Newsletter | January 2012

January 3, 2012 – DJIA = 12,217– S&P 500 = 1,257 – Nasdaq = 2,605

“O, that deceit should dwell In such a gorgeous palace!”

It is often said that the stock market does its best to deceive the most.  While emotional extremes and deception increase the interest in a dramatic storyline, they are incredibly frustrating in reality.  During 2011 they were daily adversaries as we faced twists, panics, natural disasters, crises and crosscurrents.  Yet, as the year ended, the S&P 500 beguilingly finished the year 4 pennies lower than where it began 2011.  

That the year started as it began is remarkable.  Since 1928 the total return on the S&P 500 has finished between +5% and -5% only 9 times – the first being 1934 and the most recent in 2005.  Interestingly the average return following these 9 instances is an impressive 26.3%. 

Someone holding the script of 2011’s events at this time last year would certainly not have predicted an unchanged stock market 12 months hence.  And to be sure, the capital markets’ path last year was anything but smooth.  One year ago we were in the middle of QE2 and many Wall Street strategists were getting comfortable that this monetary stimulus would ultimately get the economy on a self-sustaining recovery. 

The first quarter had its headwinds.  There were protests and overthrows in Tunisia, Egypt, Libya, Bahrain, and Syria.  Then on March 11th a record breaking earthquake and its resultant tsunami struck Japan.  It was about this time that European sovereign debt crisis began to gain momentum and in April Standard & Poor’s cut the credit rating on Greek debt.  Of course the European banking and sovereign debt crisis became one of the year’s top stories. 

Stocks reached their peak of the year at the beginning of May at which point the averages were higher by mid-single digit numbers.  In fact the Russell 2000 hit a record high that amazingly exceeded the mark set before the financial crisis.  After this peak the markets were pressured as the European situation got worse and worries grew over the debt ceiling debate in the U.S.  Washington’s inability to cut government spending contributed to Standard & Poor’s decision to cut the U.S.’s credit rating. 

These developments together with worries over slowing growth in the U.S. and China in addition to MF Global’s failure pressured stocks and the major averages fell to their low point of the year on October 4th.  Prices quickly reversed course helped by some better than expected employment data.  Equities surged throughout October and it resulted in the 8th best monthly gain in the past 71 years.  After a historically volatile November where stocks plunged almost 10% through Thanksgiving and then regained those losses in three days, prices held steady in December.  Here are the 2011 returns for the major averages. 

 

    Last Week 
Dow Jones Industrial Average    +5.5%  
S&P 500   0.0%  
Nasdaq Composite   -1.8%
Russell 2000 -5.5% 

Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends.

As prices swung from its peak in early May to its trough at the beginning of October (sell in May and go away), stocks experienced agonizing action.  For example, in August the Dow Jones Industrial Average had 4 consecutive days of 400 point moves each in the opposite direction of the day before!  Unsurprisingly, this was the first time this extreme volatility had occurred.  The Dow fell 4.4% in August making it the worst month of the year. 

As expected, the VIX or volatility index spiked as stocks whipped back and forth.  This measurement is derived from option pricing on the CBOE and is commonly known as the “fear index”.  Higher VIX levels are usually associated with lower stock prices.  Predictably the VIX rose in August as investor worries increased.  The index reached 48 during the month or the highest level since stocks bottomed in 2009.  The significance of the August levels was that being in the high 40’s is more than twice the average reading of the index’s history.  While these readings are more understandable within the context of the financial crisis (the VIX touched 90 during 2008’s 4th quarter), they clearly illustrate investor’s extreme caution during 2011.  This helped fuel October’s surge as August’s caution translated into exhausted sellers by the end of September. 

In addition to these extraordinary price moves, the biggest market development is likely the increased correlation across both sectors and markets.  Unfortunately, the markets are becoming a one direction bet.   There were 69 days during the year in which 90% of the S&P 500 stocks moved in the same direction.  This was more than the total of 2008 and 2009 combined!  But not only do stocks move together, they move together with such things as commodities, currencies, and real estate.  Previously these markets were used as diversification vehicles but that usefulness declined in 2011. 

Keeping in mind we are only as good as our last trade, we look forward at the possible challenges and opportunities in 2012.  The obvious obstacles from 2011 remain.  The European banking and sovereign debt problems are not solved and there is a possibility that the EU breaks up (something we are not expecting).  Further, China’s slowdown could turn into a hard landing, and U.S. growth is anemic.  New problems include less fiscal stimulus as governments everywhere switch to austerity budgets. 

On the other hand, corporate balance sheets are strong and profits keep moving from lower left to upper right.  Moreover, stock valuations remain reasonable and some economic sectors point to a strong 2012.  Jobless claims, retail sales and even some housing statistics are pointing to a good year. 

We don’t expect the next 12 months to be a bowl of cherries (instead it could easily turn out to be full of headaches soothed by dry martinis).  The current “all in” or “all out” nature of the capital markets increases the risk of violent moves in either direction such as last August’s ricochets or 2010’s flash crash.  It doesn’t help that everybody is trying to do the same thing at the same time.  To potentially add fuel to the fire, last week’s bull/bear ratio reported that bulls had increased to 50.5% (an 8 month high) while bears were only 29.5% (those looking for a correction came in at 20%).  Keep in mind that bullish responses aren’t given by investors with large cash balances or, in other words, they’ve already done their buying. 

Whatever 2012 brings, we’ll carry on monitoring the landscape and seeking out opportunities while trying to avoid the landmines.  We predict the year will keep us busy. 

Past performance is not indicative of future results.