Damn the Torpedoes and Full Speed Ahead!
Damn the torpedoes and full speed ahead! Although probably a bit shorter than any Fed announcement will ever be, the John Paul Jones quote effectively encapsulates the essence of the Fed decision to keep rates where they are as well as the $600 billion in treasury purchases going well into 2011, a decision that forced yields higher on bonds and put a bit of a lift into stocks. Generally speaking, some of the gains/losses on Fed day get reversed the next; however that did not occur yesterday as stocks continued their push to yearly highs. What is not a surprise is the attempted juicing of the economy/financial markets that historically has been the hallmark of a year prior to the presidential election.
As the holiday season gets into high gear and investors focus more on spending time with family and friends than in front of computer screens (besides, the computers seem to do most of the trading on their own!!), not only will trading volume begin drying up from already depressed levels, but also the predictions for 2011 begin to fill up the blogosphere and newsprint. While no one has a crystal ball (or why would they need to mess with the predictions?) and the foray into never-never land of financial experimentation cloud an already foggy outlook for the economy and financial markets next year, I’ll try to make some general observations about what might be next year. Reviewing comments from the end of the year last year, there were a few hits, a few misses and others that leave one wondering whether the holiday cheer was part of the economic input! The markets did follow our overall pattern projection of a good early, rough middle and better finish that would be double digits for overall gains. To be fair, expectations would be that those double digit returns could be negative as well, given my expectations for a government and Federal Reserve backing away from providing the huge support enjoyed during 2009. Since my expectations were for huge volatility during the year and potentially higher interest rates, I projected the more conservative industry groups of utilities, consumer goods and healthcare to provide better overall returns. Finally, bond investors were going to suffer in 2010 as interest rates had to rise as I projected economic growth to finally take hold during the year, instead of the persistent Fed monetary injections to keep things afloat.
With all the above as a disclaimer to take whatever is printed below with a grain of salt (or an entire saltlick), let’s delve into some of the “what maybe” during 2011 starting with what should be an easy call, the bond market. The higher rates I projected during this year only began to show up once the Fed initiated QE II and did so with a vengeance. While still a good year for bond investors (the 10 year fell from 4.5% to the current 3.4%), the mad scramble at yearend to shortening maturities and ditching any municipal bond and anything beyond a 5 year maturity is setting up for a continued rise in rates at least early in 2011, as the Fed buying binge is likely to last to mid-year. Economic data, still rather pedestrian, is getting a bit stronger and supportive of higher rates. The debate that will gather steam by spring will be the strength of the economy: will it be enough for the Fed to finally step back and allow the US economy to once again function on its own. With or without the Fed support, interest rates are likely to rise from the historically low levels as economic strength should be sufficient to at least not allow rates to drop back to their lows of 2010.
Far from being a champion thoroughbred, the US economy resembles more a plow horse on the last lap in the field that is being weighed down by a poor housing and employment situation. The economic “call” for 2011 is also further confused by the machinations in Europe and beholden to China as they try to provide some control to their economy. The safe call (and one I’m comfortable making) is that the US economy will continue to demonstrate frustrating slow overall growth as the housing and employment picture will not likely clear until maybe late in the year (employment) or well into 2012 or beyond (housing). If global economic growth avoids the potholes of sovereign default risks and can continue to muddle through, general inflation worries could remain subdued. Rifling through a litany of issues from consumer debt to still modest durable goods orders is offset by a rising ECRI index (that bottomed nicely in August after slumping during the middle third of the year) and spending showing few signs of fatigue. In a classical sense, the economy is fraught with “on the other hand” when looking at the wide range of data points reported on a weekly/monthly basis as well as revisions to back month data that rendered some of the current release tamer than without the upgrading/downgrading of prior month’s data. What historically has been a bit easier (guessing overall economic direction) is much harder due to the monetary experimentation as well as the government expansion of involvement in the economy (ObamaCare, extension of unemployment benefits, etc.)
Finally, the market that gets the most attention from investors – equities is likely to be buffeted by all the issues above, from higher interest rates to still slow economic growth and what is “fair value” given the assumptions above all will keep investors on their toes during the year. Some investors get excited about looking at the decennial cycle – or how does the market act in years ending in “1” or at the election cycle. Using data going back to 1951 (OTC only to ’71), the chart below shows the tendencies of the markets, showing similar to 2010, where the early/late periods are very good, while the middle part of the year is a push. The OTC graph is heavily influenced by the big decline in 2001 that does not show up as strongly in the SP500.
Using valuations to hopefully glean a bit of additional information than just looking at a couple of squiggly lines, I lean on the data provided by Shiller (http://www.econ.yale.edu/~shiller/data/ie_data.xls) when looking at various valuation methods to better guess the overall markets for the coming year. Based upon the valuation method used by Shiller (a 10 year average of earnings), the current market P/E is nearly 22. Outside of the 1990/2000s, a P/E above 20 has occurred during the following periods: 1960s, 1928/29 (briefly 1938) and very early in the turn of the last century. Subsequent returns for those periods were negative over the following 3-5 years. Using a method popularized by John Hussmann of Hussmann funds, he looks at the peak earnings of the prior 10 year period and applies those maximum earnings to today’s price. Here the P/E is a much more modest 14, toward the lower end of the historical range. To be fair, Mr. Hussmann has modified his analysis and incorporates margins into his calculation, so his P/E on more normalized earnings margins is closer to those from the Shiller data. Throw in earnings estimates for 2011 of somewhere around $90/share for the SP500 and the resultant P/E is close to the original Hussmann estimate. It should also be noted that the projections Mr. Hussmann makes is designed for 5-10 years, not for a particular year.
Given the conflicting data and lack of consensus (not a real surprise), there is plenty of room to make a case for significantly higher prices not only in 2011, but also well into 2012 as well as relatively flat or even significantly lower well into 2012. How best to reconcile the disparate guesses? As the economic analysis is clouded by the heavy hand of the government, so too will the equity markets. Driven higher by the lack of places to invest extra cash, many companies have resorted to buyouts or buying back stock, effectively pushing stock prices higher. The end result of excess money sloshing around the financial system is higher prices and in this case the higher prices are not necessarily goods/services, but stock prices. In general, I’m looking for a decent start to the year as Fed policy continues to support equities. However, sometime toward the end of the QE II program, there is likely to be some retrenchment of stocks as a review of economic strength and corporate earnings fall short of the current very ebullient views.
As much as I would like to say I’m cock-sure of how the economy and financial markets will unfold during 2011, I and less certain due to the various fiscal moving parts in addition to the debt and real estate overhang. I feel more certain that buy/hold investing is likely to be a tougher policy to implement as daily/weekly volatility will test the fortitude of all kinds of investors. Investors will do well to keep in mind Mark Twain’s caution about investing: December is the toughest month of the year. Others are July, January, September, April, November, May, March, June, October, August, and February.
About Paul J Nolte CFA
Paul J Nolte CFA Archive
|10/19/2012||Years Ending in “2” and the Election Year||story|
|09/20/2012||Pushing on a String||story|
|08/16/2012||Industrials Set to Outperform||story|
|06/21/2012||A Wet Blanket of Debt||story|
|05/17/2012||Keeping Money Close to Home||story|
|04/19/2012||Economic Data: Focus on the Direction||story|
|03/15/2012||Alternative Options for Fixed Income Investors||story|
|01/20/2012||Dragging the Consumer Along||story|
|12/15/2011||Economic Indicators in Review for 2011||story|