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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From our friends at The Chartist comes this tidbit of information:
“We remain bullish on the stock markets prospects from both a technical and fundamental standpoint. The benchmark S&P 500 finished last year with a price earnings ratio of 13.2 based on its last 12 months earnings multiple. The last time it was this low was at the conclusion of 1884 and over the next two years the S&P 500 gained 44%.”
I just came across this story on CBS Money Watch segment: The issues with Socially Responsible Investing”. My comments appear in parenthesis.
“MoneyWatch) Socially responsible investing (SRI) has been referred to as “double-bottom-line” investing. The implication is that you’re seeking not only profitable investments, but also investments that meet your personal standards. For instance, some investors don’t want to support companies that sell tobacco products or rely on animal testing. Of course, not everyone has the same set of beliefs, so SRI can mean different things to different people.
According to the Social Investment Forum, total SRI assets in the United States rose from $639 billion in 1995 to $3.07 trillion at the start of 2010. Clearly investors believe in SRI. One question for investors in SRI funds is: Is there a price to pay for avoiding “sin stocks”?
Expenses To answer the question, we begin by considering that SRI funds are typically more expensive than index funds and passive funds in general. One reason is that they incur the extra costs of screening out the undesirables. Those extra costs hurt returns.
(How and why is screening an extra expense, it isn’t with RMHI.)
Diversification SRI investors also typically sacrifice diversification. SRI funds typically are domestic and large cap. Thus, investors sacrifice exposure to small-cap and value stocks, and perhaps international and emerging market stocks as well. They also then lose exposure to the higher expected returns provided by small-cap, value and emerging market stocks.
SRI investors also may be accepting other risks. Because they avoid investing is “sin” stocks, they’re not fully diversified across industries.
(He has a major point here, but I feel like the kid in the back of his class with his hand raised and not being called upon by the teacher: He is spot on regarding Small Cap and Value stocks, which is why we focus on them. Several academic studies have proven small cap value to be an ideal combination.)
Cost of Capital There’s one other important point to consider. Economic theory tells us that because there are $3 trillion of SRI investments that avoid “sin” stocks, the cost of capital of sin stocks is driven higher than it would otherwise be, and the cost of capital of the non-sin stocks is driven lower. In other words, by avoiding investing in sin stocks, investors make those stocks cheaper (smaller and more value-oriented). And since the flip side of the cost of capital is the expected return to investors, SRI investors are missing out on the higher expected returns of “sin” stocks.
The authors of the study, “The Price of Sin: The Effects of Social Norms on Markets,” provide evidence that the hypothesis that there’s a societal norm against investing in “sin” stocks is correct, and that it does impact the cost of capital. The following is a summary of the findings:
- When compared to stocks of otherwise comparable characteristics, sin stocks have less institutional ownership — approximately 18 percent lower institutional ownership than comparable stocks (23 percent versus 28 percent).
- Sin stocks receive 21 percent less analyst coverage.
- Sin stocks are less held by norm-constrained institutions such as pension plans as compared to mutual or hedge funds that are natural arbitrageurs.
- The prices of sin stocks are relatively depressed, and, therefore, have higher expected returns than otherwise comparable stocks — consistent with them being neglected by norm-constrained investors and facing greater litigation risk (e.g., tobacco stocks) heightened by social norms.
- For the period 1965-2006, a portfolio long sin stocks and short their comparables has a return of 29 basis points per month after adjusting for a four-factor model comprising of the three Fama-French factors and the momentum factor. The statistics are economically significant. And just looking at a portfolio long sin stocks would yield even more significant out-performance of sin stocks relative to these benchmarks.
- The market-to-book ratios of sin stocks are on average about 15 percent lower than those of other comparable companies. These valuation ratios, using a Gordon growth model calibration, imply excess returns of about 2 percent a year.
- As out of sample support, sin stocks in seven large European markets and Canada outperform similar stocks by about 2.5 percent a year.
