2012 has gotten off to an interesting start. Over the last three weeks Greek bondholders have stood up and told the world that they are not going to roll over and green light just any EuroZone plan to avoid total collapse. France has been downgraded, as has the European rescue fund itself. Flagship firm Goldman Sachs announced that their revenue and earnings are down more than 50 percent compared to last year. Iran has rattled its saber and threatened to use force to cut off the flow of oil from the Persian Gulf. And, the stock market is off to its best start since 1987. Which one of these scenarios doesn’t seem to fit?
In fairness, not all the news in 2012 has been bad. Our economy does seem to be improving at the margins. Unemployment is below nine percent for the first time in several years, and manufacturing and consumer spending have both notched up a bit. However, corporate earnings growth is showing signs of slowing and the early results indicate fewer companies are beating expectations. Yet, optimism abounds everywhere. This brings to mind one of the more famous Warren Buffett quotes, which, like most of his better quotes, actually originated with his mentor Benjamin Graham, “Be greedy when others are fearful and fearful when others are greedy.”
The problem with 2012, other than apocalyptic visions of the Mayans, is that none of the problems from 2011 have actually been solved. Things have been quiet on the European front and we seem to be following the “out of sight, out of mind” mindset. Unemployment has improved, but then unemployment was improving this time last year. In the meantime earnings growth has slowed. According to Standard and Poor’s, fourth quarter 2011 estimates on the S&P 500 companies are for 6.8% growth, while in October the estimate was for 14.6% growth. Since October the market is up nearly 15% on what everyone expects to be worse earnings. If that seems curious to you, you are not alone.
It is possible, as many optimistic forecasters are suggesting, that we make it through 2012 with no flare-ups from Europe; that Iran is once again just full of talk; that the European recession is mild; and that the rest of the globe, led by the U.S., experiences decent growth. Under this scenario stocks should continue to climb. But, if just one domino falls we will be in for a big shock to the market. Those of us who remember October of 1987 get a little nervous when people start comparing what is happening now to that fateful year.
We believe equity markets will end the year very close to where they began, and in the interim we are likely to witness a great deal of volatility. The probability of a major geo-political issue sending shock waves through the markets seems higher than normal. In this environment we believe caution is still in order.
One of the things we always ask ourselves is, “What if we are wrong?” If we are wrong, then we may very well lag the market in the upturn, but likely still have a solid absolute return. This is a much better mistake than getting killed in a dramatic sell-off.
We believe that domestic large cap equities are the most attractive place to be in the equity market, and we remain cautious on domestic small cap stocks. Developed foreign is the worst place to be, especially Europe, but we think emerging market equities may have bottomed and we are cautiously wading back into these securities.
Fixed income remains the biggest long-term concern, but Treasuries have proven a safe haven in times of distress. They make sense as a diversifier here to protect from the potential market shock. Corporate high-yield and emerging market debt remain the most attractive long-term in the fixed income landscape.
A word of caution: To paraphrase the late, legendary golf instructor Harvey Penick, when we proscribe an aspirin, take an aspirin, not the whole bottle. Graham’s warning to be fearful means to show caution, not panic. That is exactly what we are doing.
Chuck Osborne, CFA