A look back at 2010,

A look forward to 2011,

and investment themes to live by

 

"Good evening, ladies and gentlemen.  Thanks for coming to our New Year's Eve Party.  I know the party has been going on for a while already, and why shouldn't it?  We've been celebrating not only the end of another year of hard work and accomplishments, but our recovery from that nasty recession that only two years ago, had most of us believing that the financial system was not just 'on the brink' but actually broken.  Aren't we glad we'll never go through that again! 

 

"Now, as you probably have already talked about with your fellow guests tonight, this party does not have a curfew, at least not that we know of.  With so many people, so much going on, so much to chat about, I frankly have no idea when the party will end.  But, I do want to caution you: it will end, and when it does, as with all celebrations where you party hard, the inevitable hangover occurs.  Some of you, perhaps many of you, will wake up the following morning and say "how the heck did I allow myself to get like this, feel like this again?!" 

 

"Well, for some, that's just who they are, and I applaud them for going back to the well for more water, so to speak, again and again.  As the old expression goes, 'often wrong, but never in doubt!'  I can tell you though, from where I sit, that while the party's final moments will come, there is a good chance it may go on a bit longer. 

 

"The other good news is, despite the nasty hangover you will endure yet again when it does end (unless you curtail your intoxicating ways between now and then), I think this one will be less horrific than the one we all experienced in 2008.  I also think that this hangover will, for the most responsible among us, be a typically painful but brief event, and one whose sting will fade away much quicker than past hangovers.  For those of you who insist on trying to match your personal records for 'intake' this year, just beware that we have no control over when the party will end.  Just don't be looking the wrong way when it does. 

 

"Finally, remember that there will be another party and another and another as we move into the next decade.  And in between, there will be hangovers.  All I suggest is that you learn how to handle yourself so that you can enjoy the parties, but spare yourself the nastiest of hangovers that we all know will befall some of our fellow partiers, as they always do."

 

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THE ANALYSIS AND GUIDANCE

OK, if you find the financial markets and matters of asset allocation and wealth management to be utterly boring, you can stop reading here and accept my wishes for a very Happy New Year.  The messages from the above story, reading between the lines (and cocktails) and adding specific examples to the general opinions expressed here are:

 

1.      The stock market has been a party for the past four months (S&P 500 up 19.8% from 8/31/10 - 12/23/10), and if we look further back, for the past 22 months (S&P 500 up  85.9% from 3/9/09 - 12/23/10).  Enjoy it, but don't forget that it is still the stock market.   Reward AND risk are always intertwined.  I am constantly amazed at how quickly that straightforward lesson is lost on so many investors who look at a calendar year, even a quarter, and decide what is and is not a good investment.  It is not like we haven't seen both sides of the reward/risk coin many times!

 

As of December 23, the S&P 500 was up 10.66% during the fourth quarter.  THAT is a big, positive number!  This occurred despite many issues that (as of the end of last summer) had many market watchers (us included) concerned that the autumn and early winter would erupt into shades of the panic of 2008's fourth quarter.  While we do not expect that magnitude of misery any time soon, a junior version is likely out there, so we are a bit suspicious of quarterly surges such as this one, when the exuberance of the early signs of US economic recovery push the threats of ongoing unemployment, municipal budget crises, European bank strife and the Fed's money-printing factory to the back pages. 

 

It seemed to us that we have been talking a lot lately about double-digit quarterly changes in the S&P 500, so we looked at some data on that index.  Here is what we found:

 

·        This is the third quarter in a row in which the S&P 500 changed by at least 10% (Q2 was down, Q3 and Q4 were up).

·        Each of the past three years (2008, 2009, 2010) has had exactly three quarters out of four in which the S&P changed by 8% or more (a total of 5 down, 4 up).  That's 9 of 12 quarters with at least an 8% swing.

