2011: What to Watch

Year’s end is neither an end nor a beginning but a going on, with all the wisdom that experience can instill in us.

~ Hal Borland

2011 Investment Themes

Objectively, there’s nothing magical about the beginning of a New Year. Midnight on January 1st is just another minute. But it does serve as a reminder to us that time marches on and that it’s a good idea to look at where we’ve been and where we might be going. We’ve been doing that this week, and we finish off today by zooming in on some more specific themes that will continue to evolve in 2011. Many of these themes will serve as hinges for the markets and the economy: a swing in one direction is bullish, while a move the other way would be bearish. (You might want to read Part I of this analysis as well: 2011 What Ifs: Overview.)


It would be difficult to talk about the future of the global economy – next year, or for many years to come – without beginning with China. When China recently announced that it would be buying Spanish debt, the Euro rallied. Although their recent interest rate boost didn’t move the markets much, that could have been because they chose to do it on Christmas Day. Still, China can’t save all of its big news for holidays where no one is paying attention, so I’m sure each of its moves will continue to be dissected by market participants in 2011.

David Rosenberg believes that China is overheating, but lots of other analysts are confident that China can engineer a soft landing. If they can manage to cool their economy without sending it into a tailspin while simultaneously supporting the debt-laden countries of the world, that would be very bullish. If, however, there are any glitches on either front, such as runaway inflation, civil unrest, a real estate collapse, or an unstoppable debt crisis, things could turn ugly very quickly.

I covered the bull and bear cases on China late last year, wondering in the end whether China is different. After all of that research, I’m still not sure exactly how this will play out. Many believe China could see a correction in the near term, but that its long-term growth prospects are undeniable. I suppose that sums up my basic view as well as any.


The debt issues from last year are still with us. In fact, they’ve gotten worse. More and more countries in Europe have very high levels of debt and the fiscal problems throughout the globe have only deteriorated thanks to repeated bank bailouts and continued spending. Société Générale had an interesting graphic on global leverage that showed the U.S. and U.K. in very precarious positions.

The bifurcation we discussed on Wednesday is very apparent on the debt front, both at the sovereign and personal level. Surplus countries and their citizens tend to be saddled with less debt and the personal savings rate for those countries is generally higher. On the other hand, countries with high deficits tend to have a high (and increasing) amount of debt and lower savings rates. (Japan may be an exception, with personal savings rates that remain quite high even as public debt balloons.) Even Canada, which weathered the recent economic storm comparatively well, has seen its central bank chief repeatedly warn citizens to reduce their very high personal debt levels in preparation for higher interest rates.

Again, these problems were with us throughout 2010. They did cause some tremors in the market, but were largely ignored in the end. The hope is that the stimulative efforts of governments will eventually take hold and allow for self-sustaining economic growth. If that happens, we may be able to buy the time we need to restructure the mountains of debt out there. If it doesn’t happen in time, the debt restructuring will still take place, but it could turn quite disorderly.

Currency Wars

One of the effects of high sovereign debt levels is that the affected countries would like to devalue their currencies in order to reduce the value of their debts. The problem is that everyone can’t do it at once without creating tremendous instability in the global financial markets. Niels Jensen cited this type of “beggar thy neighbour” mindset as one of his dirty dozen risk factors for 2011.

In 2010, we saw glimpses of trade protectionism and currency jawboning around the globe. So far, it hasn’t caused much more than a lot of water cooler “what if” discussions. But if market participants start to feel like the jawboning is going to convert to real actions, we could be in for a bumpy ride.


Bonds rose through the middle of 2010, but experienced quite a sell-off in the last quarter of the year. That had market participants scratching their heads, since QE was supposed to keep rates low. The size and swiftness of the move sparked a great debate about the prospect of a bond bubble. Some argued that the rise in yields reflected an improving economy while others warned that the bond vigilantes had finally decided to draw a line in the sand, punishing countries with poor fiscal practices.

