2012 Financial Market Analysis

I. U.S. Markets

2011 was a disappointing year for U.S. stock markets, especially in view of the fact that the third year of the presidential cycle has historically been the best. The S&P 500 returned 1.9% in 2011, including dividends. If you take into account the volatility one had to endure in order to garner 1.9% last year, it was indeed a sub-par performance for stocks. U.S. Treasury bonds were a different story. Global risk aversion drove investors into treasuries last year in spite of anemic yields (~2% for a 10 year bond). U.S. Treasuries were up by an amazing 34% in 2011, due almost purely to capital appreciation.

My prediction last year for U.S. stocks to be up by 10% was obviously too optimistic, as was my U.S. GDP forecast of one year ago. I wrote that GDP would increase by 3% in 2011, which is a very sub-par growth rate for the second year of an economic recovery. It looks at this point (4th quarter numbers not in yet) that GDP growth will come it at ~1.5% for all of 2011. U.S. households and governments continue to be over-leveraged, and a new threat emerged from across the pond. Europe’s troubles stemming from excessive sovereign debt and the resulting credit risk to their banking system has been a major drag on global growth, and will continue to be so in 2012. Of course paralysis of our political system exacerbated the economic problems last year, even though it was not a primary cause. I predict that in 2012 U.S. stock market returns will be 5% because of uncertainty over elections and continuing economic problems in Europe. There may be pockets of strength in U.S. markets, such as the micro-cap sector (small companies with a market cap of <$1.0 B), which I believe are undervalued. Small companies have had a harder time accessing capital over the past few years compared to their bigger brethren. Additionally, the U.S. dollar’s recent strength should place more emphasis on domestic operations where micro-caps excel. A U.S. recession would undermine this prediction, but I don’t believe that is in the cards. Unemployment is slowly coming down, corporations are flush with cash, and the housing market should finally bottom in 2012. GDP growth should still be stuck at ~2.0%. As I mentioned last year, 2% is the new baseline for U.S. (and all developed markets, i.e. Europe and Japan) GDP growth because of a secular shift in economic dynamism to emerging markets. Another area of relative strength in 2012 should be income-producing securities that do not have excessive leverage. Because of inordinately low U.S. interest rates and widespread risk aversion, any security that is relatively safe and produces a steady, high income stream will be in demand. When I say high, I don’t mean double-digit, but anything higher than a Treasury bond (a very low bar indeed). This should include dividend-paying stocks, preferred stocks, publicly-traded Master Limited Partnerships, securitized bank loans and mortgages, REITS (real-estate investment trusts), and high-yield corporate (junk) bonds. It may sound like anathema to recommend securitized mortgages after the destruction and well-deserved reputation they garnered over the past few years, but remember Fannie and Freddie guarantee a lot of them. It’s your tax dollars propping them up, you might as well take advantage of the high dividends they throw off. With leverage, many of these vehicles yield in the double digits.

I predict that as soon as the existential threat to the EU is removed, the long rally in U.S. treasuries will be over, and interest rates will begin to climb, probably in the second half of 2012. Until then, however, the 10 year Treasury bond yield can stay under 2%. Normally climbing bond yields are a bad sign. These are not normal times, however. Rising interest rates will be a signal that risk taking is returning to capital markets.


II. Foreign Stock Markets

The only way European nations can get out of their debt morass is to let the ECB (European Central Bank) print money hand over fist the way our Federal Reserve has for the past three years. Of course Germans hate this option because it implies rising inflation, but it is the least painful option. The EU cannot allow austerity to rule the Eurozone countries without a counterweight from the ECB (by buying up sovereign debt of the weaker economies and keeping rock-bottom interest rates and easy funding for banks). An austerity-induced depression would impose severe hardship on all Eurozone countries, including Germany.

Emerging-market stock markets performed abysmally in 2011, in direct contrast to my prediction of a 25% return. Most markets were in fact down by 25% last year, hammered by currency depreciation and inflation fears. The currency depreciation was related to global risk aversion caused mainly by Europe. Inflation has also plagued many emerging markets due to their relatively high economic growth (5-10%), high commodity prices in 2010 filtering through the supply chains, and influx of foreign capital (“hot money”) over the past few years. The strongest stock markets were in Southeast Asia, namely Thailand, Malaysia, and Indonesia. They were almost break-even last year, while many markets, such as India and Vietnam were down by ~40%.

