2012 Investment Outlook
I made 10 specific recommendations for 2011 back in January. I will look at how each of these recommendations performed in order. It’s time to turn in my scorecard for 2011.
- Diversify. Diversification always makes sense when playing defense and 2011 was no exception. As I said in last year’s Outlook: “Diversification is simply good common sense and asset allocation – the organized and strategic process of diversification – is a necessity for good planning. It is the closest thing to a ‘free lunch’ in the financial world.”
- Use alternative investments, albeit judiciously, to obtain wider diversification. The success of this recommendation is all but impossible to quantify. Since the reasoning behind this recommendation was to provide diversification and since many alternative strategies and investments have performed well, beginning with REITs generally and including some choices that I specifically recommended, I’ll call this recommendation a qualified success.
- Explore managed futures. Managed futures performed no better but also no worse than stocks in 2011 (see here). However, managed futures did provide the desired diversification and non-correlation. I cannot call this recommendation a success, but the reasoning behind it was and remains sound and it was by no means a failure.
- Focus on dividend producing stocks. In 2011, dividend producing stocks had an outstanding year. For example, the S&P 500 “Dividend Aristocrats” (an index that measures the performance of companies within the S&P 500 that have followed a policy of increasing dividends every year for at least 25 consecutive years) returned 8.3% (including dividends) compared with 2.1% for the S&P 500 (including dividends – the index itself was flat). These returns reflect investor interest in dividend yields of more than 4 percent on many utilities, household-goods manufacturers and telecommunications companies, a level twice that of 10-year Treasury notes. This idea is a standard defensive play because stocks that pay steady dividends tend to fall less than others when times are tough.
- Consider multi-strategy absolute return funds. So-called “absolute-return” funds have a simple mission: make money regardless of market conditions. Unfortunately, the average year-to-date results for the 23 funds that started the year with “absolute return” in their names, as of mid-December, were losses of more than 2.5%, according to Morningstar. Fifteen of those funds have year-to-date losses, and none entered December with a gain above 2%. The rising number of absolute-return funds is part of a trend bringing hedge-fund strategies into traditional mutual funds, as investors expect long-short, market-neutral, absolute-return and other hedge-fund ideas to deliver consistent results. For all the headlines and drama that this idea has wrought, this approach has not worked well overall when applied to conventional funds, and one need only look at the originals for an idea why that is. According to Hedge Fund Research, the average hedge-fund manager had lost roughly 4.4% this year (through November, and even that bad report is probably better than reality) and 60% of hedge funds lost money this year. Indeed, all seven trading strategies tracked by the Dow Jones Credit Suisse “Core Hedge Fund Index” showed losses as of Wednesday, December 14, with the entire index dropping nearly 8%. “Go-anywhere” funds tanked too. In truth, hedge funds have been punished generally since 2003. Money invested in hedge funds since 2003 would have generated a return of 18% through November, 2011 according to data compiled by Hedge Fund Research. That puts it far behind the S&P 500 index, which has generated returns of 29% over that same period, once dividends are factored in, and far behind bonds. Add in costs (typically 2% of assets plus 20% of profits) and the ugliness cannot be painted over. Big names (and big funds) have been hit especially hard. Meanwhile, correlations to the S&P 500 have come eerily close to 100% in the past couple of years. These facts should make investors question if they are not better off avoiding them altogether.
- Beware of bonds generally. I noted the performance of bonds above and it was quite good. Even though my reasoning was that the risks in bonds were not worth playing – and I still think that analysis was (and is) sound, this was my biggest “miss” from among my 2011 recommendations.
- Use TIPS for additional inflation protection. The TIPS market performed very well in 2011, with steady gains throughout the year. Overall, TIPS returned 12.2% and returned 1.9% in the 2011 first quarter, 3.5% in the second quarter, 3.8% in the third quarter and 2.5% in the fourth quarter. This recommendation was a winner.
