This year, we believe that the markets will finally pressure policymakers to move beyond temporary half measures and make substantive fixes to the financial system’s problems. In other words, the “can” that policymakers have been kicking ineffectually down the road for the past few years may finally kick back and compel positive long-term structural changes.
Yet we also believe we’re facing another year of sharp market volatility and a continued short supply of quality yield. Investors should be prepared to take advantage of periods of positive sentiment (and rising prices) to continue to reduce their portfolios’ exposure to market risk and the business cycle, shifting assets to higher-yield, cash flow–driven and dividend-based strategies. At the same time, we would continue to position portfolios to take advantage of opportunities that appear likely to benefit from the global rebalancing theme — that is, the shifting of growth from the developed to the developing world — that we’ve been talking about for the past few years. That should remain the dominant driver of performance over the long term.
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- We would take advantage of large rallies to reduce market risk and lower cyclicality in portfolios across asset classes.
- We are neutral on equities relative to fixed income at current levels. As market averages hover at the upper end of our range, look to reduce equity exposure.
- Within equities, we remain overweight in large caps because of their greater exposure to global growth and are moving to a neutral weight in small- and mid-cap equities. We continue to prefer technology, industrials and certain consumer staples, although some companies in these sectors are vulnerable to the expected European recession.
- Within fixed income, we would emphasize corporate bonds and further emphasize high yield. In the tax-exempt space, we prefer high-quality municipals (essential-service revenue bonds and general obligations of states and high-quality local governments).
- Within hedge funds, reduce market risk by focusing on managers of diversified strategies and “all-asset” managers as a replacement for equity-only managers.
- In private equity, we would pay close attention to vintage year diversification among managers who have strong track records in the full private equity cycle.
- Reduce commodity exposure to a neutral tactical weighting.
- Allocate the proceeds from reducing commodity exposure to cash until more attractive opportunities develop.
We’re forecasting the Standard & Poor’s 500 to finish this year at around 1350, based on profit of close to $100 per share for the year, slightly higher than the profit numbers for 2011. This implies a discount on a normal market multiple because of a policy-heavy environment, once again, in 2012. With current levels around 1380 on the S&P 500 (as of March 14, 2012), we are neutral on the equity asset class.
The New Paradigm
The credit crisis of a few years ago brought a new paradigm in its wake, and it affects virtually everything from commerce to geopolitics; it influences the ways businesses operate and the ways we conduct our personal lives and finances. Basically, we are all — in one way or another — repairing the bloated debt structure of the past few decades. This repair process requires structural change, and that is what’s happening around the world right now. In the emerging markets, we’re seeing an expansion of balance sheets and the creation of a middle class. In the developed world, it’s the exact opposite. We are restructuring our balance sheets and deleveraging, paring down liabilities and repairing our capital structure so we can create a new base from which to grow. This is all part of the long-term global rebalancing theme.
We would continue to remove market risk and lower cyclical exposure during periods of positive momentum.
This repair process has made for a high degree of uncertainty and difficult market conditions, and 2011 was particularly challenging for equities (the S&P 500 had approximately a 24% range during the year) and global credit spreads (European bond yield spreads hit euro-area record highs during the year). It was an extreme “binary outcome” year with sentiment changing dramatically seemingly every other week. Policy concerns took control over the summer, as the world waited for the congressional Super Committee to fix the budget deficit in the United States and for European policymakers to bring in the “big bazooka” to address their mounting problems. Unfortunately, 2011 proved to be a year of words rather than concrete action.
2012: Payback Time For Policymakers
This should be the year that the economy, the markets and investors will finally force policymakers into action (not necessarily action that is implemented this year however), though the policy moves themselves are likely to contribute to another year of sharp volatility at times. We believe we’ll see some positive momentum early in the year, based on better economic and job growth in the United States, potential enthusiasm over Europe “moving in the right direction,” and portfolio positioning that began prior to year-end. After that, we expect the European economic recession to become more visible, and that should filter into the industrial and technology sectors globally, causing consensus estimates to be lowered. (Current consensus estimates for U.S. profits in 2012 are $104 per the S&P 500; we’re looking for $97 to $99.) At the same time, fears of a further slowdown in China could gather momentum once again, and the U.S. campaign season should take off in earnest with its destructive class warfare theme.
