Through the Looking-Glass: 2012 Economic and Stock Market Outlook

In the Lewis Carroll classic, Alice, fresh off her adventures in Wonderland, finds herself one snowy evening wondering about life on the other side of the mirror that hangs over the fireplace. She climbs atop the mantelpiece and discovers that she can step through into a looking-glass world. Once there, Alice encounters a reality that is anything but normal. Left is right, forward is backward and a new set of rules applies. We too find ourselves pulled into a new environment, one that if not so real would seem to be a farce. Consider these situations, that we have seen in 2011:

 

• A country gets its sovereign debt downgraded, but yet yields on that debt fall sharply.

 

• The parliament in the second-poorest (based on per capita output) country in the EU (Slovakia) casts the final and decisive vote for a European stability fund that at the time seemed crucial to the ongoing viability of the EU and the euro. After first rejecting the measure, the Slovakian parliament in the end approved it.

 

• The United States, which has funded operations of late more by continuing resolutions than a comprehensive budgeting process, and has had to borrow 38 cents on every dollar spent over the past three years (in the process accumulating $4 trillion in new debt), is now lecturing the EU and its member countries on the need for fiscal reform and getting debt and deficits under control.

 

2012 Outlook Summary

 

Risk on S&P 500 to 1000, Reward to 1400.

 

Election and European Debt Uncertainties Are Dominant Risks in First-Half. Headwinds Could Abate Later In The Year.

 

GDP Outlook – Lack of Income Gains Could Cap U.S. Growth At 2%. Europe In Recession.

 

Secular Base-Building Means Volatility Unlikely To Ebb; Manage Portfolios For Risk As Well As Return.

 

This is our “looking-glass” world of today. It is not normal – in a new sense or old – but is real. It is not permanent but it persists, and we must operate within it. Just as Alice had to learn how to negotiate her way across the chess board and toward her destination, so too must we navigate the financial markets. Even as we look forward and move toward a better tomorrow, we confront our current reality.

 

As we consider that better tomorrow, we see changes just over the horizon that could reflect a secular shift for the economy and the financial markets. Right now, the need for change is being recognized primarily at the grass-roots level, so figuring out the exact scope and timing of that change will take more time, as will convincing the powers that be of the need for change. The major grass-roots efforts that have emerged across the country over the past couple of years (principally, the Tea Party movement and, more recently, Occupy Wall Street) are, in our view, different manifestations of a similar sentiment. Underlying both is the sense that the current political/economic/corporate structure needs massive reform, beginning with a disentangling of special interests and entrenched politicians.

 

Aspects of this change include:

 

Tax reform

 

There is little doubt that the U.S. tax code needs reform. It is hopelessly complex, doles out favors to special interests, and has a distortionary effect on production and investment. Current complications in the tax code make “simple” ideas appealing, but reform must not be premised on simple alone. Issues of fairness also must be addressed. Marginal rates need not be flat, but they should be as low as possible. High marginal rates are a disincentive to production. More effective, and fairer, simplification” would come from reform in the calculation of taxable income and tax credits. It is here that favors to special interests create complications, distortions and a deep sense of unfairness. A similar story is seen in the corporate tax code – rates in the U.S. are among the highest in the world, and the code is full of loopholes for favored industries. We are past the point where solutions are found in slogans or temporary measures. Comprehensive reform is needed, and the proposals by the Simpson-Bowles or Domenici-Rivlin commissions are good starting points. We also need to move beyond the point where the removal of special breaks counts as a tax increase.

 

Monetary policy

 

Dysfunctional fiscal policy has put the onus of action on the Federal Reserve. If Fed Chairman Ben Bernanke is to be taken at his word, there is a strong

desire on the part of the Fed to cede the mantle of “economic/financial market savior.” One way to do this is to focus more of the Fed’s energies on protecting the value of the dollar. Raising short-term interest rates would reward domestic savers and make the U.S. dollar more attractive, rather than just a haven in periods of stress. Federal Reserve policy in recent years has gone from counter-cyclically providing the punch bowl in bad times and removing it in good times, to seemingly augmenting the boom/bust cycle. Later, we will look more closely at what the Federal Reserve and other central banks are doing, and what we expect them to do. In terms of what they should do, protecting the value of the dollar and having a less active role in the economy are desired.

