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2007: My Predictions

January 18, 2007
Stephen Martin

Stephen Martin

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It is that time of the year again when investment strategists pull out their crystal ball to gaze into the future. I am no different, despite the risks inherent in trying to predict the future. First of all, I would like to look at my performance over the past year and analyze where I went wrong and what I got right.

In 2006, I developed a theme called the Four Horsemen of The Capital Markets. Pretty dramatic title which I needed to grab readers attention. The purpose behind my theme was a desire to highlight some major risks that I saw which at the time were largely ignored by the markets. I tend to follow a top-down approach in my investment analysis as I believe if one can get the big picture right then the rest can follow. I felt that the market had become complacent and was ignoring dark clouds on the horizon. The four risks, as represented by horsemen, were War, Plague, Nationalism and Deflation. I will briefly outline where we are with respect to each of those risks.

With regards War, it is the rising geopolitical tensions that continue unabated that raise the risk of a major multi-national confrontation. I have outlined my logic on this risk in previous articles. Basically, there is an immediate risk in a wider confrontation in the Middle-East and a global arms race representing a longer term risk. In some of my articles I predicted that a confrontation between U.S.A./Israel and Iran was likely sometime between the fourth quarter of 2006 and the first quarter of 2007. I made this prediction in early 2006 and at that time it looked like a wiild prediction. While 2006 has passed without a direct conflict I believe that we are moving closer to that eventuality. I may be wrong with regards the timing but I will emphasise that this risk is greater now than it was at this time last year. Therefore, the probability of a wider Middle-East conflict has increased going into 2007. The capital markets may be pricing in some of this risk but clearly not to a great extent. If this risk was being priced in I would expect both oil and gold prices to be higher. In fact, the recent sell-off in oil prices is as I predicted. In 2006, I predicted oil will test $50 /bl. I now believe there is a great buying opportunity in oil and its related investments. Oil price declines are demand driven (as predicted) but an escalation in Middle-East tensions and a conflict involving Iran will create a supply shock as well as speculative activity. Currently, we are witnessing a cyclical downturn in energy prices within a long-term secular uptrend. Oil cannot stay below $50 for long as the cost of production has risen enough to force shut-downs below this level as many companies would find it uneconomical to produce and certainly exploration/exploitation activities would be curtailed. If global economic growth continues without a serious disruption and there is a Middle-East conflict then oil will bounce back very strongly indeed. Either way, whether you are a short-term player or a longer-term player it is time to begin adding oil to your portfolio. Another beneficiary of rising geopolitical tensions are defence stocks. Stocks like Ultra-Electronics, Cobham, Lockheed Martin, Raytheon should continue to perform well in this environment.

Plague, in the form of bird flu, does not appear to be the threat it was predicted to be. It is virtually impossible to gauge the probability of a pandemic but nevertheless it is out there and most experts agree it is only a matter of time before another global pandemic hits. I believe this would have a devasting economic impact and while it does not get much of a mention, investors would be wise to be aware of the implications should a pandemic reveal itself. Either way, largecap pharma is still a favorite for me. Pfizer, Roche, Novartis should be considered in portfolios. Largecap pharma has had a few tough years but it looks like the clouds might be clearing. Stronger pipelines, demographics, politics and rotation to largecap/defensive stocks should continue to support these stocks.

Nationalism, and its companion in crime ... protectionism, continue to grow and this counter-trend to globalization is the biggest threat to capital markets. 2007 will likely be a year of transition and perhaps an inflection point in history. Much will depend on whether laissez-faire economics prevail or whether socio-political trends swing policy decisions back to a darker era. Investors may be wise to consider a world where globalization is in retreat and prepare themselves accordingly. Given the size of global financial imbalances it is not unreasonable to suggest a period of turmoil as both market and political forces attempt to rectify these imbalances.

I wrote much about the forces of defaltion and inflation last year. As long as central banks remain focused on fighting inflation then deflation remains the biggest risk. Generally speaking, the developed world has seen inflation in asset prices, commodities and services but deflation in goods. Much of this is due to globalization. China, in particular has bid up the price of commodities which it converts to goods which it then sells to the developed world at low prices. A slowdown in China reduces commodity inflation but will likely contribute further to goods deflation due to excess capacity and inventory liquidation. There is still no significant wage-cost spiral developing and this is necessary to create an inflationary spiral in the developed world. China is in a long-term economic expansion but this does not mean it will not experience cyclical downturns within this upward trend. In my opinion, the risk is growing that China may be heading for one of those cyclical downturns. The evidence may be in the massive drop in commodity prices as well as the attempt to rectify global financial imbalances mentioned earlier.

So, finally, I arrive at my predictions for 2007:

- Energy prices will continue to be volatile in 2007 as demand erosion competes with supply shocks. I would be a buyer of oil below $50. I still like Natural Gas but this commodity is even more volatile. Longer-term, supply/demand factors favor investments in energy and combined with global warming issues, growth investors should continue to build a basket of alternative energy investments. I still prefer solar and my favorite is SolarWorld (quoted in Germany).

- A wider Middle-East conflict involving Iran seems likely and this has positive implications for Gold, Oil and defence stocks. Either way, a global arms race is underway and this is a long-term phenomena. I would not be surprised to see measures of market volatility increase dramatically this year. We have had a long period of relatively low volatility and this has bred complacency. Therefore, the stock market will suffer some dramatic set-backs and there could be more flight-to-quality scares this year.

- I actually think U.S. taxes are heading higher. The U.S. needs to fund its war on terror, participate in the global arms race, balance its budget, improve the trade balance and rein in the consumer. Monetary policy is a blunt tool and may be ineffective under the current circumstances. I don't know how and when but I bet taxes are heading higher.

- I am still not convinced by the soft-landing or goldilocks scenario. More than likely we have passed through the eye of the storm that started in May 2006. This may have been perceived as a 1995 type soft-landing but that perception is likely to change as 2007 unfolds. I would not be surprised if the U.S. were to enter a recession in 2007.

- The U.S.$ is still in a bear market and we will see further sell-offs this year. A consumer led slowdown that begins to reduce the trade deficit and a flight-to-quality from a geopolitical or financial crisis might renew support for the U.S.$.

- Largecap, defensive, dividend-paying stocks should do well initially. I would avoid most cyclicals early in 2007 and a buying opportunity may develop in the second half. True growth stocks should do well.

- This year will be the test as to whether globalization continues or if the counter-trend of protectionism becomes the leading trend. It is too early to tell but the implications for capital market activity are significant. In the past year, nationalism and protectionism have reared their ugly head and this counter-trend is growing. I am not optimistic that protectionism and nationalism will reverse trend. I hope I am wrong because if globalization was good for capital market activity the opposite is also true.

I will continue to update my views as the year progresses. Best of luck investing in 2007.

About the author:

Stephen Martin
Stephen L. Martin has published articles, studies and research on investments over 20 years and has appeared on national television and radio. He currently works for Fairfax I.S., a private U.K. based investment bank. The views expressed are his own and are not representative of his employer.

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