The major U.S. equity markets ended 2011 not far from where they began in terms of their index values. Nonetheless, they gave investors an exciting (some might say breathtaking) ride during the year. But now that the New Year has arrived, the big question is where these markets might be headed in 2012. Three important considerations behind this question are: (1) How key “macro-factors”—e.g. the European Union debt crisis—are or aren’t addressed; (2) Can U.S. corporations continue to deliver the earnings growth they have for the past three years; and (3) What are the prospects for U.S. consumers and households—an increasingly important consideration as the global recovery slowed in the fourth quarter of last year.

2011 in Review

The chart below plots the 2011 cumulative trends in three major U.S. equity indices—the DJIA (Dow Jones Industrial Average) Index, the S&P 500 (Standard and Poor’s 500) Index, and the NASDAQ (National Association of Securities Dealers Automated Quotations) Index. One can see how each index ended the year not far from their initial values of 1.00 on January 3. An additional observation is how closely these three U.S. equity indices tracked each other for most of the year. Economists and statisticians call this behavior a high degree of correlation. This type of behavior often occurs when macro-factors (which affect the profitability and riskiness of all stocks) play a large role—in addition to the unique risk-return factors of individual stocks—in driving earnings and investor expectations.

There was also a high degree of correlation among individual stocks within each index for 2011. For example, more than 90% of the stocks in the S&P 500 moved in the same daily direction (up or down) at least five trading days each month for eight of the twelve months in 2011 (that’s about a quarter of all trading days in an average month).  And in four consecutive months (August to November), it was at least ten trading days each month when this level of correlation was seen.

 

These three indices also exhibited a high degree of volatility (on the downside and upside) throughout the year as the table below illustrates. The largest decline came in early August as Standard and Poor’s downgraded its rating on U.S. government debt from its highest category (AAA) to its next highest rating (AA+).  This action was the result of their concerns about the growing national debt and stalemate between the two major political parties over how to address the huge budget deficits contributing to this problem. Between July 21 and August 8 the three major indices fell by approximately 16% each. This was also followed by disappointing news of second quarter GDP (Gross Domestic Product) growth that helped further depressed stocks. By October 3, each index reached its low for the year.

 

	DJIA Index	S&P 500 Index	NASDAQ Index
Open (Jan. 3, 2011)	11,577	1,258	2,677
High for Year (date)	12,811 (Apr. 29)	1,364 (Apr. 29)	2,874 (Apr. 29)
% Increase from Open	+10.7%	+8.4%	+7.4%
Low for Year (date)	10,655 (Oct. 3)	1,099 (Oct. 3)	2,336 (Oct. 3)
% Decrease from Open	-8.0%	-12.6%	-12.7%
Close for Year (Dec. 30, 2011)	12,218	1,258	2,605
% Change for Year (Open-Close)	5.5%	0%	-2.7%
% Range for Year (High-Low)	18.6%	21.1%	20.1%

Source: Bloomberg and American Century Investments (ACI) Analysis

Notes (1): The DJIA is a price weighted index while the S&P 500 and NASDAQ indices are market cap weighted.

 (2) The % Change for Year (Open-Close) equals the closing value for each index on Dec. 30 minus the opening value on Jan. 3 divided by the opening value.

 (3) The % Range for Year (High-Low) equals the High minus Low values for each index divided by opening value.

           (4) Index values and percentage changes do not reflect the contributions of dividends earned.

 

While the downgrading of U.S. debt by Standard and Poor’s was a major event that affected U.S. equity market values in 2011, a number of other events and developments also played a role. The table below lists selected news stories and events which occurred during the year.

 

Selected News and Events for 2011
Dates	Event(s)
January 14	The Tunisian government falls and president of 23 years flees after a month of protests.
February 11	Egyptian President Hosni Mubarak resigns amidst civil unrest after 29 years in power.
March 11	A tsunami and 9.1 magnitude earthquake cause a major nuclear disaster in Japan.
March 17	A no-fly zone is established over Libya in response to government aggression against civilians protesting the Gaddafi regime.
April 27	S&P cuts its rating on Greek government debt to “junk” status and downgrades Portugal’s government debt by two notches.
April 29	Oil peaks at $113.93 per barrel in response to turmoil in the Middle East and loss of Libyan oil exports.
May 1	Osama bin Laden is killed by U.S. special forces in Pakistan.
May 16	The European Union agrees to a €78 billion rescue package for Portugal.
June 12	Thousands of Syrians flee to Turkey as Syrian troops attack civilians protesting the Assad regime.
June 30	The Federal Reserve ends round 2 of its Quantitative Easing program.
July 21	Greece receives a €109 billion bailout to avoid default.
August 1	Congress reaches a debt ceiling deal to avoid a U.S. default.
August 5	Standard and Poor’s downgrades its U.S. government credit rating from AAA to AA+.
September 17	The Occupy Wall Street movement begins.
September 19	S&P lowers its credit rating on Italian government bonds to A from A+
October 7	Fitch Ratings Service lowers its credit ratings on Italian and Spanish government bonds.
October 27	The European Union announces an agreement to address the debt crisis including a 50% write-down on Greek government bonds and a €1 trillion increase in the Financial Stability Facility (bailout fund).
November 11	Italian Prime Minister Berlusconi resigns under growing pressure regarding Italian government debt and deficits.
November 30	Markets rise on strong initial holiday spending reports by consumers and decision by central banks to pump money into European financial system.
December 10	Major street protests erupt in Moscow over tainted Parliamentary elections and demanding an end to the Putin regime.
December 23	Congress approves a two month renewal of the payroll tax cut after months of stalemate.
December 26	Iran suggests it could easily close the Straits of Hormuz at the start of a ten day naval exercise by the nation.