- Consider municipal bonds. Just over a year ago, analyst Meredith Whitney predicted a financial Armageddon for municipal securities. She claimed that we should expect at least 50-100 “sizable” muni bond defaults totaling hundreds of billions of dollars in 2011. Whitney’s prediction evoked great fanfare and was highlighted on 60 Minutes. Similarly, New Jersey Gov. Chris Christie claimed that “the day of reckoning” had arrived. I disagreed and have been correct (at least thus far). I suggested focusing on quality generally and pre-refunded issues and revenue bonds backed by reliable revenue streams more specifically as well as caution with respect to general obligation bonds. An investor who bought $10,000 of muni bonds the day after Whitney’s December 19, 2010 60 Minutes appearance would have made returns well in excess of 10 percent on that money in one year (based upon the Merrill Lynch Municipal Master Index, which calculates price changes and interest income). Lower interest rates and overblown credit risk claims both contributed to this performance, which beats U.S. Treasuries, stocks, corporate bonds and commodities over the same time period. This return is better still as a practical matter because muni interest income is tax-exempt.
- Focus on guaranty products. Given market difficulties generally and maddening day-to-day (and even moment-to-moment) volatility, this recommendation was an unqualified success. Indeed, even during market outperformance, having suitable guaranty products in place makes tremendous sense for the ballast the guarantees provide. If one doesn’t like the returns provided by guaranteed products, imagine how hard it would be to take the negative returns provided by stocks when risk shows up and especially when risk shows up at an inopportune time – such as within the few years before and the few years after retirement.
- Rebalance portfolios systematically. This recommendation was a “no brainer.” It always makes sense.
So, what do I recommend for 2012? Many of my 2011 recommendations still hold. Diversification and rebalancing continue to make sense and will for the foreseeable future. Guaranty products should be a necessity. The judicious use of alternative investments and strategies, including managed futures, remain good choices. That said, few investors realize that most alternative assets’ returns are credit-dependent, and that these asset classes’ outperformance was often due to the credit and real estate bubble’s increasing availability of credit. Because the global credit bubble continues to deflate, many investors’ expected returns for alternative asset classes may be too optimistic going forward.
Careful selection remains crucial with respect to alternative investments. For example, well-managed REITs performed very well across-the-board in 2011 even though they now appear overpriced and vulnerable to higher interest rates and a stronger dollar. Residential REITs have performed nicely but construction is picking up. An increased supply of apartments will probably not be good for rents. Valuations in other REIT categories are stretched due to low interest rates and further price deterioration would obviously be a problem.
Some of my 2011 recommendations worked well but appear played out. This year’s run in dividend stocks is not likely to be sustained if and when economic conditions improve in that investors are likely to switch to higher-growth companies that tend to pay lower or no dividends. Probably of greater relevance is that this trade is now very crowded – we shouldn’t expect miracles here. That risk is now enhanced because valuations on high-dividend stocks have now caught up with their no-dividend peers for the first time since the late 1970s, as shown below.
Municipal bonds had a great run this year and state-level revenues appear to be rising. Moreover, munis appear cheap to treasuries. However, even though they have not come to fruition thus far, the risks warned against by Meredith Whitney are real, even if dramatically overstated. Therefore, I think the muni trade is largely played out. Similarly, TIPS remain a valuable inflation hedge, but are not nearly as likely to be a substantial source of gains in 2012.
The risks in bonds remain high. Indeed, they are higher now than they were when I counseled caution a year ago. However, because the Federal Reserve has committed to maintaining low interest rates for at least another year-and-a-half and U.S. Treasuries are the world’s go-to crisis investment, even though I expect rates to rise this year, I cannot be as negative on bonds generally as I was a year ago. Finally, unless and until multi-strategy absolute return funds show the ability to provide consistent performance, I recommend extreme caution with respect to them.
Instead, I offer five additional recommendations (once again making for 10 in all) for 2012.
In the current environment, I think investors’ default position should be to buy American. The dollar is the still the world’s reserve currency, the U.S. Treasury market is still the world’s favored port in any storm, and the U.S. stock market remains the largest and most liquid in the world. In a year where tremendous shocks to the system are likely and with many of those shocks likely focused overseas, investors who lean toward the U.S. generally should be rewarded.
I expect this year to be a good one for high yield bonds. Current valuations offer huge spreads (more here) to U.S. Treasuries as well as the potential for 7+% dividends. The fundamentals of high-yield corporate debt look appealing, with falling corporate debt levels and low default rates expected to continue. Indeed, current spreads imply a much higher default rate than the market is experiencing. These bonds have a great deal of risk, so they should be chosen carefully and one’s exposure to them should remain quite limited. If the economy weakens substantially, these bonds will underperform. Small allocations are warranted with tight risk controls.