 

Government spending/entitlement reform

 

In the wake of the inability by the Congressional super committee to make even token budget cuts and with seemingly little impetus toward extending the payroll tax cuts that expire at the end of this year and next, the federal budget deficit is, on paper, poised to improve dramatically. This outlook is based, though, on the budgeting assumption that tax increases and budget cuts will have no impact on economic activity. This is almost certainly not the case. Rather than back-dooring our way to an improved fiscal situation on paper, we need comprehensive reform of government spending and entitlements. A Federal Reserve official recently pegged the unfunded liability from Medicare alone at $70 trillion – vastly higher than the current total government debt outstanding. This is a structural deficit issue that a cyclical economic recovery is not going to solve.

 

In some ways, the lack of a super committee deal may actually be a long-term positive. It has been our view that the worst-case outcome would be a perceived solution that actually did nothing, or that the sequestration rule (the mandated budget cuts starting in 2013) would just be reversed. At this point neither of these outcomes has been realized, so there is still an awareness of the need for actual reform. Hindering the process has been the breakdown in the level of trust in Washington, D.C., and because of this, no one appears willing to take the first step. The solution must be comprehensive and likely lies somewhere toward the middle (between the loosely outlined proposals on either side). Importantly, an honest solution needs to tackle sacred cows for both parties.

 

Energy policy

 

The United States lacks a cohesive energy policy, relying on an amalgamation of reactive regulations, unsupported mandates, political favors/subsidies, and ideals that are unmet in reality. Take ethanol for example: corn-based ethanol and the mandates associated with it are a legacy of Iowa’s historical role as an early participant in the presidential candidate nomination process. Modern corn-farming, ironically enough, is petroleum-intensive, and corn is ill-suited to the production of ethanol. When it is all said and done, corn-based ethanol may actually consume more energy than it produces. Ethanol is much more effectively derived from sugar cane, but Brazilian-produced sugar cane-based ethanol faces tariffs, and in some cases, corn-based ethanol is legislatively required. While alternative forms of energy may eventually be viable, they are not now, particularly at the scale needed. Natural gas, however, is a proven fuel source, and is readily available in the United States. An energy policy focused on the domestic production and distribution of natural gas would help secure a cheap and reliable source of energy for the country.

 

Changes along the lines discussed above can help build a base for the economy from which a robust, self-sustaining recovery can emerge. That is the better tomorrow that we see. We will get there, but patience along the way is required. Admittedly, the election of 2012 may delay near-term progress, but it may also help crystallize, in the electorate and politicians, long-term goals. With the Democrats looking back at 2008 as their mandate for change and the Republicans seeing 2010 as their call to action, the 2012 elections set up as a tie-breaker of sorts. We’ll talk more about the expected effect of the election on the financial markets when we consider the seasonal patterns in the weight of the evidence section below.

 

For now, particularly as we consider the financial markets, we remain on the other side of the mirror. Like Alice, we are trying to make sense of our own Tweedledum and Tweedledee. At this point, getting our hands on a vorpal sword with which to slay the Jabberwocky would be particularly useful. We are faced with the question of whether, in the current environment, the usefulness of long-used indicators has changed. As long as macro uncertainties remain elevated and liquidity continues to ebb and flow in an exaggerated manner, volatility in the market is likely to remain elevated. In part, we risk over-reading changes in the indicators (i.e., they still work, but not necessarily in the way we have expected), and in part, certain indicators are less useful. Trading days on which up volume outpaced down volume by more than 10 to 1 (and vice-versa) used to be rarities, and offered important signals to the market. They are now relatively common, and little is gained from their observation.

 

Our basic premise remains this: the secular bear market that has been in place for over a decade is intact. Cyclical trends emerge and fade. The cyclical bull market that emerged off of the March 2009 lows ended in 2011. The pertinent question now is whether the cyclical bear market that was in place in the middle part of 2011 has run its course. From its April peak at 1364 to its October trough at 1099, the S&P 500 fell more than 19%. The small-cap Russell 2000 fell nearly 30% in that time period. Has the rally seen since the early October low been a bear market rally or has it represented a new cyclical bull market? For now the jury is still out, but absent conclusive broad market evidence that points to a change in the primary trend, we assume that the previous trend is intact. For 2012, our working assumption is that the cyclical bear may re-emerge in the first half, with market conditions growing more favorable in the second half of the year. These ongoing cyclical swings accompanied by unrelenting volatility represent a period of secular base building. As we make progress on the secular issues outlined above, the probability of a meaningful secular low emerging increases.

