• Bouts of extremism, both negative and positive continues to govern markets in the midst of both uncertainty on the economic and policy front and short-term fixes to stem the pessimistic tide.

• Liquidity in almost all markets has been poor, and we expect it to become even more challenged as we move toward the end of the year.

• The European sovereign debt crisis continues  to worsen.  The need for political leadership is apparent but little is forthcoming thus far.  The economic toll for this uncertainty in Europe and the rest of the globe will become clearer over the next few quarters.  We see Europe moving into recession.

• The coming European Bank deleveraging  is going to be a tremendous growth retardant for the foreseeable future.

• U.S. growth will likely remain slow during 2012 due to fiscal restraint from the federal government.  Our expectation is that the federal government will not be able to get any meaningful growth-enhancing bills passed in this election year.

• The risk of QE3 is substantial over the next 12 months.  If the European situation deteriorates rapidly, the Fed will announce QE3 in short order and the markets will already begin to look for QE4 and beyond.  If there is no extreme meltdown in Europe, the odds are still high as the Fed will become increasingly concerned about contagion into the U.S. economy.  If there is a ‘solution’ in the Eurozone over the next few months, the odds of QE3 drop because of the resulting rally in the financial markets to this big ‘risk on’ event.

• The high grade fixed income sectors valuations will remain highly volatile.  Long term positioning or short term trading will be our anticipated way to add value over the next year.

• U.S. treasury rates should remain well behaved due to slow growth prospects.  A QE3 would put some pressure on rates to go upward as this would be viewed as a ‘risk on’ opportunity by the investing community.

We at the Auer Growth Fund (who have been bullish 100% of the time since 1987) still have no idea what the market will do in 2012.

• Given that, we would recommend to do the same as we have done for 25 years, only buy companies that have just reported 25% increased EPS for the quarter, and 20% revenue growth for the quarter, that trade below 12 times earnings.  If they stop doing that, sell them, or if they double sell them.

• Representative stocks that are in our fund now and DOING that are:

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• Fiscal policy will continue to be restrictive as plans to trim excessive federal budget deficits continue to unfold. Private sector demand looks gloomy because households will continue to deleverage from high debt levels while unemployment remains a problem. The uncertain future of the Euro-zone debt situation remains a major setback to future economic growth. The consensus of economic research is projecting a lower U.S. real GDP growth rate in 2012 of about 1.5%.

• International developed market economies, particularly in the Euro-zone, have been stuck in a slow growth mode in 2011, at a 1.7% rate. Consensus among economic forecasters is for a greater probability of a decline in this growth rate going into 2012. We estimate the Euro-zone’s GDP growth will be flat to slight negative in 2012 maybe even worse in 2013.

• Emerging markets remain relatively more robust. China has been a big driver of global growth, with real GDP growing at a 9.3% in 2011. Other areas of stronger growth include the other Asia-Pacific economies at a 7.3% rate and Latin America growing at 4.3%. There are still risks of downward revisions depending on if the recent downtick in leading economic indicators is confirmed in future reports.

• Currency markets have gone through a bout of risk aversion in the third quarter of 2011 as the sovereign debt crisis in Europe has sparked a flight to safe-haven assets. The U.S. Dollar has been one of the main beneficiaries of this risk-aversion trade. The U.S. Dollar Index, a leading benchmark for the trade-weighted international value of the U.S. Dollar, rose roughly 7% in the third quarter. The one factor that could impact the U.S. Dollar to the downside would be renewed easing policies from an already stretched Federal Reserve.

• The twin forces of declining economic fundamentals and investor risk aversion are two trends that appear to be persisting over time, and as such, indicate further declines for commodity prices in general.  Despite the weakness in broad commodity markets, gold remains an outlier. Even though it has pulled back from all-time highs hit earlier this year, it remains elevated from a historical perspective both in the short term and long term.

• Ultra-low interest rates and persistently strong credit-quality in the commercial REIT universe have been supports to REIT markets in general.

• Very worrisome macro issues have created an atmosphere of pervasive pessimism. Bottom-up fundamentals of companies tend to be drowned out in times like these creating an attractive entry point for investors heading into 2012.

• Companies continue to maintain excellent balance sheets which augur well for continued buybacks, dividend increases, and M&A. 2011 share repurchase activity is at the highest levels since 2007, dividend payouts will come close to their 2008 peak, and companies are generating excellent free cash flow which will add to their record $2 trillion+ hoard of liquid assets.

