We hope everyone had a wonderful holiday season.  Let us add to your Happy New Year Wishes!  The year 2012 is upon us and looms large for a number of different reasons.  Within the next few days, the first of the Presidential primaries will begin and by early November we will know who our next President is and who controls Congress, along with many State Houses.  Some astrologists believe this is the Age of Aquarius (where is The 5^th Dimension now?) and according to the Mayan calendar, December 21^st will be the “end of time”, or as some prefer to think of it (ourselves included) – the “beginning of a new age”.  Maybe the astrologists and Mayans have something going.

 

• Let’s take a moment to talk about inflation.  As we entered 2010, there was a lot being said about potential inflation we were facing given the huge amount of money created by the Federal Reserve, as well as the money being spent by the government on the stimulus programs.  While there have been momentary bouts of inflation for the past two years, especially in the volatile food, energy, and commodities areas, inflation has increased and decreased based on investor speculation.  Perhaps one of the major reasons we did not see the inflation that was expected was the deflation experienced in other sectors of the economy…most notably, housing.  We expect inflation to remain relatively under control during 2012, but it won’t remain so forever.  The classic definition of inflation is “too much money chasing too few goods” and this usually happens in a fast growing economy.  But, it is also possible to have inflation during slow times – just think back to the mid ‘70s (for those who can remember it), when the term “stagflation” was first used.  We had rampant inflation and stagnant growth.  Given the inability of Washington to rein in its spending thus increasing government debt, this will eventually translate into inflation and higher interest rates.  As the world begins to recover from this stagnant period, demand will increase and prices will go up.  Ironically, some inflation at higher than normal rates for a brief period of time might actually be good for the economy, as it could spur growth.  Higher inflation would also allow companies to increase their prices and hopefully their profits, which would translate into higher earnings and thus potentially higher stock prices.

 

As this happens, interest rates are bound to increase, which means that people who are holding long-term bonds are likely going to experience a significant bear market in bonds, the likes of which has not been seen in almost 40 years. 

 

• At the beginning of the year, we said that if the markets were kind to us, we might be lucky to get a return of 8% to 10%.  The markets were not kind.  For the year, the Dow Jones Industrial finished up 8.35%, the S&P 500 finished with a gain of 2.11%, the Russell 2000 (small companies) finished down 4.18%, and the MSCI EAFE (international index) finished with a loss of 12.14%, with emerging markets down considerably more.  The year produced various results, and of course there was extreme volatility.  Just how extreme was the volatility?  If we add the total daily point change (that is, we ignore the ups and downs, but simply add up the changes) for 2011 the Dow Jones traded 27,954.43 total points.  In other words, it turned over about 2.5 times!  The S&P 500 was just as bad, trading 3,119.84 points; turning over almost the same 2.5 times for the year!  In the early part of the year the markets increased around 10%, and we suggested that the domestic markets might be ahead of themselves and to expect a correction.  From April through the rest of the year, the market moved up and down with violent swings, at one point finishing down nearly 20% from its high, a point at which a bear market is traditionally declared.  Being true to itself, however, as soon as it declined that severely, it immediately cut those losses by more than half, bouncing back to finish the year much stronger than many believed was possible.

 

Even though we were convinced that the market was ahead of itself, we did not believe that, based on fundamental analysis, there was justification to reduce exposure except on a case by case basis.  We thought then, and continue to believe, that the bond market contains more risk over the next few years than the stock market.  In 2009 when the S&P 500 hit its low point on March 9^th, investors were looking at perhaps $50 in earnings on the S&P 500 and it actually turned out to be $56.98.  Earnings bounced back smartly in 2010 to $83.25, and while 2011 isn’t on the books just yet, it is likely to come in somewhere around $95.  While some pundits have been paring back their estimates for 2012, we expect earnings to come in somewhere north of $105, or about a 10% increase.  That means that, at its 2011 closing level, the S&P 500 was selling at approximately 13 times 2011 earnings and 11.5 times 2012 anticipated earnings.  Therefore, we think there remains upside potential in the equity markets, especially at the current relatively low inflation rate. 

 

The markets generally did not reward the S&P 500 companies who collectively increased their earnings about 14% year-over-year through the third quarter.  Through December 15^th, the Dow Jones Industrial Average was up a little over 3% and the S&P 500 was down about 3%.  The results, sector-by-sector through the middle of December were:  energy -2.7%; materials -14.7%; industrials -6.4%; consumer discretionary +1.4%, consumer staples +7.4%; healthcare +6.4%; financials -21.5%; information technology -0.5%; tel com services -3.6%; and utilities +10.8%.  If you assumed an equal weighting for these sectors, they produced a negative return of 3% - exactly where the S&P 500 sat at that time.   