 

While we have expectations of what might happen, we need to balance this with our observable reality. We rely on our weight-of-the-evidence approach to do so. Heading into 2012, the weight of the evidence is mildly bullish. Federal Reserve policy, sentiment, and seasonal trends support higher stock prices, while poor economic fundamentals and broad market divergences could weigh on stocks. Valuations are neutral from a cyclical perspective. Putting this into context for our 2012 outlook, stocks could work higher into January, but the path forward from there will rely on the evolution of the sentiment and breadth data. A surge in optimism could reduce the opportunity for rally, while improvements in the broad market could help fuel further gains and signal confirmation of a cyclical bull market.

 

Federal Reserve policy is bullish

 

While we have already reviewed our perspective on what the Fed should be doing, we need to consider what it is doing and what we expect it will do. The acronym-intensive intervention in the markets that the Federal Reserve pursued in 2008/2009 has been replaced by more direct intervention, the buying of Treasurys and mortgage securities.The second round of quantitative easing (QE2) was wrapped up by mid-2011, but was soon followed by a program to lengthen the maturity of the Fed’s Treasury holdings (Operation TWIST), with the Fed also declaring its expectation that short-term interest rates will remain low into 2013. Late-2011 has seen a coordinated effort by the Federal Reserve and other global central banks to ease the liquidity strains that have emerged in Europe. This effort, while ensuring sufficient dollar-funding as the European banks come under pressure, is a short-term liquidity mechanism that is designed to prevent a seizing up of the financial markets. Indicators of financial stress improved following this joint intervention. The reaction in the commodity markets to this news suggests that this may be the first of several coordinated efforts that, we expect, will culminate in a third round of quantitative easing domestically and more active intervention by the ECB. Even before the November announcement on swap rates, the Federal Reserve was floating trial balloons for QE3, with the most overt being the dissenting vote at the November FOMC meeting calling for more easing by the Fed.

 

The Fed’s strategy appears to be an effort to buy the economy as much time as possible to right itself and begin to move back toward trend growth. The problem is that the economy and the markets are increasingly dependent on Fed-supplied liquidity. The Fed continues to discuss exit strategies, the first of which would be to allow natural contraction of its balance sheet as its fixed income holdings come to maturity. For now, however, this is a theoretical discussion, and the next step is likely to be more intervention rather than less.

 

While the Fed has its hands on the money supply levers, its crystal ball is far from omniscient. The Fed (and most economic forecasters) has consistently overestimated the strength of the U.S. economy in recent quarters. The Fed’s January 2011 estimates for growth were for better than 3.5% growth in 2011 and nearly 4% growth in 2012. By November, those estimates had been revised down to 1.7% growth for 2011and 2.7% growth in 2012 (expectations for 2013 growth were revised down from 4.2% to 3.2%). The Fed’s expectation for the unemployment rate in 2012 rose from a January 2011 estimate of 7.8% to a November estimate of 8.6%. The point here is not to bash the Fed’s ability to forecast economic variables. Precise forecasting tends to be a futile exercise, and one in which we do not engage. Rather, the Fed has consistently overestimated its ability to back away from active intervention in the market and support of the economy.

 

We do not believe that another round of bond-buying by the Fed (or ECB) represents a long-term path to prosperity, but it may be necessary (particularly in Europe) to prevent further destabilizing. It is much more likely that flooding the system with dollars and euros will allow a commodity and/or stock bubble to build rather than the emergence of sustainable growth. Ultimately, the world economies will have to stand on their own, unsupported by central banks. Getting to that point will require time, but getting there will be important. For now, though, we see little evidence that the Federal Reserve will be able to back away from its active role. Further easing is likely, and this is bullish (at least near-term) for stocks and gold.

 

Economic fundamentals remain poor

 

Growth in Europe has stalled, and a continent-wide recession may be emerging. Emerging economies remain vulnerable to the cumulative effects of interest rate hikes and weakness in their end markets. The United States economy is beset by weak aggregate demand, persistent unemployment and a weak housing market (to say nothing of the lack of fiscal clarity/leadership out of Washington, D.C.).

