4th Quarter Client Note

2011 was one of the most volatile years on record. In the fourth quarter, the S&P 500 Total Return Index (including dividends) gained 11.82 percent, following a loss of 13.87 percent in the third quarter. For the year, the Index had a gain of 2.11 percent, all of which was attributable to dividends. On a price-only basis the Index had a long, strange trip, ending the year exactly flat … out to two decimal points. (A change, either positive or negative, of one percent or less happens about once every 30 years.)

Remember the Fight Over the Debt Ceiling?

Daily share swings in the S&P 500 averaged 2.2 percent in August, the most for that month since 1932. The Dow Jones Industrial Average alternated between gains and losses of more than 400 points on four days for the first time ever in August. The S&P moved an average of 1.3 percent a day since April, compared with the 50-year average of 0.6 percent before the collapse of Lehman Brothers in 2008.

Speaking of dividends, income-producing equities were the best performers for the year, including utilities, real estate, consumer staples, health care and energy companies. The Dow Jones Select Dividend Index produced a 12.42 percent return, with these kinds of stocks actually ending the year trading at a premium to the market.

Foreign Intrigue

Although US equities on average eked out a positive performance, overall portfolio performances were dragged down for the year by the significant negative returns in international equities. The MSCI EAFE Index (for international developed markets) was down 12.14 percent and the MSCI EEM Index (for emerging markets) was down 18.42 percent for the year. In total, 37 out 45 markets tracked by MSCI posted negative returns. Although the value of the dollar was flat vs. the Euro, some of the losses are attributable to strengthening in the US dollar vs. other currencies.  (This demonstrates the double-edged sword of diversification. Sometimes it helps. Sometimes it hurts. But over long time horizons it has proved to be a useful strategy, particularly in relation to managing the market risk required for building long-term wealth.)

Fixed Income

Bonds had another extraordinary year. The Barclays Capital Aggregate Index (for intermediate-term) rose 7.84 percent. Much of the gain was attributable to price appreciation, as the yield on the 10 year Treasury Note fell from 3.75 percent to 1.88 percent. (Movements in bond prices and interest rates have an inverse relationship.) But this can’t go on forever. Eventually interest rates will begin to rise and longer-term bonds will face some head winds.

Looking Forward

To borrow a phrase coined by Donald Rumsfeld, these concerns would be properly characterized as “known unknowns”:

• Continued deleveraging that began in 2007.
• The European sovereign debt crisis. Resolution is exceedingly complex and difficult to handicap.  The major issues are: 1) whether there will be sovereign defaults, especially by Greece, Spain or Italy; 2) solvency of major European banks who hold these nations’ bonds; 3) austerity in the affected countries; and 4) survival of the Euro.
• The strength of US and global economies. There have been some recent signs of improved strength in the US economy with a dip in unemployment.
• Interest rates.
• The continuing rancorous political debates over US fiscal and tax policies.
• The upcoming presidential election.
• The Supreme Court decision on the health care law.
• Current stock prices compared to underlying values, as measured by price-to-earning (P/E) values. Stocks, while not as cheap as they were in spring 2009, are not particularly expensive, at P/E ratios of approximately 15:1.
• Tremendous cash or near-cash hoards on both personal and business balance sheets.

Both bullish and bearish cases can be made from the foregoing.  Greek mythology (which sure has a long history of survival) is replete with animal hybrids such as the unicorn, centaur, Pegasus and the mermaid. So why not a bull/bear combination for modern investment mythology, representing the equilibrium of market prices? This is why we adopt a strategic asset allocation, acknowledging the powerful outcome of the daily grudge match between these two magnificent animals. If we imagine their combat ensuing along a forward-moving path, we advise investing in the overall movement, rather than betting on any one contender at any given time.

Seatbelts, Please

Expect continued volatility as these events play out.  It’s impractical if not impossible to time the market by trying to consistently leap out as uncertainty rages, and jump back in once the turbulence subsides. It’s also costly, with academic evidence indicating there will be little if any to show in the end for the added expenses.  As Einstein said, “Not everything that can be counted counts and not everything that counts can be counted.”

But that shouldn’t stop us from counting our blessings. We count your continued faith in our services as among our greatest favors. Please be in touch whenever we can assist you in managing your own life challenges and opportunities.

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Steve Smith, Principal Right Path Investments

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