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2012 in Review: Learning from the Past, Looking to the Future (written January 2013)

As we enter 2013, I’m writing to summarize what happened in the markets last year and to share my thoughts on the impact of current conditions on portfolios for the year ahead.

Last year we saw continued shifts in the market that have been typical since the global financial crisis (which will be marking its fifth anniversary in September). Despite continued investor concerns about European finances and worries that the U.S. would go over the “fiscal cliff”, the U.S., Europe and emerging stock markets all made strong gains in the mid-teens.

Much of the focus was on the ebb and flow of good and bad news about Europe. Positive indications for Europe’s economy in the first quarter led to the strongest start for markets in recent memory. These gains promptly receded as concerns rose again in the second quarter. Markets then rallied in the second half of the year when the European Central Bank announced that it would provide liquidity to governments and financial institutions—to the point that for 2012 as a whole, Europe’s stock market outperformed ours. Back in the spring of 2012, who would have guessed that Europe would have extremely competitive results, or that the emerging markets would rebound so strongly?

The table below shows returns for the past five years, all in local currency. Note that when including dividends, the U.S. and emerging markets ended 2012 above their five-year high, which occurred shortly after global markets hit all-time highs in the fall of 2007.

Annual Returns 2008-2012
All Returns in Local Currency
Year U.S. Europe Emerging Markets World Markets
2012 16.2% 16.4% 17.2% 16.6%
2011 2.0 -8.8 -12.6 -6.1
2010 15.5 7.5 14.7 11.1
2009 27.1 28.6 60.6 30.1
Average Annual Return: 5 years* 1.8 -2.0 0.3 -0.8
Average Annual Return: 10 years 7.3 7.0 14.9 7.2

*Returns to Dec. 31, 2012, including dividends

Putting Big-Picture Problems in Perspective

It’s easy to feel discouraged by all the bad news and problems facing the world. Recently, though I came across a December 1990 article from the Knight-Ridder newspaper chain that helped provide some interesting perspective on today’s issues.

Here’s what was going on at the end of 1990:

  • In August of that year, Iraq invaded Kuwait. It was not until January of 1991 that a coalition of Western and Arab nations led by the United States responded. In the meantime, there was huge uncertainty about what would happen, and oil prices doubled as a result.
  • Starting early that year, Western economies went into a significant recession, which hit its peak in the fourth quarter of 1990. In the four months from July to October, the stock market was off 15%. For the year as a whole, the market was down almost 7%.
  • In the aftermath of $500 billion in write-offs in the savings-and-loan sector, there was a widespread view that the U.S. was on the threshold of a full-fledged banking crisis. Loan defaults were up and bank profits were down. Some 900 U.S. banks had failed in the previous five years, and another 1,000 were on the problem list. In response, banks were cutting back on loans, even to creditworthy borrowers.

Prices of bank stocks such as Citibank and Chase Manhattan Bank dropped by half from July to December (is any of this beginning to sound familiar?). An editorial in Business Week had a typical view: “The banking sector is under enormous strain. Should it begin to unravel, recession could become an economic disaster.”

Wow! Of course, we now know that the period that followed saw strong growth in the economy and a buoyant stock market. This is not to suggest that the same will happen today, but we have worked through significant problems before, including the issues in the early 1990s, the shock in oil prices that led to a global recession in the 1970s, and numerous others.

Possibilities for 2013

Even in the face of all the global problems, many analysts entered 2013 cautiously optimistic about the outlook for the stock markets. The reason is not that there is any expectation of an easy resolution to the developed world’s debt woes, unemployment, or slow economic growth; on the contrary, there is universal agreement that it will take years to work through these issues.

The reason for optimism arises from the fact that around the world, companies are generally in very good condition, with strong operating margins and sold balance sheets. An October interview in Barron’s magazine gave a good example of the positive mood on stocks, as 45-year industry veteran and former Morgan Stanley strategist Byron Wien explained the reasons for his positive forecast for the U.S.

  • A bottoming in the U.S. housing market, which he expected to be a positive force in 2013. (Another analyst, Charles Lieberman, in a more recent edition of Barrons noted that there is huge pent-up demand for housing which is widely underestimated by many. It is simply the function of many who could not have their separate homes—think unemployed college grads—but who are now getting jobs and forming their own households.)
  • Growth in the middle class in emerging markets will continue to provide opportunities for investors and for companies selling to those markets.
  • Dramatic new oil discoveries will put a cap on the price of oil and help buoy the U.S. economy. (If you’ve filled your gas tank lately, you have observed this first hand.)
  • Large multinational stocks offer predictable growth, solid balance sheets, and attractive yields at reasonable valuations.
Here is a link to the interview with Byron Wien, should you wish to read more (you may need to copy and paste into your browser):

When it comes to bonds, there are growing concerns about the future direction of their prices. Extremely low yields are causing growing concern by many strategists that this may bode poorly, despite the “flight to quality” appeal bonds have enjoyed. Indeed a recent New York Times article, “Bond Craze Could Run Its Course in New Year,” pointed to research from Morningstar that bonds have grown from 14% of U.S. investor portfolios five years ago to 26% today.

What This Means for Your Portfolio

When I wrote to clients about the fiscal cliff late last year, despite all the confusion about what 2013 might bring, I recommended maintaining a balanced portfolio.  The following are tenants I follow in all the investment work I do:

  • Taking the right level of risk. This is the biggest issue of all to determine before beginning to assemble a portfolio. As those of you who have worked with me know, in assessing the best risk level for your portfolio, we look at more than your reaction to market events. The real goal is to construct a portfolio that will move you toward your objectives, but without taking any more risk than necessary. We look at not only risk tolerance (your attitude toward making or losing money), but also your capacity for risk based on life stage, employment prospects, health, upcoming cash flow needs, etc. If you are already retired, we build in a buffer of a number of years’ expenses to reduce the risk of needing to sell holdings at inopportune times. Frankly, this discussion is an easier proposition than it was prior to 2008. Most investors are keenly aware of their risk tolerance today, and may be erring in being too conservative, assuming their circumstances were not dramatically changed by the financial crisis.
  • Adhering to your plan. This can be difficult, but regardless of what happens to markets in the short term, barring a significant change in your circumstances, we should stick to the investment parameters to which we have agreed. If we have done a good job of designing a portfolio to target a particular level of risk, then that should help you to ride out rougher periods in the market.
  • Diversifying portfolios. Change in the markets can bring risks, but they can also bring opportunities. Last summer, valuations became very compelling on global companies headquartered in Europe (whose business was not solely concentrated on the Continent) and in emerging markets. There is no guarantee they will continue their recent outperformance over a short-term horizon, but over 10 or more years, they may have represented a compelling opportunity. Of course, if you had a diversified portfolio, you were already there.