The Fed’s Alice In Wonderland Economy - What Happens Next?

By Nick Giambruno

After the president of the United States, the most powerful person on the planet is the chairman of the Federal Reserve. Ask almost anyone on the street for the name of the U.S. president, and you’ll get a quick answer. But if you ask the same person what the Federal Reserve is, you’ll likely get a blank stare. They don’t know - partly due to the institution’s deliberately obscure name - that the Fed is really the third iteration of the country’s central bank. Or that the Fed manipulates the nation’s economic destiny by controlling the money supply.

And that’s just how the Fed likes it. They’d prefer Boobus americanus not understand the king like power they wield. By simply choosing to utter the right words, the chairman of the Fed can create or extinguish trillions of dollars of wealth both in and outside of the U.S. He holds the economic fate of billions of people in his hands. So it’s no shocker that investors carefully parse everything he says. They have to, if they want to be successful. Some even go as far as to analyze the almighty chairman’s body language. Of course, the mainstream financial media revere the Fed.

You may recall the unhealthy spectacle that occurred in 1996. That’s when Alan Greenspan, the Fed chairman at the time, spoke the now famous phrase “irrational exuberance” in what should have otherwise been a dull and forgettable speech. Investors heard Greenspan’s phrase to mean that the Fed would soon raise interest rates to slow the global economy. It’s worth mentioning that Greenspan didn’t actually say the Fed would raise rates. Nor did he intend to signal that.

Nonetheless, the reaction was swift and panicky. U.S. markets were closed at the time, but stocks in Japan and Hong Kong dropped 3%. The German stock market fell 4%. When trading started in the U.S. market the next day, the market opened down 2%. Billions of dollars of wealth vanished in a period of 16 hours. That’s the absurd power over the global economy that the Federal Reserve gives to one human being. The words of the chairman can make or break the fortunes of anyone with a brokerage account.

The Fed’s Alice in Wonderland Economy

I almost fell out of my chair when I heard it….. A journalist recently asked Janet Yellen, the current chair of the Federal Reserve, if the central bank would keep interest rates at 0% forever. Her response: “I can’t completely rule it out.” I was stunned. The deferential financial media hurried to ignore the significance of that statement. Instead, it acted the way big city police might act after making a messy arrest on a busy sidewalk. “Move along folks, nothing to see here!”

Clearly, there was something to see. Something very important. Yellen’s words came amidst one of the most anticipated economic pronouncements in a generation… whether the Fed would finally raise interest rates for the first time in nine years. Short term rates have been at zero since the 2008 financial crisis. Interest rates are simply the price of borrowing money. Setting them at an artificial level is nothing other than price fixing. Not surprisingly, it has led to enormous amounts of malinvestment and other distortions in the economy.

Malinvestment is the result of faulty decision-making. Any investor or business can make a mistake, but central bank manipulation of interest rates subsidizes bad, wasteful decisions. Cheap borrowing costs trick companies. It causes them to plow money into plants, equipment, and other assets that appear profitable because borrowing costs are low. Only later, when the profits don’t show up, do they discover that the capital was wasted.

Seven years of quantitative easing (QE) and Fed engineered zero interest rates have drawn the U.S. and much of the world into an unsustainable "Alice in Wonderland" bubble economy riddled with malinvestment. The pundits had expected that, at this recent meeting, the Fed would move to raise rates just a little and give the global economy a tiny taste of sobriety. Not even that nudge materialized.

Instead, the Fed sat on its hands. It kept interest rates at zero. And Janet Yellen couldn’t even rule out that rates would stay at zero forever. If she can’t even do that, how is she going to start a sustained series of rate hikes, as many of those same pundits now expect her to do a few months down the road?

The truth is, seven years of 0% yields and successive rounds of money printing has so distorted the U.S. economy that it can’t handle even the tiniest increase in interest rates. It would be the pin that pricks the biggest stock and bond market bubble in all of human history. The Fed cannot let that happen.

What Happens Next

It’s clear that the Fed can’t raise interest rates in any meaningful way. It would trigger a financial meltdown that would quickly force them to reverse course. The Fed might be able to get away with a token increase, but that’s all. In other words, the Fed has trapped itself. Former Fed chairman Ben Bernanke admitted as much recently when he said he didn’t expect rates to normalize in his lifetime.

And then, we have the current chair Janet Yellen saying that rates might stay at zero forever!

Yellen’s belief that she has the power to suppress interest rates until the end of time is a frightening sign. As powerful as the Fed is, it isn’t stronger than the markets. A crisis in the markets could force rates higher even if the Fed doesn’t want them to go there. And the longer the Fed tries to sustain abnormalities like QE and 0% interest rates, the more likely it is that the whole business will end with the markets crushing the Fed.

And that’s not even considering a collapse of the petrodollar system or China pushing the establishment of a New Silk Road in Eurasia…two catalysts that would likely force interest rates higher. So I’ll go ahead and disagree with Yellen and rule out the possibility that rates might stay at zero forever. They won’t, because they can’t.

At the next sign of a market swoon or of a weakening economy, or with the next episode of deflationary jitters, the Fed will again ramp up the easy money. It could be another round of QE. Or the Fed could push interest rates into negative territory. If that fails, the Fed could go for the nuclear option and drop freshly printed money out of helicopters as Bernanke once infamously suggested – or, more likely, into everyone’s bank account. They’ll do whatever it takes, no matter what the eventual damage to the dollar’s value.
Whatever the details, one thing should be clear. This politburo of unaccountable central planners is the greatest risk to your financial wellbeing today.

What You Can Do About It

It’s a terrifying thought that the actions of a few people at the Fed so endanger your financial security.
But the facts are worse than that. There’s more to worry about than just the financial effects. The social and political implications of the Fed’s actions are even more dangerous. An economic depression and currency inflation (perhaps hyperinflation) are very much in the cards. These things rarely lead to anything but bigger government, less freedom, and shrinking prosperity. Sometimes they lead to much worse.

Fortunately, your destiny doesn’t need to be hostage to what’s coming. We’ve published a groundbreaking step by step manual that sets out the three essential measures all Americans should take right now to protect themselves and their families. These measures are easy and straightforward to implement. You just need to understand what they are and how they keep you safe. New York Times best selling author Doug Casey and his team describe how you can do it all from home. And there’s still time to get it done without any extraordinary cost or effort.

Normally, this "get it done" manual retails for $99. But I believe it’s so important for you to act now to protect yourself and your family that I’ve arranged for anyone who is a resident of the U.S. to get a free copy.

Click here to secure your free copy.

The article was originally published at internationalman.com.

Get our latest FREE eBook "Understanding Options"....Just Click Here!

The People’s Republic of Debt

By John Mauldin

It wasn’t that many centuries ago that China was the absolute economic center of the world. That center gravitated to Europe and then towards North America and has now begun moving back to China. My colleague Jawad Mian provided this chart showing the evolution of Earth’s economic center of gravity from 2000 years ago to a few years and into the future:



Most investors are well aware of the enormous impact China has had on the modern world. Thirty-five years ago China’s was primarily an agrarian society, with much of the nation trapped in medieval technologies and living standards. Today 500 million people have moved from the country to the cities; and China’s urban infrastructure is, if not the best in the world, close to that standard.

The economic miracle that is China is unprecedented in human history. There has simply been nothing like it. Deng Xiaoping took control of the nation in the late ’70s and propelled it into the 21^st century. But now the story is changing. Those who think that all progression is linear are in for a rude awakening if they are betting on China to unfold in the future as it has in the past.

Among the most important questions for all investors and businessmen is, how will China manage its future and the problems it faces? There are many problems, some of them monumental – and at the same time there is an amazing amount of opportunity and potential. Understanding the challenges and deciphering the likely outcomes is itself an immense challenge.

A Brand-New Book Available Online

My colleague Worth Wray and I have been investigating and writing about China for some time now. Today I’m announcing a book that we have written and edited in collaboration with 17 well-known experts on China. The book is called A Great Leap Forward? Making Sense of China’s Cooling Credit Boom, Technological Transformation, High Stakes Rebalancing, Geopolitical Rise, & Reserve Currency Dream, and we think it will help you to a solid understanding of both China’s problems and its opportunities. I know, the subtitle is a tad long, but the book does really cover all those aspects of today’s China.

