In case you missed it, here’s part one ^[1] of our predictions for the year ahead.

Last week I framed the basic secular and cyclical backdrops.  From that, I then made a few calls on the three major asset classes: stocks, bonds, and real estate.  Today we’re going to look at some more obscure and specific predictions.  I always hate to use the word “action” in conjunction with making predictions, but a few of these will be a bit more “actionable” than what we discussed last week.

4. The world (of earnings) is flat.

According to Standard & Poor’s, 2013 earnings are estimated to come in at 100.71.  You can go look it up yourself ^[2].

This is pure madness.  Madness!

Right now, 2012 earnings are set to come in around 87.10.

15% earnings growth?  Are you serious?  2012 earnings hardly grew over 2011.  And 2011 grew 12% over 2010.

No way do S&P Reported earnings top $100/share.  In fact, I don’t think they get above $90.

Here’s an updated version of my inflation-adjusted S&P Earnings chart.  It’s log scale because that’s how we roll:

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I wonder if Wall Street consensus or even the very intelligent people at Standard & Poor’s have looked at that chart.  What are they seeing that I’m not?  100.71 is way up there.

Are they seeing what will almost certainly be an economically weak first half as consumers deal with smaller paychecks from the payroll tax hike?  Are they seeing more magical stimulus, stimulus which didn’t even do much to 2012′s earnings?  Are they seeing continued expansion of profit margins?

Consider that period between 1900 and 1947.  Between those years, earnings didn’t grow at all, at least not when adjusted for inflation.

Compare that with the period between 1947 and today:

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Earnings in the 20th century were a tale of two halves.  After nearly 50 years of flat growth, they’ve trended steadily higher since the end of WWII, oscillating up and down during different cyclical environments.

But as we outlined last week, this is a whole new world for the economy.  This is the land of 1.5% economic growth.

Look, Corporate America has been crushing it since 2009.  Large companies went from the Brink of Disaster to Back to Normal and they did it faster than everyone, myself included, would have expected.  And that’s part the problem.  We’re back to normal now.  All the cost cuts, efficiency enhancements, and operational cleanup is done, or at least enough of it to matter.  The economy has recovered, too, at least as much as we could have reasonably expected it to recover.

S&P Earnings are at a place where nearly all of the growth beyond this point is going to have to come from legitimate economic expansion.  Given the secular backdrop, I think the next few decades will more closely resemble the first part of the 20th century than the second.  I don’t think earnings will trend higher and higher.  I think they’ll bounce around in a big range and in a couple of decades we’ll look back and notice that, after adjusting for inflation, earnings for S&P companies haven’t really grown all that much.

Investors entering the market today need to pay extra careful attention to valuation.  Trends in valuation and risk appetite will be what drive the performance of the market on a year-to-year basis in this new environment.

Anyway, I think this is going to be a tricky year for earnings.  The first two quarters have the potential to be pretty gruesome.  I wouldn’t be surprised at all to see consensus 2013 earnings estimates slashed after Q1 or Q2 this year.  Maybe then whoever is doing the estimates on that S&P spreadsheet will get with the program.

It’ll be a flat year for earnings.  The data seem to suggest that this is a ridiculously obvious call.  But consensus is quite a bit above “flat” and this qualifies as a contrarian forecast.

Weird.

5. Durables over non-durables

This leads me into my first trade of the year.  Durables — or non-cyclicals, or staples, or whatever you wish to call them — will outperform non-durables — or cyclicals, or discretionary, etc.

Financials were the top performer in 2012, but consumer discretionary was #2.  Most people make forecasts by taking the trends that are in place and projecting them out into the future.  I know this may sound crazy, but a disturbingly large percentage of professional fund managers just look at whatever sectors did best in the previous year and then weight those sectors higher in the current year.  Even hedge fund managers are slavish performance chasers.  Not even the pros can resist shiny things and running with the herd.

All these guys are overweight the financials and discretionary right now.  The zombie banks are baaack!  Fund managers are all feeling comfortable and in a “risk on” mode and if you don’t believe me, hedge fund leverage is now at its highest level since 2004.  That hardly suggests the shell-shocked conservatism we saw when the market was going straight up in 2009 and 2010.