(Sin stocks, by and large and slow but consistent growers and have a tendency to do relatively well in recessions. However, an alternative to owning sin stocks is to merely cut stock exposure when earnings estimates on the S&P 500 begin to show material weakness. However, the author is using a simplistic “buy and hold” approach that is great in a secular bull market but is frustrating in a secular bear which we have today.)
The conclusion we can draw from this study is that social norms have important consequences in for the cost of capital of sin companies. They also have consequences for investors who pay a price in the form of lower expected returns and less effective diversification.
(He would largely be correct but he’s assuming there aren’t other methods of circumventing sin stocks as I’ve mentioned previously. I’m starting to think that he’s “talking his own book”)
While many investors will vote “conscious” over “pocketbook,” there’s an alternative to socially responsible investing that’s at least worth considering: Avoid socially responsible funds and donate the higher expected returns to the charities that you are most passionate about. In that way, you can directly impact the causes you care most about and get a tax deduction at the same time!
(Or! Why not find a manager who uses Small Cap Value and can still post very good and competitive returns while still avoiding Sin stocks…..yes, now I’m talking my own book 🙂
Its been no secret that 2011 has been a difficult year. A year that can make you doubt everything you’ve ever learned, tested and retested our models countless times even on vacation. (I refuse to allow the glare of the sun on the beach disable my ability to read our strategy test results on my Ipad. I know, that’s pretty pathetic.)
It should be a given to any investor that no strategy works wonderfully all the time, 2011 is enough to prove that. Long term investing has more to do with perseverance and discipline to your strategy regardless of your emotions and the market environment. With persistence, in the long run you should do quite well.
I’ve never made it a secret that I’ve been a fan of James O’Shaughnessy and his book: “What works on Wall Street”. The RMHI investment model is based on Shaughnessy’s “Trending Value” model but interpreted for Socially Responsible Investors.
But more importantly what strategy has worked the best for the past 50 years?
Well, Shaughnessy has released a new paper on “Trending Value” and it has trounced every other model that I’m aware of for the past 50 years.
“Its annualized return of 20.58% through Sept. 30 crushes the All Stocks benchmark (an equally weighted benchmark of stocks with an inflation adjusted market cap great than $200 million), which has a return of 10.71%. Plus, the Trending Value approach achieves its return with a volatility of 17.69%, lower than the benchmark’s 18.26%.
“The strategy makes use of one of the main innovations from the book: the use of a composite value factor. In the original publication, we identified price-to-sales as the most effective value factor. In this latest edition of the book, we have learned that a composite that combines several different value factors delivers stronger returns and more consistency than any individual factor.
By spreading our bets and ensuring that a stock is cheap in a variety of ways, we believe we can identify better stocks. One version of the composite value factor combines the following measures of value:
• Price-to-Sales
• Price-to-Earnings
• Price-to-Book
• Price-to-Cash Flow
• EBITDA/Enterprise Value
• Shareholder yield (dividend yield + rate of share repurchases)”
Now this gets interesting since RMHI has been using a composite model since the beginning of our model based strategy. It would be fair to say that we were one step ahead of Mr. O’Shaughnessy but now the gap is closing and I find that confirmation of research affirming our strategy a major confidence boost in a difficult environment.
Significant differences remain between O’Shaughnessy’s model and our own. Its impossible to know what the weighting of each criteria are since they have not been provided. In addition, the O’Shaughnessy model focuses on only holding stocks ranked in the top 10% of their ranking system while we have found that holding the top 1% versus the top 10% over time sharply improves returns.
Chart courtesy of American Association of Individual Investors
It should be noted at this time that O’Shaughnessy does not have a public fund that exclusively advertises itself as “Trend Value” but many of the stocks highlighted on AAII as acceptable to the TV and included in his “Tiny Titans” screen are also stocks found in our portfolios in the recent past:
Material Sciences
Core Molding Technology
Datalink
Town Sports International – current RMHI long position
While its obvious to see that the volatility of the portfolio is greater than that of the S&P 500 the returns more than make up for it in the long run.
