2012 Investment Outlook
III. 2012 Outlook
Clearly, the so-called experts were pretty far off in their projections for 2011. Why wasn’t the consensus view accurate? In addition to the inherent optimism of Wall Street analysts (a big part of their job is to get investors to put their money to work), there were three primary factors leading to the markets’ tepid performance in 2011 and thus the erroneous forecasts. These factors remain crucial impediments to market performance and drive my outlook for 2012.
The Secular Bear Market
The first such factor is that we have been in the midst of a secular bear market – characterized by sharp swings in both directions amidst little overall change – since March of 2000. During such periods we should not expect significant stock market advances overall, despite aggressive moves both up and down, sometimes for significant periods of time. Since the beginning of 2000 to the end of 2011, the S&P 500 lost 13.58%. Dividends added 23.59%, but inflation was 34.69% over that period, making real total return -20.70%.
That’s dreadful performance. Indeed, the average real long-term return of the stock market was roughly 8% annually from 1925 through 1999. But the last 12 years have been so bad that this long-term average is now down to 6.58%. Accordingly, while on average the stock market has more than doubled investors’ money in real terms every 12 years, over the last 12 years, investors have lost 20%.
Based upon current valuations, I see little reason to expect the current secular bear market to end anytime soon. Historically, shorter-term investment forecasting has been a fool’s errand as there is little evidence that it works very well. However, there are a variety of measures which provide helpful indicators of longer-term investment performance. These indicators do not provide a great deal of guidance to what the next 10 days will bring, or even the next 10 weeks or 10 months. But they are very helpful in forecasting what the markets will bring over the next 10 years.
These indicators are best used as longer term indicators of value, risk and expected returns. However, the stock market can continue higher regardless of what any metric of valuation is showing. I caution that these indicators are designed to be a helpful tool to help shape an overall investment thesis and process as well as to separate short-term and long-term concerns, not to dictate trading decisions.
Over the longer term, valuations matter. A lot. Accordingly, current valuations demand overall caution. These measures all confirm what I have been saying repeatedly (for example, here and here) – we are (since 2000) in the throes of a secular bear market. As I wrote in May:
“During secular bear markets, investment portfolios should be diversified across a range of investments that are diligently selected and carefully managed, especially ones that control risk first and only after risk is appropriately managed seek to enhance return. In particular, investors should not simply avoid the markets. …These periods demand an adjustment to bull market investment strategy.
“Portfolio performance evaluation is often put in relative terms (‘we’re great because we lost less than our peers’), but families live in a world where losses matter, even if they may be less than someone else’s. Thus a careful investment approach, which uses a dual strategy of risk management and careful investment selection, makes especially good sense in secular bear markets.”
I continue to encourage investors to be skeptical, cautious, and defensive yet opportunistic, especially because volatility has been so high. I suggest that they look to take advantage of the opportunities that present themselves while carefully managing and mitigating risk.
The second reason stocks underperformed this year is political uncertainty both here and abroad. With respect to the U.S., gross debt stands at $14.5 trillion while unemployment is 8.5% and remains a huge problem. Except for a brief period at the peak of the business cycle around the turn of the century, deficits have been a constant for decades.
Federal tax revenue was equal to 14.9% of the economy in 2009 and 2010, the least since 1950, according to the Office of Management and Budget. At the same time, total U.S. debt generally and as a percentage of GDP has grown substantially.
Until recently, post-WWII federal tax revenue had tended to hold fairly steady at about 19.5% (“Hauser’s Law”) irrespective of the highest marginal tax rates. Accordingly, the current figure of less than 15% is a dramatic decline and a major problem given committed government expenditures.
The debt ceiling deal reached last year provided for almost no immediate debt relief and surprisingly little relief longer term (more here), as shown below. The economic problems described by Standard & Poor’s when it downgraded the credit rating of the United States in August are real, substantial and growing.
Near-term global economic growth in the years leading up to the 2008-09 financial crisis benefited from a number of bad choices by policymakers — excessive leverage, financial engineering and, to some degree, poor regulation. But on account of the financial crisis, government leverage has now replaced consumer leverage as the most imminent danger. The financial crisis did not trigger a normal business-cycle recession. Instead, we have experienced a balance sheet recession, which can be conquered only when governments reduce their debt burdens.
The debt-to-GDP ratio for the U.S. is about 100% today – a level the best experts consider very dangerous. Once a country reaches this debt “tipping point,” the capital markets recognize that it can no longer be counted upon to service its debts. Countries may be forced to issue debt at higher interest rates and eventually default or inflate their way out of it by printing money. Unprecedented Fed actions have blunted these results to this point, but cannot be expected to stem the tide indefinitely.
It remains possible that we could grow our way out of trouble, but that scenario does not seem very likely to me. For example, $252 billion of the $498 billion U.S. trade deficit last year came from importing petroleum-related products. A comprehensive effort to create alternative energy and reduce carbon emissions could make a real difference here, but I do not see it as politically likely.
