First and foremost, Happy New Year to all! I apologize for the longish time between newsletters; December was a busy and eventful month for me. I am flattered by the several people who asked when they’d see my next missive; a few even called to make sure I had their correct email! (It’s nice to be missed.) My plan for 2012 is to write a newsletter roughly twice a month; with Adam Bragman now helping me, I should be able to stick to that schedule.
Many of you were able to attend our annual New Year’s Day party at my home. It was a great success, with over 90 attendees. If you did not receive an invitation for this year and want to be on next year’s invite list, please let me know.
And now, down to business!
The Market Roller Coaster of 2011: U.S. Stocks
If you were to guess how the U.S. stock market performed in 2011 based solely on news headlines, I couldn’t fault you for thinking that the market gave back a meaningful portion of its gains over the past two years. But somehow, between the budget standoff and federal debt downgrade, the continuing crisis in Europe, the collapse of MF Global Securities, an earthquake/tsunami in Japan, floods in Thailand and worries about a slowdown in China, the S&P 500 index finished the year right where it started. It’s almost comical that 2011 ended flat when we saw a -16% decline in just 10 trading days during the summer.
This past year is a perfect illustration of one of the facts about stocks that amateur investors regularly forget (or maybe never knew in the first place): the annual variation in stock prices is nearly double their average annual return. In other words, stock prices move much more within a year than they do from one year to the next. That’s exactly why the successful investor must think long term, and ignore the daily, weekly and even monthly price swings in the markets. Otherwise, you’ll lose too much sleep and may end up buying high and selling low—the opposite of what you want.
A strong finish in 2010 and a fast start in 2011 had many convinced that we were on our way to another year of double-digit returns. However, few could have foreseen that the final months of the year would bring a U.S. debt downgrade and a significant worsening of the sovereign debt crisis in Europe. During these months we experienced extremes of volatility in both domestic and overseas markets, occasionally as much as +/- 5% in a single day. Yet somehow, through all the uncertainty, the U.S. market was resilient enough to recoup the summer’s losses. If you listen mostly to Fox or CNN, you’ll likely have missed the events—concerted action by central banks around the world, continued economic strength in many countries (including the U.S.), and strong corporate earnings and balance sheets—that were likely the main contributors to market strength late in the year.
The Market Roller Coaster of 2011: Overseas Stocks
The rest of the world’s markets did not fare as well as the U.S. during 2011, posting a return of –14.0%. (Our equity benchmark, the MSCI ACWI, which includes the U.S., returned –7.8% for 2011.). After promising performance in 2010, the stock markets of many countries dropped decisively; Germany, for example, saw its stock index decline –17.6%. From the graph below, you can see just how poorly some countries performed, especially India, which has given up nearly all of its post-2008 gains.
Only a few countries saw positive returns in 2011: Ireland (+11.71%), New Zealand (+3.32%) and Indonesia (+4.18%).
Other significant 2011 performances include:
Europe (–13.4% overall): Italy (–25.7%), Netherlands (–15.1%), Spain (–17.2%), United Kingdom (–5.6%), Greece (–63.6%).
Asia (–14.1% overall): Hong Kong (–20.5%), Singapore (–18.9%), Australia (–9.6%), Israel (–26.8%).
The Market Roller Coaster of 2011: Other Assets
Stocks weren’t the only asset class to have a wild 2011; bonds, real estate, commodities and hedge funds all swung wildly, with some positive and some negative for the year. Here are the numbers for you data hounds:
US Treasuries (10-Year): +15.66% (IEF)
US Corporate Bonds (investment grade): +9.13% (CFT)
US High-Yield (junk) Bonds: +5.11% (JNK)
Foreign Bonds (developed): +5.32% (PFBDX)
Foreign Bonds (emerging): +7.65% (EMB)
REITs (US): +8.63% (VNQ)
REITs (foreign): -14.42% (DRW)
Commodities (GSCI index): -3.28% (GSG)
Gold: +9.57% (GLD)
Hedge Funds: -7.4% (DJ-CS Core Hedge Fund Index)
Money Market Funds: +0.03%
What’s Likely to Be on Investors’ Minds in 2012?
