Optimism is returning to Wall Street. The economy has shown some improvement in recent months, as has the employment picture. Holiday sales were reasonably strong with December’s same-store number up 3.4%, slightly better than a year ago. Manufacturing also showed better than expected strength as the Institute for Supply Management Manufacturing Index increased for the 29^th consecutive month, up 1.2 percent over November’s reading. Economists are upgrading their fourth quarter GDP forecasts, with some suggesting we could see 4% for the final quarter of 2011. While no one is saying that the U.S. economy is robust, the recent improvement is causing some pundits to suggest that our economy can decouple from Europe. In fact, I have heard the term decouple used more in the last week than at any time in the last year or two. Clearly, there is an increasing hope that investors will begin to look past the problems in Europe and focus more on the strengthening economy here in the U.S. I don’t agree with this thesis of decoupling, but for a short period it could help propel our markets higher. My forecast calls for the U.S. equity markets to make their highs for the year in the first quarter, probably early in the first quarter, before undergoing what I expect will be the worst sell-off in eighty years. I think we will see the S&P 500 rise to 1350 and perhaps even a bit higher in the next several weeks, as investors switch from risk-off to risk-on once again. I believe this renewed optimism will be short-lived, however, and I expect a decline of sixty to seventy percent to follow.

I have been talking and writing about the risks of a deflationary meltdown for quite some time. I think 2012 is the year that the world pays a huge price for the massive over-leverage that has built up over several decades. Policymakers, both here and abroad, have been trying to contain the crisis ever since the Lehman collapse in 2008. They had hoped to manage the deleveraging process, providing fiscal and monetary support until such time as the respective economies could sustain themselves. In other words, politicians and policymakers have kicked the can down the road, hoping to buy time and avoid what I believe is an inevitable collapse. Even if our policymakers were perfect, I think the risks of meltdown would be high, given the magnitude of the debt crisis. Unfortunately, policymakers have been far from perfect, pursuing policies that this analyst would describe as flawed, inadequate and often counter-productive. They have layered on more debt to deal with an excessive debt problem. They have pursued highly punitive austerity programs at a time when economies are already weak. Perhaps most importantly, central bankers have wrongly implemented contractionary monetary policies in countries whose economies are already faltering under the weight of debt and in desperate need of reflationary growth. Even in the U.S., the Fed has been way behind the curve, pursuing a monetary policy that is far too restrictive. I know this flies in the face of conventional wisdom on Wall Street, where most pundits are highly critical of Bernanke for keeping rates so low and pumping $2.2 trillion into the system in the last three years. For two years we’ve heard pundits warn of the hyperinflation that was going to result from this “reckless” pumping of money.  The truth is that the Fed has not grown the monetary base nearly fast enough to overcome the contractionary and deflationary effects of the ongoing deleveraging process. Here we are thirty years removed from the big inflation cycle of the early 1980’s, perched on the doorstep of a major deflationary cycle, and yet, most of Wall Street and some members of the Fed are still concerned that the Fed is pursuing a policy of aggressive ease that will lead to an inflation problem. That reasoning could not be more wrong.  The Great Depression was primarily the result of an overly restrictive monetary policy. I think the Fed is making a similar mistake today and I believe the results will be equally devastating.

As critical as I am of Bernanke and the Fed, I am far more critical of Trichet, Draghi and the ECB. Trichet, in particular, should go down in history as the most misguided policymaker this side of the Great Depression. At least Bernanke understood the need for accommodative policy. He just misjudged the magnitude of monetary ease required to overcome the effects of a deleveraging economy. Trichet, on the other hand, refused to provide any accommodation when the situation demanded very substantial monetary expansion. His misread and mismanagement greatly exacerbated the sovereign debt crisis, and is a primary reason why much of Europe is now back in recession. Draghi has been a bit better, but he is still behind the curve. At least, the ECB’s monetary base is now growing at a twenty percent annual rate. It is not nearly enough to head off a Euroland collapse, but perhaps enough to buy a bit more time. Given the fiscal situation among the PIIGS, given the poor quality of the European bank balance sheets, and given the recessionary conditions in Euroland, a deflationary collapse seems but a matter of time and not very much time.

What a difference a few months can make. Last summer, the dollar was under such duress that much of Wall Street was questioning how much longer it would keep its reserve status. Virtually everyone on Wall Street was calling for significantly lower lows. I was a lonely bull.  The dollar index had fallen eighteen percent in the previous year and Congress was at an impasse regarding the debt ceiling. A default seemed imminent. Now here we are four or five months later and the dollar is up ten percent from the levels in August and dollar bulls are everywhere. Europe’s sovereign debt crisis and the slowdown in China have caused investors to reevaluate the dollar and again see it as relative safety play. It hasn’t hurt that there has been no growth in the monetary base in the past six months, meaning the supply of dollars has not been growing. Now that so many investors have turned bullish on the dollar, it looks poised for a significant pullback of 7-8%. I suspect we are about to see an acceleration of the risk-on trade over the next several weeks, meaning investors will be selling U.S. dollars and Treasury bonds and buying stocks. While the dollar sells off, the Euro is likely to reverse to the upside. Currency traders are universally bearish on the Euro. No one can see any reason for it to rally, particularly given the seemingly insurmountable problems regarding the sovereign debt crisis. There are real questions as to whether the Euro can survive. With this degree of bearish sentiment, and given the fact that the ECB has finally begun to ease and reduce some of the financial stress in Euroland, my contrarian instincts tell me we are at or very near an inflection point from which the Euro could rally ten percent. This forecast of a Euro rally and dollar sell-off is a near-term counter-trend move, nothing more than that. Once this move is over, I fully expect the dollar index to head for 95 – 100 and the Euro to head for dollar parity. We should see those levels reached later this year.