Despite these big and difficult problems, there seems to be little chance of any political solution. As I wrote when S&P downgraded U.S. government debt back in August:
“Simply put, a majority in Congress (consisting of members of both parties) has been and remains unwilling to require the federal government to live within its means over the long-term while the President cannot or will not do anything about it. At the same time, a (different but still) majority in Congress (consisting of members of both parties) has been and remains unwilling to enact tax legislation sufficient to pay for the spending it has authorized while the President cannot or will not do anything about it. …Finally, and perhaps most tellingly, there is little reason in the current political climate to expect one side to compromise if there is a significant chance that credit for any subsequent benefit will be attributed to the other side. Today, political positioning seems to take precedence over the national interest far too often.”
The worldwide picture is no more compelling. Governments of the world’s leading economies have more than $7.6 trillion of debt maturing this year, with most facing a rise in borrowing costs. Led by Japan’s $3 trillion and the U.S.’s $2.8 trillion, the amount coming due for the Group of Seven nations and Brazil, Russia, India and China is up from $7.4 trillion at this time last year, according to data compiled by Bloomberg. Unfunded government liabilities remain a major international problem. Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. Danger lurks both domestically and internationally on account of political uncertainty.
The third major factor hurting the markets is the sad state of the U.S. and world economies. The risk of recession in the U.S. remains high. Indeed, despite some good recent data, the very highly regarded Economic Cycle Research Institute says that another recession will happen early this year (more here, here, here, here and here). Forward corporate earnings estimates seem to have stalled and real wages have not kept pace with inflation.
Unemployment remains high at 8.5% and effective unemployment is much higher still because (a) so many people have stopped looking for work; and (b) so many people are underemployed, even as their numbers decrease the unemployment rate.
We also need to deleverage. Debt of all kinds remains extremely high, even though business and consumer balance sheets have improved somewhat. Housing prices don’t seem to have hit bottom either. And consumer confidence, although it has improved some of late, remains generally poor. Finally, non-financial firms may have a lot of cash, but they have a ton of debt too and corporate balance sheets are not as strong as they look.
Overseas, the news is even worse. The European debt crisis escalated as leaders repeatedly failed to craft a solution, political upheaval roiled the Arab world, a major earthquake and resulting tsunami paralyzed Japan and economic growth slowed in China and other emerging markets.
These conditions are ongoing. That the calendar has turned from 2011 to 2012 does nothing to change the economic climate. Financial contagion in Europe (due to government debt, European bank worries or both), the economic slowdown in China and falling house prices here (among other risks) could all lead to slower U.S. growth in 2012. The need for caution is well established. It might be a difficult ride in 2012. We should all be prepared to hang-on.
Where am I most likely to be wrong?
Historically, down years in the stock markets happen about one year in four. And as bad as the current secular bear market has been since March of 2000, only four of these years have recorded an annual loss for the index (2000, 2001, 2002 and 2008). Thus the historical one down-year in four became only one in three. Therefore, we should not overdo the doom and gloom.
Indeed, prolonged cyclical bull markets exist within secular bears (for example, March 2009-March 2011). Accordingly, while I am very skeptical about stock market returns over the longer term, there is a reasonable likelihood of a turnaround at some point this year. Moreover, forecasting of any sort is fraught with peril (see here and here, for example). Thus all outlooks and forecasts ought to be “lightly held” with clear contingency plans in place.
There is an obvious case to be made that the economy will continue to muddle through. Despite extreme weather (significant snow storms, flooding, hurricane Irene), oil price increases related to the “Arab Spring,” the tsunami in Japan, and all the political uncertainties in Washington, 2011 real GDP growth was still positive and the markets did not suffer major losses year-over-year. As noted above, there are still plenty of scars from the financial crisis (such as excessive debt, high unemployment, excess capacity, excess housing supply, a large number of homeowners with negative equity, and high foreclosure activity), but the case can be made that the economy continues its slow healing. Residential investment even made a positive contribution to GDP growth for the first time since 2005.
Fourth years of presidential terms are generally good ones economically (but so are third years). QE3 by the Fed remains possible. Many think there is a great deal of cash available to be put to work (even though I think it’s overstated). Business confidence is reasonably strong.
M&A activity seems poised to increase. Moreover, unlike the other indicators noted above, current P/E ratios appear to suggest that stocks are cheap while earnings are projected to be strong.
Overall the U.S, market P/E ratio traded in the 12.5 to 13x range last year, well below its long-term average of 15.9, and stocks are cheap when compared to bonds. Dividends are rising. Corporate earnings and margins are good, and it is earnings that, over the long haul, determine the value of the stock market. When the final data is in, earnings per share of the S&P 500 should have risen about 16 percent in 2011.
These realities could suggest a stronger market this year. Other positive indicators for nearer-term market strength include some kind of “muddle-through” solution in Europe, a “soft landing” for Asian economies (most notably China), the overturning of the Patient Protection and Affordable Care Act (better known as “ObamaCare”) by the U.S. Supreme Court, relatively stable oil prices and relative stability in the Middle East, tame inflation, continued employment growth (see below), and even tepid GDP growth – say 2.5%.
It should also be noted that the U.S., while troubled, remains in much better shape than most of the rest of the world in terms of growth, liquidity and capital. We are politically stable and the dollar is still the world’s reserve currency. We remain the best port overall in a financial storm.
Finally, overall equity investment is at very low levels (per Gallup), investors (both individual and institutional) are terrified and financial advisors hate equities. These factors suggest to the contrarian in me that some good opportunities may exist and the markets could indeed rally in 2012.