Notice that there is a “?” after the title “A Great Leap Forward.” The first Great Leap Forward, initiated by Mao Tse-tung in the early ’60s, was an utter disaster. It devastated the nation, bankrupted the economy, and caused the deaths of tens of millions of people. Let’s review a little history from the introduction to the book:

When Chairman Mao decided in 1958 to transform China’s largely agrarian economy into a socialist paradise through rapid industrialization, collectivization, and a complete subjugation of the market to Chinese Communist Party (CCP) central planners, the widespread misallocation of resources led to the worst famine in recorded history and the outright collapse of China’s economy.

With very little capital at China’s disposal after its long civil war and even longer subjugation to foreign colonialists in the nineteenth and early twentieth centuries, Mao decided the best way to fund the country’s rapid industrialization was for his government to monopolize agricultural production, use the nation’s bounty to support industrializing urban populations, and finance fixed-asset investments with crop exports.

1959 –– “Prosperity brought by the dragon & the phoenix”

Seeing grain and steel production as the essential elements of China’s rapid development, Mao boasted in 1958 that China would produce more steel than the United Kingdom within fifteen years.

1959 –– “Smelt a lot of good steel and accelerate socialist construction.”

Mao had very limited knowledge of agriculture or industrial production, yet he ruled China with an iron fist and silenced even well-intentioned opposition. China’s rural peasants were forced into collectives; households were torn apart; and private property rights were completely abolished. Mao ordered agricultural collectives to produce more grain while forcing farmers to employ less productive methods; he mobilized farmers to kill off “pests” like mosquitos, rats, flies, and sparrows (a campaign that upset the ecological balance in China’s farmlands); and insisted on a doubling of steel production to be achieved by diverting farmers with no industrial skill into operating poorly supplied backyard furnaces (which could not burn hot enough to produce high-quality steel).

1959 – Unskilled workers smelt steel in China’s backyard furnaces.

Steel production surged, and the economy appeared to boom… but at least half of that new production was unusable. A proliferation of crop eating locusts (after the sparrows had been killed off) and the diversion of farm workers to industrial and public works projects led to a collapse in crop yields. Still, local officials all over China falsified their production figures in an effort to win favor with Beijing (and to spare themselves Mao’s wrath), which led to larger and larger grain shipments to China’s cities… and smaller and smaller rations for those living in its agricultural collectives.

Instead of taking a Great Leap Forward to a harmonious industrial society….

1959 –– “The commune is like a gigantic dragon, production is noticeably awe-inspiring.”

Mao’s command and control system dismantled the Chinese economy, ruined millions of lives, and left an enormous share of China’s population disillusioned.

Industrialization failed. From 1958 to 1961, millions died of starvation and exhaustion across China’s countryside (independent estimates range from 30 million to 70 million, while the CCP still insists the death toll was only 17 million), and the People’s Republic remained a net exporter of grain. As Harvard economist Dwight Perkins remembers it, “Enormous amounts of investment produced only modest increases in production or none at all.... In short, the Great Leap was a very expensive disaster.

As production and productivity collapsed along with the CCP’s social contract, Mao struggled to retain power as a number of influential officials sought to implement more market oriented policies in response to the Great Famine. Fearing that growing opposition could lead the Party to reject its Marxist spirit (as the Soviet Union had done under Nikita Khrushchev a decade earlier), in 1966 Mao and his Red Guards launched the Cultural Revolution – a decade long series of purges intended to root out enemies of Communist thought lurking within the Party, cleanse Chinese society of many of its traditional values, eliminate elitist urban social structures, and renew the spirit of China’s Communist revolution.

1967 – “Scatter the old world, build a new world.”

Under Mao’s leadership, the Party destroyed cultural artifacts, banned the vast majority of books, dismantled the educational system, and silenced millions for thought crimes against the Party. In a devastating blow to China’s human capital, Mao ordered children of privileged urban families – including current President Xi Jinping, when his father, Xi Zhongxun, was purged – to relocate far away from their families to be re-educated through manual labor in China’s countryside. What may have been the most promising youth of that “Lost Generation” were deprived of their educations and forced into hardship.

1972 –– President Xi Jinping during the Cultural Revolution

Considering the legacy of the Great Leap Forward, the Great Chinese Famine, and the Cultural Revolution, it is an understatement to say that Mao’s hardline policies devastated the economy and left deep scars at all levels of Chinese society. After Mao’s death in 1976, it didn’t take long for the pragmatic Deng Xiaoping to win control of the Party and take China in a new economic direction –– though with essentially the same repressive political system.

And now young XI Jinping has come from experiencing the Cultural Revolution, getting ready to embark upon what we believe is something as equally as revolutionary as the first Great Leap Forward. The question mark is whether it will be another disaster or a decisive leap into a new future, perhaps even a new world order.

My friend Woody Brock reminds us in his latest PROFILE that the theory of growth in emerging markets dates from 1960, with the publication of Walt Whitman Rostow’s book The Stages of Economic Growth. Rostow gave us a description of five different stages that “mark the transformation of traditional, agricultural societies and modern, mass-consumption societies.”

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best selling author, and Chairman of Mauldin Economics – please click here.

The article Thoughts from the Frontline: The People’s Republic of Debt was originally published at mauldineconomics.com.

Get our latest FREE eBook "Understanding Options"....Just Click Here!

Protecting Yourself with Gold, Oil and Index ETF’s.....Our Three Part Series

In 2009 I shared my big picture analysis, investment forecast and strategy in a book called “New World Order Economics – What you can do to protect yourself” [Buy it Here on Amazon]. In January 2009 I forecasted that the Dow Jones Industrial Average was going to make a bottom within a couple months which it did. I also predicted the price of gold to start another major rally, and for crude oil to bottom and rally for years, which were also correct.

You can call it luck, skill or a mix of both… but the truth is that the markets cannot be predicted with 100% certainty. With that said, the US stock market, gold and oil look to be setting up for their NEXT BIG multiyear moves.

THE NEXT FINANCIAL CRISIS – Part I "U.S. Equities Bull Market is About to End"

2014 was a tough year for small cap stocks. The Russell 2000 index which is a great barometer of what speculative money is doing as a whole. History has shown that small capitalization stocks are the first group to show weakness after a multi-year bull market.

For all of 2014 this group of stocks has been struggling to hold up. Each time it nears a previous high, sellers come out of the woodwork and unload shares in large volume. This was the first tell tale sign that institutions are starting to rotate their positions out of these high beta stocks.....Click here to read the entire article


THE NEXT FINANCIAL CRISIS – Part II "Gold Bear Market is About to End"

Gold and silver have a little trickier of a situation to navigate and invest for maximum returns over the next 2+ years. The most important thing to realize is that when a full blown bear market starts virtually all stocks and commodities drop including gold, silver and oil. Knowing that, investors must be aware that when the stock market starts its bear market the fear will rise and investors will inevitably sell their holdings and this means we could see gold and oil continue to fall much further from these levels before a true bottom is in place.

Is this time different than the 2008/09 bear market? Yes, this time we have possible wars starting, oil pipelines overseas being cut off, counties and currencies failing and even negative bond yields in some parts of the world – it’s a mess to say the least. There are a lot of things unfolding, most seem to be negative for the economy.....Click here to read the entire article


NEXT FINANCIAL CRISIS – Part III – OIL "The Oil Bear Market is About to End"

Crude oil and energy stocks are tricky to navigate in a situation like this where the equities market is nearing a bull market top. It is critical to remember that when the US stock market turns down and starts a bear market virtually all stocks and commodities will fall in value including oil and energy stocks. Investors need to understand that even though the price of crude oil is nearing a bottom it could and will likely stay low for a considerable amount of time “IF” the stock market turns down.

Over the last 100 years we have seen nearly 30 bear markets. The average length of a bear market is 18 months and has an average decline of 30%.....Click here to read the entire article



Get our latest FREE eBook "Understanding Options"....Just Click Here!

15 Surprises for 2015

By John Mauldin

It’s that time of year when people start thinking about New Year’s resolutions and investment planning for the future. It’s also the time of year when analysts feel more or less compelled to offer up forecasts. My friend Doug Kass turns the forecasting process on its head by offering 15 potential surprises for 2015 (plus 10 also-rans).  But he does so with a healthy measure of humility, starting out with a quote from our mutual friend James Montier (now at GMO):

(E)conomists can't forecast for toffee ... They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else ... If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!