I also recommend U.S. small cap stocks. Smaller U.S. companies have been starved for capital in much the same way that emerging markets, energy, and commodities companies were a decade ago. By definition, capital starved companies’ higher cost of capital translates to higher expected returns for investors. Yet investors seem to be overlooking smaller U.S. companies’ fundamentals. Companies in the Russell 2000 have been producing positive earnings surprises at a better rate than most other regions of the world. Although smaller U.S. companies’ earnings fundamentals are not superior to their larger counterparts at this time, this relationship can reverse as the large caps’ credit-access advantage is reduced. Moreover, U.S. small caps remain one of the fastest growing segments of the global equity markets. In fact, the 2012 projected earnings growth rate for the Russell 2000 is presently three times that of China and nearly four times that of emerging markets in general.
The primary risk to investing in smaller companies is their stocks’ typical volatility. Smaller companies are extremely sensitive to changes in the macro-economy. In the “risk on/risk off” world, smaller companies tend to outperform when risk is “on” and underperform when risk is “off.” However, despite the volatility seen in 2011, the Russell 2000 still outperformed the MSCI Emerging Market Index by a substantial margin.
Now is also a good time for individuals to guarantee value if not return by paying down debt, refinancing where possible, reducing consumption and reducing spending. They should consider giving more away too. While they are not investments per se, these actions will pay remarkable “dividends” immediately and will strengthen consumers’ financial position substantially so that when the next secular bull market comes around – as it inevitably will – they will be in a position to take advantage of it.
I have written about this next recommendation so often (for example, here and here) that I’m almost sick of it (except that it’s so important). Retirees with income needs (not wants) in excess of what Social Security and pension income provide should secure those needs with the purchase of an income annuity or the annuitization of a deferred annuity. About one in four 65-year-olds today will live past 90 and, according to the Society of Actuaries, there is a 47 percent chance that at least one of a 65 year-old couple will live to age 90 and a 23 percent chance that at least one of them will live to age 95. This longevity comes with serious financial risks. Indeed, according to data from the Employee Benefit Research Institute, roughly half of near-retirees today are likely to run out of money in retirement.
The United States Government Accountability Office (an independent, non-partisan research agency that works for Congress) released a significant report on retirement income in 2011 with two headline conclusions. One was simple. Retirees should buy more income annuities to supplement their other primary sources of assured income — Social Security and pensions.
As the GAO points out, “[a}nnuities provide income at a rate that can help retirees avoid overspending their assets and provide a floor of guaranteed income to prevent unnecessarily spending too little for fear of outliving assets.” Moreover, “[a]nnuities can also relieve retirees of some of the burden of managing their investments at older ages when their capacity to do so may diminish….” That’s why they make so much sense for so many people. Indeed, even at current low rates, an income annuity guarantees income for life at a cost 25-40% cheaper than trying to do it without one. Sadly, they are rarely purchased and deferred annuities are rarely annuitized. Economists call this disconnect between what retirees should do and what they actually do the “annuity puzzle.” In 2012 – and as soon as possible – they should do the right thing and make sure they have sufficient assured income.
As 2012 begins, few are close to as optimistic as they were a year ago. However, a survey by The Wall Street Journal of market strategists shows typically optimistic 2012 forecasts by Wall Street anyway, as shown below.
And, once again, the 2012 Barron’s survey of strategists and investment managers is similarly optimistic – they expect 12% growth overall, but “deal with” current problems by forecasting most of those returns in the second half of the year.
Once again, I disagree.
Current market valuations demand that I am not a longer-term bull. Multiple political and economic uncertainties demand that I remain cautious and defensive in the nearer-term. The U.S. faces huge challenges. The situation overseas is even worse.
The anticipated clear sailing could indeed come to pass and might even last for a good while. Indeed, as noted, I recognize the possibility that the markets could become strong this year. But, in a secular bear market, such favorable market conditions will only last until, inevitably, they don’t. And when it comes, I still expect the change to be rapid and the drop deep. Economic and market difficulties create a variety of risks and problems. But they also create tremendous opportunities. I therefore once again encourage investors to remain skeptical, cautious, defensive and opportunistic. In 2012, as in 2011, investors should look to take advantage of the opportunities that present themselves while carefully managing and mitigating risk.