 

The ongoing source of consternation is elevated debt and deficit levels. While we are hopeful that increased awareness will bring about real change (the first step to solving a problem is admitting that you have one), the path forward is not easy. Academic studies have shown that historically there are four main avenues for governments to reduce high debt/GDP ratios: robust nominal growth, higher taxes, default, and/or inflation. The key, in our view, is robust nominal growth, and from a policy perspective that should be the focus in both the United States and Europe. Absent an expanding economy, higher taxes and/or budget cuts (the austerity measures that are being pursued aggressively throughout Europe and more hesitantly in the United States) are unlikely to achieve success. They are contractionary in nature, and it is much more difficult to reduce the overall debt to GDP ratio when the denominator (GDP) is declining. Better would be an effort to limit the growth in the numerator (particularly over the longer term) while stimulating growth in the denominator (particularly in the near term). Importantly, growth in GDP must outpace growth in debt if the overall ratio is to decline. This is a process, not an event, and takes time to evolve. The policy improvements that we described at the outset would be important steps in the process of supporting nominal growth in the economy and limiting the growth of debt. For now, the growth outlook remains uneven, with risks skewed to the downside.

 

While the European Commission’s forecast for growth in the euro area is for +0.5% in 2012 (down from a previous estimate of 1.8%), the data being seen at the end of 2011 increasingly suggest that the area is slipping into recession (almost certainly outside of Germany, and probably even when Germany is included). This has brought to the surface design flaws within the structure of the EU. While monetary policy is coordinated, fiscal policy remains discrete. With both strong and weak alike using the same currency, there is cajoling and resurgent nationalism. Investors in the U.S. have learned more about the local politics of Slovakia, Greece, and Italy (to name a few) than many would have cared to. While no system of government is perfect, the strains in Europe have exposed one of the weaknesses of a parliamentary government. The lack of an independent executive makes politically unpopular decisions harder to sustain. While the first half of 2011 was marked by the Arab Spring that saw the collapse of governments on the southern shore of the Mediterranean Sea, the latter half of the year saw the collapse of governments on the northern shore (there must be something in the water).

 

As we move into 2012, the outcome in Europe remains in doubt. What is clear, though, is that the time has come to address the actual issues, not just hold summits and release vague communiqués. More work needs to be done on determining a path to solvency, which likely means a more concerted effort to recapitalize the banking system and shore up liquidity. Absent confidence that there is an ultimate backstop – not to prevent losses from occurring but to ensure orderly operations – rumors and fears will lead to ongoing turmoil, which can be seen in the recent spikes in sovereign debt yields across Europe.

 

Data in the United States show a moderate firming in activity in the fourth quarter of 2011. Much ink has been spilled discussing whether the United States is just lagging Europe’s decline into recession, or whether there has actually been a decoupling. As a history professor once reminded us (in the context of the French revolution), events throughout history happen in real-time as decisions are made, and the course that we can look back on now was not preordained or necessarily inevitable. Likewise, the outcome for the United States economy in 2012 is largely contingent on events that have not yet occurred, although its weakened state leaves it vulnerable to shocks. Spillover effects from Europe – not so much poor economic growth, but rather financial market disruptions – could weigh on the United States, as could the expiration of the payroll tax cut at the end of 2011 and continued lack of fiscal policy leadership.

 

It is not as though the U.S. economy has nothing going for it. There have been areas of improvement in the economy in 2011 that could bode well for 2012. Liquidity is returning and credit market conditions have improved considerably. Further, the housing market may finally be hitting bottom. Inventories of new and existing homes for sale remain elevated, and this could continue to weigh on construction activity. However, the ratio of the median home sale price to median income has dropped to a historically low level, and the Obama administration has unveiled new efforts to support the housing market through the reworking of current mortgages. Programs of this nature have been announced in the past, but have produced little in terms of results. While hopeful that this latest program will find broader implementation (as is its design), we are cautious given the lack of follow through seen on this front. The Federal Reserve’s efforts to keep mortgage rates low are also supportive. Concerted progress in easing the debt burdens of homeowners would be good news for the economy and probably more stimulative than short-term tax cuts.