Lessons Learned Over the Years

"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." – Woody Allen

There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:

1. How wrong conventional wisdom can consistently be.
    
2. That uncertainty will persist.
    
3. To expect the unexpected.
    
4. That the occurrence of black swan events are growing in frequency.
    
5. With rapidly-changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

Quoting from a very eclectic group of names, Doug does indeed give us a few surprises to think about, and I pass his thoughts on to you as this week’s Outside the Box. (Doug publishes his regular writings in RealMoneyPro on theStreet.com.)

As a bonus, and as a thoughtful way to begin the new year, we have a letter that my good friend and co-author of my last two books Jonathan Tepper wrote to his nephews. He began penning it on a very turbulent plane ride that he was uncertain of surviving. It made him think hard about what was really important that he would want to pass on to his nephews. As the song goes, I found a few aces that I can keep in this hand. I think you will too.

His letter made me think about what I want to be passing on to my grandchildren, including the newest one, Henry Junior, who showed up less than 24 hours ago. They are going to grow up in a very different world than the one I grew up in, and I mostly think that’s a good thing. But the values that I hope can be passed on don’t change. Good character never goes out of fashion.

My associate Worth Wray came down with a very nasty bug this past weekend, so he missed his deadline for delivering his 2015 forecast to you. We’re giving him a few more days and will run it this weekend – which also of course gives me a little more time to mull over my own forecast. Taking to heart James Montier’s quote above, I’m going to forgo the usual 12-month forecast and look farther out, thinking about what major events are likely to come our way over the next five years. I actually think that approach will be for more useful for our longer term planning.

Thanks for being with me and the rest of the team at Mauldin Economics this past year; and from all of us, but especially from me, we wish you the best and most prosperous of new years.
You’re staring hard at crystal balls analyst,

John Mauldin, Editor
Outside the Boxsubscribers@mauldineconomics.com

Stay Ahead of the Latest Tech News and Investing Trends...

Click here to sign up for Patrick Cox’s free daily tech news digest.

Each day, you get the three tech news stories with the biggest potential impact.

---

15 Surprises for 2015

Doug Kass, Seabreeze Partners
Dec. 29, 2014 | 8:12 AM EST
Stock quotes in this article:
C, SBUX, TSLA, TWTR, GM, GLD, JNK, SPY, QQQ, AAPL, BAC, GOOGL, FB, CSCO

It’s that time of year again.
"Never make predictions, especially about the future." – Casey Stengel

By means of background and for those new to Real Money Pro, 12 years ago I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien's playbook. Wien originally delivered his list while chief investment strategist at Morgan Stanley, then Pequot Capital Management and now at Blackstone. (Byron Wien's list will be out in early January and it will be fun to compare our surprises.)

It takes me about two to three weeks of thinking and writing to compile and construct my annual surprise list column. I typically start with about 30-40 surprises, which are accumulated during the months leading up to my column. In the days leading up to this publication I cull the list to come up with my final 15 surprises. (Last year I included five also ran surprises.)

I often speak to and get input from some of the wise men and women that I know in the investment and media businesses. I have always associated the moment of writing the final draft (in the weekend before publication) of my annual surprise list with a moment of lift, of joy and hopefully with the thought of unexpected investment rewards in the New Year.

This year is no different.

I set out as a primary objective for my surprise list to deliver a critical and variant view relative to consensus that can provide alpha or excess returns.  The publication of my annual surprise list is in recognition that economic and stock market histories have proven that (more often than generally thought) consensus expectations of critical economic and market variables may be off base.

History demonstrates that inflection points are relatively rare and that the crowds often outsmart the remnants. In recognition, investors, strategists, economists and money managers tend to operate and think in crowds. They are far more comfortable being a part of the herd rather than expressing – in their views and portfolio structure – a variant or extreme vision.

Confidence is the most abundant quality on Wall Street as, over time, stocks climb higher. Good markets mean happy investors and even happier investment professionals.

The factors stated above help to explain the crowded and benign consensus that every year begins with, whether measured either by economic, market or interest-rate forecasts.

But an outlier's studied view can be profitable and add alpha. Consider the course of interest rates and commodities in 2014, which differed dramatically from the consensus expectations.

To a large degree the business media perpetuates group-think. Consider the preponderance of bullish talk in the financial press. All too often the opinions of guests who failed to see the crippling 2007-09 drama are forgotten and some of the same (and previously wrong-footed) talking heads are paraded as seers in the media after continued market gains in recent years.

Memories are short (especially of a media kind). Nevertheless, if the criteria for appearances was accuracy there would have been few available guests in 2009-2010 qualified to appear on CNBC, Bloomberg and Fox News Business.

Indeed, the few bears remaining are now ridiculed openly by the business media in their limited appearances, reminding me of Mickey Mantle's quote, "You don't know how easy this game is until you enter the broadcasting booth."

Abba Eban, the Israeli foreign minister in the late 1960s and early 1970s once said that the consensus is what many people say in chorus, but do not believe as individuals.

GMO's James Moniter, in an excellent essay published several years ago, made note of the consistent weakness embodied in consensus forecasts.

As he put it:

"(E)conomists can't forecast for toffee ... They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else ... If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!"

Lessons Learned Over the Years

"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." – Woody Allen
There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:

1. How wrong conventional wisdom can consistently be.
    
2. That uncertainty will persist.
    
3. To expect the unexpected.
    
4. That the occurrence of black swan events are growing in frequency.
    
5. With rapidly-changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

"Let's face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well-known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins." – UBS (top 10 surprises for 2012)

Let's get back to what I mean to accomplish in creating my annual surprise list.

It is important to note that my surprises are not intended to be predictions, but rather events that have a reasonable chance of occurring despite being at odds with the consensus. I call these possible-improbable events. In sports, betting my surprises would be called an overlay, a term commonly used when the odds on a proposition are in favor of the bettor rather than the house.

The real purpose of this endeavor is a practical one – that is, to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs on small wagers/investments.

Since the mid-1990s, Wall Street research has deteriorated in quantity and quality (due to competition for human capital at hedge funds, brokerage industry consolidation and former New York Attorney General Eliot Spitzer-initiated reforms) and remains, more than ever, maintenance-oriented, conventional and group-think (or group-stink, as I prefer to call it). Mainstream and consensus expectations are just that and, in most cases, they are deeply embedded into today's stock prices.

It has been said that if life were predictable, it would cease to be life, so if I succeed in making you think (and possibly position) for outlier events, then my endeavor has been worthwhile.

Nothing is more obstinate than a fashionable consensus and my annual exercise recognizes that, over the course of time, conventional wisdom is often wrong.

As a society (and as investors), we are consistently bamboozled by appearance and consensus.

Too often, we are played as suckers, as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein's weapons of mass destruction, the heroic home run production of steroid laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank, Citigroup (C), the uninterrupted profit growth at Fannie Mae and Freddie Mac, housing's new paradigm (in the mid-2000s) of non-cyclical growth and ever rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff's investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.

My Surprises for 2014

These generally proved in line with my historic percentages.
"How'm I doin'?" –  Ed Koch, former New York City mayor

While over recent years many of my surprise lists have been eerily prescient (e.g. my 2011 surprise that the S&P 500 would end exactly flat was exactly correct), my 15 Surprises for 2014 had a success rate of about 40%, about in line with what I have achieved over the last 11 years.

As we entered 2014, most strategists expressed a constructive economic view of a self sustaining domestic recovery, held to an upbeat (though not wide-eyed) corporate profits picture and generally shared the view that the S&P 500 would rise by between 8-10%.

Those strategists proved to be correct on profit growth (but only because of several non operating factors and financial engineering), were too optimistic regarding domestic and global economic growth and recognized (unlike myself) that excessive liquidity provided by the world's central bankers would continue to lift valuations and promote attractive market gains in 2015. Not one major strategist foresaw the emerging deflationary conditions, the precipitous drop in the price of oil and the broad decline in domestic and non-U.S. interest rates.

