Market Perspective Full Year 2011 |
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Securities markets were roiled by uncertainty and volatility in 2011, slowing, if not ending, one of the most impressive recoveries in the history of the capital markets. External shocks to the global economy for the year included the earthquake and tsunami in Japan; the revolutions throughout the Arab world; the debt problems in Greece, and now other European countries; and the continuing political clashes in the United States over spending and taxes, along with Standard & Poor's downgrade of the country's credit rating in August. The repeated shocks culminated in a spike in stock market volatility, especially from August onward, and induced "risk-on, risk-off" lock-step market movements as investors swung quickly and indiscriminately between "risky" and "safe" investments. Global developed country governments, and especially the U.S. government, continued accommodative monetary policy to keep interest rates low to encourage corporations to spend and investors to allocate funds to risk-based assets. This easy-money policy proved to be less successful in 2011 as the European debt crisis accelerated and generally restrictive monetary policies in emerging countries to fight inflation slowed growth there. U.S. equities, and particularly riskier segments of global stock markets, fell during the year but fixed income securities posted solid positive returns. The average diversified U.S. equity fund returned -2%, and the average diversified foreign equity fund returned -14% according to Morningstar. The Barclays Capital U.S. Aggregate Bond Index rose 8%. U.S. government bonds earned 9%, aided by the flight to quality, and credit-sensitive intermediate investment-grade bonds returned 5% according to Barclays indexes. The average high yield bond fund returned "only" 3% according to Morningstar. Finally, foreign government bonds provided a total return of 5%. Time is an investor's best friend, and any year-end review is a snapshot of a short period. We must remind ourselves that markets' movements are cyclical; they retreat and rebound due to reversion to the mean, and they move upward as rapidly as they move down. It is very easy to linger too long in the perceived safety of a recently high-performing asset class. Particularly, it is easy to get comfortable with a decreased exposure to stocks, thereby incurring an opportunity cost by missing the benefit of the ensuing bull market run-up. Economic ReviewDespite the volatility of the capital markets, the U.S. economy continued to slowly improve during 2011. The U.S. economy, as measured by gross domestic product (GDP), expanded 1.8% (annualized) during the third quarter of 2011, 1.3% during the second quarter, and 0.4% for the first quarter following expansions of 2.3% and 2.5% during the fourth and third quarters of 2010. Due to the slower rate of expansion of this recovery, real GDP is expected to be in the range of 1.5-1.8% for 2011. The U.S. economy continued to show signs of improvement during 2011. The Manufacturing ISM Index ranged from 50.6-61.4 during 2011 and finished the year at 53.9 in December. The Non-Manufacturing or Service ISM Index ranged from 52.0-59.7 during 2011 and finished the year at 52.6 in December. Readings above 50 indicate that the economy is generally expanding while readings below 50 indicate a contracting economy. December was the 29th consecutive month of growth in the manufacturing sector, the 25th consecutive month for the service sector, and the 31st straight month of expansion in the overall economy according to the indexes. We note that although the economy has been expanding for approximately 2.5 years, the rate of expansion is extremely low, particularly considering the very low starting point at the bottom of the Great Recession. The Federal Reserve Board reported in its January Beige Book that "national economic activity expanded at a modest to moderate pace during the reporting period of late November through the end of December…with most Districts highlighting more favorable conditions than identified in reports from the late spring through early fall." The employment situation continued to improve slowly during 2011. According to the Bureau of Labor Statistics, 1.6 million non-farm jobs were added to payrolls during 2011, including 131,600 in October, 131,700 in November, and 200,000 in December. Transportation and warehousing, retail trade, manufacturing, health care, and mining added jobs, while local and state government lost jobs. Unemployment fell throughout the year from 9.4% at the end of 2010 to 8.5% in December 2011. The lowest unemployment rate in almost three years and cheaper gasoline appear to be bolstering consumer spending. Consumer spending is important, as up to 70% of the economic growth in the U.S. has historically been driven by the consumer. The Consumer Confidence Index was 64.5 in December 2011 compared to 52.5 a year ago. Finally, the Consumers Expectation Index, a measure of how individuals feel about their finances six months in the future, increased to 76.4 in December 2011, compared to 68.2 a year ago. Despite an increase of 1.7% in home sales in 2011, the outlook for