And so another year has passed into the history books – the older I get, the faster they seem to go – and investors must again try to position their portfolios for a profitable year. It hasn’t been easy to do the last few years and this year promises to be just as challenging. The usual suspects that made last year one of the most volatile on record are still with us – Europe imploding, China crashing and the US dawdling along at sub par growth – and this year we’ll also have to deal with the daily effluent of a US Presidential election campaign. While I would like to just ignore what happens in Brussels, Beijing and Washington, it is an unfortunate fact of life that investing today requires one to keep an eye – both eyes actually – on the trolls who yank on the levers of fiscal and monetary policy. In addition to the US elections, we’ll also have to worry about French elections, Fed policy, ECB policy, Bank of China policy, a Supreme Court ruling on Obamacare, the nuclear ambitions of Iran and whether Kim (Jong Un, not Kardashian) does something really stupid. And for sure something that isn’t on that less than exhaustive list. It promises to be a very interesting year.
I’ve spent the last few weeks reading over all the market predictions for the coming year and thinking deeply about the NFL playoffs. Both exercises have produced in me a feeling of supreme confidence that I have no idea what the future holds. Will the ECB finally resort to full blown quantitative easing? Will any team be able to stop Drew Brees and the New Orleans offense? I have no idea. Will China be able to engineer a soft landing by reversing their monetary tightening of last year? Is Tim Tebow good or just lucky? Again, no clue. Predicting how the global economy will perform this year and which team will win the Super Bowl are not equally difficult tasks. Truth be told, your odds on predicting the Super Bowl are probably better by a considerable margin.
Our Chief Economist, John Chapman, has produced a thoughtful piece laying out his expectations for the coming year which can be read here. It is hard to argue with his logic and if forced to make predictions, I would probably come up with something similar. It largely reflects the internal discussions we’ve been having over the last few weeks and so is a good representation of our views right now. Like John Maynard Keynes, however, if the facts change so will our minds so don’t take it as a road map that can be followed blindly. As John himself points out, “economic forecasting has as much credibility as tarot card-reading”. That might be more of an insult to tarot card readers than economists. Economists can’t even agree on what happened in the past much less predict the future. The debate over what happened during the Great Depression is as lively today as it was during the Roosevelt administration.
So if we can’t predict the future – and neither can anyone else – how do we invest amidst all this uncertainty? Luckily, investing doesn’t require an ability to predict the future. It does, however, require a certain confidence that the past is at least a reasonable facsimile of the future. One has to believe that humans will continue to strive to improve their well being and that they will be reasonably successful. One has to believe that despite their best efforts, the politicians won’t impede that progress completely. One has to believe that the vast majority of investors will do the wrong thing at the wrong time and produce opportunity for those willing to buck the consensus. One has to believe that the price one pays for an asset matters a lot and is a determinant of the future return. And finally, one has to understand that managing investments will involve misjudgments and mistakes. It isn’t how often you are right but how much you lose when you are wrong and how much you make when you are right that determines success.
So, with all that as preamble, here’s how I see the investing landscape right now:
- US stocks are extraordinarily cheap compared to bonds based on the known information about the US economy. The earnings yield on the S&P 500, based on trailing earnings, is 6.81%. This compares to a 10 Year Treasury note that yields less than 2% (and less than the rate of inflation). While this isn’t as absolutely cheap as stocks have been at points in the past, it seems likely this gap will close in coming years. How it closes is something I can’t predict but given a choice between bonds and stocks, stocks are the clear winner. Sentiment, although excessively bullish in the short term, is still negative with mutual fund outflows of $140 billion last year.
- European stocks are even cheaper than US stocks reflecting the obvious additional risks. The Euro is falling – a head wind for US dollar based investors – and the economy has weakened. On the other hand, everyone hates Europe and I think prices have fallen far enough to warrant investment, favoring multinationals with US and emerging market exposure. Higher risk alternatives would include the stronger financials – and yes there are some – that will gain market share from the weaker ones.
- China’s economy has weakened but they are now easing monetary policy. Much of China’s “success” over the last few years was nothing more than inflation and they seem intent on repeating the process after tightening policy last year. The consensus is that China will continue to slow but with money supply growth and bank lending jumping again, I have my doubts. The implications for commodity prices, other emerging markets and Asian economies are significant.
- Emerging market stocks are also cheaper than US stocks but the future depends to a large degree on the fate of China’s economy. If China avoids a hard landing, emerging market stocks will probably reverse their poor performance of last year. Given my view of China, a small allocation to emerging market stocks is warranted.
- Treasuries, as noted above, are yielding less than inflation and absent a severe US recession, are overpriced. Given loose monetary policy around the world and the risk of inflation that implies, Treasuries make me very nervous. With huge inflows to bond mutual funds last year ($160 billion), sentiment toward bonds is overly optimistic. Investors got burned piling into internet stocks and houses. They’ll probably get burned again in bonds.