Many readers of this annual column assume that my surprise list will have a bearish bent (to be sure that is the case for 2015). But I have not always expressed a negative outlook in my surprise list. Two years ago my 2012 surprise list had an out-of-consensus positive tone to it, but 2013's list was noticeably downbeat relative to the general expectations. I specifically called for a stock market top in early 2013, which couldn't have been further from last year's reality, as January proved to be the market's nadir. The S&P closed at its high on the last day of the year and exhibited its largest yearly advance since 1997. (I steadily increased my fair market value calculation throughout the year and, at last count, I concluded that the S&P 500's fair market value was about 1645.)

As I said, in 2014 my success rate was at about 40% (which included five also-ran predictions).
This contrasted with my 15 surprises for 2013, which had the poorest success rate since 2005's list (20%).
By comparison, my 2012 surprise list achieved about a 50% hit ratio, similar to my experience in 2011.

About 40% of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, 33% in 2006, 20% in 2005, 45% in 2004 and 33% came to pass in the first year of my surprises in 2003.

Below is a report card of my 15 surprises for 2014 (and the five also-ran  surprises).

Surprise No. 1: Slowing global economic growth. RIGHT

Surprise No. 2: Corporate profits disappoint. HALF RIGHT (as financial engineering buoyed EPS).

Surprise No. 3: Stock prices and P/E multiples decline. WRONG

Surprise No. 4: Bonds outperform stocks. Closed-end municipal bond funds are among the best asset classes, achieving a total return of +15%. VERY RIGHT

Surprise No. 5: A number of major surprises affect individual stocks and sectors. (Starbucks (SBUX) falls, 3D printing stocks halve in price, General Motors (GM) drops by 20% in 2014). MORE WRONG THAN RIGHT

Surprise No. 6: Volkswagen AG acquires Tesla Motors (TSLA). WRONG

Surprise No. 7: Twitter's (TWTR) shares fall by 70% as a disruptive competitor appears. MORE RIGHT THAN WRONG

Surprise No. 8:  Buffett names successor. WRONG

Surprise No. 9: Bitcoin becomes a roller coaster. RIGHT

Surprise No. 10: The Republican Party gains control of the Senate and maintains control of the House. Obama becomes a lame duck President incapable of launching policy initiatives. RIGHT

Surprise No. 11: Secretary Hillary Clinton bows out as a presidential candidate. WRONG

Surprise No. 12: Social unrest and riots appear in the U.S. RIGHT

Surprise No. 13: Africa becomes a new hotbed of turmoil and South Africa precipitates an emerging debt crisis. HALF RIGHT

Surprise No. 14: The next big thing? A marijuana IPO rises by more than 400% on its first day of trading. WRONG

Surprise No. 15: An escalation of friction between China and Japan hints at war-like behavior between the two countries. WRONG

Also-Ran Surprises: Crude oil trades under $75 a barrel (short crude and energy stocks) RIGHT, VIX trades under 10 (short VIX) RIGHT, gold trades under $1,000 (Short GLD) DIRECTIONALLY RIGHT.

What Was the Consensus for 2014 and What Is the Consensus for 2015?

"The only thing people are worried about is that no one is worried about anything ... That isn't a real worry." – Adam Parker, chief U.S. strategist at Morgan Stanley

"In ambiguous situations, it's a good bet that the crowd will generally stick together – and be wrong." – Doug Sherman and William Hendricks

As mentioned earlier, we entered 2014 there was a generally upbeat outlook for global economic and profit growth, as well as upbeat prospects for the U.S. stock market. Projections for bond yields were universally for higher yields throughout the year and the same could be said for the general expectation of rising oil prices.  As is typical, most sell-side projections for earnings, the economy, bond yields and stock prices were grouped in an extraordinarily tight range.

• Both U.S. and global economic growth disappointed the consensus (despite a strong third quarter 2014 U.S. GDP number).
   
• S&P earnings were a slight beat, but only because of more aggressive than anticipated share repurchase programs, lower depreciation and interest expenses and a decline in effective tax rates.
   
• Bond yields declined unexpectedly. The 10-year yield dropped to about 2.2% from 3.05%.
   
• Deflationary forces were also a surprise, most notably no one projected that oil prices would fall to under $60 s barrel and that the Bloomberg Commodity Index would hit a five-year low in December, 2014.
   
• Stock prices ended the year about 5% above beginning of the year consensus forecasts.

Virtually all strategists are now self-confident bulls, as gloom and doom forecasts have all but disappeared. After another year with no reactions of 10% or more, any future setbacks are being viewed by the consensus as bumps in the road and as opportunities to buy because (after the correction(s)) we will be up, up and away."

After missing the 25% rise in valuations in 2013 (and a further expansion in P/E ratios in 2014), the consensus now assumes that valuations will expand slightly again in 2015. (Note: The average P/E ratio has increased by about 2% per year over the last 25 years.)

The domestic economy has forward momentum (as witnessed by +5% Real GDP growth in 3Q 2014), so the extrapolation of heady growth is now in full force by the consensus.

In terms of the markets, the consensus remains of the view that liquidity (albeit, at a slowing rate) will overcome complacency and valuations again as it did last year, but my surprises incorporate the notion that the extremes that exist today (in price and bullish sentiment) put the markets in a different and less secure starting point in 2015.

"We expect the growth recovery to broaden as global growth picks up to 3.4% in 2015 from 3% in 2014. Inflation is likely to remain low, in part due to declines in commodity prices, and as a result monetary policy should remain easy. We think this backdrop supports a pro-risk asset allocation." – Goldman Sachs, Global Opportunity Asset Locator (December 2014)

As we enter 2015, investors and strategists are again grouped in a narrow consensus and expect a sweet spot of global economic corporate profit growth that will translate to higher stock prices.

The consensus is for U.S. economic growth of +2.5% to +3.25% real GDP, bond yields to be 50-75 basis points higher than year-end 2014 and closing 2015 stock market price targets to be up by about 8-10% (on average). Indeed, most strategists suggest (in sharp contrast to their views 12 months ago) that the big surprise for 2015 will be that there is upside to consensus economic growth and stock market price targets.
Here were Goldman Sach's views for 2014 made 12 months ago (with actual in parentheses). As can be seen, the brokerage's growth forecasts for the real economy (as was the entire sell side) were too optimistic, while price targets for the S&P were not ambitious enough:

• U.S. real GDP was estimated at +3.1% for 2014. ( +2.4%A)
   
• Global real GDP was estimated at+3.6% for 2014. (+3.0%A)
   
• S&P 500 EPS $116 top-down estimate and $119 bottom-up estimate for 2014 ($119/shareA)
   
• Year-end S&P 2014 S&P 500 price target was estimated for 2014 at 1900 (2080A)
   
• Inflation/headline CPI +1.5% for 2014. (+1.1%A)
   
• U.S 10-year Treasury yield 3.25% for year-end 2014. (2.20%A)

Again, let's use Goldman Sachs' principal 2015s views of expected economic growth, corporate profits, inflation, interest rates and stock market performance as a proxy for the consensus for the coming year. This year the brokerage, like most, is following the bullish trend and is more optimistic on the market relative to its uninspiring expectations last year.

• 2015/2016 U.S. real GDP +3.1%, +3.0%
   
• 2015/2016 global real GDP +3.6%, +3.9%
   
• 2015 S&P 500 operating per share profits $122/share
   
• Year-end 2015 S&P 500 price target 2100
   
• 2015/2016 Consumer Prices +1.0%, +2.4%
   
• 2015 closing yield on the U.S. 10 year Treasury note 3%

The Rationale Behind My Downbeat Surprises for 2015

There are numerous reasons for my downbeat theme this year. In no order of importance: corporate profit margins remain elevated, the rate of domestic economic growth is decelerating (despite five years of QE and ZIRP), a quarter of the world is experiencing minimum growth in GDP, optimism and complacency are elevated, signs of malinvestment are appearing, valuations (P/E ratios) rose again after a 25% expansion in 2013 (compared to only +2% annual growth since the late-1980s. As well, so many gauges of valuations are stretched (market cap/GDP, the Shiller P/E ratio and many others).

Above all, I expect the theme of the U.S. as an oasis of prosperity will be tested in 2015-16 as contagion might be a bi**h.

Moreover, given the large array of potentially adverse economic, geopolitical and other outcomes, the markets have grown complacent after a trebling in prices over the last five years.

