Once again the stock market proved totally unpredictable in the fourth quarter of 2011 delivering impressive returns in the face of continued economic and political headwinds. U.S. companies across the board produced double-digit gains, much to the dismay of investors who might have given up on equities after the third quarter’s severe drubbing. And pity those who sold their stocks to buy gold in the second half of the year. Contrary to countless predictions of $2,000 gold by Christmas, the shiny metal finished the year at $1,565 per ounce, down from a record of $1,888 in August.
In a year that gave new meaning to the concept of volatility, a few fund managers made headlines they would rather have avoided. Bill Miller, legendary manager of Legg Mason Value Trust, finally threw in the towel after under-performing his benchmark five of the past six years; this from a fund that previously beat its index for 15 consecutive years. Makes you wonder if his former stellar record was skill or merely luck. If fund companies would just follow the practice of college football programs they could save their investors a lot of money. Two bad years and you’re out.
Even sophisticated hedge fund managers had a rough year, losing about 5% on average, according to Hedge Fund Research, Inc. That’s three straight years hedge funds have lagged behind stocks. One of the most notable gurus was John Paulson, who made a fortune predicting the housing and financial collapse in 2007 and 2008. His Paulson Advantage Plus fund lost about 50% in 2011. Has he lost the keen insight that made him rich and famous or did his luck just run out? And then there’s Jon Corzine, former CEO of Goldman Sachs, who bankrupted MF Global when he bet wrong on distressed EU debt. I guess he was just unlucky, since whatever skills he formerly possessed at Goldman he forgot to bring with him during his brief tenure at MF Global.
Those who follow our musings know we believe markets are too efficient for anyone to exploit for long. This is why we avoid chasing relative performance, preferring instead low cost, tax-efficient index strategies. We believe adequate saving, careful planning and prudent diversification can enable one to attain their financial goals over time without taking the risks of blowing up as Paulson did in 2011 or of continued and severe under-performance as Miller has exhibited over the past six years.
Most investors who put their faith in these types of strategies do so with the expectation that they too will “beat the market” and reap bountiful rewards. Investors chasing relative performance might as well be wishing on a rabbit’s foot. The only thing that truly matters is whether you are making consistent, sustainable and measureable progress toward your goals without unnecessary risk and at the lowest reasonable costs. Investors who measure their success by performance relative to an impersonal benchmark are truly chasing the wrong rabbit.
Economic Summary
The economy continues to send mixed signals. The jobs picture is definitely improved as employers have now added to their payrolls for 14 straight months at an average of 133,000 per month. Most of those gains have come at the expense of the public sector with state and local governments facing deficits and trimming wherever possible.
The unemployment rate fell from 9.0% to 8.6% in November due to an increase of 120,000 new jobs and another 300,000 people exiting the workforce. A closely watched number is weekly claims for new unemployment benefits which recently hit the lowest level in more than three years at 375,000. Anything below 400,000 suggests the economy is adding net jobs.
Third quarter GDP was revised down to 1.8% from an earlier 2.0% estimate. Even that was an improvement over the 2nd quarter rate of 1.3%. 4Q and FY-2011 GDP numbers will not be released until late January but most economists believe the U.S. grew under 2% for all of 2011 and will grow at about 2.4% in 2012. On a bright note, retail sales for the Thanksgiving holiday hit a record $52 billion vs. $45 billion in 2010.
Market Summary
Shares of U.S. companies delivered impressive gains in the 4th quarter to salvage an otherwise forgettable year. Large (S&P 500), mid (S&P 400) and small (S&P 600) stocks returned 11.82%, 12.98% and 17.17% respectively during the quarter. For the year those same sectors earned 2.11%, -1.73% and 1.02% respectively, making 2011 a do-over. Developed (EAFE) and emerging (EM) international markets didn’t match the U.S. but still produced acceptable 4th quarter returns of 3.33% and 4.42% respectively. Unfortunately, the full year was on the ugly side, down -12.14% (EAFE) and -18.42% (EM) as debt concerns in Europe and slowing growth rates in China and other emerging countries took the wind out of international’s sails.
And the winner for 2011 is – gold. Not! Gold was up about 11% for 2011 but the real victor was U.S. Government bonds – the longer the better. In fact, for the first time since 1997 bonds out-performed all other financial assets. It’s counter-intuitive, but in the same year S&P downgraded Uncle Sam from AAA to AA+ investors sought safety from increasing global and political economic uncertainties. Interest rates fell to all-time lows causing bond prices to soar. The 10-year Treasury gained 17% and the 30-year gained 35%. Shorter bonds as measured by the 1-5 Year Government/Credit index delivered less impressive gains for the quarter and year of 0.43% and 3.13% respectively. Commodities, as measured by the S&P GSCI Total Return Index fell -1.18% for the year.
What’s Next?
A hobbled housing market, debt-ridden consumers and European turmoil point to meager improvements in the jobs picture this year. For example, if you can’t sell your home, you may not be able to relocate to pursue a more favorable employment opportunity. With consumers in a de-leveraging mode they are not inclined to make major purchases that require debt, this in spite of record low interest rates. And the EU debt crisis threatens to throw Europe into a recession if mishandled.
Earnings from S&P 500 companies grew at an estimated 14% in 2011, on top of 38% growth in 2010. For 2012, consensus estimates call for earnings growth of about 9%. If earnings grow at just 6% instead of 9% that equals growth of about 20% over a two-year period. The S&P would need to increase about 20% in 2012 just to remain at current valuation levels since 2011 was essentially a flat year.
Another method to judge stock valuations is to look at earnings yield. This is earnings divided by price and is the opposite of P/E ratio (price divided by earnings). A high earnings yield (low P/E) has historically been a reflection of value. When compared to the yields on treasuries it becomes even more compelling. Stock yields are more divergent from bond yields than they have been in decades. The earnings yield for the S&P 500 at year-end was about 7.8% compared to the 10-year Treasury yield of about 2.0%. The larger the divergence, the more under/over-valued one of the two asset classes becomes.
Either stocks are greatly under-valued or bonds are greatly over-valued, or both. There is one rational explanation for this divergence – fear. The European debt crisis is real and if it goes bad it could have tremendous negative world-wide implications. On the other hand a portion of that bad out-come scenario is already factored into stock valuations. Watch earnings and Europe for 2012.