 

While the year started strongly, it quickly slid with the tsunami, earthquake, and nuclear disaster in Japan, emerging markets sinking, followed by the Arab Spring, the U.S. debt downgrade by Standard & Poor’s, the euro under extreme pressure, Greece on the brink of default, and the wonder of how quickly Spain and Italy might follow suit.  And all of this was with the backdrop of a Congress that simply chooses to argue rather than solve problems.  Is it any wonder the markets went through such gyrations?  If, at the beginning of 2011, we knew all of these things were going to happen and we also told you that the market would end up flat for the year, you probably would have called us crazy.  Given the most recent economic data, it would not surprise us to see the fourth quarter GDP up 2.5% or more.  Looking ahead to 2012, we see growth, albeit continued slow growth, i.e., 2 – 3%.  Expect volatility in the U.S. markets to continue well into the year at least until it becomes clear who our next President will be.  Remember, regardless of who is elected, at least 50% of Americans are likely to be pleased with the results and that generally produces positive feelings in the market.

 

• Identifying trends that have staying power is quite difficult in our ever-changing and fast-paced world.  Some trends turn out to be just fads, but trends that become permanent can have a dramatic impact on investors.  Let’s look at two potential trends.  A little over 15 years ago we wrote about Baby Boomers potentially retiring early and then re-entering the workforce because their intellectual knowledge could not be replaced by the next generation.  This would force employers to offer a lot of money to attract the Boomers back to work.  Unfortunately, the last 10 or 12 years have not produced stock market returns that Boomers had come to expect.  Consequently, some of the Boomers never left the workplace.  Instead, they are attempting to repair their balance sheets by waiting for their portfolios to recover, and adding to their savings, and paying down debt.  Unfortunately many Boomers may not be able to retire in the near term, if at all.

 

More than this, however, a trend is emerging, because the early Baby Boomers simply are not ready to retire.  Unlike their parents’ and grandparents’ generations, the Baby Boomer of today did not toil for 40 years at hard labor – working on a farm, at a manufacturing plant, in a coal mine, etc.  This generation is healthier than the previous two as they smoke less, exercise more, and have better medical care available.  For better or worse, many are defined by their jobs and would find it difficult to be “retired”.  In fact, we have one client (age 65) who has retired three times already and is now looking at buying an up and coming franchise operation.  Perhaps for many people of this generation 75 will become the “new” 65. 

 

The implications of this are significant.  Since people will delay retirement and the move to warmer climates, the percentage of people migrating south will decline.  Thus, population shifts may slow as fewer people migrate or at least don’t do so until later in life.  The normal process of retirement – making room in the workplace for younger people to be promoted – won’t happen in the same manner.  This may cause younger employees to become frustrated with corporate life and perhaps drive them to seek entrepreneurial opportunities or to job hop more.  Since they can begin to draw on Social Security without penalty at full retirement age, many Boomers will take this money and save it, while continuing to work into their late 60s and early 70s – assuming their health holds up.  On the other hand, some Boomers will delay taking Social Security until their age 70, and in essence give themselves an 8% annual raise in Social Security over a three to four year time frame.  The Boomers who believe they will live a long time are likely to choose this option, and while it will lessen the strain on Social Security temporarily, it will increase the strain significantly in the future.  Space does not permit us to talk about all of the ramifications of Boomers continuing to work, but if you let your mind wander, you can see the tremendous impact this will have on society.

 

Let’s turn to another emerging trend.  It doesn’t come as any surprise that manufacturing jobs have left the United States over the past 10 or 12 years, seeking cheaper labor.  While China has clearly benefited from this trend in numerous ways, so have other emerging economies.  What would happen on a worldwide basis if technology, which basically made manufacturing workers virtually obsolete, advanced rapidly?  Not possible you think?  If you go back a century, 50% of the U.S. population was involved in the agricultural industry in some form or fashion.  This has shrunk to something close to 1% of the population and of course we are producing significantly more goods with only 1% than when we had the 50% working in agriculture.  What if the same thing happened in the manufacturing area because robots (which have been utilized for quite some time) reached a level of sophistication that did not require the same number of people working in manufacturing plants?  The impact of this in the U.S. would be dramatic, but the countries that expected their cheap labor to help increase the standard of living in their respective countries could find themselves with an elite few (think owners – not workers) who would benefit from such a trend.  The social implications are dramatic; especially in any country that was just beginning to get a taste of the good life and suddenly finds that the jobs have disappeared.  This type of trend means that those who are better educated will have jobs and opportunities that less skilled workers will not.  It means that the middle class might shrink with the entire world reaching a have/have not state.  It won’t be Occupy Wall Street, Occupy Seattle, Occupy Tampa, or Occupy anywhere else for that matter, but rather, Occupy Several Places around the World.  It means an education is more important than ever.  