So far, the fall in bond prices has been positive for equities, but many worry that it reflects some unsustainable economic trends and could turn disorderly in a hurry. Jonathan Wellum had this to say in an interview posted at Investing Thesis in November:

There is no way we can expect to maintain interest rates at the current levels throughout North America. Eventually, interest rates will reflect the underlying risks in our economy which have never been higher, post World War II. The super low rates we are experiencing now are an artificial construct forced on us by the central banks. This artificiality is leading to another bubble, a debt bubble that when it breaks will shake the foundation of our global economy.

There’s one factor that may come out of left field in 2011 to touch off a debt crisis. Ironically, economic improvement could serve as the trigger that sends bond yields above their tipping point, setting off an avalanche on the mountain of global debt. Even a relatively small, but sustained increase in interest rates could seriously hamper the ability of sovereigns and consumers to service their debt obligations.

Housing and Municipal Bonds

The U.S. housing market continues to be plagued by declining prices and increasing scandals. It has yet to show any signs of recovery, and may even be in the process of a fresh dip. It will likely be important to watch how the fraudclosure drama plays out in the United States, as some think investors are underestimating the severity of the housing problem. So far, the authorities are more interested in insider trading rings than bank fraud, but that could change with some timely reporting and the public outrage that would likely ensue.

The housing markets in Canada and Australia did not suffer throughout the recession, but Mike Shedlock thinks they are bubbles that could burst in 2011. He also thinks we could see China overheat and some municipal bankruptcies in the United States. Municipal bonds, normally a safe and sleepy asset class, have made it onto a lot of “What to Watch in 2011” lists.


I’ll be brief on commodities as I’m running out of room and what happens with commodities will depend on many of the factors mentioned above. It’s worth noting that, while many bullish analysts think energy and agricultural commodities will continue to rise in 2011, a lot of the same experts are somewhat bearish on gold. Doug Kass predicted a significant pullback in gold for the coming year in his 15 Surprises for 2011. Still, the $250 correction he’s calling for would leave gold at levels that many said would never be attained only a few years ago.

Final Thoughts and a Dark Horse

I would just add one final thing to keep your eye on. We have been putting off major restructuring in pension plans globally for many years now. Demographics mean that we will have fewer people paying into pension plans than collecting on them. A lot of pension plans are already underfunded. Further, many of these plans depend on models that include annual returns in the neighbourhood of 7%. We all know that has not been a reality for many years now.

If the markets have another accident, the math looks even worse. Either way, many are not saving enough for retirement and that will have consequences at some point. This is yet another financial can that we can’t afford to kick down the road any longer. So that’s my dark horse. It may not be a factor in 2011, but it should be on the agenda for all of us.

Trying to predict the future can be fun, like the childhood fortune telling game in the photo above. Unfortunately, it’s usually not any more accurate than the silly phrases your friend wrote on those paper sections. The continuing divergences in the global economy mean we’re likely in for another highly unpredictable year in the markets. There will be money to be made on the long and the short side for nimble traders, but long term investors may find the market action a bit frustrating. It’s always true that anything can happen. Somehow, though, it seems a little more true these days.

Are there any factors I didn’t mention that you’re watching closely in 2011?

(Photo Credit: katerha)

Written by Kim Petch

14 Responses to 2011: What to Watch

  1. Are there any factors I didn’t mention that you’re watching closely in 2011?

    I take a very different approach than most, Two Cents.

    I ignore all the economic stuff. My view is that lots of smart people are studying that stuff to death, so there’s nothing that I could add by studying it myself. The one thing that I think others do not study enough is investor emotion. So I focus on that.

    You can pick up a lot of clues by listening to how discussions go on discussion boards and blogs. Post-crash conversations were a lot different than pre-crash conversations. But things were even better in 2010 than they were in the months immediately following the crash, in my assessment. Following the crash, lots of people had the thought in the back of their minds that prices were going to return to pre-crash levels in not too long a time. Not too many continue to hold to that idea today.

    It takes time for new ideas to permeate one’s consciousness. My sense is that we are going through that process as a society and making slow progress. I am looking for investing discussions to be more balanced in 2011 than they were in 2010, in which they were more balanced than they were in 2009. At some point, we will get to a tipping point. Then — watch out!