·        Now, in how many of the preceding 12 quarters (2005, 2006, 2007) did the S&P 500 post a gain or loss of at least 8%?  NONE.  And it happened only once in 2004 (a gain of 9.23% in the fourth quarter of that year).  This is feast or famine, isn't it?

 

Conclusion: we are living through a period of extreme volatility in quarter-to-quarter stock market levels, though you would not know it by the "official" indicator of market volatility and fear, the VIX, which is within a short distance of its lowest level since the summer of 2007.  As you may recall, the market's complete lack of fear at that point in time was unwarranted, to say the least!  At the same time, the S&P is still down over the past three years and is up less than 2% a year for the last five.  Did we take a break from the misery in 2009 and 2010, or is all of this a sign that, while there will be some investor shake-downs and shake-outs in the coming months or year, the longer-term case for growth investments is getting stronger, based on the old "reversion to the mean" argument, if nothing else.  Reversion to the mean refers to the tendency for the market to climb back toward its long-term average return, so that when it lags behind a lot as it has recently, we conclude that the trend is likely to improve.  This has probably already started with the market's rise from the "near-death" levels of early 2009. This may all seem like technical talk and statistical mumbo-jumbo to some, but our experience has been that such behavioral tendencies are often better indicators than how traders react to the latest economic news, or how companies do versus their "expected" earnings levels. Let's face it, if your estimates are low enough, any company can "beat to the upside" and get everyone giddy again.  We think there is some of that going on now, and with that and the global economic threats discussed above, it seems there is more turmoil to invest through.

 

2.      The bond market has been partying for nearly 30 years, with interest rates falling from the high teens in early 1980s to the depths of 2008 to the modestly higher levels today.  That party is over, and the implications are many.  Simply put, few of us have actually lived as investors through a period of time where bond returns were not friendly. 

 

Note I did not say rising rates.  That may or may not happen in 2011, following a move higher in rates in the second half of 2010.  I am talking about a period of time, like many in the distant past, where investing in high-quality US Bonds and Bond Funds did not boost returns the way many investors and investment advisors have gotten used to.  In the decade following the go-go 1990s for stocks, investors came to realize that equity market returns of 10% - 20% a year were not a given, and in fact were not even close to the up and down pattern that has defined most of history.  This decade will likely see the bond market's equivalent of that, and will likely catch just as many investors off-guard. 

 

3.      Now, the good news: while there is likely another stock market decline of some magnitude waiting out there for us (i.e., end of the party), there is good reason to believe that things are gradually getting better.  We are in a period of US consumer austerity, where people are defining what they WANT versus what they NEED.  After three decades of grasping for whatever car, house or toy they wanted, they are becoming more rational consumers.  Hopefully, they don't "go off the wagon" again, and reverse the progress that is being made.  And, hopefully the US government (yes, Federal Reserve, that includes you too) will follow suit and do what is necessary to stop the cycle of bubbles and "hangovers."  But, as we all know, hope is not a strategy, so we must watch carefully for short-term signs that the long-term picture is continuing on track.  At this point, the US consumer, economy and stock market are in recovery mode, but recovery is not a headline -- it's a process, and a long one at that.  One patient will flourish, while others will invest according to that one definition of the word "insanity" - doing the same thing over and over and expecting a different result.  Falling prey to bubbles, doing what feels right because it's popular, and letting greed dominate fear at times when that should be reversed, are all ways to get yourself a well-deserved hangover in your portfolio.  This is the best time of year to make a resolution not to have that happen to you!

 

Just a little investor humility in place of some of the hubris will do wonders for your returns in what we think will be an ultimately successful 3-5 years for equity investors, despite the occasional 15% - 25% "speed bump/decline" along the way.