Finally, my downbeat surprises this year recognize, that as we enter 2015, we should not lose sight of the notion that if pessimism is the friend of the rational buyer, optimism is the enemy of the rational buyer.

My 15 Surprises for 2015

At last, here are my 15 surprises for 2015 (with a strategy that might be employed in order for an investor to profit from the occurrence of these possible improbables).

Surprise No.1 – Faith in central bankers is tested (stocks sink and gold soars).

"Investment bubbles and high animal spirits do not materialize out of thin air.  They need extremely favorable economic fundamentals together with free and easy, cheap credit and they need it for at least two or three years. Importantly, they also need serial pleasant surprises in such critical variables as global GNP growth." – Jeremy Grantham

"The highly abnormal is becoming uncomfortably normal. Central banks and markets have been pushing benchmark sovereign yields to extraordinary lows – unimaginable just a few years back. Three-year government bond yields are well below zero in Germany, around zero in Japan and below 1 per cent in the United States. Moreover, estimates of term premia are pointing south again, with some evolving firmly in negative territory. And as all this is happening, global growth – in inflation-adjusted terms – is close to historical averages. There is something vaguely troubling when the unthinkable becomes routine." – Claudio Borio

European QE Backfires: The ECB initiates a sovereign QE in January 2015, but it is modest in scale (relative to expectations) as Germany won't permit a more aggressive strategy. Markets are disappointed with the small size of the ECB's initiative and European banks choose to hold their bonds instead of selling. ECB balance sheet still can't get to 3 trillion euros and the euro actually rallies sharply. Bottom line, QE fails to work (economic growth doesn't accelerate and inflationary expectations don't lift).

Draghi Is Exposed: Mario Draghi is exposed for what he really is: the big kid of which everyone is scared. For some time, no one wanted to fight him (or fade sovereign debt bonds, which would be contra to his policy). But, after the meek January QE, the response changes. He is now seen as the bully who never throws a punch and who always has gotten his way. But at the time of the January QE a medium sized kid (and a market participant) teases him and Draghi warns him again to stop it. The kid keeps teasing. Draghi the bully takes a swing, it turns out he can't fight and the medium-sized kid whips his butt. From then on, the big kid is feared no more. For some time Draghi has said he will do "whatever it takes," but he never really had to do anything. When he finally gets going and has to act rather than talk, he will expose himself as only a bully and as a weak big kid. Mario Draghi gets fed up with the Germans and returns to Italy (where he was governor of the Bank of Italy between 2006-2011) and becomes the country's president.

Shinzo Abe and Haruhiko Kuroda Resign: Kuroda, an advocate of looser monetary policy, stays on at the Bank of Japan (for most of the year), but the yen enters freefall to 140 vs. the dollar and wage growth lags badly. Japanese people have had enough and, by year end, Prime Minister Shinzo Abe and Haruhiko Kuroda are forced to resign.

The Fed Is Trapped: The Federal Reserve surprises the markets and hikes the federal funds rate in April 2015. A modest 25-basis-point rise in rates causes such global market turmoil that it is the only hike made all year. The Federal Reserve is now viewed by market participants as completely trapped, as an ah-ha-moment arrives in which there is limited policy flexibility to cope with a steepening downturn in the business cycle in late 2015/early 2016. Stated simply, the bull market in confidence in the Federal Reserve comes to an abrupt halt.

Malinvestment Becomes the It-Word in 2015: Steeped in denial of past mistakes and bathing in the buoyancy of liquidity and the elevation of stock prices in 2014, market participants come to the realization that the world's central bankers in general, and the Fed in particular, once again has taken us down an all too familiar and dangerous path that previously set the stage for The Great Decession of 2007-09. It becomes clear that the consequences of unprecedented monetary easing and the repression of interest rates has only invited unproductive investment and speculative carry trades. The impact of a lengthy period of depressed interest rates uncork malinvestment that has percolated and detonates among differing asset classes as the year progresses. Already seen in the deterioration and heightened volatility in commodities (the price of crude, copper, etc.), in widening spreads in the energy high yield (with yields up to 10% today, compared with only 5% a few months ago) and with the average yield on the SPDR Barclays High Yield Bond ETF (JNK) up to 7% (from a low of 5% earlier in 2014), the consequences of financial engineering (zero-interest-rate policy and quantitative easing) and lack of attention to burgeoning country debt loads and central bankers' balance sheets, in addition to inertia on the fiscal front result in rising volatility in the currency markets. Malinvestment in countries like Brazil (where consumer debt has risen by 8x and export accounts have quintupled over the last eight years on the strength of a peaking export boom, in oil and iron ore, so dependent on the China infrastructure story that has now ended) translate into a deepening economic crisis in Latin America and in other emerging markets.

Then, EU sovereign debt yields, suppressed so long by Draghi's jawboning, begin to rise. Slowly at first and then more rapidly, EU bond prices fall, putting intense pressure on the entire European banking system. (In his greatest score, George Soros makes $2.5 billion shorting German Bunds). The contagion spreads to other region's financial institutions. Shortly after, social media and high valuation stocks get routed and, ultimately, so does the world's stock markets.

As a result of the influences above, the VIX rises above 30. The price of gold soars to $1,800-$2000 and the precious metal is the best-performing asset class for all of 2015. Strategy: Buy GLD and VIX, Short SPY/QQQ and German Bunds

Surprise No. 2 – The U.S. stock market falters in 2015.

"In a theater, it happened that a fire started offstage. The clown came out to tell the audience. They thought it was a joke and applauded. He told them again and they became more hilarious. This is the way, I suppose, that the world will be destroyed – amid the universal hilarity of wits and wags who think it is all a joke." – Soren Kierkegaard.

Market High Seen in January, Low Seen in December (at Year End): The U.S. stock market experiences a 10%+ loss for the full year. (Note: Not one single strategist in Barron's Survey is calling for a lower stock market in 2015. Projected gains by the sell side are between +6-16%, with a median market gain forecast at +11%). The S&P Index makes its yearly high in the first quarter and closes 2015 at its yearly low as signs of a deepening global economic slowdown intensify in the June-December period.

While earnings expectations disappoint, the real source of the market decline in 2015 is a contraction in valuations (price-earnings multiples) after several years of robust gains. Investors begin to recognize that low interest rates, massive corporate buybacks, the suppression of wages, phony stock option accounting and other factors artificially goosed reported earnings and that earnings power and organic earnings are less than previously thought. So, 2015 is a year in which the relevant ways of measuring overvaluation (market cap/GDP currently at 1.25 vs. 0.70 mean) and the Shiller CAPE ratio (currently at 27x vs. 17x mean) become, well, relevant.

With few having the intestinal fortitude to maintain skepticism and short positions into the unrelenting bull market of 2013-14, there is none of the customary support of short sellers to cover positions and soften the market decline, when it occurs.

Stocks begin to drop in the first half, well before the real economy tapers, underscoring the notion (often forgotten) that the stock market is not the economy.

But by mid-year it becomes clear that U.S. economic growth is unable to thrive without the Fed's support.
Year-over-year profits for the S&P decline modestly in the second half of 2015. Domestic Real GDP growth falls to under +1.5% in the third and fourth quarters.

By year end the market begins to focus on The Recession of 2016-17, which looms ahead in the not so distant future. Strategy: Short SPY

Surprise No. 3 – The drop in oil prices fails to help the economy.

"In its November 14, 2014 Daily Observations ("The Implications of $75 Oil for the US Economy"), the highly respected hedge fund Bridgewater Associates, LP confirmed that lower oil prices will have a negative impact on the economy. After an initial transitory positive impact on GDP, Bridgewater explains that lower oil investment and production will lead to a drag on real growth of 0.5% of GDP. The firm noted that over the past few years, oil production and investment have been adding about 0.5% to nominal GDP growth but that if oil levels out at $75 per barrel, this would shift to something like -0.7% over the next year, creating a material hit to income growth of 1-1.5%." – Mike Lewitt, The Credit Strategist

Despite the near universal view that lower oil prices will benefit the economy, the reverse turns out to be the case in 2015 as the economy as a whole may not have more money – it might have less money.