(1) Europe – I know you’re probably as tired of hearing about it as I am writing about it. But the problems in Europe are not over, not by a long shot. However, during the second half of last year, European politicians and bureaucrats finally understood the depth of the Eurozone’s problems and are taking steps, however halting, to fix them. I expect continued ups and downs related to events in Europe during 2012, but I doubt they’ll be as marked as in 2011. The big issues are the refinancing of maturing debt in Italy and Spain, whether Greece will be able to stay on the Euro, and the recapitalization of Europe’s banks. There will probably be more than a few surprises, both good and bad. Fortunately, markets seem to have mostly priced in the bad, so that good news could have a larger effect on prices.
(2) “Re-risking” – The stock market’s decline and volatility during 2011 caused many investors to sell equities in favor of traditionally less risky assets such as investment-grade bonds, Treasuries and cash. This flight to safety will cost these investors when interest rates eventually rise: their bonds will fall in value and their cash will be devalued by inflation. When interest rates will go up is anyone’s guess, but we know they can’t go much lower, and they won’t stay super low forever. Individual investors will eventually buy back into stocks, but if history is any guide, most of the buying will occur well after prices recover. The successful investor buys ahead of the crowd.
(3) Bipartisan bickering – Usually investors respond favorably when politicians butt heads and nothing gets done in Washington. That is, unless the stalemate leads the U.S. to nearly default on its debt. Given that this is an election year, there’s little chance that Democrats and Republicans will learn to “play nice” before November. Election uncertainly can also lead to market volatility. The good news is that, as usual, the incumbent party will do their best to stimulate the economy so that things look better when voters enter the polling booth.
(4) Jobs and more jobs (and farewell to Steve Jobs) – Although not particularly important to the stock market, employment in the U.S. appears to have turned the corner. I expect continued and probably strengthening employment growth during 2012 and a progressive drop in the unemployment rate. The main effects of an improving employment picture will be better consumer sentiment, which may well translate into higher spending.
(5) Tail risks/catastrophic events – With global stocks priced cheaply by almost any valuation measure, the market appears to be discounting the possibility of catastrophic events (often called “tail risks” owing to their very low likelihood). The most widely feared tail risk is the collapse of the Euro, which may be the largest contributor to the market’s current discount. While anything can happen, the Eurozone countries have way too much invested in the Euro to let it collapse, and we finally see them working towards a sustainable plan for currency’s future. Once it becomes clear that the Euro will survive, perhaps sometime this year, markets may rally strongly. Most other tail risks are completely unpredictable, and thus not worth worrying about.
(6) Asian action – With most of the focus on Europe and the U.S., we tend to forget about Asia, which is huge and mostly growing very quickly. Fears of a “hard landing” in China have put a damper on both commodity prices and Asian stock markets, but recent data suggest that these fears are unfounded. Inflation is coming down, allowing China to ease monetary policy (which it has already started), while economic indicators show a re-acceleration of growth. In the meantime, Japan continues to rebuild, expectations for India couldn’t be lower, and Thailand is cleaning up after the floods. The latter put much more of a damper on technology spending than most people appreciate. Nearly all conventional hard drive production depends on Thailand for components, assembly or both; the floods knocked out most of the factories, creating a worldwide shortage of hard drives. This shortage should finally be alleviated by the 2nd or 3rd quarter of this year, and the pent-up demand could cause a surge in technology spending.
Whatever else happens in 2012, you can be sure of the following:
1. Stock prices will fluctuate.
2. People’s emotions will fluctuate, often in tandem with #1.
3. There will be at least a couple of major surprises.
Life is inherently uncertain, so why should investing be any different? And how boring life would be if we knew everything in advance!
May you have a healthy and prosperous 2012!