housing markets in 2012 remains uncertain. Lower mortgage rates, improved job conditions, and rising rents helped the housing market in late 2011. The inventory of homes for sale declined to a 6.2 month supply, the lowest level since 2005. A range of 7-9 months supply is generally consistent with stable home prices. But as Federal Reserve officials said in a Jan. 5 report delivered to Congress, "high unemployment and weak income growth have made it difficult for many households to purchase homes despite the large declines in house prices and mortgage rates." In addition, banks may seize more than a million U.S. homes in 2012 after legal scrutiny of their foreclosure practices slowed actions against delinquent property owners in 2011. Inflation accelerated in 2011 as the Total Consumer Price Index (CPI) rose 3.0% versus a 1.5% increase in 2010, and the Core CPI (excluding food and energy) rose 2.2% following an historical low of .8% in 2010. This was the largest annual increase since 2007. The acceleration in Total CPI was primarily due to increases in energy and food: the energy index was up 6.6%, fueled by an 18.0% increase in the fuel oil index and a 9.9% rise in the gasoline index; and the food index rose 4.7%. The Core CPI was primarily influenced by a 4.6% increase in the apparel index and a 4.0% rise in the new vehicles index. Asia's fast growing economies continued to expand but at a lower rate in 2011, slowed by reduced European demand. China, the world's second largest economy, expanded at it's slowest pace in 10 quarters as Europe's debt crisis curbed export demand and the property market weakened. For 2011, China GDP slowed to 9.2% from 10.4% in 2010, staying above the 8% rate that SinoPac Financial Holdings Co. says would signal a "soft landing." The Chinese government has set a target of 7% annual growth through 2015. China has been trying to curb inflation and rein in housing prices. The slowing growth in expected to allow China to ease monetary policies to boost domestic demand without setting back progress made in curbing inflation. In Japan, GDP grew an annualized 5.6% in the third quarter of 2011. This followed two quarters of contraction after the March 2011 earthquake and tsunami severely damaged manufacturing supply lines around the world. Japan's economy continues to suffer from 1) high government debt limiting the government's options to stimulate the economy, 2) crippling domestic deflation prompting consumers to delay purchases, and 3) shrinking exports as a strengthening yen makes Japanese products more expensive overseas. In Europe, economic growth slowed to a crawl during the third and fourth quarters and many economists predict a recession in 2012 (recession is usually defined as two consecutive quarters of economic decline). The European economy is important because 1) its combined economy is the largest in the world, and 2) the size and influence of the European financial sector. According to Eurostat, the statistical office of the European Union, Euro area GDP increased by 0.2% in both the second and third quarters, as Greece teetered on the brink of default and the contagion spread to Italy and eventually France – part of the core of the Eurozone. As the credit quality of sovereign debt deteriorated, banks sold sovereign bonds and other assets to increase reserves, governments enacted austerity measures that created a drag on economic growth, which perversely reduced tax revenues and worsened fiscal deficits, keeping investors reluctant to buy bonds even as yields rose. Even the normally strong German economy slowed in 2011; German GDP rose 3% for the year but contracted by .25% in the fourth quarter. France grew 1.6% for the year, but decreased .4% in the fourth quarter. Please note fourth quarter GDP statistics are preliminary. Equity ReviewResults were just about breakeven for U.S. stock investors but very negative abroad for local and U.S. dollar investors. The broad U.S. stock market gained 0.6% in 2011 as measured by the Wilshire 5000 Index (equal-weighted). For U.S. dollar investors, the MSCI EAFE Index of large developed country foreign stocks was down 12.1%, and the MSCI Emerging Markets Index lost 18.4%. Price-to-earning ratios are one indicator of the level of stock valuations, be they either high or low. According to Morningstar, from the end of 2010 to the end of 2011, the price-to-prospective earnings of diversified equity mutual funds declined. None of the 2011-ending ratios were out of their typical ranges. Data are as follows:
After trading at a higher P/E ratio at the end of 2010 relative to foreign developed country stocks, emerging countries stock funds returned to trading at a lower ratio at the end of 2011. Emerging stocks traditionally trade at lower P/E ratios than those of foreign developed countries stocks due to the perceived additional risks of investing in emerging markets. The year 2011 included three contrasting time intervals, as shown by the following table of global stock returns:
Many U.S. stock sectors provided negative returns for the year, and the sectors that gained the most in 2010 were generally the losers in 2011. Utilities (10.6%), health (7.7%) and real estate (7.5%) stocks held up the best. Communications (-5.3%), technology (-7.6%), energy and other commodities (-14.0%), and financials (-15.1%) stocks fell the most during the year. Among the more common ways to differentiate among stocks is by size (larger capitalization versus smaller) and by style (value versus growth). Large-cap stocks are measured by the Russell 1000 Index and small-cap stocks are measured by the Russell 2000 Index. Ignoring style considerations, large-caps gained 1.5% and small-caps lost 4.2%. This year's results reflect the flight to safety in 2011, in contrast to the pattern of higher performance of small caps that has characterized markets since the Internet Bubble burst in 2000. For the full year, growth style indices modestly outperformed value style indices by about 2 percentage points. Results by style for mutual funds were about the same as indices, though variations were somewhat smaller. Large-cap growth funds beat large-cap value funds by about 1.7 percentage points. Similarly, small-cap growth funds outperformed small-cap value funds by about .9 percentage points. The preference for growth stocks was a repeat from 2009 and 2010. Before 2009, a preference for value stocks had persisted since the Internet Bubble burst in 2000. Like the representative indices, the average diversified large cap fund moderately outperformed the average diversified small cap fund (-1.5% versus -3.9%, respectively). Please note that classifications of mutual funds by style have their limitations. Longer-term U.S. stock data reflect the deep 2008 slump and the extent of the 2000-2002 bear market correction, especially among larger capitalization and growth-oriented stocks. The table below covers two bear markets, one bull market (2003-2007), and the 2009-11 rebound, and shows annualized twelve-year returns for 2000 – 2011:
As noted previously, value stock returns should equal or exceed growth stock returns, and small cap returns should equal or exceed large cap returns in the long run. The unwinding of the tremendous disparity between the performance of small value funds and large growth funds over the first seven years of this period has made negligible net headway over the last five years of the twelve year period. In 2011, the weak returns for broad, capitalization-weighted market indexes were indeed representative of performance at the level of individual stocks. For the three U.S. stock exchanges combined, 2,958 stocks advanced and 4,874 stocks declined. The corresponding advance/decline ratio of .61 places fourth lowest, well below the 1.80 mean and 1.45 median, in the 22-year period we have been tracking. As reviewed in the past, the advance/decline ratio has its limitations. Nonetheless, the low value of the advance/decline ratio in 2011 after an extremely high value of 4.09 in 2009 and more moderate value of 2.75 in 2010 provides some credence to the hope that U.S. stocks begin to appreciate again over the next year. Foreign stock markets significantly underperformed the U.S. market in 2011 in both local currencies and as translated into dollars. For U.S. investors, foreign returns in local currencies are decreased by the currency gains associated with any strengthening of the dollar, and vice versa when the dollar depreciates. The U.S. dollar gained about 2.1% verses 6 currencies tracked by the U.S. Dollar Index, primarily due to gains against the euro, British pound, Swiss frank and Canadian dollar; the dollar fell against the Japanese yen. Dollar appreciation thus generally hurt results in foreign developed countries. Against emerging markets currencies, the dollar also appreciated significantly and was a further drag on very weak results in local currencies. The average mutual fund investing in international stocks lost -13.6% for the year, somewhat worse than the MSCI EAFE return of -12.1% in U.S. dollars. The MSCI EAFE Index covers developed markets outside of the U.S. and Canada. Emerging markets stocks' significantly negative returns in 2011 suffered from repeated "risk-off" periods during the year as investors sought the relative safety of bonds and U.S. stocks. The MSCI Emerging Markets Index fell 18.4% in U.S. dollars, depressed by currency losses due to the strengthening U.S. dollar versus emerging market currencies noted above. Over the five-year period 2007-2011, emerging markets stocks have provided a positive return of 2.4% per year in U.S. dollars, as measured by the MSCI EM Index, notwithstanding catastrophic losses in 2008. U.S. stocks broke even for the 5 years, and foreign developed country markets lost about 5% per year. Despite the recent sell-off, the economies of emerging countries are expected to continue growing faster than those of developed countries and will be prime beneficiaries when recovery of the global economy pushes up demand for energy and commodities. Looking at global stock performance over the past five years, as measured by mutual fund returns, other salient observations are:
Global stock returns are summarized in the table on the next page; please see footnotes for enhanced understanding:
* Mutual fund return data are from Morningstar. ** Capitalization-weighted index of 500 very large U.S. companies. The 500 are chosen to achieve a fair cross-section of U.S. industrial and service sectors. Recent median capitalization of approximately $49.1 billion. ***Barclays index of U.S. Treasury bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years. No mortgage-backed securities included. ? Barclays index of U.S. investment grade corporate bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years. # Index of small U.S. companies. Recent median capitalization of approximately $1.0 billion. Somewhat overweighted toward financial stocks. ## International stock index indicating return of large foreign companies of 21 major developed countries (Japan, UK, and Germany have the highest weightings). Returns are unhedged and converted to U.S. dollars. No emerging market stocks are included. Stock Fund Managers Versus IndexesAlthough they have beaten a passive or indexing approach for nine of the past thirteen years, active U.S. stock pickers underperformed the S&P 500 Index in 2011. This result was not particularly surprising given that small caps, which typically comprise a higher allocation of fund portfolios than found in capitalization-weighted market indexes, significantly underperformed large caps for the year. Also, many domestic-focused funds had at least a small allocation to underperforming foreign stocks. As reported above, active international stock pickers also underperformed the EAFE index of developed country market returns. This underperformance probably had two causes. First, it resulted because most diversified foreign funds include some emerging market stocks, which underperformed considerably versus developed country stocks for the year. Second, as with U.S. small caps, foreign small caps typically comprise a higher allocation of fund portfolios than found in capitalization-weighted market indexes, and foreign small caps significantly underperformed foreign large caps for the year. Finally, it is noteworthy that active stock pickers, whether U.S.- or international-focused, must overcome fees for management of typically 1-2% per year versus zero cost for indexes. Alternative StrategiesWe began the year using six open-end funds. We eliminated one long-short fund from the grouping at mid-year. The six and then five funds used during 2011 provided a weighted average return of about 2.2% for the year. Consistent with their hedged, defensive positioning, they were beneficial for portfolio results given 2011’s choppy and mixed markets that were ultimately considerably in the red for stocks. Our alternative strategies grouping had results significantly better than the returns of global stocks but below those for global bonds. We note that our funds’ performance was considerably better than for the two relevant Morningstar categories. The category Morningstar calls Long-Short lost 2.8% in 2011, and the Morningstar category Market Neutral lost .3% for the year. For a typical Caves & Associates portfolio, the inclusion of alternative strategies produced a modest increase in 2011 return of about .3% (30 basis points) respecting the money allocated to alternative strategies, plus an increase in stability due to limited correlation of results with stock and bond markets. It should be noted that alternative strategies are particularly effective in down markets, and they had their best quarter compared with traditional asset classes when stocks were at their worst during the third quarter of 2011, when they added about 4.2 percentage points to investment results (again, respecting only the money allocated to alternative strategies, not the total portfolio). Looking at results covering the last four years of high market volatility, the alternative strategy fund grouping provided a four-year return of about 2.8% (cumulative; not annualized). For a typical Caves & Associates portfolio, the inclusion of alternative strategies therefore produced a decrease in the cumulative, non-annualized 2008-2011 return of about -9.1% (910 basis points) for the money committed to alternative strategies, including the impact of compounding. Most of this cumulative detriment occurred in 2010 when stocks had a very strong year, and our grouping also underperformed our expectations. Again, however, the inclusion of alternative strategies helped smooth client returns and thereby helped them “hold the course.” We are continuing to evaluate our use of alternative strategies funds overall, the representativeness of 2010 results, and the weightings of each of the funds in the group. Given our very cautious outlook (see below), alternative strategies will continue to be a part of our efforts to help clients stay disciplined and achieve long-term goals. Fixed Income ReviewFixed income performance was fueled by the European debt problems, the Fed’s low interest rate policies, and modest U.S. economic growth. Even the unprecedented downgrade of the U.S. credit rating increased demand for U.S. Treasuries. Long-term government and investment-grade bond funds returned a positive 29.2% and 17.1% including interest income for the year, respectively, according to Morningstar. Intermediate-term government and investment grade bonds produced more modest returns of 6.1% and 6.2%, respectively, for the year. Municipal bonds also provided positive returns for the