- Municipal bonds are cheap relative to Treasuries but probably only offer coupon returns at this level. I’m not worried about default risk at the state level as tax revenue is rising. Bonds at the local level hold more risk as property tax revenues haven’t recovered and won’t until housing prices rise.
- Emerging market and high yield bonds offer more opportunity for capital gains but also carry higher risks. If the global economy weakens further these bonds will perform poorly relative to Treasuries. Small allocations are warranted with tight risk control.
- Commodity prices are dependent on the value of the dollar and Chinese demand. The dollar has recently strengthened and if that continues it will be a headwind for commodities. Gold is a special case but also depends on the movements of the dollar. Gold will also move in reaction to the election and perceptions about future fiscal policy. Any movement toward more pro growth policies will be negative for gold. With global central banks continuing to ease policy, a fairly normal commodity allocation is warranted.
- REITs continue to be overpriced and vulnerable to higher interest rates and a stronger dollar. Residential REITs have performed well but construction is picking up. An increased supply of apartments will probably not be good for rents. Valuations in other areas are stretched due to low interest rates.
This is how I see things today and our portfolios are positioned accordingly. I’ll spend this year as I’ve spent the last 20, observing markets and economies. If – when – things change so will the portfolios. We’ll get some things wrong and adjust. We’ll get some things right too though and hopefully that will be enough to produce another year of good returns.
The economic data released since my last update has been fairly positive. Last week’s reports reinforced the perception that the US economy is slowly improving. Whether it continues into the new year is something no one can predict but so far there are few signs of impending recession. I hesitate to say that we are out of the danger zone though; the US economy still faces significant challenges. Monetary policy is mysterious at best (see this post by John Chapman) and fiscal policy looks locked in until after the election. I see little reason to expect any major improvements in policy for at least 18 months. Still, the economy so far seems to be avoiding any fallout from the European mess and the data continues to surprise to the upside.
The ISM indexes were both released last week and pointed to continued expansion. The manufacturing version came in at 53.9 and the details were pretty positive. New orders rose nearly a point to 57.6 signaling an acceleration in order growth. Even export orders improved. Employment was up 3.5 points to 55.1. The non manufacturing index wasn’t as positive but still showed modest expansion at 52.6. New orders were up 0.2 to 53.2. Backlog contracted at an accelerating rate which probably explains the employment component coming in at 49.4. Factory orders were also up in November by 1.8%, led by strong aircraft orders. Ex-transportation, orders rose a more modest 0.3%. Capital goods orders ex-aircraft were down 1.2% which doesn’t bode well for investment. One positive was a 1.3% surge in unfilled orders.
Construction spending for November was up 1.2% with residential outlays rising 2%. Non residential was unchanged. The year over year rate of change for construction has now turned positive, up 0.5%. Construction will probably add to GDP this year but the gain will probably be modest.
The Redbook and Goldman retail reports both showed acceleration, with same store sales now up roughly 5% year over year. Chain stores generally reported better sales but with large markdowns at some stores. Auto sales were basically flat in December compared to November at 13.6 million units. The official retail sales report should show a slight improvement over November.
The big reports for the week were on employment and all were positive. ADP reported a large gain in private sector jobs, up 325,000. Weekly jobless claims fell to 372k in a continuation of the trend lower. As I’ve said in the past though, I don’t trust the seasonal adjustments for claims this time of year so I’ll need to see continued improvement in the new year. The official jobs report Friday also showed a robust gain of 200,000 jobs with the private sector gaining 212k while government lost 12k. The underlying stats also were generally positive. Goods producing jobs were up 48k; construction added 17k, manufacturing jumped 23k. Service jobs were up 164k but some of that was just temporary hiring for the holidays. We saw something similar last year and it was reversed in January so hold the champagne. Average hourly earnings were up 0.2% and the workweek extended to 34.4 hours. The unemployment rate was 8.5% based on the household survey but that includes a 50k drop in the workforce. Overall, it was a positive report but still not enough to say all clear. Let’s hope it is the start of a new trend for 2012.
Markets were generally better last week with the S&P 500 up 1.6%. That’s better price appreciation than we had all of last year and the market is acting pretty good right now. Unfortunately, everyone has noticed and bears in the weekly AAII poll have dropped to less than 20%. In the past that hasn’t been good news for the near term outlook and I would not chase this rally. Emerging markets and Europe were also higher last week but are still lagging the US. Gold rose on the week but is now trapped just below the 200 day moving average. Gold continues to look bearish against a dollar index that is trending nicely higher.
We have not made any changes to our portfolios recently and are maintaining a healthy cash reserve. The outlook from Europe and Asia remains too murky to get overly aggressive in my opinion. Bond yields in Europe were higher across the board last week with the ECB apparently buying Italian bonds late in the week. While we seem to have dodged any fallout from Europe so far, the economic data comes with a lag and I expect to see some effect in the reports over the next few months. Sentiment could turn on a dime and I would prefer to have too much cash than too little.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: email@example.com
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