Despite a terrific first quarter, 2011 morphed into a miserable year as the combination of US political bickering and misplaced worry over the prospects of a European debt contagion caused both professional and individual investors to flee to ultra safe alternatives. What made 2011 especially maddening was that investors who did stick with equities chose to hold their assets in the Dow 30 stocks which became almost bond surrogates at the expense of small and mid cap equities. This bifurcated situation created one of the largest spreads ever in performance between the Dow Jones Industrial Index of 30 stocks (+1%) and the Russell 3000 (-7%).
Consistently ignored in second half of 2011 was improving domestic economic data: Improvements in Housing, Consumer Confidence, Auto Sales and Jobs was ignored by the deafening, attention grabbing headlines from Europe. Corporate earnings which are the primary driver of stock prices continued to grow at an approximate 10% pace and look to repeat this performance in 2012.
Despite the improving data, the consensus of opinion amongst investors is gloomy and that is where I believe the opportunity for 2012 is. Professional and individual investors have abandoned equities with a ferocity unseen since 2008 and are settling for yields in Treasuries in the 2% range. Simply put, at a yield of 2% it will take 36 years for the principal to double in value.
Investors having sold heavily in the second half of 2011 have likely discounted the bad news from Europe and the unfounded fears of a US recession. I seriously doubt renewed fears of European recession or budget issue can muster a second similar selloff. Domestic and European issues are well known and have a likely probability of diminishing in consequence.
It’s a frequently commented upon topic that the consensus view of economics and investing will usually be the strategy that bites you the hardest since it’s rare that the consensus view actually comes to fruition. Investing would be quite easy if that was the case, since you could simply find what the prevailing opinion was and invest accordingly.
For 2012 I offer what I believe will be five minority/contrarian views that have a better than average chance of being accurate in 2012.
1. The stock market has a very good year and our models and client portfolios have a very good year. The long term top of 1500 on the S&P 500 is a very good possibility by 2013 as
investors realize the fear driven mistakes of 2011 and move assets from bonds back to equities. A Romney victory would likely be a significant market positive (I am a Democrat) and could propel stocks to 1500 sooner than expected. Newt, on the other hand would likely be a major market headwind while the re-election of President Obama (the likeliest possibility) would be a moderate positive for stocks.
Investors who shunned small and mid-cap sized equities in favor of Index mutual funds and bonds had either minute gains or losses while the vast majority of Value portfolios had a terrible 10 months. The biggest groups of investors: Institutional, Hedge Funds and especially Individual investors are very poorly positioned with very high allocations to cash, gold and bonds.
It’s my belief that 2012 will be a year of mean reversion, where the investments that performed poorly in 2011 will produce outsized gains while bonds post negative returns and Indexes lag managed portfolios by a wide degree.
The 50 year average yield on the 10-year Treasury note is 6.6% and now its 2% while the 50 year average multiple on stocks is 15 times earnings, now it is at 12.
As mentioned in my blog previously: The US market risk premium (earnings yield minus the risk free rate of return) is at a 37 year high. This is another statistical metric highlighting the unusual value and upside potential in equities at present.
2. Treasury bonds will post negative returns in 2012.
I expect 10 year Treasury bond yields to rise in excess of 3.25% resulting from an expanding economy and less worldwide fear. The decline in bond values should provide the impetus for an asset allocation shift away from bonds and into stocks.
3. There will be no recession in the US and we will have at least one quarter where our GDP growth is in excess of 3%. Earnings growth in 2012 remains at a moderate 10% growth rate and the US Federal Reserve leaves interest rates unchanged which is very friendly to a rising stock market.
4. President Obama is re-elected. In my opinion the President’s electability will have much to do with the comparative un-electability of the Republican opposition. Be it Romney, Gingrich, Paul or Santorum, they all have major comparative flaws and would be hard pressed to gain the important Moderate electorate. If I’m wrong and Romney is elected, there is the possibility of reaching 1500 on the S&P 500 earlier than expected as his election would be viewed as a market positive.
5. The European Union will not crash. Problem solving in Democracies is almost always a messy proposition. Seamless and definitive political decisions are the hallmark of Authoritarian rule. Only until a crisis is upon the decision makers do they generally drop their political biases and come to an agreement. I don’t think that there will even be a defining moment when the Euro crisis has been solved; it will be from a series of decisions and actions rather than an all encompassing point in time.
Deep discounted financing (loans provided by central banks at very low interest rates) worked in 2008 to avert our banking crisis and they will likely work again for Europe. The import issue is that their banks simply get financing, the rate is of secondary importance.
Investment Status: Equity markets at present are in excellent shape with all major US indices breaking out to new rally highs. I believe it’s quite possible that that the rally will continue for several more months at least and that 1500 on the S&P 500 are attainable. As you can see in the chart below the SPX has been making a series of higher lows since September but our portfolios really began to out-perform in early December.
Another positive factor for equities over the next several months is that volatility continues to subside. This is necessary for investors to feel secure to deploy funds into equities and is frequently common in the early stages of new market rallies.
One of the biggest factors that I see driving markets higher in 2012 is that the alternative investments, particularly money market funds, CD’s and US Treasury Bills all pay under 1%. Should markets continue to move higher there will be a tremendous amount of cash coming out of those investments to seeking a higher rate of return. Investors may actually panic at the thought of being left out while their present fixed income returns so little.
All in all I expect that 2012 will result is a good year for our clients. Investor expectations are virtually nil and the masses have parked a huge amount of capital in ultra low yielding money markets and short term bonds. 1% returns are not going to help anyone in their retirement or capital growth plans. If equity markets continue to show strength and reduced volatility I do expect a very large asset allocation swap out of low-risk investments and into equities. Regarding equities, I am especially in favor of equities that had a rough year in 2011 due to their expected better than average risk / reward rather than the much beloved darlings like Apple and Google.
RMHI Model: There was no surprise that our investment model took a beating last year. Since my own retirement accounts are invested in the model as well, I can certainly identify with investor pain.
The chart above is the hypothetical back-test of the RMHI model (without hedging) dating back to 2001 till the first week of 2012. Actual client portfolios have tracked very closely to the chart below and while 2011’s decline was severe the performance began to curl higher in December. The chart is divided into thirds and the blue line is the S&P 500, which appears as a simple flat line over 10 years due to its lack of net progress.
The best way to gauge the model will be to track its progress during our current rally and all appears positive at this present time. As of today (1/23/2012) equity portfolios year to date are up an average of 7.5% net of fees and expenses versus 3% for the S&P 500.
All in all, I expect a good to very good year.
Brad Pappas
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