 

The household sector in the United States faces a looming structural issue – nearly one in five workers under the age of 25 is unemployed. This becomes a generational issue as the older workers begin to view the younger generation as lazy, and the younger generation becomes discouraged. Recent research from the NBER (National Bureau of Economic Research) supports these views. Of the “extra” hours of each day gained by not working (i.e., time that would be spent at work if employed), only 1% goes towards looking for a job, while 30% goes toward extra sleep and watching T.V. This goes beyond just inter-generational resentments. Unemployed workers, of all ages, face skill degradation, which accelerates over time and hampers the underlying dynamism of our economy (not only are current skills lost, but new ones are not learned on the job). Rather than having the government acting as a venture capitalist and investing in unproven (and perhaps ultimately untenable) technologies, an aggressive investment in job-training and education may be more worthwhile.

 

Just as debt is an issue at the national level, so too is it a problem at the household level. While more work has been achieved by households than the government in terms of reducing debt loads, this process has fallen prey to the unevenness of the economic recovery and overall disappointing job growth. Poor job growth has translated into a stalling in income growth. Real disposable personal income fell in both the second and third quarters of 2011. While households would like to pay down debts, they are not willing to do so at the expense of eating or purchasing necessities (a vague term which changes with every generation). This has put downward pressure on the savings rate and delayed improvements in the household balance sheet. Renewed efforts at household austerity will re-emerge as the income picture improves.

 

Business activity re-accelerated in late 2011, spurred by a relieving of mid-year supply constraints and as businesses moved ahead of the year-end expiration of related tax credits. Much has been made of the strength of corporate balance sheets and the amount of cash they have on hand. While this in part reflects a newfound conservatism in corporate finance, it may also reflect a lack of global growth opportunities. Moreover, the improvement in the corporate balance sheet may not be as significant as many believe. Corporations are awash in cash, but non-financial corporate debt levels remain high. Short-term debt has declined relative to cash, but also relative to longer-term debt. Further, capital spending is a function of corporate sentiment. Companies that are optimistic about the future will tend to invest. CEO confidence has declined sharply in recent quarters, and this may weigh on business spending in 2012.

 

Even aside from policy actions (or inactions), government will likely weigh on growth in 2012 as federal and local governments cut back on spending. This can best be seen in the employment data. Gone are the days in which government payrolls consistently expanded and when a government job lasted a lifetime. Over the past twelve months (December 2010 – November 2011), private sector payroll gains averaged 150,000 per month, while government at all levels trimmed payrolls by 25,000 jobs per month. While having more resources devoted to the private sector is ultimately a good thing for the economy, the transition exacerbates the over-supply in the labor market and could weigh on growth in 2012.

 

Inflation – The ending of the debt super-cycle and trends in globalization are both strongly deflationary (to clarify, the inter-connectedness of the global economy is deflationary for developed countries; it is inflationary for emerging economies). Moreover, weakness in aggregate demand and excess supply in the domestic labor market are also helping contain inflation. One area in which we have largely agreed with the Federal Reserve is that the threat of deflation has been greater than widely appreciated, and that the aforementioned counterweights keep near-term upswings in inflation from being persistent. That was seen in 2011. The six-month change (annualized) in the CPI rose from 1.8% in November 2010 to 5.1% in May 2011 (near the culmination of QE2), before falling back to 2.1% in October 2011 (the most recent data available). This can also be seen in inflation expectations. The University of Michigan’s five-year inflation expectation figure has hardly budged over the past couple years, remaining well-anchored even as the Fed has dramatically expanded its balance sheet. Given the view by some at the Federal Reserve (including Chairman Bernanke) that for the conduct of monetary policy, economic expectations matter more than recent observations, it is possible that the Fed would tolerate (if not welcome) higher inflation in the short term if expectations do not rise. This would help support nominal growth. While another round of quantitative easing in 2012 would likely lead to a greater swing in recorded inflation, we do not view it as a sustainable threat to the economy at this point.

 

Bond yields – Short-term interest rates remain near zero, while the 10-year T-Note yield is near 2.0%. With the Fed buying Treasurys and debt continuing to act as an anchor, there is unlikely to be much sustainable upward pressure in yields. Beyond the Fed, though, past buyers of U.S. government debt seem less inclined to add to their positions. The Fed’s efforts to spur growth by keeping interest rates low have been devastating to savers, who must now move into riskier assets to find yield.