Now that earnings have reverted to or beyond a very clear and obvious normal and the U.S. economy is about to get its first taste of austerity — why is everybody talking about the debt ceiling instead of U.S. austerity?! — I’m wondering if this isn’t a good time to rotate into more defensive sectors?  You’d think that most people would agree with that strategy given the consensus about the backdrop, but again, they don’t seem to.

If you want a bonus trade, here’s another one: tech over financials.

And here’s another: high quality dividend stocks over junk bonds.

6. Emerging Market Bonds – A New Buzzword

I started hearing really savvy bond people start talking about this on Bloomberg Radio a couple of months ago.  I think that 2013 is the year where CNBC really grabs hold of the story and turns this into a hot new sector.  Yields in the developed world have been pushed to unfathomable lows.  But yields in the emerging world are noticeably higher.  As soon as the Yield Vigilantes ^[5] catch a whiff of that, I think they attack.

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For what it’s worth, I do like the opportunity here.  A lot of these economies have better fundamentals than the U.S., though some present larger and more obvious risks.

The best way that I can figure out of how to play this trend is the WisdomTree Emerging Markets Local Debt Fund (ELD).  As of today, it’s only got $1.5 billion in assets.  My bold prediction is that by December this thing has doubled in size.  There isn’t much competition in the space yet and I can just feel demand for higher-yielding debt ready to spill into other pockets of the planet.

The ETF yields around 4% and it holds bonds of countries like Russia, Chile, Brazil, Malaysia, and the Philippines.  Remember that bonds just aren’t about yield.  There’s a price component as well and that’s what will really drive performance in a bond fund like this more demand for these higher-yielding bonds means higher prices.

This one is a little more risky as bond funds go, but I’d much rather have the risk-adjusted total return prospects of something like this right now than a junk bond fund.

7. A new trend in politics.

Ready for a waaay outside consensus call?  I think 2012 represented Peak Partisanship.

I think we’re on a new political trajectory now, one of compromise and pragmatic problem solving.  It will start slow, at first, but the dysfunction that we’ve seen in the last few years is bottoming out.  In fact, if I had to point to an exact bottom, it’d be the debt-ceiling negotiations of mid-2011.

Americans can and do get pretty feisty about politics.  But when you sit down with people and have a sensible conversation with them, what they really want are solutions.  They want to get stuff done.  They’re tired of the anger and they’re tired of the uncertainty.  And the further down from the Baby Boomer generation you look, the more you see of this.

If you want to put it into investment terms, here’s my political portfolio:

• Short Grover Norquist
• Short the Tea Party
• Long Obama — For better and worse, the Obama of the next 4 years will look more like the Obama the country was promised back in 2008, the figure of change and compromise.
• Long Paul Ryan (look how quickly ^[7] he rebranded himself into a weapon of compromise under Boehner) and Chris Christie and other young, rising stars of political — particularly fiscal — pragmatism in the GOP
• Long Elizabeth Warren and a tougher, more transparent life ahead for banks.
• Long Bobby Jindal and this bold, new social stance on women’s rights ^[8].
• Short whatever dregs are left of the “Occupy” movement and other populist waves.
• Long political centrism & pragmatism

I know that we’ve got a debt-ceiling / budget debate on tap in less than 2 months.  Don’t worry, it’ll be plenty dramatic and sufficiently embarrassing.  But it’ll be better than the fiscal cliff and certainly better than some of the fighting we saw pre-election or during the last debt-ceiling debate.

8. Gold struggles.

In 2010 I predicted that gold would bubble up.

In 2011 I predicted that gold would bubble on.

In 2012 I predicted that all the bubbling was done and it’d flatten out.

After three straight years of totally nailing it for gold, no matter what I predict this year for gold will be wrong.  It’s karma.  I’ve been too lucky for too long.  This is just how it works in gold.  It has a knack for punishing your hubris and dragging you naked through the streets of analyst shame.