    • Emotion is an undeniable factor in the markets. Expecting markets to behave rationally is actually pretty irrational. You need the perception of a psychologist coupled with the discipline of a mathematician. I haven’t mastered the balance myself, but I’m sure it won’t keep me from trying.

      I’m not clear on your last sentence. What does the tipping point look like to you?


      • I think of a massively overvalued stock market as being similar to an alcoholic, Two Cents. There’s always a part of the alcoholic’s mind in which he wants to stop destroying himself. What holds him back is that it would be emotionally devastating to for him to acknowledge how much pain he has already caused himself. So there is another part of his mind that is in complete denial.

        Tell the alcoholic that he needs to stop drinking and he will tell you that he can stop drinking anytime he pleases. Does he believe this? Yes and no. Part of him absolutely believes it (otherwise, his self-hate would be so great that he could not get through the day). Part of him doesn’t believe it at all (that’s why he becomes so defensive when asked about his drinking).

        We all know on some level of consciousness that we destroyed our economy by participating in the bull market of the late 1990s. But we cannot bear to acknowledge what we did. So we are in deep denial. We really, really believe that we destroyed the economy and we really, really believe that we did not. We really, really believe two opposite things. That’s cognitive dissonance. That’s where we are today.

        An alcoholic starts on the road back when he lands in the gutter. We are getting there and we are seeing conversations start to open up. But as of today we still imagine that the pain that will follow from opening things up all the way will be greater than the pain that will follow from remaining in denial. Another stock crash will change that. Another crash will put us in the Second Great Depression. At that point, large numbers of us will just throw up our hands and say “nothing could be worse than this — let’s just permit free discussions!” That’s like going to an AA meeting. That’s when things start looking up in a permanent sense.

        I don’t agree that rational investing is impossible. There have been large periods of time when stocks remained at reasonable prices. If we could pull that off before, we can pull it off again. And there has never in history been a time when investing became as irrational as it became in the late 1990s. I attribute that to Buy-and-Hold. This is the first time that there have been people saying that there is some scientific, data-based reason to believe that there is no need to lower one’s stock allocation in response to insane prices. It’s our belief in science (in this case a discredited science) that made things so much worse this time.

        That same belief in science can be put to GOOD uses. We don’t really all need to be psychologists to become effective investors. Irrational investing always evidences itself in overvaluation. All we need to do is to flip the core principle of Buy-and-Hold and, instead of telling people never to time the market tell them ALWAYS to time the market (that is, always to change their allocations in response to big price swings). Once large numbers of people are doing that, significant overvaluation becomes a logical impossibility. Each move in the direction of overvaluation brings on sales, which bring prices down.

        The market WANTS to be rational and efficient (just as alcoholics at some level of consciousness really want to live productive, honest, clean lives). It is mistaken investing theories (developed at a time when there wasn’t enough research done to permit the development of workable theories) that threw everything off track.

        It’s true that there has never been a time in the past when we avoided extreme overvaluation for more than 30 years or so. But there was a time when we could not treat polio and there was a time when we did not have electricity and there was a time when we did not have indoor plumbing. Humankind has ADVANCED knowledge in many areas of life endeavor over the years. I believe that we are now at the threshold of an era when we are going to see the biggest advances in our understanding of how stock investing works ever seen in history. This will bring on huge economic growth, enough to make us all look back at this economic crisis as the best thing that ever happened to us.

        The first step is hitting bottom and picking ourselves up in humility and heading off to that first AA meeting. Ask any former alcoholic what he thinks about that day and he will tell you it was the best day of his life. What I hear when I listen in to conversations going on today at discussion boards and blogs is an investing community slowly but steadily working up its courage to attend its first AA meeting. I don’t say that this will happen in 2011 but my belief is that we will be closer to that magic moment in January 2012 than we are in January 2011. And we are already closer to it in January 2011 than we were in January 2010.

        Things are getting better by getting worse. Because its ultimately pride that needs to be broken (the pride that followed when we thought we had it all figured out with the introduction of the Buy-and-Hold Model). Pride comes before a fall. The other side of the story is that a big fall often is required to bring about a giant leap forward.

        Those are one man’s sincere (but out there!) thoughts, in any event.


