring?"  Every month we're disappointed.  In the most recent report, non-farm payrolls gained an anemic 103K jobs.  The unemployment rate fell 0.4% to 9.4% but the change is accounted for by a reduction in the overall size of the labor force.  This is the slowest rate of job creation of any recession in the last 60 years.  To substantially reduce unemployment, the jobs creation rate should be in the range of 300-500K/month.  The only ray of hope: average hours worked continue to rise as employers push overtime to the max.  Eventually, current workers will rebel, leading to increased hiring.  Still, the halcyon days of 3.5% unemployment that prevailed through the end of the Clinton administration, or even the 4.5% rate achieved in early 2007, before the financial system blew up, must seem like ancient history to someone whose 99 weeks of unemployment insurance are about to expire.

US housing

We've predicted that US housing prices would be range bound for the next 10 years, and the recent housing statistics seem to bear out this theory.  There remains a huge overhang of foreclosed properties (or properties that would be foreclosed if the paperwork wasn't all screwed up.) Meanwhile, homebuilders continue to add to inventory.  On the plus side, with mortgage rates still low, housing is very affordable if you qualify for a mortgage.  Still, notice that long stretch of no gains between 1989-1999?  That what we expect 2010-2020 to look like.

US economic situation

After all the discussion of a "double-dip recession," US GDP continues to grow at a modest 2.6% rate through Q3 2010.  Growth over the next 4 quarters is forecast in a range of 2.6-3.1%, which is low coming out of a recession.  Consumer confidence is sharply depressed by job worries and the negative "wealth effect" of the housing implosion, so consumer spending remains muted as we saw through the holiday season.  Indeed, as we see in the sharp decline of the US consumer debt service ratio (mortgage and consumer credit payments versus personal income), repairing personal balance sheets appears to be the number one priority of average Americans.

Mid and small sized businesses still struggle to obtain conventional bank financing as banks continue to hoard cash.  Compared to previous post-recession experiences, US GDP is running about 1% below "normal" expectations.


Inflation remains contained in the 0.0-0.5% range.  We see energy and food prices continuing to rise - a combination of increasing worldwide demand and the falling dollar.  Prices continue to fall rapidly for things like consumer electronics, while major purchases like houses and cars are seeing flat to lower prices.  The biggest inflation risks are higher education expenses (+3-6%/year) and healthcare.  So far the primary effect of Obamacare is that health insurance premiums jumped by up to 60%.  Both education and healthcare are labor intensive services where economies of scale are hard to achieve.  Also factoring into inflation is "qualitative improvement."  A heart by-pass operation performed in 2011 is considerably more sophisticated than the same operation performed in 1981, but with significantly better outcomes. 

In this environment, the Federal Reserve can cautiously raise short term rates, which we expect to be over 2% by 2013.

S&P 500 earnings

Actual earnings continue to impress.  For the quarter ending September 2010, final results were a gain of 25.3% versus expectations of a gain of 17.9%.  US corporations continued to gain from strong overseas sales amplified by a falling dollar.  Also, US corporations continue to focus on cost containment, particularly labor costs (just won't hire.)  Earnings for Q4 201 are expected to grow 32%, including ridiculous gains in financials as banks return to profitability.  Without financials, earnings will still grow 11.1%.

S&P 500 earnings are expected to generate record numbers in 2011, which is interesting because the S&P 500 is still 19% below October 2007 record levels.  Given current yields, the S&P 500 is about 24-30% below fair value.


Commodities are divided between precious metals, industrial metals, agricultural products and energy.  We have remarked that Gold seems unable to stay about $1400, peaking at $1423/oz on 12/8/2010, last at $1366/oz.  As gold goes, so go Silver, Platinum, and Palladium.  Industrial metals like Copper and Steel, however, are pushing higher, particularly on demand from emerging economies.  Agricultural products like Corn and Wheat are rising towards levels last seen in July 2007 - increased demand and weather problems in certain parts of the world.  Oil traded over $90/barrel in December and could reach $105/barrel in Spring 2011.

Add it all together, we see aggregate commodity prices rising through 2011 and into 2012.  The effect on inflation will be modest as commodities only account for 5% of inputs to GDP, but US consumers will definitely feel a pinch at the gas pump.


We commented last month "We would forecast gains in the S&P 500 of 8-10%, but now wonder whether December's 6.9% gain has already accounted for most of 2011's stock market returns."  We would not be surprised to see stocks trade in a range for the first 6 months of 2011 as traders digest recent gains.  We would not jump out of the stock market because we have no desire to inflict unnecessary capital gains on our clients and, with money flows picking up, the rally could extend longer that perhaps can be supported by current valuations.  We will do what is the hardest thing for investors to do, which is sit on our hands with our current investments and wait for more information.