So here’s my certain-to-be-wrong gold forecast for 2013: should gold make an attempt at the current local high of 1800, it will fail in spectacular fashion.  At one point in the year, I think it tests its local low of around 1525 and fails, sending it into a technical no man’s land.  I think gold has a down year and I think fair weather fans start to jump ship, hedge funds start reducing their exposure, and gold bugs amp up the public displays of gold affection.

I realize that this forecast represents abject heresy.  So be it.  Go ahead and ready your pitchforks.

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For what it’s worth, I really hope I’m wrong here.  I’ve loved and owned gold for a long time.  I’ll continue own it because it’s different and I love things that are different.  But last year was the year where I made sure it didn’t represent too large a portion of my total net worth and this could be the year where I start to feel better about having made that decision.

9. It’s a great year for mergers & acquisitions.

Here’s my thesis: the corporate landscape is now flush with cash and doesn’t really know what to do with it.  They’re not spending it on hiring.  They’re not deploying capital for growth.  They’re just kinda sitting on it.  At first they were sitting on it defensively, in case the economy fell off another cliff.  We now know that isn’t going to happen, but we also know that that economic growth still won’t be enough to justify putting it to work aggressively.

We’ve also got some policy clarity too, to whatever extent that was making corporations nervous.

I don’t expect massive hiring or capital deployment, but I do think that one of the ways in which corporations will start responding to this more certain environment is by buying other companies.

If you’re on board with this idea of increased M&A, you can actually do something about it.

One of my favorite old skool alternative strategies is called “risk arbitrage.”  Despite the name, it’s actually a rather conservative strategy that involves buying the company getting acquired in a merger and selling short the company doing the acquiring.  The profit in the strategy is the spread between the two as they converge towards the agreed upon purchase price.

Most of the people that do it live in the hedge fund space.  But there are a handful mutual funds that trade similar strategies, one of which is The Merger Fund (MERFX).  Want a specific forecast?  That fund has a 5yr average annual rate of return of 3.3% and I think it easily beats that in 2013.

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I also have to disclose that this is one of those rare occasions where I do actually own this fund personally.

If you qualify for hedge funds, perhaps it’s time to take another look at the risk arb space.  There are several good managers out there.

And if you ever want to have a conversation about alternative strategies, feel free to email me ^[11].  I can point you in the direction of a few resources and introduce you to some interesting people to talk to.  I can also give you the straight dope on hedge funds.  I’ve worked in this industry for long enough to sort the myth from the reality.

10. Netflix gets its swagger back.

Prediction #10 last year was a fun, specific one about a company I had a lot of experience with (Groupon).  So let’s do it again!

Last year was a rough year for Netflix.  Better than its disastrous 2011, but still pretty rough.  Its fall from darling to doghouse is quite remarkable.

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The stock trades  around $100 today.  Could it get to $125?  Absolutely.  This is a year where I think it returns as a favorite pick of mutual funds and hedge funds.  Short-term trends like that tend to shape the performance of a stock like Netflix more than the company’s actual financial performance.

But it’s not just the stock that I think re-emerges from the ashes, I think the company itself ascends to new cultural heights.

Reed Hastings is a brilliant guy whose biggest crime is that he’s a little bit too forward looking for a CEO.  Netflix is technically two businesses — a high-margin, cash-cow DVD-by-mail business that everybody knows will be obsolete in a decade and a low-margin, still-emerging streaming service that everybody knows is The Future.  Back in 2011 he tried to cleave the company in two and sell off the DVD portion of the business to get maximum value for it, capital which he could then put to use towards helping their streaming business leapfrog its competition.

But the move was totally bungled and in retrospect, way too early.  Since that PR debacle, Mr. Hastings has made a lot of really shrewd moves and has begun to re-position the company on more defensible ground.  The crux of the streaming side’s profitability comes down to the cost of licensing content.  And Netflix’s strategic response has been both bold and clever: develop their own content.