year. Long-term and intermediate-term California municipal bond funds returned 11.7% and8.7%, respectively, for the year according to Morningstar, including tax-free interest earnings. It should be noted that effective returns to investors will be higher and depend on each investor’s tax bracket. Unhedged foreign bonds returns were disadvantaged due to the strengthening of the dollar during the year. However, they still provided solid results. The government bonds of major developed countries returned 5.2% in U.S. dollars for the year, as measured by the Citigroup Non-U.S. World Government Bond Index. Demand for the bonds of emerging markets was generally maintained due to the relatively strong economic advantages discussed previously. Emerging market bonds returned 7.4% for the U.S. dollar investor for the year, as measured by the JPM Emerging Markets Bond Index, but it should be noted this index does not cover bonds issued in local currencies and thus does not reflect the negative impact of U.S. dollar appreciation against many emerging market currencies. The average emerging market bond fund, which is typically unhedged, returned only 2.0% according to Morningstar. For the 5-year period 2007-2011, compound annual results for all major categories of bonds were solidly positive. Foreign bonds somewhat outperformed U.S. bonds. The following table and footnotes present fixed income results:
* Mutual fund return data are from Morningstar. ** Barclays index of U.S. Treasury bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years. No mortgage-backed securities included. *** Barclays index of U.S. investment grade corporate bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years. # Citigroup index of total return of foreign government bonds issued by major developed foreign countries (Japan, Germany, France, and UK have the highest weightings). Returns are converted to US dollars. ## J.P. Morgan index of total return of debt instruments issued mostly in dollars by 13 emerging markets countries (Argentina, Brazil, and Chile have the highest weightings). Returns are converted to U.S. dollars, as needed. Key Issues and Outlook for 2012Our outlook for 2012 is not rosy, but we think it is realistic. We expect a challenging year for the global economy and continued high volatility as investor sentiment turns almost on-a-dime from hot to cold, and vice versa, as witnessed for much of 2011. And we expect weak returns from both stocks and bonds. However, results for the year for a balanced portfolio could be positive, say mid-single digits, but again, that’s all we should realistically expect. Due to high uncertainty, as further described below, especially in Euroland, we must place a high degree of emphasis on defensiveness, be very selective in going on the offensive, and be as prepared as possible for a worst-case environment in which financial market results end up being rather negative for the year. And at the same time we must avoid market timing! The key issue for the 2012 outlook is debt crisis resolution in Europe. As goes the eurozone deleveraging, so goes the global economy over the next six to twelve months. The rapidly progressing sovereign debt crisis (think Greece, Spain, Portugal, Ireland, and the latest, Italy) is generating a debt deflationary feedback loop. The Great Recession caught these and other countries at a very vulnerable time due to profligate spending and borrowing in the years after creation of the European Union. Due to the economic downturn and associated high unemployment, these countries cannot afford to service their debt. Their credit ratings have plummeted, costs of borrowing have risen significantly, and creditors are demanding seemingly Draconian austerity measures to reduce government expenditures and increase government reserves exactly at a time when the opposite fiscal and monetary measures are needed to stimulate their struggling economies: a definite “Catch 22.” PIMCO’s December 2011 Economic Outlook explains the history, details the issues, and forecasts as follows: “The eurozone is facing an accelerated reversal of imbalances accumulated over several years after the creation of the euro. These imbalances are the product of differing real trends in productivity, labor flexibility, and national savings and investment rates across the member nations of the eurozone.” And further: “To judge the impact of eurozone deleveraging on the global economy, we must answer three questions. First, how much austerity will the eurozone impose upon itself to restore the balance between debtors and creditors? Second, will eurozone sovereign haircuts or defaults remain a part of the deleveraging process? And third, what role will the European Central Bank (ECB) play in controlling the depth, breadth and velocity of sovereign debt deleveraging?” Finally, “Will the ECB act aggressively to combat deflation, as it does to combat above-target inflation when the time comes? And if it will, what tools will it be willing to use, especially if policy rates are already at the zero-bound and the transmission mechanism of policy is broken? At this point, the rate of inflation in the eurozone is too high for the ECB’s liking and is thus likely to prevent the ECB from