 

• It’s the time of year that people make fools of themselves by making predictions.  Think about Meredith Whitney, who has done everything she can to roil the municipal bond markets over the past year by not only saying once how bad things were going to be, but then managing to get on 60 Minutes and talking about how bad the municipal market would be for a second time.  For the year, the municipal bond market turned in a rather enviable 10.5% positive return, which even beat the return on Treasuries.  While the politicians at the federal level continue to bicker and not get much done, the politicians at the state and local levels have done what they needed to do (for the most part) to cut expenses and/or increase revenue.  That is not to say there are not state governments that still have issues, but look at what they did – state and local governments cut about 650,000 jobs over the past couple of years; Rhode Island lowered pension benefits; and California put in automatic spending cuts if revenue doesn’t meet budget projections.  Although there are likely to be some defaults in the future, it does not appear that these defaults will come anywhere close to Ms. Whitney’s prediction.

 

• In the coming year we expect China and other emerging markets to be in the news a lot.  Some of the deleveraging that occurred in the U.S. a few years ago, and began to occur in Europe this year, is likely to hit the emerging markets in 2012 or perhaps early 2013.  China’s communist rulers will do everything possible to keep the economy rolling, but at some point the reality of their fast growth, easy credit, etc., will manifest itself.  China simply can’t continue to grow at the current pace forever, nor can it do so without having some type of slow down, and possibly even a recession. 

 

There is no denying the fantastic growth they have had and the impact this has had on commodity prices.  Here are a few things to consider when people tell you how great China is and that someday, in the not too distant future, it will (according to many) overtake the United States as the world’s largest economy.  With 1.3 billion Chinese to a little over 312 million Americans, this is entirely possible.  However, on a per capita basis, China only represents 16% of the U.S. output.  If you think their living standard even comes close to ours, you must be kidding yourself.  Only 20% of Chinese have toilets that flush.  There are a lot of people in the cities who still go to a community bathroom every day.

 

China has built its economy on exporting – just as Japan did after the Second World War.  If the Chinese don’t become more consumer-oriented within their country, they could easily face some of the same issues as Japan.  Of course, for this to happen, China’s population will have to earn more money, which will potentially lead to significant inflation.  As consumers begin to buy within China, the trade deficit with the U.S. will likely go down.  Chinese consumers will demand a higher quality product from Chinese manufacturers, or they will want to buy those things from other countries – something the Chinese government is completely against.

 

You can look for China to go on a buying binge and try to invest in U.S. companies, especially in those industries where they feel there is an important future.  Of course, China will not only invest in the U.S., but will invest in other emerging countries, especially Africa, other Asian countries, and even in South America.  They will do this to protect their position on natural resources.

 

Another big issue for which China is very unprepared is their aging population.  Long before the one child rule (which is not followed anyway) China had its own Baby Boomer generation.  Soon, that group will make itself known.  China’s politics are such that they are ill prepared for this growing issue. 

While it is impossible to ignore China, and foolish to underestimate them, it’s not smart to ignore the problems they face.

 

• Now that New Year’s has come and gone, we need to think about those resolutions we made last year that we perhaps did not keep.  As we wrap up the Bullets, we offer a baker’s dozen of financial strategies to apply to your personal financial planning in 2012:

 

(1)  Get started today.  If you spent much of 2011 in denial or ignoring what you knew you needed to do financially, don’t be embarrassed.  You had plenty of company.  The best way to come to grips with your financial future is to review your financial plan.  If you don’t already have one, make a written plan.  You will want to analyze your asset base, debts, your earning potential, and your spending.  Most importantly, you will want to review your goals.  Are they still attainable or even reasonable?  You can do it yourself, but a professional financial planner has the knowledge and tools to calculate what it will take to reach your goals and help you manage your finances along the way to increase your chances of success.

 

(2)  Spend less.  Save more.  The best way to provide, i.e., recoup the money you will need to cover future goals is to save more now.  The most important dollar you invest is the dollar you save today because it has the longest time to grow.  Here’s a good way to start – pay yourself first through payroll deductions into your 401(k), health savings account, etc.  Another way to do this is with your credit cards – instead of paying high interest rates, you will be “earning” market-beating 9%, 12%, 18%, or even higher returns on every dollar you don’t have to pay in interest to a credit card company.  Only spend cash or use a debit card for future purchases.  If you can’t pay for it within the month, delay the purchase.

