A YEAR OF TURBULENCE
If we had been told a year ago that 2011 would bring a worsening and near collapse of the European financial crisis, a downgrade of the US’s AAA credit rating, a 9.1 magnitude earthquake and tsunami in Japan and multiple social uprisings in the Middle East, we likely would have projected significant declines in global stock markets. When the dust finally settled, however, the MSCI All-Country World Index (our primary benchmark for stock exposure in our portfolios) was down a relatively modest -7.4% for the year while the S&P 500 price index closed at 1257.60 compared to 1257.64 a year earlier.
Despite the end result, 2011 was a year of extreme turbulence in financial markets. Given the experience of the past several years and the still unstable position of the global economy, investors seem to be exhibiting low conviction and shortened time horizons in their investment decisions. As a result, money is moving in and out of “risk” in herds which creates a lot of volatility and a high level of correlation (everything moving the same direction) across securities and even asset classes.
We have seen this quantified a number of different ways. For instance, the S&P 500 crossed over the positive/negative line for the year 22 times in 2011. Additionally, there were 34 days in which at least 400 of the 500 stocks in the S&P 500 Index moved in the same direction in the last five months of the year. There were only 29 such days in the entire decade of the 90’s.
The most interesting study came from Mike Wilson, one of our favorite analysts at Morgan Stanley. Mike looked at the ratio of realized volatility (a measure of the magnitude and speed of the swings) to the size of the trading range (the difference between the highs and the lows) during 2011. Given the fickleness of the market during the year, that ratio was unusually high. In other words, the market was swinging back and forth wildly, but never breaking out into a trend in one direction or the other. There have been only three instances historically of this ratio being higher than it was in 2011: 1939, 2000 and 2007 – all years that were followed by large declines in the market.
2012 MACRO RADAR
As we head into the New Year there are four factors on our “Macro Radar” that we believe will be the primary drivers of financial market performance in 2012, which means we will spend a lot of time proactively focusing our research efforts on understanding and monitoring their development throughout the year. This list will be revisited frequently in these update emails, and will change over time as areas of importance emerge.
1) Eurozone Sovereign Debt Crisis
This should come as no surprise, as a disorderly unraveling of the crisis in Europe clearly poses the greatest potential threat out of all of the “known” risks to investors. We chose not to include a Eurozone recession on this list given its high probability, but a significant negative surprise (a depression) in Eurozone growth would only exacerbate the situation.
2) Global Central Bank Policy
Central banks globally have already begun to cut interest rates and expand money supply further. Most importantly, the central banks of emerging market economies have much more room to work with as compared to our Federal Reserve which is already holding interest rates near zero percent. In addition to conventional policies, further rounds of money printing from the Fed or the European Central Bank will dramatically influence investor sentiment and asset prices.
3) China’s Engineered Slowdown
China is proactively addressing a number of short-term headwinds to stability and growth, namely high inflation, excessive lending and a potential bubble in property. The extent to which the Chinese are successful of engineering an orderly rebalance of these issues, as opposed to what many refer to as a “hard landing”, will greatly impact the performance of commodities and emerging market stocks. This issue is important to monitor closely as it will directly impact some of the more volatile holdings in our portfolios.
4) US Fiscal Policy
There is little room for any new fiscal stimulus during this election year, but whether or not Congress agrees on a way to extend certain parts of the Obama stimulus, including the payroll tax cut and extended unemployment benefits, will play a role in the consensus views on US economic growth. We think this has the potential to create volatile swings in sentiment and risk taking, and thus want to pay close attention to it over the next couple months.
These risk factors will have a tremendous impact one way or the other on asset prices, and thus on the performance of our investment strategy throughout the year. Unfortunately we expect a lot more uncertainty and volatility in 2012. Being nimble and changing allocations tactically will be important. As a recent research report from Goldman Sachs put it, “A commitment to managing and diversifying risk can create more consistency for investors seeking fewer unsettling swings.” This is especially true in the current environment.
We want Transparency to be one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. Regular Macro Updates will address our economic and capital market viewpoints and discuss top-down portfolio positioning. Also watch for Micro Updates which convey our reasoning behind specific investments.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.