True Reflections … on 2011 and 2012
By Liz Ann Sonders
January 4, 2012
"I always avoid prophesying beforehand because it is much better to prophesy after the event has already taken place."
It's that time of year again, when we review the year that was and look ahead to the year that is. It's a time rife with forecasts, outlooks and predictions. At Schwab we do our part, but not quite like the others. At our company's core is the belief that disciplined investing is the key to long-term success, and that investing based on forecasts—yours, mine or anyone else's—is gambling in disguise. That is why we don't publish year-end price forecasts … I haven't a clue where the market will close the day I'm writing this and that's only a few hours away, let alone where it will close on December 31, 2012.
Expect the unexpected
What we do try to do is review trends, scenarios, possibilities and probabilities, while always keeping a close eye on the contrarian view. As Oscar Wilde said, "To expect the unexpected shows a thoroughly modern intellect."
Last year was a doozy. From the start of 2011 to the end of April, the S&P 500 Index rallied nearly 10%, only to plunge nearly into bear-market territory (-20%) by early October. It rallied back nearly that much by the end of October, giving back another 10% by Thanksgiving, but finishing with a nearly full recovery of that 10% over the holiday season.
The real trouble erupted in August thanks to a dysfunctional Congressional debate about the debt ceiling, a subsequent US credit-rating downgrade and the re-eruption of the eurozone debt crisis. The DJIA averaged a daily intraday swing of 270 points between August and November, more than double the spread over the same period in 2010.
A market full of "sound and fury, signifying nothing"
When all was said and done, the S&P 500 and the Dow did eke out gains for the year (though only thanks to dividends for the S&P). But that performance belied the turmoil of the year and few investors have been celebrating save for maybe those who stuck with US Treasury bonds over the year. Even the so-called smart-money hedge funds had a tough year: the average return was -5% according to Hedge Fund Research. There's little worse for a hedge fund than posting a negative sign before returns with the major indices in positive territory.
You can see the array of returns across many of the key global indices below:
2011 Asset Class Performance
Source: Bloomberg, Thomson Reuters, as of December 30, 2011.
Key to the year's initial surge into late April was the expectation that the economic recovery was picking up momentum. Those hopes, along with the market's rally, were dashed with a very weak second-quarter GDP report that was not only weaker than expected, but brought significant downward revisions to prior quarters' growth rates (including a whopping revision to 2011's first quarter from 1.9% to 0.4%). What we ultimately learned about the year's first several months was that a sharp increase in inflation took a big bite out of "real" (inflation-adjusted) GDP.
The $30 surge in oil prices in the five months through April 2011 likely carved about 1.5% out of GDP growth. There were also major weather disruptions to crop production that caused a spike in food inflation, and ushered in the Arab Spring. Add to that the March earthquake and tsunami in Japan, which wreaked havoc with the global supply chain, and we had the recipe for a brutal first half of 2011. The mistake some made was extrapolating this weakness into the future and assuming the weakness was secular, not cyclical and reversible.
Inflation takes over from Federal Reserve policy
Inflation has been, and will remain, a big driver on the margin of growth. In cycles past, Fed policy and its influence on short-term rates would move the needle on growth with nearly every tick. But with short rates pegged at zero since the end of 2008, this is no longer the case. What appears to now move the needle, given other growth constraints, is consumer inflation, which can make a big difference given limited income gains. Here's where there's some good news recently, and as we look ahead to 2012.
As you can see in the table below, monthly inflation gains have slowed markedly, while year-over-year comparisons are coming down quickly. In the first half of 2011, a rising GDP deflator was being subtracted from nominal growth, putting pressure on real growth. The opposite is set to occur in at least the first half of 2012, with a lower deflator taking less of a bite out of nominal growth.
Inflation Gains Slowing
Source: ISI Group.
Lower inflation, higher real growth
Below you can see more easily how inflation impacts real growth. Note the period initially highlighted with the vertical line between the two charts. In late 2008 inflation began to plunge and real GDP eventually surged. Inflation began to accelerate in early 2009 and subsequently we saw growth level out and then downward pressure. Given the improving outlook for inflation in the first half of this year, and a lower deflator, expect real GDP to have an upward bias.