This dynamic is likely to weigh on the market as we head into the second quarter. Decent U.S. job growth and more accommodative emerging market monetary policy led by China and Brazil should mute some of the negative pressure from what we expect will be fractious presidential politics. However, a further bite from Europe’s downturn, skepticism over its long-term structural plan and higher U.S. housing inventories (based on the release of foreclosure backlogs) could spark another market downturn in the summer months similar to those we saw in 2011 and 2010.
Position portfolios to take advantage of opportunities and themes that appear likely to benefit from global rebalancing.
We expect the market to end 2012 on an upswing. As we head into the fourth quarter, the market should start to digest the expected U.S. election outcome, economic improvement in the emerging markets as monetary stimulus takes effect and, perhaps, “the can kicking back” on the fiscal front in the United States as we head into 2013.
In terms of forecasts, we started 2011 with a target of close to 1400 for the S&P 500, which we lowered to 1300 in early August, because we believed policy issues would continue to overshadow fundamentals for the next 12 months. At that point, we established a wider range of 1100 to 1300 (down from our earlier range of 1300 to 1400, because of the political overhang) for the remainder of 2011. The S&P 500 closed 2011 at 1257.60.
Now we’re looking for the S&P 500 to close out 2012 around 1350, as we expect the S&P to produce a few dollars more in profits in 2012. So 2012 is likely to hold a similar pattern as 2011, with bouts of volatility but with slightly higher targets.
Whether the S&P 500 closes 2012 at 1200 or 1400, the overwhelming portfolio theme this year should still be the short supply of quality yield. So, to deal with that issue, we are emphasizing active management around this dynamic coupled with an overlay of growth stories/thematic opportunities in various corners of the world.
Within this context, we would continue to use periods of positive momentum that carry the market toward the upper end of our ranges to remove market risk and lower cyclical exposure. We have a risk-neutral stance on equities at this time. We also expect volatile episodes to present opportunities to improve portfolio yield through rebalancing within each asset class to more fundamental-driven strategies. These adjustments are designed to achieve a more effective risk balance over time and to produce portfolios that are less sensitive to market movements while allowing cash flow and yield-oriented strategies to be the primary drivers of total return.
At the same time, we would continue to position portfolios to take advantage of opportunities and themes that appear likely to benefit from global rebalancing, which is still early in a long-lasting cycle and stands to be the dominant driver of performance over the long term.
Projections made may not come to pass due to market conditions and fluctuations.
Investing involves risk. There is always the potential of losing money when you invest in securities.
Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not assure a profit or protect against loss in declining markets.
Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy.
OTHER IMPORTANT INFORMATION
Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.
Stocks of small- and mid-cap companies pose special risks, including possible illiquidity and greater price volatility than stocks of larger, more established companies.
Fixed Income Investing in fixed income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop and vice versa.
There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Tax-exempt investing offers current tax-exempt income, but it also involves special risks. Income from investing in municipal bonds is generally exempt from Federal and state taxes for residents of the issuing state. Interest income from certain tax-exempt bonds may be subject to certain state and local taxes and, if applicable, the Alternative Minimum Tax (AMT).
Investments in high-yield bonds (sometimes referred to as “junk bonds”) offer the potential for high current income and attractive total return, but involves certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuer’s ability to make principal and interest payments.
International Investing International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.
Commodities There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors.
Alternative Investments Alternative investments are intended for qualified and suitable investors only. Alternative investments are speculative and involve a high degree of risk. Alternative Investments such as derivatives, hedge funds, private equity funds, and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, and your tolerance for risk.
Other Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time.