• Various underlying economic data measures have been improving, albeit modestly, throughout the year which we believe argues against a double-dip scenario. Industrial data, consumer sentiment gauges, unemployment, and retail sales have been trending in a positive direction. Also, some of our favorite forward indicators such as railcar loads and transportation activity have seen strong sequential improvement year-to-date.

• Below are six investment themes about which we are most excited:

• Emotions are Driving the Market:  Before August 4th of this year, the Dow Jones did not have a single day that the index moved either up or down more than 300 points. Since then, the Dow has experienced more than 12 of those days. What has fundamentally changed?  Nothing. Investors are reacting to the non-stop barrage of negative headlines.

• Still No Clarity, No Hiring:  We are no closer than we were a year ago to getting clarity from our leaders in Washington on corporate tax rates, healthcare costs, or regulation, which makes prudent long-term decisions about hiring nearly impossible. There is no cost for companies to defer hiring.

• US Companies are Doing Well:  Corporate profits are at an all-time high. Companies are sitting on mountains of cash – over $2 trillion among the S&P 500 companies alone. While companies are reluctant to hire they are deploying capital in other ways: initiating and increasing dividends, buying back stock, building internal infrastructure and making acquisitions.

• The Market is Undervalued:  Whether looking at Price to Earnings, Price to Sales, Price to Cash Flow or Price to Book, the market is significantly undervalued versus its five- and ten-year historical average, and the last five to ten years haven’t been that great. The market will move on the fundamentals, it is just a matter of time. For those with the guts to jump in, we think today’s equity market presents a huge buying opportunity.

• Lower End Consumer Spending:  We continue to see opportunities in the lower end consumer discretionary and consumer staples sectors. Look for consumers to continue the trend of “selectively shopping,” which we define as looking for great values on premium brands, or “getting more for less.” We expect that value conscious consumers, returning to living within their means, will continue to drive top line revenues for these lower end retailers for the foreseeable future.

• Look for the Bare Necessities:  People are not going to stop using water or electricity or stop heating their homes, and chances are you’re never going to see your electric company have a 20% off sale. So, we believe the Utilities sector is a great place to be. Utility companies have a predictable and recurring revenue stream and most pay a dividend, that in some cases is double that of a ten-year U.S. Treasury.

• Stocks:

• Near term we look for the economy to slow due to deleveraging in the consumer and government sectors

• Long term we look for a stronger economy  due to positive political, social, and economic trends

• US needs a stable monetary and fiscal policy along with a balanced budget where  spending = revenues

• US dollar to remain “King” of currencies and treasuries will do well in times of stress

• Don’t expect a repeat of 2011 

• Favor high quality bonds as stability questions linger

• Look for underperforming bonds to rebound as questions about Europe are answered, Corporates, TIPS, Municipals

• Tactical moves preferred over buy and hold until maternity

• Eurozone problems will persist

• Emerging Asia shows good prospects

• Japan’s rebuilding will help stabilize the global economy

• Global inflation will become a rising threat

• Valuation levels such as Price / Average Long-Term Earnings suggest no new bull market for stocks.

• Although deficit spending creates many economic problems, in the short term it provides more cash into the system than the economy actually produces.  Stocks often do well in this environment.

• Corporate insiders, who are often considered the “Smart Money” on Wall Street have been lowering their ownership; a dubious sign.

• Although election years are generally good for stocks, the true key is voter disapproval.  High levels of Presidential disapproval suggest discontentment by the public and stocks usually offer sub-par returns. Recent disapproval numbers are elevated.

• The inflation differential, which helps measure the difference between input costs and final sales suggest companies will have difficulty passing along rising costs.    Historically, this crimps earnings and produces lower stock returns.

• The U.S. Dollar is ascending.  Given that over 40% of the S&P 500’s sales come from abroad, the data suggests corporations may see sales stagnate and stock returns disappoint.

• There are areas of opportunity with a rising dollar.  Investors should invest in industries like discount retailers and oil refiners as the dollar’s move will help lower their costs. 

• In 2012 volatility will remain elevated.  In this environment investors need to take an active approach and look to favor those companies showing shareholder appreciation with good dividends or stock buybacks.