I distinctly remember one of Netflix’s conference calls last year where Mr. Hastings was asked a question about what kind of threat the major cable companies represented.  Most people think media delivery outlets like Time Warner or Charter represent Netflix’s chief competitor.  But he kinda laughed and said they don’t look at those companies that way.  He said their #1 competitor is HBO. The comment should tell you everything you need to know about what kind of company Netflix wants to be.

In a world where the marginal cost of content delivery is negligible, everything spins around the axis of content value.  It’s all about content now.  This is why Disney shelled out $10 billion for Marvel, Pixar, and Lucasfilm.  Original programming will be the only way that Netflix will ultimately stay competitive with Amazon and its increasingly-awesome Prime Video.

Netflix’s first entry, Lilyhammer, was really just a low-budget proof of concept.  But their second show, House of Cards, will make some waves.

Trust me.  This show could literally blow up water coolers this year in the unexpected way that Game of Thrones did two years ago.  Get ready for some friend somewhere suggesting that you watch it at some point this year.  And it’ll only be available on Netflix.

The reason why I think this show is going to be worth watching is that the source material is rock solid and the guy doing the adapting, David Fincher, is one of Hollywood’s most talented and innovative directors.  Generally speaking, media properties like that tend to have a higher probability of being good quality.  You’re probably not familiar with the source material, the 22 year old BBC series, but it is awesome.  Seriously.  The three of you who have seen it will attest to the utter badassery of Francis Urquhart.

Solid source material + incredibly talented producer + strong cast = win.

Sub-prediction #1:

House of Cards will be a critical smash.  I think it could even make an appearance at the Emmys and the fact that NETFLIX (WTF?!) HAS A SHOW AT THE EMMYS could create all sorts of new buzz and a halo effect.  It’s going to make talented show runners and filmmakers open to working with Netflix.  It’s going to make new customers want to subscribe.  And these positive vibes could get investors intrigued about the stock again.

If you don’t believe me check out the trailer!

Before we get carried away, let me throw some cold water on the discussion.  The audience for political thrillers is small.  It’s basically me and like 0.25% of the population.

But that’s OK.  Because for Netflix this year is really going to be about the return of Arrested Development!

I can’t imagine that you’re still unfamiliar with this cult sensation, and I’d bet my last dollar that somebody in the last few years has said, “Have you seen Arrested Development???  It’s a great show!”  (Or maybe that was you doing the evangelizing.)

Despite critical acclaim, it never really found a big audience back when it was airing and Fox killed it after 3 short seasons.  But it grew in to something of a cult sensation in the streaming world.  And this May, Netflix is delivering an exclusive 4th season.  That’s as good a bet as any to create additional Netflix buzz.  Personally, I can’t wait for another installment of the Bluth family.

Moving into original content isn’t going to move the financial needle for Netflix in 2013.  Nor will it do so until they’ve built a meaningful proprietary library.  But some day it will be the only thing that matters.  And it will matter because it will give them pricing power.  That will be one of the dials they’ll be able to turn to improve margins in a low-margin business.

Sub-prediction #2:

Along these lines, I think this is a year where the discussion about services like Netflix replacing cable TV is raised to a new level.  It’s likely Apple and Google play a role here as well.

The cable companies are in the exact same position the record labels were a decade ago.  The ground is shifting beneath their feet.  I’m just not sure they know it yet, and even with history as their guide, I still think they fight tooth and nail to protect their status quo rather than aggressively embrace the change companies like Netflix are wreaking.

Lastly, there’s a heavy demographic component in this discussion.  Who among Gen X who doesn’t enjoy having access to subscription-based on-demand media services?  Is there anyone in the Millennial generation capable of living without them?  Have you ever asked a 16 year old about how unnatural a concept sitting down to watch a specific show at a specific time is?  How long until we’re too lazy to program our DVRs or decide that $100/month is simply too much to spend on programming we can get much less expensively elsewhere?

The ways in which media is delivered and programmed will change dramatically in the next decade and content-owning companies like Netflix and HBO and Disney (who owns cable’s single most valuable property, ESPN) will be at the center of the conversation.

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Well, are you convinced I’m crazy?  Let’s see how the year unfolds.  Follow me on Facebook so you can make fun of me when I’m wrong!