Market Update: January 2012

Overview of 2011

While I am certain to be accused of using clichés in the past, I am somewhat loathe to the majority of them.  In particular, the “roller coaster” ride of market volatility is used again and again and again anytime someone has a bad day in the stock market.  Well, despite my greater sensibilities, here we go.  The market performance in 2011 can be summed up in one phrase: “It was a roller coaster of a ride!”

In the sense that a roller coaster takes you to exciting peaks and nauseating valleys with the speed of a falling asteroid, it has another characteristic that is often ignored.  You get off the roller coaster exactly where you began, except for perhaps some subtle shifts in the earth or cosmos during your ride.  For 2011, the broad US Stock market (S&P 500) ended the year exactly 0.04 points below where it began, for a -0.0003% loss.  Combined with swings of 25% during the year, some of which occurred in the span of just a few hours and minutes, you had the roller-coaster ride of a generation.  In fact, you have to go back to the 1930s to find as volatile and quirky a market.  (To make the point perfectly clear, the market swung from a 3-point gain to its loss in the final 12 seconds of trading).

Another part of the cliché might be the residue that one collects on your ride.  In the same way that an open mouth on a roller coaster will inevitably result in a collection of bugs lodged between your teeth (they are protein), an investor in this market did come away with a nice collection of dividends during the year.  In fact, the 2.1% dividend yield on the market is the sole benefit to maintaining full stock exposure throughout the year.

It turns out that dividends are one of the main themes for stock investors in 2011.  If you had a portfolio of high dividend stocks, you were going to do far better than the broad market as investors sought their relative safety.  Another theme was domestic versus foreign.  We here in the US were fortunate – if you stayed in the market for the duration you came out intact.  Overseas was a far different story.  The most stable of the foreign indices – large-cap developed economy stocks – lost -12% last year.  If you were invested anywhere near the emerging markets, the loss was closer to -20%.

Another theme I’ve noticed is the lack of news about the year’s return.  Whereas I usually see a barrage of in-depth financial articles on the “year in review” they have been scant and thin this month.  Maybe it is early, or maybe this is just the year to forget.  Or maybe it is because there is no good news.  One tidbit I was able to catch is that 84% of large-cap mutual funds failed to beat the market, and most actually lost money.  My favorite whipping post, Fidelity, is a good case in point.  Of the 59 domestic equity mutual funds that they list on their website, six beat the market.  Only three of those beat it by more than 0.5%.  Yet another nail in the coffin of the mutual fund industry.

The message here is a simple one – volatility killed the year.  With so many days with such large swings up and down, it was a market that was going to punish anyone who tried to master it.  No matter what sort of risk you took, it got beaten down.  And while the market did limp back to neutral by the last week of December, it took a heavy toll on all asset classes and investors.

(NOTE:  As an aside, I want to address this disparity between the Dow Jones Industrials Average and the S&P 500.  The Dow was up +5.5% for the year with dividends, as compared to the S&P’s +2.1% rise, a wide disparity for seemingly similar measures of the market.  The difference is in the manner in which the Dow is calculated.  By averaging the prices of just a few companies (30 versus 500 for the S&P), and weighting those companies based on the share price (as opposed to the actual size of the company), the Dow can develop significant distortions.  In this year’s case, IBM with its $100+ stock price, generated half of the Dow’s returns.  Bank of America, on the other hand with a single digit stock price, had a far smaller impact on the Dow even though they lost -50% in value.

In the end, the Dow is not a true representation of the broader market or the general economic situation.  And don’t be swayed by the headlines in The Wall Street Journal promoting the Dow’s performance – the WSJ is owned by Dow Jones… who is now in turn owned by Fox.)

Analysis

The primary culprits from 2011 were politicians, debt and jobs.

Whether you look to the Greek parliament debating if they really need to pay back their debts, or our own politicians debating the best way to torch our economy, we encountered such dysfunction in the US and abroad that damage to the economy was an afterthought.  While I have not yet seen an analysis, I estimate that the debt-ceiling debates took at least 0.5% out of our GDP and increased unemployment commensurately.  Rather than find ways to govern, our leaders are finding new ways to fail.

The debt does not go away, however.  While Paul Krugman has made some interesting points about sovereign debt (namely, you don’t need to eliminate it, just keep it in check with economic growth), debt has grown so rapidly in most developed countries that it now challenges their economic prospects.  The fear is not default, which is irrelevant when you can print money, but instead a currency battle in which your dollars (or euros or sterling) are worth half their value tomorrow.  We saw this in Germany in the 1920s, and it led to disastrous consequences.  It can happen again, and the results will be unpredictable at best.

While debt in its many forms is a fuel for economic growth, in a stagnant economy it can lead to contraction and decay.  The impact that we see today starts with the banking sector.  Largely responsible for providing the credit necessary for business to function and individuals to monetize their future earnings, the banks control trillions in lending and new loans.  With their profits under fire from the excesses of the past decade, and in some cases their very survival dependent on government largess, banks have stopped taking on new risks.  In fact, they are so risk adverse that their behavior is not unlike a child who burns her hand on a stove.  It might take her months before she wanders past to that very stove without fear.  The banks are no better in this economy.

The global banking conundrum would not be as bad if the economy were stronger.  But with joblessness so high (pushing 20% depending on the true measure that you use), any contraction in credit is going to have a devastating effect on many businesses and families.  We have an economy that is rooted in consumption (73% by last measure), and without credit people cut back on consumption, whether it be personal items or new homes.  The problem continues to spiral as you incorporate the housing problems – millions of homes under foreclosure and banks unwilling to address the core of the problem.

The silver lining to debt is that it can become irrelevant over time.  As long as payments are made as expected and the economy moves back into a steady growth scenario the problem becomes self correcting.  We do eventually inflate our way out of the debt burden (over decades however) and investor confidence returns which allows for short-term debt maturities to be rolled over.  While I’m not saying with certainty that our problems will fall away, and a significant moral hazard is likely to develop, there is a road out of this that doesn’t lead to a disastrous outcome.

Outlook for 2012

Unfortunately I don’t have a resounding answer for “what’s next.”  It was a brutal year in 2011, one that emphasized the point that we’re experiencing a tectonic shift in the economy – a function of social and technological changes.  In the way that the last half of 2011 was a week-by-week affair, this year may be much more of the same.  There will likely be a period of relief where the market calms, as we’re starting to witness in the earnings numbers, but the problems are still lurking below the surface.  Iran and Israel is perhaps the most pressing of those problems – what happens there will impact all of us.

In a practical sense, some trends are likely to continue.  We expect:

• Stable, cash-flow oriented companies to be the better performers in the equity markets
• Fixed income to continue to be the better of the two investments, but with short maturities
• The yield curve could suffer some dramatic shifts, impacting investment grade bond pricing in hard swings
• Commodities to continue to be constrained from water scarcity and population growth
• Currency movements and dollar devaluation being the largest risks to investment portfolios in 2012

This is just a brief overview of where we stand today – we will be publishing more detailed analysis of these trends and issues in the coming months.  In the interim, have a great winter.

Regards,

David B. Matias, CPA

Managing Principal

¹ One of my favorite quotes of the year came from a Greek cabinet member, “Europe needs Greece more than Greece needs Europe” in reference to their obligations to pay back European debt holders.  This attitude still prevails today in many European countries that have ballooned their debts while gutting their economies.