• We believe that equity valuations remain compelling based on several measures.  As of 9/30/11, the trailing p/e on the S&P 500 Index was at a 20 year low.  Current dividend yields, roughly equivalent to the yield on a 10-year Treasury, also suggest that equity market valuations are compelling.  In contrast, over the past 20 years, Treasury yields have been 230 basis points higher than those of equities, on average.

• Corporate profitability has been strong and improving, yet may have reached a plateau.  Companies that can continue to generate growth in revenues and earnings may, as a result, command premiums in the market.  Profit margins among members of the S&P 500 were 8.2% during the fourth quarter 2010, representing the third consecutive quarter with margins above 8%.  This compares favorably to the 15-year average of 6.1%.

• Emerging markets, while slowing, remain a compelling growth opportunity for globally-oriented businesses; for 2010, the seven largest emerging markets represented approximately 21% of global GDP, and are expected to represent approximately 23% in 2011.

• Negatives persist, including stubbornly high unemployment, continued weakness in the U.S. housing market and deep ideological divides within the U.S. government.  Globally, headwinds include increased political unrest, the economic fallout from the tragic events in Japan and concerns over the stability of the European Union.

• Against this backdrop, we believe that quality U.S. companies with stable earnings remain a compelling investment.  The stocks of many of these businesses have been marked down along with the broader market in recent months, yet business performance, reflected in metrics including Returns on Equity and Returns on Invested Capital, remain consistently high.  These companies have benefited from durable business models supported by what we believe are sustainable competitive advantages.  While opportunities for growth in developed markets may remain challenged, these global businesses have diverse sources of revenues including plentiful exposure to faster growing emerging markets.  Ample free cash flows should be produced to support reinvestment in growth areas of their businesses, share buybacks, acquisitions where prudent and the return of cash to shareholders in the form of dividends.  

• The 3 most important things investors should have on their radar going into 2012:

• 1 thing we’re watching closely in 2012:

• Stock picks -- We’re taking a barbell approach in retail:

• A highly uncertain economic and political backdrop should make 2012 a challenging year for bond investors.

• Political uncertainty, and thus business risk, should remain elevated for 6 to 12 months after the presidential election in 2012.  We also expect European uncertainties to continue to add to volatility.

• Fed’s commitment to keep short term rates near 0% until June 2013 should continue to have an overarching impact on the short to intermediate part of the yield curve…keeping yields low!

• We continue to build our MBS position in 15 and 30 year conventional prime mortgages for a variety of reasons.  With interest rates expected to be range bound over the next 6 months, a dampening in interest rate volatility should help the MBS sector.  Second, the Fed has started to purchase roughly $25 billion monthly in MBS in its Operation Twist strategy.  This, along with the fact that MBS origination is low, should also help mortgages.  Third, it is our expectation that if there is a QE III, it will be centered on even more purchases of MBS.  Finally, MBS affords us the opportunity to diversify away from U.S. Treasuries and corporate securities while adding a yield we find attractive in the current environment.

• We are focused on adding corporate exposure in the 3 to 5 year part of the yield curve.   With the Fed on hold until June of 2013, we view the 3 to 5 year portion of the corporate yield curve as offering the most value during these uncertain times, especially as the 10 year U.S. Treasury is yielding roughly 2%.

• We also anticipate that the corporate sector will offer investors relative value in 2012 as global investors scramble to find yield.   Balance sheet restoration is well underway and stable credit profiles are expected to continue.  We especially favor the industrial sector of the corporate bond market, as the economy is expected to plug along and exports have continued to move higher.

• We have created a core allocation in the fund in names like Google, Microsoft, and Conoco Phillips. These companies are very highly rated, leaders in their field, have excellent balance sheets, and record levels of liquidity.  We also like companies at the lower end of the investment grade spectrum that have executed a global strategy well, have pricing power, and have a clean balance sheet and liquidity - YUM, Kraft, DTV - and companies that have very high levels of brand equity globally, that have demonstrated over multiple economic cycles that they can maintain pricing power: Hanes Brands, Harley Davidson, McCormick Spice are other holdings.

• We continue to be overweighed in healthcare REITS - names like HCP, HCN, BioMed Healthcare – that have continued to be one of the fastest expanding sectors in the U.S. economy. 

• The United States economy appears to be muddling along.  Recent data points indicate we are not headed for a double dip scenario - rail traffic continues to grow, and ISM and ISM non-manufacturing indices, while weak, are still in expansive territory.