 

4.      The US consumer is recovering from decades of excess.  The Asian consumer is just learning how to spend.  Add the fact that their economies did not suffer through the buildup of debt and leverage that our consumers and governments did, and you get what could just be not only the Asian Decade, but the Asian Century.  The same goes for Latin America, which many investors still remember as Brazil and Argentina pumping out sky-high inflation back in the day.  Here's the news: Latin America has cleaned up its act, and now it is we who are the inflation-producers of the free world!  The so-called "Frontier Markets" of Africa, some smaller Asian and Latin countries, and the progressive economies of the Middle East are earlier-stage versions of the Asian-Latin story.  This too will have ups and downs of noticeable magnitude, but it's time more investors recognize that this, along with select global themes such as Infrastructure and Alternative Energy, are where the most satisfying multi-year returns are most likely to come from.  Go where the growth is, be patient, take both a long-term and short-term view of those select thematic areas, and you likely have a formula for success in whatever it is we call the next decade.

 

5.      Risk Management IS investing.  Let me repeat: risk management IS investing.  All of the best thematic ideas in the world (literally) can leave you with a big fat zero after years of effort (think US stocks in the recent "lost decade") IF you don't have a pre-meditated approach to how you will navigate through the "pops and drops" of the markets.  "I am a long-term investor" means something very different today than when most of us grew up as investors (1980s and 1990s).  Back then it meant to invest for growth and assume that growth would occur without much interruption.  Today, at a minimum it means AVOIDING THE BIG LOSS at all costs.  That goes for all investors, whether you are a reward-seeker or "just beat T-bills" style investor.  The latter will go beyond the basic mantra of avoiding big drops in portfolio value along the way, and employ additional, more tactical methods of keeping risk low at all times (raising cash more quickly, hedging more regularly, using put options to protect against near-term and long-term declines).  This is where financial advisors earn their keep, and where portfolio managers stick to their process.  That is, the financial advisor is responsible for customizing the reward and risk "tools" for each investor, and the portfolio manager/investment strategist targets a specific reward-risk tradeoff for each type of portfolio they manage.  If you have been a client of Emerald over the years, you know that we have historically offered three different strategies, each with very different tradeoffs between reward and risk.  I think they have each done what they have set out to do, and each year is another proving ground.  The bottom line is that reward-seeking behavior without effective risk-management riding side-saddle with it is a good way to get oneself a first-class investor's hangover.  This is forgotten quickly, particularly in periods like the one we are in right now, where what looks like a great year in the US stock market was in fact eight months of going nowhere, followed by a nice push upward in the final 1/3 of the year, despite clearly mixed news on the economic front, and continued redemptions of mutual funds by investors (net outflows for 33 straight months!), signaling that the "retail" investor has, to some degree, given up.

 

 

THE FORECAST

 

As my friends know, I am not much for investment predictions.  I think many of my fellow professional investors feel the same way.  However, we realize that it's not enough to wax poetic about investment approach, process, broad thematic outlook, etc.  We all like to keep score, even before the game has started, because it gives us a starting point and puts real (though guesstimated) data in front of us as a starting point to work from.  You have to start somewhere, right?  So in that spirit, here are some things I think might happen in 2011.  Put them together, add in the standard ability to adapt as changes to the environment and outlook occur, and you have a set of unscientific best-guesses to start the conversation at your own New Year's Eve celebration (I used to observe that financial markets were the last thing people wanted to talk about at parties.  Since 2008, money matters are much more topical, whether you have a coke, beer, wine or "other" in your hand at a gathering). 

 

1.      Four scenarios for the S&P 500, with percentage probabilities attached:

 

a.      Hold 'til May, then hope and pray (25%) - my spin on the old Wall Street adage "Sell in May and go away," based on the historical averages that say that the May-October period is typically worse for stocks than the November-April period.  If this holds up in 2011, the market will continue its slow but very steady advance higher into the second quarter, before a bit more reality sets in and the economy's future problems (unemployment, commodity price inflation, fading profit margins for companies that have wrung all of the financial benefits out of cost cutting, huge state budget deficits, etc.) start to feel more imminent.  The New Year's party ends in the spring, and the aforementioned hangover ensues.  This leads to a decline of 15% - 25% from the 2011 highs, and while that may be more than justified, emotion has a strange way of making every real decline worse than it really should be.   