 

Valuations are neutral

 

Overall economic growth remains uneven, but corporate earnings have remained strong, generally meeting or exceeding elevated expectations. Over the long run, earnings growth is going to match overall economic growth, although in the short term divergences can emerge and persist for a time. This strength in the E of the P/E ratio has allowed our most preferred valuations to remain near or slightly below their long-term medians. While not arguing that a secular low has been made, valuations do not currently present a headwind to stocks. In a continuing positive, expectations for future earnings growth are moderating.

 

Stocks tend to fare best when not saddled with high expectations for earnings growth. This is not a reflection on analysts’ abilities to forecast earnings growth, but rather a recognition that elevated expectations leave little margin for error and less ability to surprise on the upside.

 

The divergence between overall growth and corporate earnings can be explained by expanding profit margins. That is, earnings growth at the bottom line has not been driven by gains in revenue at the top line. With profit margins now at record levels, it seems unlikely that this engine of growth will remain as robust as in recent years. This would increase the need to expand the revenue line to fuel earnings growth. We believe that it is in the corporate sector that the seeming disconnect between higher commodity prices and moderate inflation gets resolved. Lackluster final demand and weak income growth could make it difficult to pass higher costs on to consumers, leaving corporations to absorb the higher commodity costs that have been seen and could continue to be seen as central banks ease monetary policy. Therefore, not only does continued expansion in profit margins seem unlikely, but they could actually contract somewhat moving forward. Corporations have been buying back their stock in recent quarters, pushing the net issuance of corporate equities in to negative territory. Even without any improvement in its aggregate financial situation, reducing the number of shares of a company will improve per share metrics, including earnings per share and price. This trend reflects general cautiousness on the part of companies – choosing to return cash to investors rather than putting it to work. We will be watching for an expansion in the net issuance of corporate equities, as this could cause excessive supply, which would be a headwind for stocks. Not only would it reveal renewed (perhaps excessive) optimism in the corporate sector, but would put more pressure on earnings and valuations.

 

Right now, our preferred valuation measure, which looks at trailing earnings, shows that stocks are near fair value. Longer-term measures that look at normalized earnings offer a more cautious outlook.

 

Seasonals/trends

 

Seasonals/trends are bullish into year-end 2011, before becoming more mixed in 2012. The trend indicators are mixed. While the popular averages are generally trading above their 50-day averages, which are generally now rising, they are below their 200-day averages, which are falling. By mid-January, we may have more confidence about whether we are experiencing a typical rally within a cyclical bear market (those tend to be sharp moves that fail in key resistance levels), or are indeed in the early stages of a cyclical bull market that could enjoy further upside. A break by most indexes below their 50-day averages would suggest the former; a decisive break above their 200-day averages would point to the latter. Our long-term regression-based trend indicators are also mixed at present.

 

From a seasonal perspective, the popular averages could generally be dominated by next year’s presidential election. The cycle composite that we like to review as a potential roadmap suggests stocks could fare well into January, face growing headwinds as we move from primary elections toward the general election, and then rally as the uncertainty over the outcome of the election fades. Historically, the market has fared better in election years when the

S&P 500 Index vs. NDR Cycle Compositeincumbent is re-elected (+12% on average) versus when he is unseated by a challenger (-3%). This tendency, though, is likely not a market preference for incumbents, as much as a reflection on the economic circumstance that led to an incumbent’s re-election/defeat.

 

Presidential elections in which there is an incumbent and a challenger can generally be boiled down to two basic questions: 1. Do voters approve of the incumbent’s handling of the economy? and 2. Can voters see the challenger as “presidential”? If the answer to the first is “yes,” the second does not matter and the incumbent is likely to win. If, on the other hand, the answer to the first is “no,” the second question becomes the key – a “yes” answer gives the presidency to the challenger and a “no” allows the incumbent to keep his job despite poor marks.

 

Now, a year ahead of the election, President Obama gets generally poor marks on his handling of the economy (recent polls show him with a favorability rating in the low 40’s, below even Jimmy Carter at a similar juncture), and incumbents have been defeated when the unemployment rate has been well below current levels. While much can change between now and the election, if voters are going to reward an improving economy, those gains would likely need to be seen in the near future – after the first quarter of 2012 it may be too late to change economic perceptions.

 

The strategy for the Republican challenger, whoever it ends up being, will likely be to hammer on President Obama’s handling of the economy. Not only could this depress sentiment (recall the mid-2011 malaise that accompanied the debt-ceiling debate), but it provides Republicans in Congress with a disincentive to try to accomplish anything between now and the election lest it provide the president with a tailwind for his re-election campaign.