taking any dramatic steps to pre-emptively combat the forward deflation risks arising from a deteriorating economic outlook across the eurozone.” In conclusion, PIMCO believes the ECB will leap to the rescue only when it is too late, creating instability and pushing down asset prices, certainly in Europe and quite possibly also worldwide. We must turn to China and the U.S. to complete the picture of the 2012 economic outlook. Here, the news is not bright but is much less discouraging than for Euroland. China has joined the U.S., the eurozone, Japan, and the U.K. in some form of balance sheet deleveraging. Due to a combination of issues ranging from excess capacity, rising income inequality and bank capital stresses that will require a slowdown in the rate of credit creation, China is likely to slow future domestic investment in favor of a more balanced and stability-focused growth model. The major implication for the global economy is that the process of Chinese deleveraging and rebalancing could mean much slower Chinese growth and a smaller impact of Chinese aggregate demand on the global economy. In the U.S., deleveraging continues, but so does economic recovery, albeit gradually, and unfortunately, it does not seem to be accelerating. Limited job growth is frustratingly slow. According to PIMCO: “Were it not for the brewing crisis in the eurozone, and the expected slowdown in aggregate demand in China (and other emerging economies), the outlook for the U.S. economy might have been relatively sanguine for the year ahead. In 2011, U.S. GDP grew by a modest but decent 1.5% to 1.75%. But with global headwinds gathering – and U.S. expansionary fiscal policy becoming much more difficult to maintain – we think the U.S. economy will only manage 0% to 1% growth in 2012. This is substantially below the industry consensus expectation of 2% to 2.5% growth.” Even the casual reader will note the “reliance” on the world view of PIMCO. We are not their mouthpiece. They are indeed just one opinion, and there are numerous more optimistic forecasts for 2012 from major financial institutions. Nonetheless, PIMCO has excellent resources and brainpower, and a sophisticated projection process. Also, we note that the discouraging outlook of PIMCO has recently been echoed by the World Bank, and the World Bank employs a similar reasoning. In its updated report released January 18, 2012 the World Bank lowered its already moderate global growth forecast for 2012 by about 1.2 percentage points. According to the Wall Street Journal’s interpretation of the lowered forecast, “[it acknowledges] that the world is in a precarious position under threat of a Lehman-like crisis engulfing capital markets.” (The September 2008 bankruptcy of Lehman, a major U.S. investment bank and brokerage firm, precipitated the U.S. financial crisis that year.) The World Bank’s concern is that both developed and developing countries have diminished abilities to withstand a global crisis this time around, according to Mr. Andrew Burns, supervisor of the updated projection. High-income nations don’t have the fiscal resources to stabilize markets or support financial institutions in distress, he said. Emerging economies already were in the midst of a slowdown induced by raising policy rates aimed at cooling inflation, and the European crisis is adding to this weakness. It is important to note that the World Bank doesn’t expect the worst case of a Lehman-like crisis to become true, but it suggests preparing for such a possibility. Additionally, the World Bank’s lowered GDP forecast does remain somewhat above PIMCO’s. We next face the daunting task of translating economic forecasts to returns of global debt instruments and stock investments. This task reminds us of Mission Impossible, and we know not to do as Tom Cruise does; in other words, we should not take the assignment. As you know, we don’t favor market predictions, especially in absolute terms. We argue that the future is unknowable. The interplay of socio-economic and geopolitical factors is just too complicated to predict. Thus, we are against trying to time the market. However, we have tried in the past to identify factors and issues that are important in 2012 and beyond. These have been typically historical macroeconomic waypoints and trends which can help us narrow the range of potential outcomes in the future. Examples involve such key factors as global economic strength, the monetary and fiscal policies of the governments of major economic powers, rates and markets hitting all-time highs and lows, and relative valuations of major securities markets. We shall try again, albeit in vain. In 2012, the list of issues is not much changed from previous years. We said above the key issue is Europe. The threat of a failure to resolve Europe’s debt problems was still over the horizon last year but is now front and center. Additionally, 2012 brings further implementation of increased government regulation of business and consumer protection, the possibility of expiration of the 2010 Tax Relief Act (key provisions only extended to the end of February), the sunsetting of George Bush’s 2002 deep tax cuts next December, and the November Presidential election. These raise the