        • So watch the valuations, eh? Cut back on your stock allocation when they’re high and load up when they’re low. Makes sense to me, but it’s still really hard to do.

          It sounds like you’re describing the end of a Kondratieff winter as we discussed just before the New Year. (For those who missed it, see Get Me Through December.) I happen to agree with you. I think we have some more pain to come, but that may actually lead to a very prolonged period of stability, prosperity, and yes – rational valuations.

          A couple of weeks ago Chris Whalen wrote about a similar “the worse things get the closer to the end we’ll be” kind of theory: Standing on the Brink – of a Fresh Financial Start. He thinks 2011 will be a year of reckoning and restructuring, but that this will provide the basis for a much healthier financial system going forward.

          Thanks for elaborating on your ideas Rob! 🙂

  2. I especially liked the section “Final Thoughts and a Darkhorse.” Everyone does, indeed, seem to playing in the fortune-telling game these days. What will come will come. All we can do is make the best decisions we can, given the information we have. Plan for retirement, and don’t become too complacent in the market. Great post, once again. 🙂

    • “All we can do is make the best decisions we can, given the information we have.”

      I definitely concur on that one. The best decisions will only be obvious with hindsight, and then will look obvious, no matter how unlikely they appear at present.

      Renowned market technician Alexander Elder always says that the toughest decisions come at the far right edge of the chart. Only after time fills in the remaining bars do prices seem somehow rational. (Hindsight is always 20/20.)

      As you say, however, we still need to plan for retirement to the best of our ability and keep both complacency and panic at bay. 😉

  3. It looks like 2011 is rigged with mines. You don’t need all of them going off, just a couple will be enough to trigger significant market corrections. Time to increase the bond allocation?

    • On bonds: As with most other major market sectors, it depends on which crowd you listen to. Gary Shilling is still a bull on bonds, believing that the next wave of the debt crisis may play out similarly to the last, with most asset classes collapsing and bonds doing well.

      Others believe that a collapse in the bond market could actually precipitate the next crisis, or at least go along for the ride as bond investors lose confidence in the ability of borrowers to make good on their loans and the backstoppers (sovereigns) need a backstop.

      I am just as concerned (maybe more so) about bonds as stocks. If there’s a bond bust, money may at some point flow into equities – or not. I have no idea what will happen and that’s why my trigger finger has atrophied.

      Still, I think an agile trader with strict stops will do better than a buy and holder in either stocks or bonds in this volatile climate.

      Thanks for stopping by! 🙂

  4. Interest rates rising is definitely one of the risks, and I’m interested in seeing how the housing markets play out in Canada. Then again, it’s not that bad everywhere — Vancouver is very overpriced and Toronto is also expensive, but the other cities are not so far out of line, are they? Prices have shot up a lot from 2005-2008, but the increases have been mute as of late.

    • I live in Windsor, Ontario. We didn’t have the huge appreciation of some other markets and prices did come down here during the recession (unlike Toronto & Vancouver). That leads me to be hopeful that if those larger markets correct, we may not get hit so hard here.

  5. I feel that consumer spending will still be tight for 2011 and companies will be slow to open their wallet to expend and grow. If interest rate start creeping up, and it has to start inching upward, it will create more pressure on consumer debt. In my view, interest rates have been low for quite a while and REALLY low for the last 2 years.

    • There sure are a lot of wild cards out there. You would think interest rates would have to rise, but if that rise causes economic trouble, you may seem them come right back down again – unless the bond market really puts its food down.

  6. 2 Cents,

    Your predictions for 2011 are very similar to mine. I think you have a lot of insight and a solid understanding of the economy.

    However, I’m still optimistic that it’s going to be a great year, especially in the U.S. Despite the myriad of looming potenatial disasters, I believe momentum is swinging towards more reasonable and sustainable spending and governance. I also believe the Fed, Central Banks and Wall Street will be under much tighter scrutiny.

    At least that’s my hope.

    • Thank you Bret. It could very well turn out to be a great year if we’re able to skate through some of these problems. With Ron Paul in his new position, I hope you’re right about tighter scrutiny at all levels of the financial system. 🙂

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