 

One possible warning sign to look for, to let you know that this scenario is increasingly likely as the year goes on: corporate earnings look good for a while longer, then we start to hear the comments from CEOs about higher input (read: commodity) prices cutting into profits.  Eventually, the market interprets this as a combination of slowing earnings growth AND inflation pressure - a double hit to the recovery story, which dips stocks temporarily by 15% - 25%.  This sets up a multi-year buying opportunity.   But, from how high will this decline start?  That is what we have struggled with for a year now. 

 

b.      Rude awakening (25%) - those New Year's Eve hangovers fade in a few days, but don't put away that Tylenol yet...the market takes the good cheer of the past four months' rally and throws it right back in our red winter faces!  I can't tell you with any confidence what the actual trigger would be for a decline that starts within weeks of my writing this, but it has been my experience that when corrections do occur, it is often the recognition of old news, which for whatever reason, now is considered "serious."  The classic example of this: how long did we all know that the housing/mortgage market had turned into a "house of cards?"  It continued on until it didn't.  The Lehman "event" may have been the straw that broke the back of the bubble, but it's not like everything was just fine until that memorable week.  Instead, the can was kicked down the road until the ONLY option was the crisis-management option.  Expect that to be the "M-O" for a lot of our economic, regulatory and market price problems for a while.  That kind of last-minute behavior is unlearned very, very slowly. 

 

The great news?  That creates an environment of overshoots of sentiment, emotion and prices of various asset classes each year, which means great medium-term to long-term buying and selling situations will present themselves to those who practice humility and perspective over hubris and denial.  That does not guarantee success for the realists, but it does give them a real fighting chance, regardless of the variety of market conditions thrown our way.

 

c.       Treasury rates mesmerize the market, all year long (40%) - within the fourth quarter of 2010, the 10-Year US Treasury Note yield rose from about 2.3% to over 3.5%, all while the S&P 500 rose steadily without much of a correction.  This can possibly be dismissed as good news, just another sign of a re-emerging US economy.  Or, one could argue that this was an overdue reversal of the decline in yield from earlier in the year (yes, a mere two quarters ago, there were real concerns about the markets and economy, and they were reflected in volatile stock prices that ended up nowhere, and panic-induced bond yield drops, akin to 2008 - far too long ago for many traders' memories, and sadly, those of some alleged long-term investors, too). 

 

In 2011, you should expect the market to key in on rates much more closely.  The likely battle between bond bulls and bears will not only be closely watched by stock, commodity and currency investors, it will directly influence their actions and sentiment.  This would result in an up and down year with at least one 20% decline and one 20% gain within the year, with a decent positive bottom-line as of year-end.  As you can see, this is my most likely outcome, though by no means a slam-dunk versus the others.

 

Some will argue that higher rates are great for conservative investors, since they can lock into medium-term bonds like they used to, and get what appear to be decent yields.  Others will say that the falling bond prices that accompany rising bond yields will stoke reallocation into stocks, and push the market higher.  There is some validity to these theories, but the elephant in the room is this: bond investors, particular the throngs of investors who moved record amounts of money from money market funds into bond funds during 2010, are not used to seeing the value of their bond funds decline.  Should yields continue to rise even modestly from these levels during 2011, don't be surprised if the headlines reek of stories about "shocked" investors confronting for the first time the reality of "bond math": high quality bond fund investing + rising rates = an unfamiliar but miserable situation.  Even novice investors expect volatility from their stock investments, but from Treasury, Municipal and Hi-Grade Corporate Bonds?  That is a recipe for a hangover!  This is a big reason to follow data on investment flows (buying/selling behavior of investors, demonstrated by how money moves between various types of stock and bond mutual funds, ETFs and even separately-managed accounts).  This publicly-announced information (monthly) is starting to become a reliable indicator of market sentiment.  Like other measures of sentiment, just when the "obvious" move is to follow the herd into, say, stock funds, we are likely closer to a top than bottom.  Unfortunately for the investment herd, they are rarely right for a sustainable period of time. 

