January 8, 2013
Never test the depth of the water with both feet.
- African Proverb
After feasting on the U.S. stock market’s 54% run-up from 2009 to 2010, we starved for performance in 2011, suffering a 1% loss. Some said the markets were due for a respite, so this lull was healthy, but I felt we were lucky that results weren’t much worse, as they were outside the U.S., and that 2012 would be a disappointment.
I was wrong.
Stock markets both here and abroad had a good year in 2012. So is now the time to get back into the stock market? Are you ready to jump in with both feet?
Let’s take a close look at the details of what occurred in 2012 so we can assess the opportunities and prepare for the surprises that 2013 will bring. In particular, let’s look at momentum and reversal possibilities coming into 2013. I’ll give you my opinions, and you should form your own.
Here are a couple of facts worth noting about 2012. As discussed in my Q3 commentary, investors bailed from equity mutual funds, which should have depressed stock prices, but corporate-share buybacks more than offset this exodus. Also, much of the stock mutual fund redemptions found their way into stock ETFs, a move from active to passive management.
We should not forget the losses sustained in 2008. Despite popular perception, we have just now recovered 2008 losses; the 54% 2009-2010 gain did not offset the 38% loss in 2008. But 2012 has brought the U.S. stock market back into positive territory, with a 3% cumulative return for the five years 2008-2012. We’re above break-even.
I begin with a review of the lessons learned in 2012 around the globe and then extend the perspective to the longer-term history of U.S. markets over the past 87 years. My goal is to arm you for thoughtful investment decisions.
The year 2012 in review
I’ll review the year by analyzing what has worked and what has not. I begin with risk and reward for sectors and styles and then drill down further by examining the cross-sections of styles and sectors, using heat maps to identify trends.
U.S. stock market
I begin with an analysis of the risks and rewards in 2012, as shown in the following chart, and add my outlook for 2013. The total U.S. stock market returned 16% in 2012, matching the S&P 500’s return. In the following, I show total market results for 5,000 companies rather than just the S&P 500’s 500 companies.
Here are some observations from this graph:
- Infrastructure stocks – energy and materials – have lagged the total market and have exhibited higher risk. These sectors have disappointed on a relative basis, despite expectations that government spending would favor them. I think these stocks are still a good play, especially if China and India resume their growth.
- Telephones-and-utilities have lagged the market, but with lower risk. No news here – performance as usual.
- Healthcare has dominated the market on a risk-adjusted basis, providing a 20% return with below market risk. Medical companies have been among the largest share repurchasers. Obamacare will matter in 2013 and beyond, benefitting some segments of the healthcare market, like pharmaceuticals, and undermining others, like health insurers.
- Financials recovered in 2012, returning more than 25%, albeit with relatively high risk, which is uncharacteristic for this sector. This performance is a reversal of the previous four years, during which financials lost 42% while the total market lost 5%. As described in my 2011 commentary, the style classifications of fallen financials have distorted some benchmarks, until 2012 when distressed financials were once again properly classified as value stocks. But the safety implied in the word “value” is offset by the fact that we are likely to see increases in interest rates in 2013, which will hurt banks because they invest long and borrow short. Accordingly, I think financials will disappoint in 2013.
- Consumer discretionary stocks were the next best performing, after financials, with risk near the market. Investors perceived that consumers had sacrificed long enough, saving more and spending less, at least those with jobs. Christmas spending did not confirm this perception, with spending roughly the same as 2011. I would not expect consumer discretionary stocks to continue to lead in 2013.
- Technology stocks did not deliver returns commensurate with their risk. As shown below, large-value technology stocks were a drag on performance in the year, and I think these stocks will come back in 2013.
- Consumer staples underperformed the market with less risk. Look for these companies to defend well if we see another recession. We have to eat.
- Core stocks, defined as those in between value and growth, have stood still, with relatively low risk and low return, while value and growth stocks have taken off. This suggests that investors have style conviction but disagree, with some liking value while others like growth. Core frequently performs better or worse than both value and growth, much like mid-cap frequently performs better or worse than both large and small. This pattern usually reverses, so I’d expect core to move to a more natural position in 2013 between value and growth. I use Surz Style Pure style definitions throughout this commentary.
- Value outperformed growth, although growth was riskier. Value investing does dominate over long periods, despite the risk incongruity. Given the uncertainties facing the U.S. economy with the debt crisis and the possibility of another recession, value gets my vote over core and growth in 2013, as a flight to safety.
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