Most economists and pundits predict a continued upward trend for most assets next year, but they will eventually be proven wrong.
In one of my classes at the University of Chicago Business School in the 1970s, the eminent statistician Harry V. Roberts liked to tell a story showing the homespun wisdom of his colleague and idol, economist Milton Friedman. The great monetarist was part of a panel evaluating a PhD presentation on forecasting growth rates for the U.S. economy. The candidate painstakingly described his methodology for fitting a broad array of variables––global capital flows, future exchange rates, immigration trends, and sundry other factors––into a computer model that, presto, spat out a prediction for the following year's GDP.
According to Roberts, Friedman delivered a brief, cutting critique––probably in the same nasal monotone I remember when, decades later, he returned my long-distance calls collect. Declared Uncle Miltie: "Why would this extremely complex model, based on factors that are themselves hard to forecast and could easily be wrong, produce a better number than taking the growth rates for the past five years, and dividing by five?"
For Roberts, the anecdote amounted to a parable on the pitfalls of economic forecasting. Friedman also liked to use the aphorism, "Predictions are extremely difficult, especially when they're about the future."
Friedman's lesson isn't that forecasting is impossible, but that the best prediction is usually the basic assumption that prices and growth rates will go back to their historic averages, or in economic parlance, "revert to the mean." What's difficult is guessing when that will happen. Indeed, the timing is truly unpredictable. But it invariably does happen.
Now, we're in the heart of the predictions season. The forecasts for the New Year from the pundits on Fox Business News, CNBC, Bloomberg TV and dozens of websites vary a bit, but the overall message is overwhelmingly the same for most assets: stocks will remain on a roll, generating double-digit gains for 2011. The prices of gold, oil and other commodities will continue their upward march. As for bonds, rates will keep rising, but slowly. And almost no one has a good word to say about the housing sector, where prices have fallen for months, and according to the prediction mill, are destined to follow the same downward trend.
The problem with these predictions isn't that they rely on complex economic assumptions. It's just the opposite––they're really not forecasts at all, but extrapolations. The pundits are telling us that recent trends will simply keep rolling.
They could be correct, but only for a while. In the longer term, these forecasts will prove wrong, for a simple reason. Most assets are already selling at prices far above their historic averages. As economic gravity takes over, they'll inevitably return to those benchmarks -- meaning stocks, bonds and commodities have a long way to fall.
So let's briefly examine these assets, and look at the factors that govern their long-term value. For commodities, it's production cost. For stocks, it's the multiple of price to average earnings. For real estate -- the surprise in this package -- it's the cost of owning versus the cost of renting.
Commodity bubbles
From 1983 to 2004, gold prices averaged around $400 an ounce. Today, the price for an ounce stands at $1390, or 3.5 times its historic average. The rub is that the production cost of gold is still in the $400 range. It's a combination of speculative demand and a temporary shortage of supply because of the long lags in mining the yellow metal that accounts for the surge. The spread of gold ATMs and ads luring people to sell their jewelry are sure signs of a bubble. Look for gold prices to drop sharply, and silver, copper and other metals to follow.
A similar scenario is threatening oil prices. The cost of production even in deep water wells is less than $60 a barrel, yet prices are over $90. Hence, the highest cost producer is earning 50% margins. We saw what happened when builders were making huge profits––they kept building until housing prices collapsed. Oil will follow the same pattern.
Pricey equities
How about stocks? The best measure of the whether stocks are cheap or expensive is the price earnings formula devised by Yale economist Robert Shiller, which divides the current S&P price by a ten-year average of inflation-adjusted earnings. By smoothing earnings, Shiller avoids the error of judging that equities are cheap when profits are unusually high, as they are today.
Today, the Shiller PE is a lofty 22.7 -- that's more than 40% higher than its long-term average of 16. Indeed, stocks could keep rising for months or even longer. But that would make them simply more overvalued than they are today. In other words, a Friedmanesque reversion to the mean does not signal a rise in equity prices at all, but a sharp drop. The only question is when it will happen.
????Let's move on to bonds. The sudden rise in yields on the 10-year Treasury from 3% in early December to 3.49% yesterday is a chilling reminder of the high risk to bond prices at these extraordinarily low rates. Despite the recent rout, the prices of 10-year Treasuries have plenty of room to decline. If yields return to their historic average yield of 6%, Treasury prices would drop by 20%.
Housing priced right
Believe it or not, the one asset that isn't overpriced, at least in most cities, is the most vilified: housing. The 30% nationwide decrease in values since the 2006 peak has brought the cost of owning a home to where it should be––back in line with the cost of renting the same house or condo. The fall in prices in most markets is over, or nearly over, and if it isn't, housing will become a better bargain with each downward tick.
That doesn't mean that housing prices will soar. But it does signal that homes are finally priced about right, and that it's an excellent time to move out of that rented flat and buy one.
The murky economy
It's extremely hard to forecast what changes we'll see in economic policy. Those changes may not affect the health of our economy this year or next, but they could greatly influence its future course. A prediction made by one of Friedman's heroes, the legendary Austrian economist F. A. Hayek, demonstrates the treacherous challenge of charting public policy.