              Source: Wall Street Journal and American Century Investments (ACI) Analysis

              Note: In some cases, the dates shown are approximate.

Moving into 2012

Several themes stand out as macro-factors from all the events listed in the table above. The first is the European Union debt crisis. The second is the unexpected uprisings in Arab nations—the “Arab Spring” as it’s been called—that began in Tunisia last January. And the third is the continued stalemate between the two major political parties in the U.S. over the huge government budget deficits and growing national debt.

And as we ended the year on December 31, none of these has been adequately resolved—meaning they will continue to play a role as macro-factors and uncertainties in the New Year. We can also add to this the Presidential and Congressional elections in the U.S. occurring on Tuesday, November 6 which may result in some resolution of the gridlock that has plagued Washington for the past several years—or may not. Anticipation by the markets on how the elections will turn out could itself be a macro-factor affecting investor sentiment for at least the second half of the year.

Perhaps the most important consideration we should focus on in 2012 is the level and direction of corporate earnings. Coming out of the Great Recession (two and a half years now), the one consistent “good news” story has been the recovery and growth in corporate earnings. This has been accomplished without the typical burst and jump in domestic consumption by households—which makes this trend of earnings growth all the more remarkable.

Much of the growth has been driven by efficiency gains and productivity improvements that allowed profits to grow through margin expansion versus of top-line (i.e. revenue) growth. And some earnings increases have been driven by export-oriented sales growth. But as the chart below illustrates, we are now approaching historical highs for operating and net sales margins among S&P 500 companies meaning that, while some improvements are still possible through efficiency gains, large future increases in earnings by this means are probably not likely. In addition, by late December, nearly 100 companies in the S&P 500 had made downward revisions in their earnings guidance for the fourth quarter—a level not seen since 2001.

 

That brings us to the question of whether macro-economic growth can sustain the earnings growth of corporations this year.  Overseas (particularly Europe but also in Asia with China) growth slowed in the fourth quarter of 2011. In contrast, overall economic growth as measured by GDP in the U.S. has been on the upswing for the past two quarters as the chart below illustrates. Nonetheless, it is still (at the 1.8% annualized real rate of growth for the third quarter) well below what is needed to sustain a healthy economic expansion. And the contributions to this growth from government spending (as deficits at the state and federal levels are addressed) and net exports (as global growth has slowed) are likely to be muted for at least the first half of 2012.

 

What about the U.S. Consumer in 2012?

2011 ended with several small notes of good news for U.S. consumers and households. The first was that early retail sales during the holiday shopping season (the “Black Friday” weekend after Thanksgiving) were stronger than retailers’ expectations. That development seems to have carried through the entire holiday shopping season with many major retailers reporting sales up 4-7% over last year (versus the pre-holiday consensus of 3-4% sales gains). But a strong holiday spending season is not a trend.

The other piece of good news delivered in early December was that the civilian unemployment rate dropped significantly from 9.0% in October to 8.6% in November. Addressing the chronically high unemployment rate in the U.S. is a key step in putting the economy back on solid footing. However, a closer look at the data underlying this decline revealed that some of it could be explained by temporary hiring in anticipation of the holiday season and declines in the size of the overall civilian workforce as more unemployed people gave up looking for full-time work. Once again, it was a piece of good news but not something we can characterize as a major positive trend per se.

 

Late December also brought news that the Conference Board’s Consumer Confidence Index jumped nearly 10 points in December from 55.2 to 64.5 which widely beat the median expectation of 59 based on a survey of economists. In addition, the Conference Board’s expectations index (a component of the Consumer Confidence Index measuring consumers’ outlooks for the coming six months) also surged to 76.4 from 66.4 in November—its highest level since last May. Does this mean that U.S. households might finally be joining the current economic recovery and expansion after an absence of two and a half years?