Continued higher costs for food, rent, insurance, education, etc. eat up the benefit of lower oil prices. Some of the savings from lower oil is saved by the consumer who is frightened by slowing domestic growth, a slowdown in job creation and a deceleration in the rate of growth in wages and salaries.

And the unfavorable drain on oil related capital spending and lower employment levels serve to further drain the benefits of lower gasoline and heating oil prices.

In The Financial Times, recently, Martin Wolf wrote: "(A) $40 fall in the price of oil represents a shift of roughly $1.3 trillion (close to 2 per cent of world gross output) from producers to consumers annually. This is significant. Since, on balance, consumers are also more likely to spend quickly than producers, this should generate a modest boost to world demand."

But Wolf, and the many other observers, as Mike Lewitt again reminds us, "fail to explain how the $1.3 trillion that has been deducted from the global economy is able to shift from one group to another. "

Surprise No. 4: The mother of all flash crashes.

"America is the 'arch criminal' and 'unchangeable principal enemy' of North Korea." (Dec. 22, 2014)
"America is a 'toothless wolf' and 'the empire of devils."" (March 27, 2010)
"North Korean missiles will reduce Washington, D.C. to 'ashes.'" (August 19, 2014)
"America is a 'group of Satan' bent on destroying Korean religion." (April 22, 2013)
"American 'ideological and cultural poisoning' is undermining socialism around the world." (July 16, 2014)

– Selected quotes from North Korea's state-controlled media

Hackers attack the NYSE and Nasdaq computer apparatus and systems by introducing a flood of fictitious sell orders that result in a flash crash that dwarfs anything ever seen in history.

In the space of one hour the S&P Index falls by more than 5%.

The identity of the attacker goes unknown for several days and it turns out to be North Korea.  Strategy: Buy VIX, Short SPY/QQQ

Surprise No. 5: The great three-decade bull market in bonds is over in 2015.

"Take then thy bond thou thy pound of flesh..." – Portia, The Merchant of Venice
Last year not one strategist saw lower interest rates (though that was my No. 1 Surprise last year). This year, not one strategist expects a spike in interest rates.

In the first half of 2015, European yields and U.S. yields start to converge, in that European yields begin to jump to where the U.S. 10-year yield resides. The failure of Draghi's policy (see Surprise No. 1) will result in an acceleration in the European debt yields rising and in a decay in debt prices. That will mark the end of the great three-decade bond bull market in the U.S. and it will occur as global growth eases. Strategy: None

Surprise No.6 – China devalues its currency by more than 3% vs. the U.S. dollar.

"It's not like I'm anti-China. I just think it's ridiculous that we allow them to do what they're doing to this country, with the manipulation of the currency, that you write about and understand, and all of the other things that they do." – Donald Trump

For years, China has essentially pegged it's currency to the U.S. dollar. (liberalization meant that a narrow trading range is permitted). With the huge run in the U.S. Dollar, China's currency has appreciated compared with other Asian currencies. As a result, China has lost its manufacturing edge and its trade surplus has all but disappeared. Whether it's a permitted day-to-day weakening, changing the peg from the dollar to a basket of currencies or whether there is an overnight surprise devaluation, China's currency will weaken materially in 2015. Strategy: None

Surprise No. 7 – Apple (AAPL) becomes the first $1 trillion company.

"There's an old Wayne Gretzky quote that I love. 'I skate to where the puck is going to be, not where it has been.' And we've always tried to do that at Apple. Since the very, very beginning. And we always will." – Steve Jobs

Apple's next generation iPhone is seen to likely outsell its latest phone iteration as Re/Code uncovers (and reveals) some amazing and unique new features/applications that are planned for the next generation phone.
I don't know what features it will have or how it will improve design or performance. But I think there is now a near-consensus that it won't and that the next product upgrade cycle is a while away.

So, I predict Apple 2016 estimates rise significantly (to $10/share) and, despite a weak market backdrop, Apple becomes the first $1 trillion dollar market-cap company and the best-performing large-cap in 2015.
Apple becomes the only one-decision stock during the stock market swoon during the last half of 2015. It is a must own. Strategy: Buy APPL

Surprise No. 8 – Legislation is introduced that allows for repatriation for foreign cash.

"The only difference between death and taxes is that death doesn't get worse every time Congress meets." – Will Rogers
As signs of domestic economic growth fade in the second half of 2015, Congress and the Administration agree on a broad program to repatriate foreign cash at a low tax rate.
The deal briefly rallies the U.S. stock market, but equities soon succumb to a slowing domestic economy and diminishing corporate profit growth.   Strategy: None

Surprise No. 9 – Energy goes from the worst-performing group in 2014 to the best-performing group in the first half of 2015 and then falls back later in the year.

"Oil vey!" – Kass Daily Diary term
Energy stocks are on a roller coaster in 2015.

As the price of crude oil rises steadily (towards $65 a barrel) in early 2015, the energy sector (which was among the worst in 2014) becomes the best market group in the first half of the year. Slowing global economic growth during the last half of the year leads to profit-taking in the energy sector as the price of crude oil closes the year at under $50 and at its lowest price in 2015.

In a surprise move, the president signs approval for the Keystone Pipeline in the second half of the year.
Strategy: Buy oil stocks in first six months of the year, sell/short mid-year.

Surprise No. 10 – More chaos in the Democratic Party.

"Mothers all want their sons to grow up to be president, but they don't want them to become politicians in the process." – John F. Kennedy

Sen. Elizabeth Warren pushes Secretary Hillary Clinton so far to the left that she loses independent voters, though she easily gains the Democratic nomination for president.  Former President George H.W. Bush passes away during the first half of the year and Governor Jeb Bush immediately declares his candidacy. By the end of 2015, Jeb Bush is well ahead in the polls and is a big favorite to win the presidency in 2016.
Strategy: None

Surprise No. 11 – Food inflation accelerates after Russia halts wheat exports.

"As life's pleasures go, food is second only to sex. Except for salami and eggs. Now that's better than sex, but only if the salami is thickly sliced." – Alan King

Russian turmoil continues and Putin decides to halt exports of wheat again to keep as much homeland as possible, resulting in a price spike in wheat, but also corn and soybeans. This price rise, on top of U.S. food inflation that is already running higher, offsets the consumer benefit of still-relatively-low gasoline and heating oil prices. Strategy: None

Surprise No. 12 – Home prices fall in the second half of 2015.

"I told my mother-in-law that my house was her house and she said, 'Get the hell off my property.'" – Joan Rivers

Under the weight of reduced home affordability, still low household formation gains and continued pressure on real incomes, home prices fall in 2015. Builders lose pricing power. Strategy: Short homebuilders.

Surprise No. 13 – Individual and sector market surprises.

"Those who are easily shocked should be shocked more often." – Mae West

• Bank Stocks Fall – Though bank stocks have been recent market leaders, the weight of a flattening yield curve, still-tepid loan demand and an implosion in the European banking system make the sector among the worst market performers. Moreover, a major cyber attack against Bank of America (BAC) that actually destroys a percentage of customer records further diminishes enthusiasm for the group.
   
• Twitter Feeding – Carl Icahn, calling it his "new Netflix," discloses a 9.9% position in Twitter. This stimulates a bidding war between Google (GOOGL) and Facebook (FB) to acquire the company. Google wins the battle and pays $60 a share for Twitter.
   
• Volatility Rising – The VIX rises to over 30 in the second half of the year.
   
• Google Institutes a Share Buyback and Shaves Capital Spending – After a lackluster performance in 2014, Google's management reverses course on its previously outsized capital spending program on non-core businesses and becomes more shareholder friendly. The company dials back spending and institutes a stock buyback program.
   
• Corporate Inefficiency in Large-Cap Technology Targets Activist Investors –- Two hedge funds establish a filing position in Cisco (CSCO) and force Chairman John Chambers out. The new CEO announces a large special dividend and a massive stock buyback and a cutback to the employees' too-generous stock option plan. More than 10% of the workforce is laid off and Cisco's shares soar. Several other tech companies are targeted.