 

Unable to campaign on the strength of the economy, President Obama’s re-election hopes may hinge on portraying the challenger as insufficient to the office of president. Here, the hope will likely be to tie the challenger to the Republicans in Congress and campaign against a “do-nothing” Republican party that does not deserve the presidency, as well as the personal failings of the actual nominee. This provides a disincentive to the President and Democrats in Congress to getting anything accomplished (i.e., the do-nothing label cannot stick if things are indeed being done). This scenario means that we could be in for an especially negative presidential campaign that could exacerbate the normal seasonal tendencies.

 

Investor sentiment

 

Investor sentiment, as we move into 2012, is mildly bullish. Investor optimism tends to swell as we move from one year to the next, so the sentiment surveys that we watch on a weekly basis could move higher into January without offering much of a headwind for stocks (as of this writing, they show a mostly even mix between bulls and bears). The key over the near term will be the reaction of the sentiment indicators to movements in prices – price declines that are met with a surge in pessimism are unlikely to persist, while rallies that attract elevated levels of optimism are vulnerable to reversal. We’ll continue to watch sentiment on a weekly basis as we read the various sentiment surveys as well as the options data.

 

Two longer-term sentiment indicators deserve mention here. First, mutual funds are fully invested (according to data from ICI, the mutual fund cash/asset ratio near the end of 2011 was just above its all-time low near 3.1%), which could limit the ability of institutional buyers to step into weak markets to support prices. This is further exacerbated by a demand for redemptions by mutual fund investors (again according to ICI, equity mutual funds have seen net outflows in every month since May). Second, we are in a period of secular shift away from the stock market on the part of individual investors. Eventually this will be bullish for stocks (once the final investor has finally washed his hands of stocks and vows never to buy one again), but in the meanwhile it weighs on equities. Investors continue to realize that they were overinvested in stocks, bearing more risk than was appropriate. The volatility in the market has added to this desire to move away from stocks. On an anecdotal level, we hear of an increasing reluctance to maintain exposure to a stock market that appears to be schizophrenic at best and may just simply be chaotic. Prudent regulation (such as something that puts high-frequency trading firms more in the camp of market makers) may help restore investor confidence and encourage increased, long-term involvement in the stock market.

 

Breadth indicators

 

Breadth indicators are bearish entering 2012. An expansion in rally participation at an issue, industry-group or world market level would support the view that the 2011 cyclical bear market has indeed run its course. That has not yet been seen. In fact, thus far the breadth indicators have been much more consistent with the continuation of the cyclical bear into the first half of 2012. We are particularly watching our measure of the percentage of industry groups in up-trends, which historically needs to get decisively above 65% to signal breadth confirmation of a cyclical

bull market. Also, the number of issues making new highs versus new lows has been trending lower and is inconsistent with a cyclical bull market at this point.

 

The risk-on/risk-off nature of the stock market and the tendency for (nearly) everything to move in the same direction has an impact on our breadth measures. As we mentioned previously, 10-to-1 days are so common now as to be practically meaningless. In recent months, it has been the rule, rather than the exception, that 80% to 90% of the S&P 500 is moving in the same direction on any given day. It appears that this may reduce some of the leading tendencies in the breadth indicators, but does not cancel the need to see confirmation from the breadth indicators to gain confidence that movements in the indexes are significant.

 

Aside from the indicators mentioned above, we are watching three areas of the market in particular for confirmation of what we see in the S&P 500: the Financials sector, small-cap stocks and China. If two of these areas get (decisively) back in gear, we would have increased confidence that rallies seen in the S&P 500 can persist. Absent that, and without an expansion in the percentage of industry groups in up-trends, we remain cautious.

 

Portfolio implications and expectations

 

While hopeful about tomorrow and the prospect for secular change, for now we remain in a basing period that is inherently high-risk as the market swings between cyclical bull and bear. The emergence of elevated levels of volatility adds to the risk. Investors, professional or amateur, cannot (and should not attempt to) manage portfolios for the three- to four-week rallies and declines that have in the past taken months or quarters to emerge. Much of the market action on a day-to-day basis is just noise that needs to be filtered out. The remaining information, if there is any, can be reacted to. In this secular environment, investors should focus on managing risk, not chasing returns. The coming secular upswing will be the time to focus on returns.