 

(3)  Got lemons?  Make lemonade.  There is a positive side to the stock market losses.  Take advantage of any under-performing assets to harvest tax losses.  Any losses not used to offset capital gains can reduce ordinary income by up to $3,000 in 2012, and the excess is carried forward into future tax years.

 

(4)  Keep contributing to your 401(k).  Continue putting away as much as possible into your employer retirement plan.  If contributions are on auto-pilot, you are less likely to come to a sudden stop when current events are discouraging.  Also, dollars are invested throughout the year, so in a market that is up one month and down the next, you won’t buy all your shares at high points, and you will get more shares at low points.  At a minimum, put in enough money to get all of the employer’s matching dollars.

 

(5)  Keep an eye open for refinancing opportunities.  With interest rates at all-time lows, it is a good time to see if refinancing makes sense.  You may find it preferable to refinance from a 30 year mortgage to a 15 year loan, as some institutions are offering 15 year loans at less than 4%.  Run the numbers.  You may find that the payment on a new 15 year mortgage is similar to an existing 30 year mortgage and you will significantly reduce the amount of interest paid over the life of the loan.  Refinancing does not necessarily mean you have to have equity as the government still has some programs for people who qualify, even when the homeowner is upside down.

 

(6)  Get a reassessment.  With the continuing decline in home values in many locations, homeowners should consider applying for a reassessment of their home value for property tax purposes.  This can be a relatively easy process which might save significant money, especially for those living in expensive areas.  The County Property Appraiser’s Office can provide you with the forms and process for requesting a reassessment.

 

(7)  Update your estate plan.  Take a fresh look at your estate planning documents, especially if they have not been updated in the last three years.  The annual gift limit remains at $13,000 per donor per person in 2012, but the lifetime exemption of $5 million in 2011 has been adjusted for inflation and will be $5,120,000 in 2012.  Your financial planner and estate attorney will know what these changes mean for your specific situation.

 

(8)  Give a gift or make a loan.  Want to help out a family member who may be in dire straits, but don’t feel comfortable making an outright gift?  Loans to family members must use government approved rates.  It’s called the Applicable Federal Rate (AFR) and the low interest rate environment could make 2012 an excellent time to make a loan.  The current long-term AFR for loans more than nine years is only about 2.8% compounded annually.  The short-term AFR for loans less than three years is only 0.2%.  If a fair interest rate is not charged, the loan would be considered a gift subject to gift taxes.

 

(9)  Review beneficiary designations.  Use the start of the New Year to review all beneficiary designations for 401(k)s, IRAs, life insurance policies, and annuities, etc.  Remember that retirement account assets pass by beneficiary designation and not by will.  The same is true for life insurance policies.  Never make your estate the beneficiary.  Every financial planner has stories about clients who divorced and who never revised their beneficiary designations.  The client died and the life insurance policy or 401(k) was paid to the ex-spouse, leaving the current spouse and children with nothing.  Don’t just name a primary beneficiary.  You need a contingent beneficiary as well, and in many cases, it is prudent to even go to a third level which then offers the ability to do some post mortem estate planning.

 

(10)  Keep up your contribution limits.  Take advantage of 2012 increases in retirement account contributions.  The maximum 401(k), 403(b), 457 contributions increase to $17,000, and the catch up contribution for people over 50 is an additional $5,500.

 

(11)  Keep your cool.  Listening to the financial news was not easy during 2011, and we may face the same group of doomsayers in 2012.  Selling stocks when prices are down is not a successful long-term investment strategy.  And remember, when media headlines proclaim investors are dumping stocks, someone else is buying them.  As hard as it is, you must stay focused on the long term.

 

(12)  See your financial planner.  Financial planners can help you navigate through these perilous economic times.  No one knows what the future will bring, but a good planner can provide the kind of experience and objectivity that can bring clarity to difficult financial decisions.  If you have a financial planner and you have not updated your plan in light of recent economic realities, it makes sense to check to make sure you are still on track or see if there are some course corrections you could make to improve the situation.

 

(13)  Although doing all of these things is hard work, and sometimes life gets in the way, planning and saving is a lot like exercising – it’s something we all know we need to do, but it’s hard to get started.  Just do one or two of these things each month, but DO them.  By the end of the year, you will be surprised at the improvement in your financial shape.

 

As always, we encourage you to give us a call if you would like to discuss anything further.  We will visit again soon.  Proudly and successfully serving our clients for over 25 years.

 

 

 

 

(c) ProVise Management Group

www.provise.com