All the best,
Brad
Long CLUB
This may be premature but I’ve noticed that our portfolios have been outperforming for the past three days. That may not sound like much but I believe its an indication that the breadth of the market is improving and that the major indices are masking underlying strength.
When underlying market strength is weak, the major indexes that you can own via ETF’s or Index mutual funds tend to do relatively well. However, when underlying strength is weak there is a strong tendency for individual equities and small caps to outperform. This could be the case now, time will tell. It has been 10 months since we last outperformed so the tide may be turning.
We continue to hold Appliance Recycling Centers of America ARCI Green Plains Renewable Energy GPRE and have a small position in Perma Fix Environmental Solutions PESI.
Severe sell off in solar play First Solar FSLR a former high flying darling of the solar energy industry. FSLR came out with a statement that 2012 earnings will be roughly half of analysts expectations. We have no position in FSLR but I must say the price is getting interesting.
FSLR share price is $33.90
The balance sheet is solid: Book value is $46 which includes $8 in cash and the equivalent of approximately $7 in debt.
But the market cap is now below revenues, which indicates very good value.
Its probably too early to buy as the stock needs to stabilize and the source of the earnings weakness must be determined. Stating again for the umpteenth time: Europe is the primary source of Alt Energy revenues and Europe is cutting back severely through austerity programs to curb their debt. Alt Energy will be sacrificed in the meantime as for most countries its a discretionary expense.
Long ARCI, PESI and GPRE
The one thing you can always be sure of in investing is that waiting for the all-clear signal that the economy and the world is fine is to invest when its too late. Several times Warren Buffet has stated that his best buys were during times of fiscal or monetary stress.
If you consider the present market valuations with the SPX at 1233 and 2012 earnings estimates presently at $108 this translates into a market selling at 11.5 times 2012 earnings. 11.5 is very good considering we’re not going into recession anytime soon and the historical average is a market selling at 15 times earnings.
Does this mean there is significant upside? Yes there is but it also means you have to have the stomach and nervous system to close your eyes and ears to the Cassandra’s and their calls for worldwide crisis. Keep in mind the crisis is primarily in Europe and calls for investment calamity rarely work. Its my guess that the Europeans will eventually isolate and put their crisis to bed but it will be a slow and gradual process, not a swift stroke that defines a solution.
There is another market factor that I maintain a closely kept eye on……..my own state of nervousness and apprehension. Rarely have I ever been this nervous and in previous cases my state of uneasiness is usually associated with market bottoms. I can’t even go on a vacation to a beautiful island with my incredible wife without keeping an eye on my stomach churning along with the markets. Needless to say, its pretty pathetic.
What causes me the greatest stress is the lack of traction by our value oriented small cap holdings. At present large stocks are making more net progress with little progress if any by small caps. While I’m sure this is a temporary situation it still causes me a great deal of angst.
My interpretation of this action is that investors have deleveraged away from investments that provide Alpha. In English, this means investors have sold and continue to avoid investments that normally do much better than the S&P 500 over time in an effort to avoid almost all kinds of risk. While the popular theme to buy a Treasury bond yielding just under 2%, they avoid a steady 10% grower paying a 4% or more dividend as in Cedar Fair LP FUN or Tessco Technology TESS.
One nagging question that plagues any investor using quantitative strategies is: Has your model simply lost its effectiveness? I’ve given this serious thought but our models are relatively simple in construction so “curve fitting” (creating the model to have capitalized on the near term past) is very unlikely. But I also monitor close to 50 models on a daily basis and there is a trend. The trend is away from small to mid size companies. I actually take a small degree of comfort in this since it means this phenomena is very likely to be a short term cyclical issue and not a long term signal. In addition, since small companies tend to focus primarily on the US they avoid what may be a severe recession in Europe that large cap companies with overseas revenues will be exposed to.
All the best,
Brad
Long FUN and TESS
