Sunday, January 5, 2014

2014 Outlook: The Danger & Opportunity The Illusion Creates

2014 Outlook: The Greatest Illusion The World Has Ever Seen
2014 Outlook: The Danger & Opportunity The Illusion Creates
2014 Outlook: U.S. Stock Market
2014 Outlook: U.S. Residential Real Estate
2014 Outlook: U.S. Municipal Bond Market
2014 Outlook: Rogue Wave 1: Japan Is A Powder Keg Searching For A Match
2014 Outlook: Rogue Wave 2: Europe Calmly Sits In The Eye Of The Storm
2014 Outlook: Rogue Wave 3: The Global Housing Bubble Is Back
2014 Outlook: Investment Opportunities In The Year Ahead

Entering 2014 there is no obvious disaster sitting right in front of us such as a sovereign debt default or a new major war. There is no immediate rogue wave catalyst for a serious decline in risk assets. Because of this, market participants have entered into a period of unprecedented complacency. As we will see, this complacency is the true danger that faces the market.


With that immediate danger already present, there are additional unseen rogue waves lurking around the world that we will review throughout this outlook.

What is meant by complacency? This means that although the world may get better on the surface in 2014 (economic data continues to improve), many markets have already priced in this improvement and additional improvement in the years beyond.


Warren Buffett made his fortune by investing in assets with a “margin of safety.” This means that even if things turned south, he was buying an asset at a 20% discount to its full value. Lenders follow this approach by asking for a 20% down payment on a residential or commercial real estate property. 



When looking around today, are investors taking on this margin of safety by purchasing assets at these price levels? Of course not. Investors new margin of safety is their confidence that everything will be better in 2014. They are 120% sure that the fundamentals will improve, giving them their 20% margin of safety.


This type of mentality exists at the end of cyclical growth periods, where as the opposite mentality exists at the trough of cyclical downturns.


Will understanding that high yielding risk assets are being purchased today at prices with no margin of safety guarantee that they will fall tomorrow? Of course not. Having insurance on your beach home in south Florida only matters when the hurricane arrives. Until that point, you feel like an idiot for making the monthly premium payments. 



John Hussman summarized this perfectly by saying:

"The problem with bubbles is that they force one to decide whether to look like an idiot before the peak, or an idiot after the peak. There's no calling the top."


We have never been in a situation remotely close to this period in history where every major central bank around the world is running enormous QE programs simultaneously. Before 1971, the world had never experienced an environment where every currency on the planet was backed by nothing. We are so far away from "charted territory" that if someone tells you they know where an asset price is going to be tomorrow morning, you should walk away quickly. 


We live in world today of almost crystallized certainty that our central banks and government leaders have rescued us from the financial crisis and the global economy is back at full strength. That certainty or complacency has created a magnificent opportunity for those that can understand the illusion is only a trick.


How do we know this certainty and belief in magic exists?


We can hear it in the way investors, business owners and the media discuss the world. We can read it in sentiment indicators. We can watch it in the way that people are piling into risk assets in search of just a small taste of “yield.” We can pull up a Bloomberg screen and see that junk bonds are currently trading at the highest prices in recorded history.

Throughout this outlook we will review many of the asset classes that now fully believe the great illusion is real magic. This belief is reflected in their prices. We will finish with some of the few assets that are still trading at reasonable valuations and where to hide while you wait for the greatest buying opportunity in history. We will begin with 2013's greatest spectacle on earth, the U.S. stock market.

Up Next: 2014 Outlook: U.S. Stock Market


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