To try to address that question, we need to look at three important factors regarding U.S. households:

 

• Trends and levels of consumer indebtedness and spending,
• Trends in housing prices, and
• Trends and the outlook for civilian employment.

 

(1) Consumer Indebtedness and Spending

On November 1 last year, we published a Weekly Market Update titled “Households Continue to Reduce Debt and Embrace Frugality” based on the Quarterly Report on Household Debt and Credit published last August by the New York Federal Reserve for the second quarter of 2011. The Fed has since released its third quarter report in November . It confirms the continued trend of reduced overall household debt from the second quarter (down $113 billion between June and September) as consumers continue the deleveraging process. The report also noted that overall delinquency rates on debt remain high (10% of the total value of debt outstanding is past due at least 90 days) although personal bankruptcy filings decreased nearly 19% on a year-over-year basis.

However, perhaps most interesting, the Fed reported that consumer credit demand (as measured by credit card inquiries over the past six months) increased for the second quarter in a row—a positive sign for future spending and credit use.  This finding is supported by the trend in retail and food service sales by consumers as shown in the chart below. It declined 13% on a cumulative basis from the start of the Great Recession in December 2007 to March 2009. But since then it has been on a slow but steady recovery. By January of last year, these sales finally equaled their December 2007 level and continued to rise through last November. While this is both impressive and encouraging, some of the more recent gains may have come at the expense of declines in personal savings rates which have dropped from 5.6% in the second quarter of 2010 to 3.9% in the third quarter of last year.

 

(2) Trends in Housing Prices

The continued decline in the value of single family homes is a major impediment to restoring consumer spending and confidence to healthy levels again. And in late December, Standard and Poor’s announced that their S&P/Case-Shiller Composite of 20 Home Price Index declined again in October with particular weakness in the Southeast and Midwest. The overall index declined by 3.4% on a year-over-year basis versus October 2010.  

Like the S&P/Case-Shiller report, the National Association of Realtors (NAR) also issued a report on December 21 that reported a decline in home prices for November. The national median existing-home price for all housing types was $164,200 in November, down 3.5% from a year ago. Distressed homes – foreclosures and short sales typically sold at deep discounts – accounted for 29% of sales in November (19% were foreclosures and 10% were short sales), compared with 28% in October and 33% in November 2010. Total housing inventory at the end of November fell 5.8% to 2.6 million existing homes available for sale, which represents a 7 month supply at the current sales pace, down from a 7.7 month supply in October.

On the other hand, the NAR report was far more upbeat with regard to housing demand.  It found that total existing-home sales—which are completed transactions that include single-family homes, townhomes, condominiums and co-ops—increased 4% to a seasonally adjusted annual rate of 4.42 million in November from 4.25 million in October, and are 12.2% above the 3.94 million-unit sales pace in November 2010. This suggests we may finally be reaching a level of pricing (along with attractive borrowing rates for those who can qualify) where housing demand is beginning to recover. Recent increases in rental rates may also be a contributing factor. The chart below illustrates sales volume and pricing trends for single family homes based on NAR data.

Finally, the NAR report also broke down existing single family home sales volumes versus one year ago by region of the U.S. and price level of the home as the table below illustrates. The encouraging aspect of these data is how home sales volumes are up substantially year-over-year in every region of the U.S. for price ranges under $250,000 (and up marginally in most regions even for homes in the $250,000 to $500,000 range). It is in the higher price ranges of home that sales continue to decline, indicating that prices here have not fallen sufficiently—or that demand for luxury homes has structurally declined since the Great Recession.

 

Regional Sales by Price Range
Existing Single Family Homes
November 2011
Percentage Change in Sales from One Year Ago
Region	$0-100K	$100-250K	$250-500K	$500-750K	$750K-1M	$1M+
Northeast	21%	15%	7%	-9%	-14%	-10%
Midwest	13%	7%	-2%	-2%	-2%	-13%
South	18%	10%	3%	-5%	3%	-19%
West	21%	13%	6%	-3%	-8%	0%
U.S.	17%	11%	4%	-5%	-7%	-7%
Sales Distribution by Selling Price Range
Region	$0-100K	$100-250K	$250-500K	$500-750K	$750-1M	$1M+
U.S.	26%	44%	22%	5%	1%	<1%
Source: National Association of Realtors (www.realtor.org)

 

(3) Trends and the Outlook for Civilian Employment

In mid-December, a Labor Department report noted that new claims for unemployment insurance had declined to its lowest level in nearly four years (going back to April 2008) as the chart below illustrates. The decline in this number (both the sharp and sudden decline for the week of December 17 and the longer term trend since early 2009) is good news . The report noted that the declining number of applications suggests the economy may finally be regaining strength, two and a half years after the Great Recession ended. The economy added at least 100,000 jobs every month from July through December, the first six-month streak since 2006. And in the past four months, private employers added an average of 160,000 net jobs a month versus an average of 84,000 in the previous four months.