Strategy: Long AAPL TWTR, CSCO, VIX, GOOGL and short banks


Surprise No. 14 – Berkshire Hathaway (BRK.A) makes its largest acquisition in history.
"When I was 15 years old, I read an articls about Ivan Boesky, the well-known takeover trader – turned out years later it was all on inside information! But before that came to light, he was very successful, very flamboyant. And I thought, 'This is what I want to do.' So I'm 15 years old, I decide I'm going to Wall Street." –  Karen Finerman

During the depths of the market's swoon in the later part of the year, Warren Buffett scoops up his largest acquisition ever. The $55+ billion acquisition is not in his customary comfort zone (a consumer goods company), but rather the deal is for a company in the energy, retail or construction/equipment areas. Strategy: None

Surprise No. 15 – A derivative blowup precipitates an abrupt market drop.

"I view derivatives as time bombs, both for the parties that deal in them and the economic system." – Warren Buffett

The $300 trillion holdings of derivatives by the U.S. banking industry has been all but forgotten. The four largest U.S. banks account for $240 trillion of that total, dwarfing their combined $750 billion in statutory capital! This sort of exposure in which notional derivatives are more than 300x the banks' net worth, is, as my friend The Credit Strategist's Mike Lewitt has written, "would be laughable if the consequences of a financial accident were not so potentially catastrophic."

To make matters worse, the passage of the $1.1 trillion spending bill passed this month (written by lobbyists and voted on by bought-and-paid-for legislators who probably neither read nor understood the complex spending bill) has kept taxpayers on the hook –through the FDIC – for those derivatives (what Warren Buffett previously called "financial weapons of mass destruction.")

On any measure, the sheer size of these derivative portfolios pose potential risk to the world's financial stability. What we have learned from the past cycle is how opaque the exposure really is and how stupid and avaricious our bankers really are when allowed to venture into territories of leverage.

Whether it is energy derivatives or some other asset class, a derivative blowup in 2015 will serve to preserve the wise words of Benjamin Disraeli (who served twice as Great Britain's Prime Minister) that "what we have learned from history is that we haven't learned from history." It will also harm our markets, once again. Strategy: Short SPY

10 Also-Ran Suprises for 2015

By DOUG KASS
Dec. 26, 2014 | 7:32 AM EST
Stock quotes in this article: BABA, SHLD, IBM, BRK.A, MONIF

• On Monday I will deliver my 15 Surprises for 2015.  I think it is my most interesting list in years.

Here are my 10 also-ran Surprises for 2015 that I had considered but didn't make the top 15.

1. China's Real GDP growth falls below 5% in 2015 as economic growth decelerates markedly in the second half of the year.
    
2. An accounting "discrepancy" is found at Alibaba (BABA). The shares plummet and the hedge fund community feels the pain.
    
3. Under pressure from suppliers and a falling stock price, Ron Johnson is installed as CEO ofSears Holdings (SHLD).
    
4. George Soros makes $2.5 billion by shorting German Bunds.
    
5. The price of crude oil drops below $40 a barrel in the second half of 2015.
    
6. The consumer price index turns negative (year over year).
    
7. IBM (IBM) whiffs and the share price drops below $125 a share. Berkshire Hathaway(BRK.A) suffers a near-$4 billion loss (on paper). At Buffett's suggestion, senior management is replaced.
    
8. Warren Buffett announces his successor.
    
9. Uber goes public at a $50 billion capitalization. The share price never exceeds the IPO price in 2015.
    
10. Monitise's (MONIF) subscription adds far outpace expectations this year. (The shares double in price).
11. 
    

Letter to My Nephews

By Jonathan Tepper
December 29, 2014 in Uncategorized

You can learn a lot from books, but many things can only be learned the hard way by living, suffering and enjoying life. A year and a half ago, I was in a plane with very bad turbulence, and I worried that if the plane went down, many of the lessons I’ve learned in life would end up at the bottom of the ocean.  I wrote a letter to my nephews for them to read when they were older.  I hope they’ll find it useful.
—————–
Dear nephews,
I’m writing this on a plane. The reason I started writing this was that I feared the plane might go down, and if it went down, all the lessons I’ve learned in life would disappear with me. By writing this, I hope to pass on the few lessons I’ve learned.

The most important lesson is that the vast majority of things you worry about will not bother you the next day. A year later you will not even be able to remember them if you try. When you grow older, you will not worry about what grades you got. You won’t worry about games you lost.   You won’t worry about what other people thought about you. Most of the things you worry about will never happen. Even if the worst things that you worry about happen, life will still go on. Learn to enjoy every day, and try to enjoy it as if it is your last. It has taken me a long time to understand this, and I wish I had understood it sooner.

Happiness is not a destination but a journey. You will never be smart enough, rich enough, have a pretty enough girlfriend, boyfriend, husband or wife, or win enough prizes and awards. Whatever it is you want, there is always something better. Enjoy the journey of learning, working, and living. If you enjoy the journey, you’ll probably achieve a lot more than if you focused on goals.

Money can provide security, but once you have security, more money cannot buy you more happiness. If you show me someone who thinks money can buy happiness, I’ll show you someone who has never had a lot of money.

Things don’t make you happy, but memories will always stay with you. Whatever it is that you buy, you will soon get used to it. It will make you happy for a short while, but it will not make you happy forever.

Experiences and memories can make you happy forever. I can’t even remember most of the toys I’ve had in my life, but I still think of my times with Timothy and your Grandmom with great happiness and fondness. I remember walking Timothy to school and how happy we were. I remember hugging your Gradmom when I came home for a weekend. Those memories will never go away. The happiest memories of my friends are my travels and dinners with them, not the things I’ve bought for myself. You’ll remember dinners and travels with friends and family more than any shiny things you’ll ever have.

Your family is the most important thing you have in life. Friends, boyfriends, girlfriends and co-workers come and go, but the only thing that you can always count on is your family. (If you find a friend who is always there for you, you’re extremely lucky. They exist, but they’re very rare.) One day, you will have your own family. You must love them and look after them. You will understand one day that just as your grandparents die, your parents will as well. Strive to be a good son and daughter. One day, you will be like your parents. Your parents are not perfect, and you will not be either. But you can be loving and be a good son and daughter. One day you can be a good parent.

Never stop learning, and always be ready to teach yourself things you don’t know. The only things you will remember are things you care about. You will forget about all the rest. You must teach yourself and care about what you learn. No one can teach you everything you need to know at school or university. You will also forget most of what you study, and that is fine. As Jacques Barzun said, “Civilization is all that remains after you have forgot all that you specifically set out to remember.”

Never live someone else’s life. Find your gifts and the things that give you pleasure, develop those gifts, and pursue them.   Do what makes you happy and be great at it. You have skills and gifts that no one will ever have or see again. If you’re a businessman, build businesses. If you’re a writer, write. If you’re a scientist, discover. If you do what you love and love what you do, you will work very hard, but you will enjoy every day.

One of the things that most influenced me was something Steve Jobs once said:

When you grow up, you tend to get told that the world is the way it is and your life is just to live your life inside the world, try not to bash into the walls too much, try to have a nice family life, have fun, save a little money.

That’s a very limited life. Life can be much broader once you discover one simple fact, and that is that everything around you that you call life was made up by people that were no smarter than you. And you can change it, you can influence it, you can build your own things that other people can use. Once you learn that, you’ll never be the same again.

And the minute that you understand that you can poke life and actually something will, you know if you push in, something will pop out the other side, that you can change it, you can mold it. That’s maybe the most important thing. It’s to shake off this erroneous notion that life is there and you’re just going live in it, versus embrace it, change it, improve it, make your mark upon it.

I think that’s very important and however you learn that, once you learn it, you’ll want to change life and make it better, cause it’s kind of messed up, in a lot of ways. Once you learn that, you’ll never be the same again.

I hope that you will find what you love and you will change the world.

Life is full of struggle, and many bad things will happen to you. This is one thing that I can guarantee you. Most of my friends died of AIDS, and your uncle Timothy died in a car accident and your Grandmother committed suicide after suffering from a very bad brain tumor. These things happened and cannot be changed. Many people suffer great tragedies and live full and happy lives. Remember the people you love and mourn them. Accept that terrible things happen, and try to live as if each day is your last with those you love. There is nothing else you can do.

The best way to avoid anxiety, stress and unhappiness is to avoid internal contradiction. Don’t think that one thing is right and do the opposite. Listen to your conscience and obey it. Be a good person and live according to your convictions. You cannot answer for other people, but you can always answer for yourself.