Inflation's Effect on Real GDP
Source: Bureau of Economic Analysis, FactSet, ISI Group, as of September 30, 2011.
Another hit to the first half of 2011 was the headwind of tighter monetary policy outside the United States—even from the European Central Bank, which finally came to its monetary senses later in the year and began lowering rates. Most emerging economies' central banks are also now in easing mode thanks to lessening inflation pressures, a tailwind we believe isn't getting the attention it deserves. The breakdown in the price of gold from nearly $1,900 to less than $1,600 per ounce since August may be singing a lower-inflation-to-come tune.
Aside from a brighter inflation picture, there has of course also been a string of much-better-than-expected economic reports. Initial unemployment claims have made a meaningful downside breakout below the key 400,000 mark, suggesting better news on the jobs front. The Institute for Supply Management (ISM) manufacturing and non-manufacturing surveys have both rebounded sharply from their summer lows. Over the past 60 years, the ISM has proved itself the best single short-term leading indicator of US economic growth. The Conference Board's measure of consumer confidence has recuperated to an eight-month high. Also from the Conference Board we've seen a compelling improvement in the Leading Economic Index (LEI), seen below.
Leading Indicators Not Telling Recession Story
Source: Conference Board, FactSet, as of November 30, 2011.
Key to this LEI improvement has been the broadening of the sub-indices that have ticked up: the last several months brought lifts in nearly all of these, versus just the financial components (interest-rate spread and money supply) that had driven the earlier improvement.
Consumer and housing news getting better
The news about consumers has improved, too. If you're concerned the decent holiday sales were on the back of rising debt, look no further than the credit card delinquency rate, which declined in the most recent month (November) to a record low, and has plunged to less than half its recession peak. Estimates for 2011's fourth-quarter GDP growth are now approaching 4% and we're starting to see upward revisions to 2012's first-half growth estimates.
We're even seeing a light at the end of the housing tunnel. The pending-home-sales index surged more than 7% last month to its best level since April 2010. At that point, housing was artificially supported by the homebuyer tax credit. The last time pending sales were at the current level without government support was June 2007.
The latest construction spending report was also well ahead of expectations, with most of the strength in private housing. As we've noted many times, given housing's diminished weight in GDP relative to the bubble peak, the economy can grow (albeit slowly) without a strong housing market. However, a sustained and improving outlook for growth will require more heavy lifting from the real estate market … this may be on the horizon, and I'll address the topic in an upcoming report.
Under-exposed investors will likely climb "wall of worry"
As we head into 2012, I think the market "wants" to go up, and the first trading day certainly supports that view. Hedge funds are under-exposed to stocks, according to ISI's survey, with net-long exposure only slightly greater than it was back at the March 2009 market low. Individual investors' exposure to stocks also remains low relative to historical norms, with the bias in terms of fund flows having been heavily fixed-income-weighted over the past five years or so. And sentiment conditions remain supportive, with the "wall of worry" very much intact.
Furthermore, the market's rally since its March 2009 lows has been earnings-driven, not multiple-driven, with the forward P/E on the S&P 500 at a very reasonable sub-13 (compared to a historical norm of 17). Corporate profits are set to continue growing, albeit at a slower pace, driven by contained labor costs and low interest rates.
Lest I wax too optimistic for skeptics' tastes, let me close by noting the continuing turmoil in Europe—likely a continuing source of volatility for markets. Key will be whether the eurozone debt crisis more mirrors our own in 2008 or the Asian currency/debt crisis in the late-1990s. Because of 2008, I think the eurozone crisis will end up mirroring 1998. Given the proximity of the Lehman Brothers-driven implosion in 2008 and the keen awareness of the perils of a eurozone break-up, we think policymakers will do what's necessary to avoid a repeat.
In 1998, the US economy was able to escape the carnage of currency crises emanating from the Thai baht devaluation, Asian market collapses, and economic carnage throughout Southeast Asia and Russia. Unless there's a Lehman moment in Europe, I think the US economy will not be infected significantly from Europe's economic malaise.
Markets are likely to remain volatile in the near-term, but as I wrote in our recent A Look Ahead: 2012 Expert Roundtable, I think 2012 could be a year of easing volatility, lower correlations and better returns for stock investors.
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