possibility that tax, spending, and regulatory policy conflicts will only intensify, beg resolution, and thus add further to both business and personal financial uncertainty. As a consequence, developing an outlook is even more difficult than usual. As PIMCO’s Co-Chief Investment Officer Mohamed El-Erian declared, our current situation is “unusually uncertain.” To save time, and because of the potential futility, we are again presenting a condensed version of our outlook this year. We have already discussed one key determinant of securities prices, the strength of the U.S. and global economy, an important issue every year. The future course of the global economy is a major determinant of corporate profits and will therefore have a significant impact on global stock and bond markets. The expected decreasing global economic strength is a serious threat to continuation of the uptrend of corporate profitability. Numerous observers have also cautioned that 1) further cost-cutting as an avenue to increasing profits is unlikely to be continuable, and 2) previous period comparisons are growing increasingly challenging. Therefore, to summarize, the outlook is bearish for stocks and bullish for bonds. Notwithstanding the above, we believe there is a reasonable possibility that corporate profits have one more leg up. We note that a previous forecast by Caves & Associates was too pessimistic because it underestimated the persistency of the profit uptrend and stocks’ resiliency in the past. Unexpected strength of corporate profits therefore creates an upside to our stock outlook. Nevertheless, our base case, as reported above, is bearish regarding the global economy and stock prices. Another potential upside pertaining to global stock prices in 2012 is their performance since the previous market high in October 2007. Coming on the heels of stock price declines in 2011
Unfortunately, predicting future stock prices for a relatively short time horizon based on past results is an “analysis” we cannot give much credence. U.S. and global interest rates are a key determinant of bond results and also factor into stock valuations. The outlook seemed clear last year: rates had been historically low, and had but one direction to go, which was up. Instead, they went down. If interest rates have finally bottomed, future rate increases will cause capital losses on bonds, producing lower or even negative total returns. This risk of loss presents a serious challenge to portfolio allocation strategy. Bonds have been a traditional hedge against the inherent volatility of stocks and have almost always smoothed overall portfolio results. To dramatically reduce the bond allocation is to court excessive riskiness. Nonetheless, the weak global economic projection, if correct, should support stability of bond prices, or even small capital gains, until some future waypoint beyond our present time horizon when a bond bear market finally begins. As in the past, we must be resigned that the timing and magnitude of rate changes along the rate curve is not knowable. Whereas the outlook for the direction of the U.S. dollar is not particularly murky in the long-run—it must continue to depreciate—in the short run this long-run trend can be superseded by the effect of a “flight to quality” of global investors. Notwithstanding our huge deficit spending to stimulate our economy, which combines with on-going trade deficits and floods the world with U.S. dollars, at times the demand of frightened investors outweighs this large on-going incremental supply of dollars. When it does so, the dollar appreciates. The second half of 2011 is only but one of many examples. Given the precarious sovereign debt situation in Euroland plus countless potential geo-political flare-ups worldwide (e.g., Straits of Hormuz), the U.S. dollar could continue to strengthen in spite of the downward secular trend. Again, the usual caveat of no guarantee. In considering these very difficult, interrelated issues, we are swayed, as usual, by what history reveals, namely, that economies and markets are cyclical and seek equilibrium and that investment results regress to the mean. Therefore, historical patterns and averages will ultimately prevail. The question is, when. Also, since the consensus outlook is already factored into current bond and stock price levels, how differently will the future unfold compared with the consensus? Given our belief that the future is unknowable, we are again going to take only very small risks and essentially avoid market timing. Accordingly, we are planning to avoid any major tactical underweighting or overweighting. We will position client portfolios in 2012 predicated upon 1) the need for bonds to hedge against stock volatility, 2) careful selection of bond sectors and duration to manage risk, and 3) reliance on our chosen stock fund managers to navigate through the challenges of equity investing in 2012. Over and over again, we have seen the unreliability of short-term economic and market forecasts and the unpredictable nature of markets. As usual, geopolitical risks, poor policy implementation, and a host of other factors could wreak havoc with any predictions, and there is always the risk of the totally