Investing in 2012 will likely be very profitable

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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The January Barometer

The market as measured by the S&P 500 finished the month ahead +4.4%. Since 1950 there have been 18 Januarys in which the S&P 500 gained in excess of 4%, as it did this year. The S&P posted gains for the rest of the year on 17 out of the 18 occasions. The only failure was 1987 when the S&P gained 13.2% in January but ended up losing -9.8% between February and the end of the year. The last time there was a 4% plus January was in 1999 and the S&P 500 gained another 14.8% over the next 11 months.

Whether history will repeat remains to be seen, but there is no denying the prior history of 4% plus Januarys has been remarkable. Another positive today by our interpretation, was a “Golden Cross” buy signal. A buy signal is generated when the 50 day moving average of the S&P 500 closes above its 200 day moving average. There have been 5 previous “Golden Cross” buy signals since 2003. All of them were successful with the S&P 500 gaining an average of 8.6%, 12.9%, and 17.1% over the next 3, 6, and 9 months.

Whats the Top Stock Market Strategy of the past 50 years?

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

 

Potential retest of the August low

Right now the SP 500 is selling off hard to 1126 down 40 points on the day in response to Fed’s remarks yesterday.   While they see the weakness in our economy and the growing risks in Europe they’re willing to do little at this point.   I must admit to feeling much better hanging on to our SDS hedges and not getting sucked into the rally last week, as this is a moment I’ve anticipated.

The SP500 is near the bottom of its trading range of 1100 to 1230 and this morning I’ve sold our SDS hedge for $25.41.

While the economy is weak the consensus opinion is that the US is already in recession, but this may not be the case:  The Conference Boards leading economic index (LEI) rose .3% for the fourth straight month, expectations were for a .1% gain.  The Conference Board put the chances of a recession at less than 50% but also suggested risks were rising.

The Ned Davis Economic Timing index has dropped but still remains at a level consistent with modest economic growth.

In addition, the FHFA purchase only housing price index rose .8% in July and while it remains 3.3% below its reading of a year ago it could be showing early signs of stabilization since this is the highest reading of 2011.

Investor sentiment is dismal, no doubt there but one must keep an objective eye on the data.   While many consider the Fed’s lack of action as a negative, in my opinion the ball is really in the court of our political leaders.  Fiscal policies are likely to have a greater impact on our economy than monetary policy.  Monetary policy in balance sheet deleveraging economies is essentially pushing on a string since there is little loan demand.  Individuals and corporations are saving capital rather than spending, hence you could drive rates down to 1% across the board and still see little ripple effect.

Lastly, from a technical viewpoint the early August low saw over 1200 stocks on the NYSE make new annual lows.  At present the number is 735 which is a positive divergence and an early sign that selling could be exhausting itself.

While this smells acts and trades like a Bear Market, the news is not completely awful, just partially disgusting.  Hence, based on my short term trading models we’re at a short term extreme and a bounce should be expected.  Till proven otherwise we remain in a 1230 to 1100 trading range.

Brad

No positions

Not a bad day so far

Stocks are trading down heavily this morning with the Dow currently down 330.   Despite this we’re not having a bad day as our hedges remain in parabolic mode with rumors of a potential European bank failure.

GLD a new all time high of $174 corresponding to $1800 Gold.  Laggard hedge SLV trading higher up $1.65 to $38 and the Swiss Franc ETF FXF trading dow $1.21 to $135 after hitting $140 yesterday.

We remain steadfast in holding a great deal of cash as I used yesterday’s bounce to trim more equity holdings.   I have yet to deploy cash in any meaningful way towards equities, the timing just isn’t right yet.

If we had seen a strong opening in the US I likely would have added Inverse Exchanged Traded Funds “SDS”, but the weak opening does not make that a smart trade.  Hence a better opportunity to play the downside will present itself eventually.

Market bottoms tend to be a process, not a specific point in time.   Stocks will fall to a meaningful low then stage a significant bounce that could recapture 30% or 40% of the decline before selling off once more to retest the previous low.  This process can repeat itself several times, in successful bottoming action each selloff has less and less intensity.

Buying the retest is a much better option than trying to be the hero and pick the bottom.  Early rallies fail almost every time and its devastating to the psyche to think you may have bought the low only to find that a month or two later you’re right back where you started.  In 2008 the climactic low was in November but the best investable low came months later in March 2009.

Brad

 

Long GLD, SLV and FXF