In 1979, when inflation was raging and the Federal Reserve was deploying cheap money to battle rising unemployment, Hayek gave a speech declaring that the Fed could not be trusted managing the money supply. Hayek stated that it would always succumb to political pressure to use cheap money to create jobs, and that the effort would bring not prosperity, but greater inflation.
Hayek was wrong. Three months before Hayek issued his warning, Paul Volcker became chief of the Fed. Over the next several years, Volcker defied Hayek's predictions by reversing course and taming inflation.
So here are the best predictions for the New Year: Prices of stocks, bonds and commodities will gravitate towards their long-term averages––meaning the odds are they'll go lower. As for economic policy, if Hayek can be wrong, why try to forecast the truly unpredictable?
Also on Fortune.com:
Bull vs. Bear: How high will oil go in 2011?
Five investments for an inflationary New Year
Bull vs. Bear: Will housing rebound?
I think,after seeing S&P going up in 2009 and 2010, the trend is up since the worlwide economy has been going up too. So, i expect the gold price will drope 35% at least in 2011, housing prices will increase 35% in the next 18 months and the stock market will be above the 75% from today. Happy NEW YEAR!
5
After the new year the speculators will sell of their oil stocks before the drop like they did last time and they lost their a##es!
GDP growth has been shrinking since 1950, and there's no reason to believe it will improve in the near future. The US will be very lucky to see 3% GDP in any single year, and don't be surprised if we see 1-2% GDP on avg for the next few decades.
I am a fundamentalist and therefore agree with the tenor of the article but am deeply puzzled by the incorrect details in it. For example housing prices are NOT in line with rents,not even close;they have a long way to fall. Id take the specifics cited with a large grain of salt.
But wasn't Hayek right in the long run? No sooner than Reagan became president, he replaced Volker with Greenspan, who ultimately wrecked the American economy. Hayek hadn't counted on Jimmy Carter, an underrated president who could bite the bullet. Reagan was thinking about his reelection as soon as he took office and found in Greenspan a hack who do what was necessary to get unemployment down. Not keeping Volker was a huge mistake Reagan made. Deep into his second term, the market tanked.
Yet another article that confidently predicts the decline in gold and silver prices. I've been reading articles like this daily for the last two years that have said much the same. Luckily, I paid the advice no mind and my portfolio is up 79% this year! If silver and gold are truly in a peaking bubble then all of our investor friends and family should have precious metal stakes, right? Do me a favor, go ahead and conduct your own informal survey. You'll find that 98%-99% of your investment buddies own zero gold and silver, especially the real physical bullion.
What many writers and talking heads fail to realize is we are in a totally different investment paradigm now. The old tried and true methodologies that were based on a strong dollar and sound economic policies have been scrapped in favor of the money printing press and multi-trillion dollar deficits. The US dollar is headed for the trash heap of history and hyperinflation is no more than two years in the future. I'll take precious metals like gold and silver that have been valued by all human societies for over 5000 years over your green paper funny money any day of the week!
Hayek wasn't wrong. Austrian economists are rarely wrong.
"The cost of production even in deep water wells is less than $60 a barrel, yet prices are over $90. Hence, the highest cost producer is earning 50% margins."
A couple of problems.
1. Where does the $60/bbl come from? It all depends on the location, geology, contracts, etc.
2. The middle east now has economies that "require" very high prices. Water desalination, population increases, economic diversification, etc. They hold the keys.
3. Demand is increasing and supplies have been constant for 5 years. There lies your 50% margin.
Otherwise, great article.
Volker had the Fed funds rate at 14% to prove Hayak wrong, is this article saying thats what Bernanke has in mind? because with ecomomic growth and 7 trillion in stimulus he cant play black thursday forever
If we are counting on Mr. Bernanke's QE2 experiment to prop up the economy, push the market higher and sustain the value in our homes, we had better think twice. From the example of Japan where a decade of quantitative easing has been implemented by the Bank of Japan, Japanese investors have experienced entrenched deflation, near zero interest rates, a currency that is near all times highs versus the USD and debt that is second largest in the world in terms of GDP. Here is how well central bank interference has worked for Japan:
http://viableopposition.blogspot.com/2010/11/quantitative-easing-lesson-learned-from.html
Why should the United States expect any different in 2011?
Excellent article based on sound analytical reasoning.
There are other forecasts based on trends not taken into consideration in this article. How about the trend of bailouts and quantitative easing? If we double the money supply then shouldn't the markets truly double? Especially commodities? If 1 dollar today buys 1 gram of something, and we double the money supply then that 1 gram of whatever should cost 2 dollars.
Given the trend of bailouts and quantitative easing I highly doubt the FED and treasury can undo the damage they have already done and will in fact continue to increase the money supply.
I predict DOW above 20,000 however the dollar will lose much of it's value. And then in 2012 maybe we'll see the DOW at 40,000. Sure we will all have 400% profit on investment but the dollar will be worthless and we'll just keep on doing rounds of quantitative easing. This problem builds exponentially and quickly but not without warning we could have hyperinflation.
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