 

This is not to say that investors should hide their money under their mattress and do nothing for the duration of the secular bear market that emerged a dozen years ago. In fact the contrary may be true. First of all no one knows when the next bull market will emerge. Second, managing for risk rather than return addresses motivation, not action. Finally, even within the long-term trading range that we find ourselves in, cyclical opportunities emerge.

 

We continue to view favorably dynamic approaches to asset allocation that recognize that risk and risk tolerances are not static. Allocations to all asset classes (including cash) should be actively decided upon, and they will fluctuate (within bounds) as market conditions change. One of the byproducts of the current environment is the risk-on/risk-off tendency of the market. The risk-on/risk-off dynamic and the high correlations it engenders are a primary reason to focus on portfolio risk in the first place. In periods of stress, correlations across risky asset classes converge and the expected benefits of diversification fade. Effectively identifying shifts between these regimes can allow investors to more successfully manage risk. From a trading perspective, this is done by looking at the co-movements of various indexes and asset classes. From an investing perspective, this means watching for breadth confirmations/divergences and identifying periods of excessive optimism and pessimism.

 

So, then, what is an investor to do in 2012?

 

• We continue to view gold as an important component within a diversified portfolio. The secular up-trend appears to be intact, and we believe gold is likely to be a primary beneficiary from a more active European Central Bank and U.S. Federal Reserve.

 

• We believe you should use the first half of the year (assuming the 2011 cyclical bear market is intact) to focus on defensive allocations, including lower-beta, higher-quality sectors of the market and high-grade corporate debt. If and when a cyclical bull market re-emerges, tilt toward more cyclical areas and those that would benefit from a near-term ebbing in volatility (high-yield corporate debt, for one).

 

• Emerging markets have better growth prospects and better balance sheets (generally) than their developed counterparts, yet remain vulnerable to market forces in the developed world. We believe investors should increase exposure there once a cyclical upswing is evident.

 

• For investors looking to diversify equity exposure away from the U.S., we generally would look towards other countries that use dollars (Canada, Hong Kong, Singapore, and Australia). Economic and financial conditions in these countries are among the best in the world. The caveat is that all are influenced by movements in the commodity markets, which could add to their volatility.

 

• In the end, investors must remember that return (either price appreciation or dividend yields) and risk are directly correlated. Managing for risk means not chasing returns.

 

Since the individual goals of each investor vary, we encourage you to contact your Baird Financial Advisor in early 2012 to discuss the implications of this market outlook on your own portfolio and wealth management plans.

 

Article provided by Robert W. Baird & Co. with the authorization of its author for Evan Guido, Vice President, Financial Advisor at the Sarasota office of Robert W. Baird & Co., member SIPC. The opinions expressed are subject to change, are not a complete analysis of every material fact and the information is not guaranteed to be accurate.

 

Evan R. Guido
Vice President of
Private Wealth Management
One Sarasota Tower, Suite 806
Two North Tamiami Trail
Sarasota, FL  34236-4702
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888 366-6603 Toll Free
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www.EVANGUIDO.com

 

Important Disclosures

 

Disclaimers

 

This is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. The information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy.

 

Foreign and emerging market securities may be exposed to additional risks including currency fluctuation, political instability, foreign taxes and regulations and the potential for illiquid markets. Historically, small and mid cap stocks have carried greater risk and have been more volatile than stocks of larger, more established companies.

 

ADDITIONAL INFORMATION ON COMPANIES MENTIONED HEREIN IS AVAILABLE UPON REQUEST.

 

The Dow Jones Industrial Average, S&P 500, S&P 400, MSCI EAFE, Lehman U.S. Aggregate Benchmark, Lehman Municipal Bond Benchmark, Russell 1000, Russell Mid Cap, Russell 2000, and Russell 3000 are unmanaged common stock indices used to measure and report performance of various sectors of the stock market; direct investment in indices is not available.

 

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Copyright 2011 Robert W. Baird & Co. Incorporated.

 

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Robert W Baird Limited (“RWBL”) is exempt from the requirement to hold an Australian financial services license. RWBL is regulated by the Financial Services Authority (“FSA”) under UK laws and those laws may differ from Australian laws. This document has been prepared in accordance with FSA requirements and not Australian laws.

 

©2011 Robert W. Baird & Co. Incorported. Member SIPC. MC-34114. #1444