Politicians crave the spotlight, but it is unfortunate that investors watch the show. 2012, like 2011, was another year in which Washington theatrics scared investors. As a result, investors largely missed out on above-average equity returns. Corporate profits and valuations, and not Washington, continue to be the primary drivers of equity returns.
We think there are several important points to consider when reviewing 2012 performance, and when structuring portfolios for 2013.
The US economy doesn’t stink. In fact, it is reasonably strong.
Politicians love to claim that the economy is performing poorly, and that we “have to get the economy rolling.” However, the latest GDP report of 3.1% over the past year is higher than the 30-year average of 2.9%. The US economy is actually growing faster than average!
Early-cycle sectors of the economy, such as housing and autos, have been showing marked improvement. Consumer confidence has significantly risen. Corporate profits have held up reasonably well despite a stronger US dollar and weakening non-US economies. Inflation remains very subdued.
Uncertainty is good!
Many have suggested that the “uncertainty” surrounding Washington and the fiscal cliff has deterred both financial and real investment within the US economy. This uncertainty, though, has tautologically translated into attractive equity valuations that, we feel, present investors with good opportunities. Has there ever been a time in US stock market history when investors were “certain” and equities were undervalued? We doubt it.
As we have previously pointed out, the S&P 500 is presently discounting 5-6% inflation for the next twelve months despite that inflation is currently less than 2%. This shows the level of fear among investors, but also shows to us the level of opportunity.
“Austerity” will not necessarily hurt the economy and the markets.
Many commentators have mentioned that the coming fiscal “austerity” will hurt the economy and the financial markets. We are not convinced because bull markets are not always based on the combination of stimulative monetary and stimulative fiscal policy. For example, the 1982 bull market was based on very tight monetary policy (Chairman Volker aggressively tightened monetary policy to fight inflation) and very stimulative fiscal policy (the Reagan-era budget deficits which were, at the time, the largest peacetime budget deficits in history).
Fiscal austerity is bound to happen in some form over the next several years, but the Fed seems intent on keeping monetary policy loose. Without inflation and inflation expectations meaningfully accelerating, it is hard to see how the Fed would quickly reverse course.
Don’t ignore the US Industrial Renaissance.
In the December issue of The Atlantic, Jeff Immelt, GE’s CEO, is quoted as writing that outsourcing is “quickly becoming mostly outdated as a business model…” (See, Fishman, Charles. “The Insourcing Boom”. The Atlantic. December 2012.)
We continue to believe that US manufacturing companies will gain market share as the decade progresses, and this remains one of our favourite investment themes. Closing wage differentials, lower energy costs, cheaper distribution costs, and political stability are all factors that companies are increasingly considering when locating new plant and equipment.
Washington’s theatre is clouding, what we think is, one of the most interesting investment stories. We continue to favour small and mid-cap industrial and manufacturing companies.
We can’t emphasise enough that we view Washington as a sideshow (perhaps a very adequate analogy!), and that investors might be better served by focusing on fundamentals rather than politics. History shows well that corporate profits and valuations, and not Washington, ultimately drive equity returns.
European stocks outperformed everything.
Perhaps the biggest surprise at year end was that Europe’s stock performance outpaced that of other regions of the world. In fact, European stocks were the best performing major asset class. Corporate fundamentals continue to deteriorate in Europe, but it is probably worth watching those fundamentals closely for any improvement in 2013.
Bond Bubble? Not in Treasuries.
Many observers have claimed that there is a bubble in the bond market. We continue to disagree with such statements because:
The current bond market doesn’t seem to fit the historical characteristics of financial bubbles. Importantly, bubbles historically transcend society and are not simply financial market events.
The bond market has not become a widespread societal event.
According to data from ISI, bond portfolios in aggregate have consistently had durations shorter than benchmark for the past seven years. If there were indeed a bond bubble, one would expect durations to be extraordinarily long.
Treasury returns are not abnormal. In Chart 5 in the appendix, 2012’s treasury bond returns were actually quite normal relative to history.
There do seem to be abnormally high flows into short-duration bond funds, but these funds generally do not focus on treasuries.
Munis outperformed Gold – again!
We remain quite puzzled with US dollar-based investors’ enthusiasm for gold. Gold is expensive on a real basis, and came close to the all-time high in real prices set in 1980. The US dollar has been stable for almost five years, as the trough in the Dollar Index (DXY) was in April 2008.
More importantly, investors are ignoring the opportunity costs associated with investing in gold. The S&P 500 outperformed gold in 2012 and even municipal bonds have now outperformed gold in each of the past two years.
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