February 21, 2012 4:01:56 pm
Breathing a sigh of relief
There’s a feeling of relief that wells up when thinking about the stock market and 2011. The feeling one gets is analogous to the end of a horror film where the hero is driving away from catastrophe and devastation while looking in the rearview mirror, exhausted but ecstatic that the drama has come to an end. The past year reminded investors that they should hope for the best, prepare for the worst, and be thankful when reality does not match their fears.
Investors entered 2011 with hopes that the world economy would continue recovering from a long and painful deleveraging process. Equity markets had posted two straight years of positive performance, central banks remained committed to pro-growth monetary policy, and major developed nations were focused on reducing debt.
By mid-year, however, optimism faded as troubling events around the world dominated headlines. The devastating earthquake and tsunami in Japan, political unrest in the Middle East, rising oil prices, a US credit downgrade, the threat of another global recession, and an escalating debt crisis in Europe weighed heavily on markets. As stock market volatility returned to global financial crisis levels, investors faced a major test to their discipline and staying power.
Although US stocks experienced some of the highest volatility in years, the broad US market delivered flat performance in 2011. If dividends are factored, the S&P 500 had a total return of 2.11% for the year. Developed markets logged negative returns, and emerging markets had mixed performance, with most countries also underperforming the US. The bright spots were in the fixed income arena, where a flight to quality triggered by the euro debt crisis and US credit downgrade boosted returns on US government securities, inflation-protected securities, and municipal bonds.
The World Stock Market, as measured by the MSCI All Country World Index, did not fare as well as the domestic markets and finished down7.35% for the year. Commodities started 2011 with a bang fueled by expectations of an improving economy. Copper, cotton, and corn hit all-time highs in the first half of the year. Crude oil experienced double-digit returns in response to anticipated higher demand and threats of supply disruptions tied to political unrest in the Middle East. The Dow Jones-UBS Commodity Index peaked in April, then fell 20% as the global economic outlook faded. The index returned -13% for the year—its first negative return since 2008. The most notable exception was gold, which set more records in 2011 and peaked at $1,888.70 per ounce in August before declining in the fourth quarter to return about 10% for the year.
Volatility was king in 2011 as investors in US equities had to endure a heavy dose of uncertainty for their moderate gains. The S&P 500 Index reflected this volatility by closing up or down over 2% on thirty-five days in 2011, compared to twenty-two days in 2010. By contrast, before the global financial crisis, the index did not have a single day with a 2% or more movement in 2005, and only two days in 2006. Market observers also documented higher correlations among individual stocks and between asset classes. In 2011, there were sixty-nine days in which 90% of the S&P 500 stocks moved in the same direction, which is more than the combined total for 2008 and 2009. Higher correlations are common during periods of uncertainty, as macroeconomic forces overshadow the impact of a company’s business fundamentals on its stock price.
Much of the higher volatility was brought on by the reoccurring themes: European debt issues and economic uncertainty. The sovereign debt crisis intensified as European authorities struggled to avert a Greek debt default and alleviate fiscal pressures in Italy and France. But these restructuring attempts fell short of market expectations, which spooked investors and raised concerns of additional sovereign debt downgrades and a possible breakup of the Eurozone. The crisis also hurt European banks holding large positions in sovereign debt. To avoid losses, leading institutions reduced lending and dumped assets, which depressed asset values. Higher borrowing costs in the most indebted countries, combined with reduced government spending and revenues, raised more concerns that the Eurozone was entering a recession in late 2011.
Since the global financial crisis in 2008, central banks and governments have taken bold measures to fuel business activity and stabilize financial markets—and investors have eagerly awaited signs that economic recovery has taken hold. The economic signals continued to be mixed in 2011. Favorable US news included strong corporate profits and dividends, substantial levels of cash on corporate balance sheets, low interest rates and inflation, a booming domestic energy sector, continuing strength in auto sales, record-high share prices for some multinationals, and improved fourth-quarter numbers in manufacturing, exports, consumer confidence, and employment. Pessimists could point to the longstanding jobless trend, slumping home prices, tepid growth in retail sales, worrisome levels of government debt, and political gridlock at both the national and state levels.
Although emerging economies showed resilience, investors were concerned that another recession in Europe would impact its trading partners in emerging economies—and particularly in China, where high inflation and a manufacturing slowdown threatened to send its previously fast-growing economy into recession.
The economic uncertainty and European debt crisis made an already delicate world economy even more fragile. Investor sentiment seemed to change with the tides and the world wondered if the US would continue to be the safe haven in troubled times with the threat of a downgrade of US credit looming. The downgrade became a reality and concerns were put to rest. Despite the S&P’s downgrade of the US credit rating in early August, investors fled to US government securities as concerns mounted over the sovereign debt crisis in Europe and political stalemate over the US debt ceiling. Investors also reacted to uncertainty in the equity markets by buying US stocks over the equities of other developed countries.
So what does the future hold? Will 2012 outperform 2011? As is always the case it depends on to whom you talk to. The resident bears are predicting another year of extreme volatility in the markets caused by continued concerns for a possible recession in the Eurozone and a bifurcated US government unable to come to a consensus on major issues. Bulls will cite history and point out that presidential election years have overwhelmingly produced positive stock market returns. Since 1928, there have been 21 presidential elections and only three have produced a negative return for the S&P 500. Of course one of those years was 2008 when the S&P 500 lost 37%. Even with 2008 as a reminder, certainly the odds are in favor of a positive year based on these figures. REDW Stanley likes to look at the future from a fundamental standpoint. Fundamentally, the market is discounted. The Price-to-Earnings ratio (P/E), based on earnings estimates for the next year, is 11.8x compared to 13.1x a year ago and compared to a 15 year average of 16.9x. Other important valuation metrics are also well below their 15 year averages such as Price-to-Book (P/B), Price-to-Cash Flow (P/CF) and Price-to-Sales (P/S). We believe the market will continue to be volatile in 2012 and our portfolio construction will reflect this belief; however, we also believe the fundamentals will prevail and the market will trend higher in 2012.
By Jude V. Gleason, CFP®, AIF®, MBA
Chief Investment Officer
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