 

d.      True "decoupling" occurs between the developed and emerging stock markets, but unlike the recent period, the latter outperforms in 2011 by a noticeable margin and they all rise strongly throughout the year (10%) - there was some evidence of this in the fourth quarter of 2010, as US markets continued to edge higher into year-end while China, India and other Emerging Markets corrected a bit.  As stated earlier, the long-term picture may favor equities of all types but I think we are in the Asian/Emerging Market Century's early stages, so if we are trying to be on the right side of the bigger, longer-term trend, this recent difference in behavior between US and Emerging Markets is likely temporary.  Going forward, the short-term battles are likely to end in ties much of the time (that is, the global equity markets rise and fall together) with Emerging Stock Markets being the better performer most of the time, when the correlation across world markets is not as tight.  Why?  We feel economic growth, true growth based on a truly "emerging" consumer and governments not shackled with past transgressions, is just a better bet on balance versus the uphill battle that the developed, deleveraging world now faces.  Over short periods of time, anything can happen (and we have seen this over the past few years).  But, as the late value investing icon Benjamin Graham said, "in the short-term, the market is a voting machine, in the long-term it is a weighing machine."  At least that is good news for those of us who have snuck on a few pounds this month - Graham says don't weigh yourself until you have had a lot of time to drop that weight!  (OK, that's my interpretation, anyway).

 

 

 

 

BOTTOM-LINE NUMBERS (i.e. 2011 predictions)

 

My prediction for the S&P's range was 950-1250 for 2010.  As of 12/23/10, the actual range was 1011-1259.  I will press my luck and take a shot at 2011:

 

S&P 500 (closed 1256.77 on 12/23/10):

High: 1370                   Low: 990                     Close: 1320

 

10-Year US Treasury Note (closed around 3.4% on 12/23/10):

High: 4.8%                   Low: 2.8%                   Close: 4.4%

 

Average Investor's Systolic Blood Pressure (120 is considered "normal,"140 is bordering on "high")

High: 145                                 Low: 120                     Close: 125

(explanation: moments of panic, not like 2008, and by year-end a calmer, clearer, more hopeful climate for investors)

 

 

FINAL STRATEGIC THOUGHTS

 

The overhang of US unemployment, long-term inflation, and risks of temporary overheating in the Commodity and Emerging markets is a wicked one, so the best posture for 2011, and most years for that matter, is to be invested, but with a net to catch you when you fall.  However, the longer out one looks, and the wider the breadth of investment themes one is permitted to consider, the more the truly dynamic secular investment opportunities become visible.  And the ability and willingness to see the "forest" over the ever-present "trees" is not only the best advice I can give you, but it also might just make the difference between investors and their advisors retiring or staying retired in their desired lifestyle instead of a less desirable outcome.

 

Hopefully you won't need anything or anyone to catch you this New Year's Eve, because you will stay on your feet.  I wish you the best in your efforts to do so as an investor or financial professional in 2011 and beyond!

 

 

Sincerely, 

The Emerald Team

 

 

Disclosure

Green Thought$

 

The information herein has been obtained from sources believed to be reliable, but Emerald Asset Advisors, LLC ("Emerald") does not warrant its completeness or accuracy. Prices, opinions and estimates reflect Emerald's judgment on the date hereof and are subject to change at any time without notice. Any statements nonfactual in nature constitute current opinions, which are subject to change. Projections are not guaranteed and may vary significantly. Further information on the firm and its advisory fees may be obtained from the firm's Form ADV Part II, which is available without charge upon request. Complete descriptions of all Emerald's products and benchmarks are available upon request.

 

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