A Forward Looking Note 2012

At the end of each year, I compose a Forward Looking Note with my thoughts on the coming year.  Many of the themes expressed are reflected in the portfolios I manage.  The following is the note I wrote concerning 2012: 

     Now that the holidays are over and the New Year has begun, it is time to look back at what occurred in 2011 and consider what may happen going forward.  If I had to choose one word to describe the markets in 2011 it is one that unsettles many investors- volatility.  In 2011, most domestic indexes were slightly down (with the exception of the Dow Jones Industrial Average which posted a modest gain) while international indexes experienced decreases in the double digits.  Perhaps most notably, the MSCI Emerging Markets Index was down close to 20% for the year.  On the other hand, any positive return generated from a diversified portfolio was a function mainly of the percentage of bonds held.  You don’t have to look too hard to find the reasons for equities’ poor performance in 2011- the Arab Spring and its effect on oil prices, the Japanese tsunami and resulting nuclear disaster, S&P downgrading the U.S. debt from triple-A due to the manufactured debt ceiling debate, the Occupy movement, and, of course, the spread of the debt crisis in the Euro-zone.   As I’ve said before, the markets do not like uncertainty.  Unfortunately, as I review last year’s Forward Looking Note, I see many of the factors that I mentioned as causes of uncertainty persisting into 2012—  low interest rates, high unemployment, political gridlock, cash-strapped states, the European debt situation, and falling housing prices.  Two of the issues that I believe will have the greatest effect on the markets in 2012 are (1) whether the Euro-zone debt crisis resolves itself through either a stronger fiscal union or a disorderly collapse of the common currency and (2) how China manages the inevitable slow-down from the current 9% growth of its economy.  With an understanding of many of the macro issues facing the markets in 2012, the question now becomes how to adjust the portfolios I manage to best position them for the coming year.

Bonds versus Equities:

     Last year, I called for a 10% underweight of traditional bonds and cash in the 80% equities/20% fixed income portfolios I manage.  I still believe this is a prudent strategy for the long-term investor.  In 2011, however, yields fell on the 10 year Treasury note to around 2% and on the 30 year Treasury bond to below 3%.  Counter intuitively, the decline to these historically low yields came as Standard & Poor’s stripped the U.S. of its triple-A credit rating.  Not only did yields reach historically low levels in the U.S., but it was a global phenomenon with the U.K. gilt sliding below 2% for the first time to within a few basis points of the comparable-maturity German bund (the benchmark for the Euro-zone).  Since bond prices and yields move in opposite directions, the bottom line is that bonds have become extremely expensive with yields below the historical rate of inflation.  While bonds are traditionally thought of as a haven for “safe” money, I have come to think of them as the “risk” asset these days based on current valuations.  If you are nearing retirement and must own bonds to moderate the volatility of your portfolio, I am a firm believer that you should purchase individual bonds as opposed to bond mutual funds (please reference last year’s Forward Looking Note for the logic behind this). 

     In an effort to address the quandary of where to invest “bond” money, I have recommended holding floating rate debt or bank loans over the past couple years as a hedge against rising interest rates as well as inflation.  The time has now come, in my opinion, to sell bank loans for two reasons.  First, Federal Reserve Chairman Ben Bernanke declared in 2011 that the central bank expects to keep short-term interest rates (i.e. the federal funds rate) near zero through at least mid-2013.  Second, technical factors have recently provided a tailwind to the bank loan asset class as new supply of loans has failed to keep pace with increased investor demand leading to higher prices across the board. 

     If we agree that the allocation of traditional bonds and cash should be held at 10% after selling floating rate debt, the question now becomes where to invest the remaining 10% of “bond” money.  My answer is twofold – both with yields in excess of 3% and with inflation protection provided by the potential appreciation of underlying equities.  The first vehicle is a REIT (Real Estate Investment Trust) with a focus on the apartment sector.  Beyond that sector continuing to be strong as a result of millions of cash-strapped families deciding to rent instead of buy, the following are additional reasons why I feel this investment makes sense as they are indicative of a trend toward more renters:

  • When the housing bubble first burst, there was a massive inventory of 4.5 million houses available for sale in the U.S. versus a normal inventory of about 2 million.  I don’t believe that we have completely worked through the surplus inventory and expect more foreclosures to come. 
  • Homeownership peaked at 69.4% of U.S. households in the second quarter of 2004 and fell to a 13 year low of 66% in the second quarter of 2011.
  • From the first quarter of 2010 to the second quarter of 2011, the number of U.S. households rose by nearly 1.1 million to 112.5 million.  In that same timeframe, the number of homeowners fell by 600,000 while households renting rose by 1.7 million to a total of 38.2 million. 
  • It is still difficult to qualify for a mortgage.  You know what I mean if you have tried to buy a place or refinance recently. 