• Consensus expectations for S&P 500 earnings for 2012 are $102 which puts the US market at a very reasonable 11.7x 2012 EPS. These estimates do not look overly optimistic given companies earned at a rate of $101 in the 3^rd quarter

• China and other emerging market countries, while slowing, are just at the beginning on an easing cycle, and will likely continue to be the engine of global growth.

• It appears that the late October plan to expand the European Financial Stability Facility is struggling, and more significant intervention in the form of fiscal union or substantial bond purchases from the ECB will be needed to keep the EU intact

• Regardless of the ultimate solution, Europe’s debt problems will be a secular headwind to growth for years to come

• Many investors believe that current corporate profits margins cannot be sustained – we are of the view that due to the benefits of globalization and supply chain efficiencies current margin levels will remain.  In fact, margins in the US hit another all-time high in the third quarter.

• We are optimistic about equity returns for 2012 given relatively strong corporate profits and reasonable valuations, although we believe markets are likely to remain volatile until European policy makers act more aggressively to stem the crisis

• We are finding opportunities amongst globally exposed companies that have been marked down to very reasonable valuations due to overestimated exposure to Europe. In particular we are finding such opportunities amongst select European cyclicals.

• We like mining equipment providers supplying equipment to miners supporting growing resources demand in Asia

• We also like companies along the smartphone value chain that will continue to benefit from the rapid growth in that industry

• We believe US growth will expand approximately 2 ¼-2 ½%  in 2012, which remains below the longer-term average.  Headwinds restricting growth include anemic job growth, consumer deleveraging / restrictive credit conditions, probable EU recession, and continued restructuring in state and local governments.

• We anticipate a continuation of several key fiscal initiatives as we enter an election year including the FICA tax break, extended unemployment insurance benefits, and AMT adjustments.

• We have low expectations for fiscal policy initiatives beyond the basic necessities highlighted above.

• Fed policy will likely remain accommodative and we may see a shift in the types of bonds purchased, but a new round of security purchases that would significantly expand the Fed’s balance sheet is unlikely.

•  Inflation is likely to remain contained though a resumption of commodity and energy price inflation is probable.

• We currently estimate S&P 500 operating earnings to reach $100-$102 in 2012.  This provides reasonable upside potential to equities if market volatility subsides.

• We expect bond yields to remain range-bound with the 10-year Treasury fluctuating between 1.90%-2.50%.

• A major wild card is the EU sovereign debt crisis but we are encouraged by the progress and creativity thus far.

• 2011 has been a transition year, as the global economy’s growth rate peaked for the cycle off the early 2009 trough. The global economy closes 2011 near the zero bound and will likely tip into recession during the 1^st half of 2012. The US and Europe are leading the recession, but formerly resilient economies like Australia are likely to participate in a global recession this cycle.

• Many investors appear to remain in denial about the burgeoning global recession, while the sovereign debt issues in Europe and wide spread policy intervention by central banks create a very challenging backdrop for investors. We expect the Federal Reserve to launch QE III and for it to take place for most of 2012. The European situation is likely to end with significant amounts of money printed once Germany decides what role it wants to take. Either Germany will stay and tolerate the ECB printing vast amounts of money, force countries like Greece to depart and print their own currency, or depart the euro and bring back the deutsche mark. Regardless, there is likely to be a lot of paper currency printed, whether it is drachmas, lira or euros.

• Significant quantitative easing by most major developed governments in the face of a global recession is our base case forecast, which creates a very challenging environment for investors. Declining economic growth in real terms will be fighting competitive currency devaluations under our base case scenario. This presents both challenges and opportunities for global macro strategies like ours. We expect currency market volatility to remain high as countries devalue their currencies. We also expect tactical hedging opportunities to continue to be available, as financial markets are whipsawed around by the push and pull between deteriorating real GDP trends and large scale monetary policy interventions.

• Where to invest in 2012:

o   Our highest conviction long idea for 2012, which we believe to be very overlooked, is gold and silver mining stocks. The stocks, as a group on average, are trading at a historical extreme discount relative to the metals. Mainstream earnings discount models at large Wall Street firms continue to use out year forecasts for gold and silver that are well below current prices – i.e. they expect gold to be $1,400 or lower in many cases. We believe the stocks will eventually be revalued higher based upon broader adoption of the expectation that gold and silver prices will remain high and possibly even move higher.

 

(c) SunStar Strategic

www.sunstarstrategic.com