 

As noted earlier, the national unemployment rate for November dropped substantially versus October from 9.0% to 8.6% although there are questions as to how much of this decline was due to job creation. More recently, last Friday (January 6), the Bureau of Labor Statistics announced that the December unemployment rate declined again to 8.5% largely on the basis of seasonal demand for holiday workers. 8.5% is still an unacceptably high rate of unemployment for our economy. But it’s important to keep in mind that the unemployment rates one year ago (for November and December 2010) were substantially higher (9.8% and 9.4% respectively). Continued declines in the unemployment rate (and declines specifically driven by increases in employment versus the unemployed giving up and exiting the civilian labor force) are an important positive indicator that the recent trends we’ve seen emerge in the fourth quarter of 2011 are gaining momentum and could contribute to further gains in both consumer confidence and spending.

 

Summary

Macro-factors will likely remain important in determining the direction of U.S. equity markets for 2012. That is not necessarily bad news if one or more is resolved in a way that boosts the optimism and outlook of both investors and consumers. But on-going uncertainty about the sovereign debt crisis in Europe, the U.S. budget deficit, debt and future fiscal policies (e.g. taxation and spending) and unrest in the Middle East will likely contribute to more of the kinds of swings in market direction and investor confidence we saw in 2011.

Corporate earnings growth this year is unlikely to be driven primarily by margin expansion and cost reduction as it has for the past several years. And with global economic growth appearing to be in a slowdown phase, this is going to create substantial challenges for company executives. However, many large corporations and businesses continue to hold substantial cash and other short-term assets on their balance sheets, which could be put to use as part of a strategy to grow earnings via mergers and acquisitions activity.

One small bright spot (and wildcard) is U.S households. While the trends are very short-term, some important indicators do suggest that U.S. consumers may finally be nearing a point in the deleveraging process where their contributions to spending, consumption and demand growth could pick-up some of the slack created by slowing growth overseas. If this occurs (and it remains a big “If”), it will not be a sudden event but the continuation and acceleration of a slow recovery that’s been underway for several years now.  And, if this occurs, it should provide some impetus to businesses to hire new workers as their top-line revenue grows.

This will be a lot less likely in the event of more bad news and setbacks among the macro-factor challenges we face. But barring any catastrophes and new setbacks, we may someday look back at 2012 as the year when U.S. households finally turned a corner and slowly resumed their place as a key contributor to our economic growth.

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Appendix

 

S&P 500® Index

A market value-weighted index of the stocks of 500 publicly traded U.S. companies chosen for market size, liquidity, and industry group representation that are considered to be leading firms in dominant industries. Each stock's weight in the index is proportionate to its market value. Created by Standard and Poor’s, it is considered to be a broad measure of U.S. stock market performance.

 

Dow Jones Industrial Average

An average made up of 30 blue chip stocks that trade daily on the New York Stock Exchange.

NASDAQ (Price Return) Index

A market value-weighted index of all domestic and international common stocks listed on the NASDAQ stock market.

 

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

 

Diversification does not assure a profit nor does it protect against loss of principal.

 

 

Visit americancenturyblog.com to read the Weekly Market Update and other economic, market and investment insights from the experts at American Century Investments.

The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.

© 2012 American Century Proprietary Holdings, Inc.

In this chart, the opening values of each index on January 3, 2011 were assigned a value of 1.00 and the subsequent daily values (through December 30, 2011) are the ratio of the closing index value that day divided by its value on January 3. See Appendix to this Weekly Market Update (end of piece) for the definitions of each index.

Gross Domestic Product (or GDP) is the combined dollar value of all goods and services produced by a country in a given year.

The Conference Board Consumer Confidence Index ® (CCI) is a barometer of the health of the U.S. economy from the perspective of the consumer. The index is based on two components: (1) Consumers’ perceptions of current business and employment conditions; and (2) Consumers’ expectations for six months hence regarding business conditions, employment, and income (the expectations index).

See http://americancenturyblog.com/2011/11/households-continue-to-reduce-debt-and-embrace-frugality/

See http://www.newyorkfed.org/research/national_economy/householdcredit/DistrictReport_Q32011.pdf

The S&P/Case-Shiller Composite of 20 Home Price Index is a value-weighted average of the 20 metro area indices. The data are delayed by two months due to the time required to collect and process the price information. So, October is the latest index value available as of December.

Keep in mind these data do not measure continued claims for unemployment insurance by those previously unemployed—only new claims by those recently out of work.

 

 

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