unexpected. Therefore, results in 2012 could be considerably better or worse, or at least different, than indicated at the beginning of, and throughout this section. Risks to Forecast, Especially Beyond 2012We presented a lengthy presentation of longer-term risks last year. One prominent issue concerned U.S. fiscal and monetary policy “kicking the can down the road.” These policies have stimulated the economy but will exact a price in later stagnation. The various potential remedies for our growing debt levels and trade deficits are tax increases, spending cuts, and higher interest rates, in some combination. These remedies will all inflict pain, pain which we are currently deferring. Much of the discussion of this and other risks is still relevant, and we refer the reader to the Market Perspective Full Year 2010 and 2011 Outlook that accompanied the January 21, 2011 letter to clients and friends. As for risks to this forecast, early and convincing resolution of the European debt crisis, though not expected, would be quite bullish. A new series of risks would arise, but generally they would be welcome because they would be more amenable to government and central bank policy initiatives and would very likely entail a decrease in market volatility. Implications for Asset AllocationBecause an outlook is to a considerable degree an attempt to have a crystal ball, the prognostications are very subject to error and need to be discounted. We must avoid the temptation to try to be prophetic. Therefore, we are resisting this temptation, and we are continuing our emphasis on capital preservation, by insisting on maintenance of very adequate liquid reserves for short term needs. We are keeping tactical adjustments to a minimum, and we are avoiding anything resembling a significant departure from client policy allocations, as noted above. Relevance of Market Review and Outlook for the Strategic AllocatorBefore concluding, let's address the relevance of a review and outlook and clarify why we are minimizing tactical adjustments, as follows:
Outlook Scorecard, Strategies Employed, and Impact on ResultsLast year was the thirteenth time we attempted something resembling an outlook. We have been providing a scorecard to see if we are gaining anything from the effort. The 2011 outlook did not contain any detailed asset class tactical forecasts, so we cannot provide a point-by-point report card. Please refer to the accompanying letter for its comments about the low accuracy of last year’s outlook and its almost negligible impact on performance of our 2011 strategies. An overview of past report cards follows. Our report cards until 2008 were generally favorable: we had more predictions right than wrong, and our errors have not been harmful to returns. Unfortunately, we cannot say the same for our 2008 and 2009 outlooks and investment tactics. To be fair, both years were unprecedented and produced investment results which were exact opposites. Respecting the 2010 Outlook, our assessment of the global economy was accurate, but we were less optimistic than the consensus about equities, especially U.S. equities, and were surprised by their strength in the second half of 2010. We had indicated “stocks are modestly to moderately overvalued at present and will be slightly underweighted, accordingly.” The variance of actual 2011 results from the 2011 Outlook was a flip-flop from 2010. We had less concern about stocks than bonds, and a small overweight of stocks was unsuccessful because bonds had considerably better returns relative to stocks last year. The slight overweighting of equities per our 2011 Outlook in hindsight becomes a moot point in the sense that an accurate, very positive outlook would not have dramatically changed the returns of portfolios supervised by Caves & Associates. That’s because of the Caves & Associates philosophy of staying the course. Even though we overestimated economic and stock market strength in 2011, pursuing this philosophy meant clients did not miss significant gains in bonds as a result of being out of the market (or substantially underweight) because we generally “ignored” our 2011 outlook and maintained substantial bond exposure last year. We believe the scorecard highlights why we recommend strategic asset allocation rather than tactical allocation or market timing. Over the long run, we are convinced that correct predictions will be largely offset by incorrect predictions, especially when the predictions have to deal with such a broad scope as global stock and bond markets. Thus, the effort adds little or no value but can reduce returns by increasing capital gains taxes, transaction costs, and management fees if the effort induces a short-term, tactical approach. Mutual Funds Success Respecting a scorecard for the mutual funds we employ in client portfolios, they remained highly rated by and large. As evidence, three of “our” mutual funds were among the 15 recently nominated for Morningstar’s 2011 managers of the year (Morningstar is highly regarded for its mutual fund databases and mutual fund ratings). Historically, nominees and award winners have been well represented in the portfolios of Caves & Associates clients. |
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