First and foremost, Happy New Year to each of you. I wish you and your families all the best for 2012.
As we move into the New Year, let’s quickly reflect on the year that was 2011. It was a difficult year on many levels, and it was certainly a year full of high drama. So much happened last year, and most people would simply characterize much of the year’s events as “bad”. From purely an investment perspective, assets that led to sub-par performance are the same assets that have led to superior performance in the past and I fully expect to do so in the future. International markets by and large were trashed – most down in the neighborhood of 20%. Data compiled by Bloomberg indicate that emerging markets on average fared even worse. There were also negative returns across the broad spectrum of commodity and energy related assets as the fears of another global recession grew. These are all assets I believe will continue to outpace most others, but 2011 was a year of consolidation along the longer path of better longer term results.
So what to expect from 2012? First, from a news perspective, expect a ton of hyperbole! In an election year you can expect the news media to exaggerate more than their normal amount. You can also expect over the top claims in all directions from politicians as the jockeying for the White House ramps up. Keep in mind that every outrageous claim must be taken with a grain of salt, if not a full cup. With Europe teetering and the US recovery moving so slowly, every miniscule piece of economic data from around the world is likely to be made out to be so much more vital than what it actually is. Emotions are going to be attacked by the media in the effort to sell advertising time. Be careful about how much you let their efforts to strike emotional chords impact your financial decisions. I can hear it already from the TVs, radios, and websites everywhere: “This is going to be the most important (election, employment report, European bond auction, Fed interest rate decision…….) ever!!” Enjoy the theater and remember its purpose is to sell soap, not increase the value of your investments.
On that note, what about your investments for the New Year? In short, I expect it to be a modest year, but not without more drama and volatility. One positive element is that investor sentiment is low. That’s what I want to tap into here for a moment. This low sentiment seems consistent with human nature. After all we’re coming off a year in which the global markets showed losses, the all-powerful USA lost its coveted AAA status, Europe fell into a credit crisis, and Japan suffered a catastrophic earthquake that led to a full fledged nuclear scare. I’ve only touched on a few of the year’s “bad” things, and it already creates an enormous list for the optimistic human spirit to contend with.
But there was also something that can only be seen as a very “good” thing that happened throughout 2011. I want to take a minute to explain how things are going investors’ way, even though it might not immediately feel like it. This is happening around the world, but let me focus on the US to keep it relatively simple.
Last year was unique in that the US equity markets were the best performing developed markets around the world. This hasn’t happened in a very long time, and isn’t likely to be a common occurrence in the future I wouldn’t expect. But 2011 was the year of the ethnocentric investor. The US led the global pack by essentially standing still. The S&P 500 went nowhere for the year, literally. Looking across the spectrum of market cap and sector specific index performance would indicate that the broader compliment of domestic companies actually lost a handful of percent, but let’s stick with the S&P 500’s flat result for the sake of this example.
While the S&P 500 went nowhere, the internal valuation (the ‘cost’) of the market was dropping quickly. This is because the net earnings of the companies that comprise the index continued to grow very nicely – on the magnitude of 20% according to Standard and Poor’s. Different analysts will have slightly different expectations and resulting numbers, but this 20% figure is in line with the majority of the field. This is easy math because this growth against the backdrop of a flat price in the market means the market is 20% less expensive (ie, a 20% better buy) today than it was heading into 2011.
As we move into 2012, Standard and Poor’s numbers indicate the market (S&P 500) is valued at roughly 12 times the earnings that are expected for the year ahead. We entered last year at roughly 15 times earnings and ended it around this 12 level. One risk here is obvious – what if their collective earnings estimates are off; and if so, by how much, and in which direction. If I knew I’d happily share the answer. But it is important to note that we’ve had many, many months of better economic data here in the States. At some point investors need to accept the fact that things are at least somewhat improved in our domestic economy. While I am not in the camp of the bulls, I’m not blind to the data. As such, it seems like a reasonable expectation to think these analysts are in the right ballpark with their earnings projections. I don’t see a strong enough economy to think they’re far too low; and I don’t see enough reason to believe they’re off by all too much on the high side either. I think it is probable that earnings can grow by 10% or more this year. If they do, the market internals stand a good chance of being lower yet again this time next year; which is a positive development for investors with time horizons longer than 3 years.
My personal view is that 2012 will be a similar year of 2011’s consolidation with continued corporate profit growth. While my expectations are modest in the near term, my view of the following period is quite optimistic. After perhaps a couple more years of consolidation and below historical average (yet positive) market growth, I believe we could usher in a period similar to the 1980’s and ’90’s; a period of prolonged economic expansion and above historical average market growth.
This wouldn’t be as unusual as you might think. Take a look at history and you’ll see that markets have a clear pattern of moving sideways for long periods of time and eventually giving way to upward prices as the prior years’ consolidation phase completes its job of wringing out excess. One of my favorite charts, put together by Crestmont Research, shows vividly that since 1900 there have been 3 major consolidation phases in the markets (again, using the S&P 500): 1906 to 1924, 1937 to 1950, and 1966 to 1982. These are all long phases – roughly 15 years on average. We are still enduring the fourth major consolidation phase in the market, which has been underway since March 2000; roughly 12 years in the making to this point. According to more Crestmont and Standard and Poor’s data, during this current 12 year phase we’ve seen the market’s internal valuation work its way painfully down from over 40 times earnings to roughly 12 today. This means that while the markets have gone essentially nowhere for 12 years, corporate earnings have more than tripled. What was once way overpriced is now at least modestly underpriced. This is happening at a time where the stock market amazingly yields more than savings accounts, CDs, and even a ten year Treasury! These are all forces working in favor of the long term investor.
Investing is a journey like any worthwhile endeavor in that it’s not a sprint or even a straight line of progression. Since I believe the next clear upward trend in the broad market is still out on the horizon, I don’t want to be positioned overly aggressively in 2012. It is too soon, I believe. Instead, allocating a portfolio for stability with an emphasis on value and cash flows seems like the best way go. The goal is to get to the next clear upward phase in a position to continue to compound wealth, earning a reasonable rate of return leading up to that period. Large losses could be seen by investors who let their optimism get the better of them. This might lead them to invest in pure growth oriented assets at a time when there simply isn’t enough economic strength to propel or even support their values. We are likely to have those strong growth days again. But investing along that mindset too early holds serious potential to be expensive.
The takeaway:
* Happy New Year! Embrace it and make it the best year it can possibly be for you.
* It is likely to be another eventful year news-wise, but I don’t see reason to be either exuberant or fearful. After a bit more healthy consolidation markets are more likely to move higher in the years ahead, but don’t invest for those better days too soon. Investments can certainly grow in this environment, but a balanced approach is still best I believe.
* I’ve recently put together a website that we’ll be continually enhancing in the months to come. Please visit www.winnadvisory.com and let me know what types of additional information you think might be valuable to include there. The site is designed as a simple overview that will hopefully let both current and prospective clients learn a bit more about me and my business. If you have any questions about anything you see there, just let me know.
Jeff Winn, Financial Advisor
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