As long as you live according to your most basic beliefs, you will not have regrets or guilt. You will be able to die happily knowing that you looked after the poor and needy, that you were loving to those around you, and that you failed often but did your best. You will not lose a night of sleep if you always try to do your best. I love you very much.
Much love,
Uncle Jonathan

Like Outside the Box?

Sign up today and get each new issue delivered free to your inbox.

It's your opportunity to get the news John Mauldin thinks matters most to your finances.

The article Outside the Box: 15 Surprises for 2015 was originally published at mauldineconomics.com.

Get our latest FREE eBook "Understanding Options"....Just Click Here!

Floating Rate Funds Poised to Profit as Interest Rates Rise

By Andrey Dashkov

Money can’t be this cheap forever. In other words, one of the most likely scenarios the U.S. economy faces is rising interest rates. The current low interest rate climate is simply unsustainable. At some point—as it always does—the trend will turn around. We want to be prepared for that turn, and the right floating-rate fund can help.

A floating rate loan is a bank loan with interest that’s tied to some benchmark rate, often the London Interbank Offer Rate (LIBOR). When the LIBOR changes, so does the loan’s coupon. The rate is adjusted every 30 - 90 days. Floating rate funds are pools of capital that invest in these loans, earn variable-rate interest, and pay dividends that are themselves flexible.

Variable Dividends Boost Immunity

Variable dividends are the key feature of floating rate funds. They’re what separate floating rate funds from the rest of the debt market. Flexible dividends make shares of the bond funds immune to rising interest rates; the prices of the bonds and the fund’s shares don’t get punished when rates go up. What the investor sees is higher dividends; his principal is safe.

A note of caution is in order here: Even though floating rate bonds don’t have the same inverse price-yield relationship as fixed rate debt instruments, their prices can still go down. Although the automatic coupon adjustments mostly eliminate the first major risk of any debt instrument—interest-rate risk—floating-rate funds still hold the other major risk: credit risk. As a reminder, credit risk is the risk that the borrower won’t make payments on time or will default on the debt entirely.

The credit risk of floating rate loans is high because the companies that borrow under these conditions are usually rated below investment grade. They can’t go to capital markets for money because fixed rate loans would be too expensive, so they turn to banks that provide funds on floating rate terms.

Since the companies borrowing these funds are below investment grade, their default rates are close to those of speculative grade bonds. Vanguard Research reports that the average annual default rate from 1996 to 2012 for speculative grade bonds was 4.5%; for senior floating-rate loans, it was 3.4%. Better, but still much higher than investment-grade bonds at 0.1%.

High Post - Default Recovery Rates

Does this mean that you should avoid floating rate loans in favor of AAA-rated debt? No. First, floating-rate loans are high in a companies’ debt structure, which means that if the borrower defaults, investors holding floating rate debt have a priority claim on the company’s assets. This leads to very high recovery rates for senior floating rate loans in the event of default: 71.1%, or more than 70 cents on the dollar. Compare that to the next class of loans, senior secured, which are recovered at a rate of 56.8%.

Second, floating rate loans outperform both high yield loans and the aggregate U.S. bond market. According to Vanguard, during the last three rising rate periods (January 1994-February 1995, June 1999-May 2000, and June 2004-June 2006) floating rate bonds outperformed high yield instruments by 2.5 percentage points (pp) and the aggregate bond market by 4.3 pp.

After the rising rate periods end, however, floating rate funds tend to underperform both high yield instruments and the overall bond market. This is why we’re buying them now, when rates have nowhere to go but up. We don’t know when that will happen, but when it does, we want to be positioned to profit.
In addition to their excellent performance in rising interest rate periods, floating rate funds are good for diversification. Their correlation with the overall US bond market is close to zero, which makes them especially good for a portfolio focused on fixed-rate US bonds. However, they also belong in our retirement portfolio—the Money Forever portfolio—where we use them to diversify our allocation across various debt instruments and to make sure we are well positioned to profit from rising interest rates.

Entrée into the World of Big Money

To sum it up, floating rate funds provide a way to diversify into an investment class that is almost immune to rising interest rates. Like business development companies, floating rate funds offer retail investors entrée into an area of finance usually reserved for big money and institutions. In exchange for these opportunities, investors accept credit risk due to the low credit ratings of the borrowing companies. With that in mind, we pay close attention to the sectors of the funds we consider investing in, and prefer more defensive and crisis-resistant industries.

At Miller’s Money we closely monitor the bond market, constantly scouting out the best options for seniors and savers. Learn more need to know information about bonds and the role they play in today’s low-interest rate environment by downloading our free special report, Bond Basics today.

The article Floating-Rate Funds Poised to Profit as Interest Rates Rise was originally published at Millers Money

Make sure to check out our "Beginners Guide to Trading Options"....Just Click Here!

What Chimpanzees Can Teach Us about Convertible Bonds

By Dennis Miller

In a renewed commitment to finally learn Spanish, one of my colleagues spent quite a bit of time this week awkwardly saying, “Qué es eso?” into the headset Rosetta Stone provides with its language learning programs. Translation: “What’s that?”

Here in the US, the 10,000 or so people reaching retirement age each day often find themselves asking the same question—though maybe not out loud—when advisors use terms of art or casually mention sophisticated investment options. What’s that? Most of these folks didn’t earn their living in the financial services sector, so they don’t speak the language—nor should they feel embarrassed about it.

That said, no one—particularly risk-adverse retirees—should ever invest in something they don’t understand. So let me add one more type of investment to your “I know about that” toolbox: convertible bonds. Despite their obscurity, they’re not the least bit complicated.
Put simply, convertible bonds:

• have, as a rule of thumb, two-thirds of the upside of common stock and one-third of the downside; and
• can be an excellent way to diversify your portfolio.

Convertible bonds are bonds an investor (let’s say it’s you) can convert into common stock of the issuing company under certain circumstances. Imagine, for example, that Rosetta Stone wants to finance a new project—maybe it’s doing R&D on how to teach humans to speak the language of chimpanzees (hey, this is purely hypothetical). So Rosetta Stone (RST), which has a current stock price of about $8.80, issues a convertible bond and sets the conversion rate so that it’s not profitable to convert your bonds unless the stock price rises, say to $11.

Then more people start to feel a burning need to learn Spanish—or Mandarin, or Farsi—and RST’s price passes $11. At that point, you can convert your bonds into shares of RST worth more than the stream of payments from the bond alone. You own bonds with upside potential.

If RST’s price goes up, the value of your convertible bond goes with it. If it goes down, the discounted stream of underlying cash flows (the bonds’ coupon payments plus return of the principal at maturity) act as a price floor.

Now imagine that speaking multiple languages goes out of vogue, and instead of rising past $11.00, RST drops to $4.00. You’ll still receive interest and principal—meaning your convertible bonds can’t be worth less than those payments.

Of course, there’s always the threat of default. Say Rosetta Stone goes bankrupt for one reason or another (maybe it overspent on the chimp project, and it failed). The silver lining is that you’ll have a better chance of getting some money back than if you owned common stock.

What You Trade for the Option to Convert

As with any investment, there are trade offs: convertible bonds have slightly lower yields. The company pays a lower interest rate, and in exchange you have the option to convert your bonds. Also, convertible bonds often fall into the high yield/junk-bond category.

What’s more, it’s often only feasible for individuals to invest in convertible bonds through convertible bond funds. And you know what that means: fees. With an average expense ratio of 1.25%, fund managers have to get past that hurdle before they can start making you money.

With that, why would anyone want to buy a convertible bond fund? In a word, diversification. We hold one convertible bond fund in our retirement-specific portfolio for downside protection and the diversification it provides. With a gross expense ratio of 0.4% and one-third of its holdings in investment-grade bonds, this particular fund avoids the major pitfalls of most convertible bond funds.

Less common investments are worth knowing about, but understanding them doesn’t mean you should jump in whole hog—particularly when you’re investing your retirement nest egg. And that’s our focus at Miller’s Money: plain-English financial education and smart retirement investing. Read our free weekly e-letter, Miller’s Money Weekly every Thursday by signing up here.

The article What Chimpanzees Can Teach Us about Convertible Bonds was originally published at millers money

Catch Thursday evenings webinar "Beating the Market Makers Trading Weekly Options"....Just Click Here!