I made the correct call on the Irish stock market last year, predicting that it would be the strongest in Europe, which it was. Unfortunately, returns in Ireland were only break-even, while most of the rest of Europe were down by ~20%. So far the austerity and discipline of the Irish along with their low tax rates have stabilized their economy and set the stage for future growth. Not without significant pain I might add.

Political developments in the Middle East, and newfound middle-classes in some countries are important developments for the long-term health of the global economy. If new democracies can thrive in Egypt, Libya, Iraq, Tunisia, etc, and new middle-classes in Botswana, Ghana, Nigeria, and others are sustainable, then these could be prime investment locations in the future. These countries are worth a close eye, along with some better-known ones like Vietnam, Chile, Thailand, and Peru.

I predict that emerging market stocks will bottom out in the first half of 2012 as the ECB starts to get a handle on its debt problems, and the respective governments start to see progress on the inflation front. Progress on inflation will be the direct result of the deflationary policies put in place in places like China, Brazil, India, and others. Inflation worries will ameliorate next year mainly from slow growth prospects in developed countries such as Europe, U.S., and Japan. Developed country pain I believe is emerging market gain! Emerging market stock market losses in 2011 and possibly the first part of 2012 should set the stage for powerful gains thereafter. I believe this is the place to be in late 2012 and 2013. Of course within a broad brush statement like that there will be many caveats and individual country outliers, but a broad basket of emerging market stocks should do well.


III. Commodities

A fear of global economic slow-down in 2011 put a serious dent into what had been a powerful commodity rally. There was a lot of volatility during the year, and a wide range of performances between the various categories, but suffice it to say it was not a good year. The top performing commodities were oil and gold. They were up slightly on the year after much volatility. Economically-sensitive commodities were down huge on the year, such as copper and palladium (by ~20%). Anything nuclear-related got crushed by the Japanese tsunami and resultant power plant meltdown. Natural gas prices were down by ~35% due to the continuing over-supply created by the fracking industry. And worst of all was the solar power industry. Anything clean energy-related such as solar panels, wind or solar stocks, etc. got wasted last year by a wind-down of subsidies coming from cash-strapped governments, and an over-supply of manufacturing capacity (mainly in China).

I was pretty accurate on my gold and oil predictions in 2011. Just as I predicted a year ago, gold set a high of ~$1900 per oz. in the middle of the year, but then sold off hard toward the end of the year. Much the same for oil, though the moves were not as dramatic. I was also accurate in the prediction that agricultural commodities would outperform in 2011 due to the continued demand from 6 billion poor people throughout the world. Even though the agricultural complex was down by ~10% last year, that was a relative standout compared to most commodities.

2012 should see commodities in general under pressure during the first half of the year as Europe wrestles with a huge sovereign debt refinancing problem and the rate of global growth bottoms out. Oil should average ~$100 (for light sweet U.S. crude) per barrel and bottom out in the first half. I believe that gold will also bottom out in the first half at ~$1450 per oz. before starting to march higher, reaching a new high of $2000 per oz. by the end of 2012.

IV. Currencies

The predominate theme for currencies in 2011 was flight from risk. Money flowed to the perceived safest currencies such as U.S. dollar, Swiss franc, Japanese yen, Australian and Canadian dollars. This is in spite of the fact that U.S. government debt was actually downgraded for the first time from AAA to AA by S&P, and the Japanese economy was hammered by a terrible natural disaster. The economies of Switzerland, Canada, and Australia are three of the best (and best run) in the world, with sound banking, and relatively low debt levels. As mentioned earlier, risk-aversion hammered emerging market currencies, and Europe’s well documented travails put constant pressure on the Euro. The British pound fell somewhere in the middle, relatively safe compared to emerging markets or Europe, but still under pressure relative to the “safest basket.” Remember that currency appreciation is only meaningful relative to another currency. So even though the U.S. has many well documented problems, it still is perceived to be a desirable destination for global funds with respect to the alternatives.

I was accurate in my predictions for the U.S. dollar last year when I wrote that it would appreciate 5-10% against the Euro and British pound, and stay flat against the Australian and Canadian currencies.

For 2012 I predict that the U.S. dollar will appreciate again with respect to the Euro, possibly to the 1.20 range (from 1.30 at the close of 2011). Emerging market currencies will stabilize (relative to the U.S. dollar) only when instability wrought from Europe seems to be resolved (or at least contained), probably in the second half of the year.

Have a great year investing in 2012!