What a difference a year makes when it comes to the U.S. Treasury notes and bonds. A year ago, I was a very lonely bull on the Treasury market. Everyone was repeating the mantra that interest rates were so low that they could only go up from where they were. On the other hand, this contrarian was forecasting that the ten-year Treasury was headed for one percent and the thirty-year bond for two percent. This remains my forecast and I am confident we will reach these levels later this year. I recognize that investors struggle to understand why anyone would buy ten-year paper yielding one percent or thirty-year paper yielding two percent. The answer is simple. In a deflationary meltdown where defaults are piling up and risk is to be avoided at all cost, investors will be scrambling for safety and the government guarantee. It is also important to realize that in an environment of five percent deflation, a one or two percent yield provides a very substantial real return. In the very near-term, I expect the Treasury market to undergo a fairly sharp sell-off as investors shift from risk-off to risk-on. The long bond is up 25% in a year and due for a correction. Following this correction, Treasury bonds should outperform almost every other asset category in 2012. It will not pay for investors to reach down the risk curve for yield. Spreads are going to widen dramatically in this global meltdown. The U.S. government guarantee is going to become very important and much sought after in the months to come.

The stock market is in rally mode and we could see acceleration in that rally over the next few weeks, as market momentum draws money off the sidelines. I suspect we’re going to hear more pundits pushing the decoupling story. That, combined with a bit better economic news and a dollar sell-off, should be enough to trigger a risk-on trade that takes stocks up another six to ten percent. There’s some decent resistance at 1350 on the S&P, but if investors become convinced that the European crisis is being contained, it could certainly push through there and rally another 100 points.  I expect this final rally to be led by commodities, industrials and financials. Now that the gold and silver stocks have sold off, and skepticism has replaced the ebullience that surrounded the precious metals last summer, we should see outperformance in both the metals and the mining stocks. Energy stocks should also participate in the rally, as I expect crude oil (WTI) to trade up to $110 in the next few weeks.  The defensive areas of the market, such as utilities and the consumer noncyclical stocks, can be expected to underperform during this rally.

While a stock market rally that could take the indexes to new cycle highs is the immediate story, the far more significant event of 2012 is likely to be the deflationary meltdown that I expect to follow this rally. I am talking about a global collapse of historic magnitude. It will bring the world’s financial system to its knees, as banks across the globe fail. Europe is obviously most vulnerable, and it seems unlikely that the Euro can survive such a collapse. China is likely to be a big factor in this meltdown, as well. As the U.S. and European economies implode, we are going to see just how unbalanced the Chinese economy is. I suspect the excesses there are far worse than even the China bears realize. In the U.S., we could see GDP drop by double digits for a couple of quarters. I think the unemployment rate could double and real estate prices could fall by another twenty percent. I am forecasting that the S&P will plunge to 400-500 and the Dow Jones Industrial Average to 4000-5000. Policymakers across the globe have failed to grasp the magnitude of the problem and have responded with inadequate and sometimes incorrect policies. As a result, an orderly deleveraging process will turn disorderly, as involuntary liquidation takes center stage.

Conclusion

For those who thought 2011 was a volatile year, all I can say is “you ain’t seen nothing yet.” 2012 is likely to be the year of the bipolar investor. We enter the New Year with some sense of renewed optimism. I think we are about to see the risk-on trade take center stage once again. But following this “last hurrah” rally, I think we are going to see the worst market collapse in eighty years. We are on the verge of a deflationary, global meltdown.

In 2008, we took the economy and the financial system to the edge before pulling it back. If not for TARP and the other programs that were instituted to prevent an implosion, we would have seen many more failures, and would have likely triggered a worldwide financial collapse. Those demanding that the government not bail out Wall Street this time around will undoubtedly get their wish. Such a decision will be devastating to Wall Street and Main Street alike. We are in unchartered territory, and given the hundreds of trillions of dollars of notional value of derivatives, spread across the global financial system, and given the enormous leverage in the system, the collapse is likely to be swift and sharp.

I have had many people on Wall Street suggest to me that they have faith in Bernanke’s ability and willingness to do a QE3 if necessary. This, they say, will head off any meltdown. I have no doubt that the Fed and the other central banks will do much more quantitative easing, just not soon enough or fast enough to prevent a collapse. The problem is that these bankers have shown themselves incapable of anticipating the collapse. They will ultimately be panicked into providing the magnitude of liquidity necessary to overwhelm the problem and bring about a recovery, but they will only do so in reaction to a meltdown. Global markets will undergo dramatic declines. In the U.S., the averages are likely to decline by up to seventy percent, with many stocks down even more. Use the current rally to get more defensive. Once the decline begins, it could move quickly.

I expect U.S. Treasury securities to be among the very few investments that will deliver positive returns in 2012. They will likely undergo a correction in the next several weeks, as investors reallocate to equities. A better opportunity to buy bonds and sell stocks may present itself in the next month or two. As for gold, it is likely to trade up with the stock market, but then trade down during the meltdown. Gold may or may not get back to its high near $1900 during this rally, but no matter how high it gets in the rally, I expect it to sell down to $1000 during the meltdown. Look for the dollar to correct here before resuming its uptrend.

Clearly, these are not normal times and this is not a normal forecast. Most economists are calling for two to three percent economic growth. Even some of the more recognized bears are only talking about a mild recession. Most pundits are forecasting S&P earnings between $100 and $110.  I wouldn’t be surprised if earnings came in at half of the consensus expectations with GDP declining by double-digits for a couple quarters this year.  This is not a year for complacency. Don’t get too caught up in the momentum.

David A. Hunter, CFA

Chief Market Strategist

KCCI, Ltd.

(888) 267-9101

January 10, 2012