     The second vehicle is a large-cap domestic stock fund focusing on dividend paying companies.  The following reasons for investing in a dividend focused fund are essentially the same as those for overweighting domestic equities generally:

  • The average yield on S&P 500 stocks that pay dividends is 2.5%.  The last time the index had a higher yield than 10 year Treasuries was in 1958.  On a quarterly basis, this has only happened two other times in the past 25 years (as of the quarter that ended September 30, 2011).  In all, more than 200 stocks in the S&P 500 boast yields that best the Treasury mark.
  • The S&P 500 currently trades at a price/earnings multiple (i.e. P/E ratio) of 12 times expected earnings which is lower than the long-term historical average of about 15 times.  In December 1998 while the tech bubble was inflating, price to forward earnings per share was in excess of 23 times. 
  • Some 83% of tech stocks in the S&P 500 index are trading below their five-year average P/Es.
  • The spread between an 8% S&P 500 earnings yield (that’s the inverse of the P/E) and the 2% Treasury yield is near levels that have preceded big rallies for equities in the past.
  • The University of Michigan’s consumer-confidence index recently sank to its lowest level since May 1980.  The Dow Jones Industrial Average posts an average annualized gain of 13.7% when consumer confidence numbers are at their lowest. 
  • The equity risk premium is about double the average of the past 30 years.  It will come back down if either bond yields rise sharply or, more likely, equities do very well. 

The bottom line is that while it’s hard to see much upside for bonds, this is a potentially historic opportunity to purchase equities. 

Emerging Markets:

     In last year’s Forward Looking Note, I made the macro case for emerging markets which remains compelling today— a 2 billion person emerging middle class that spent $5 trillion on goods and services in 2009 and is expected to spend $15 trillion by 2020 and $30 trillion by 2030.  The reason I did not add to my portfolios’ emerging markets allocation last year is that I quite simply felt emerging market equities were generally overvalued.  With the MSCI Emerging Markets Index’s drop of 20% in 2011, the situation has changed and now is a good time, in my opinion, to move an additional 5% of “international” money to emerging markets.  The traditional emerging market BRIC economies of Brazil, Russia, India, and China have gone from making up about 8% of the world’s real gross domestic product in 2000 to having a roughly 17% share in 2010.  In the first decade of the millennium, China’s Shanghai Exchange more than doubled, markets in Brazil and India quadrupled, and Russia’s main stock index grew by a factor of nine.  The point here is that the traditional BRIC emerging market economies have emerged.  These four mature markets along with Indonesia, Korea, Mexico, and Turkey are driving the world economy with combined GDP expected to rise by $16 trillion in the current decade which is about double that of the U.S. and Euro-zone put together.  If the BRIC economies have emerged, the question becomes which emerging market economies will experience future growth similar to what the BRIC’s experienced over the past decade.  Conveniently, the investment community has come up with some helpful acronyms.  Here’s a sampling:

  • CIVETS = Colombia, Indonesia, Vietnam, Egypt, Turkey, and South Africa
  • MINT = Mexico, Indonesia, Nigeria, and Turkey
  • N-11 or Next 11 = Some of the names above plus Bangladesh, Pakistan, and the Philippines

It should go without saying that the higher risk of investing in these smaller emerging market economies needs to be moderated with investments in the more mature BRIC emerging market economies.  The point here is that when discussing emerging markets, we need to cast a wider net.  Finally, a good strategy to gain exposure to the emerging markets without making a direct investment is still to invest in domestic funds that hold the stocks of multi-national companies generating a significant percentage of their sales in the developing world. 

Alternative Energy:

     Despite many of the major players being European companies, alternative energy did not fair too poorly in 2011 (when compared to European equities generally) and the field continues to grow steadily.  Worldwide demand for solar, wind, and other non-fossil fuel energy sources is expected to increase 22% over the next five years and 85% over the next 25 years.  The U.S. government continues to offer generous tax credits for solar power, China recently doubled its solar energy target for 2015, Germany kept in place incentives for solar and wind power, and even oil-rich Saudi Arabia started talking about decreasing domestic oil consumption while bulking up its use of solar panels.  The industry is also getting a boost from Japan’s nuclear crisis with Germany announcing plans to close all of its nuclear plants by 2022 and Italian voters blocking a revival of the country’s nuclear program in favor of renewable energy sources.  Depending on your personal situation, the plan for 2012 is to continue to hold my portfolios’ positions in what I still believe to be the “next great industry.”

Final Thoughts:

     You should be aware of some tax changes on the horizon that will affect capital gains.  While long-term capital gains will be taxed at 15% through 2012, the rate will increase to 20% in 2013 absent new legislation. Also, as part of last year’s Health Care Reform Bill, tax rates on unearned income (capital gains, interest, and dividends) will be subject to an additional 3.8% Medicare tax starting in 2013 for high income taxpayers.  If you have a need for future liquidity, the planning opportunity is to lock-in low capital gains rates while you still can.

     Finally, if you have assets invested in one of my fee-based models, please look for changes following the aforementioned themes in the weeks to come.  If you have not invested in a fee-based model, I will plan on addressing the reallocation of your portfolio at your next annual review meeting.  If you would like to discuss making some changes prior to your annual review, please feel free to contact me to schedule an appointment.  I wish you a happy, healthy, and prosperous 2012!

These are the views of Shuman Financial Consulting, LLC and not necessarily those of Cambridge.  Indices mentioned cannot be invested into directly.  Past performance is no guarantee of future returns. 

"Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC.  Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor.  Shuman Financial Consulting, LLC and Cambridge are not affiliated."

Investors should consider the investment objectives, risks, and charges and expenses of the investment company carefully before investing. The prospectus contains this and other information about the investment company. Prospectuses may be obtained from your advisor and should be read in full.