Never test the depth of the water with both feet.
- African Proverb
After feasting on the U.S. stock market’s 54% run-up from 2009 to 2010, we starved for performance in 2011, suffering a 1% loss. Some said the markets were due for a respite, so this lull was healthy, but I felt we were lucky that results weren’t much worse, as they were outside the U.S., and that 2012 would be a disappointment.
I was wrong.
Stock markets both here and abroad had a good year in 2012. So is now the time to get back into the stock market? Are you ready to jump in with both feet?
I’m not.
Let’s take a close look at the details of what occurred in 2012 so we can assess the opportunities and prepare for the surprises that 2013 will bring. In particular, let’s look at momentum and reversal possibilities coming into 2013. I’ll give you my opinions, and you should form your own.
Here are a couple of facts worth noting about 2012. As discussed in my Q3 commentary, investors bailed from equity mutual funds, which should have depressed stock prices, but corporate-share buybacks more than offset this exodus. Also, much of the stock mutual fund redemptions found their way into stock ETFs, a move from active to passive management.
We should not forget the losses sustained in 2008. Despite popular perception, we have just now recovered 2008 losses; the 54% 2009-2010 gain did not offset the 38% loss in 2008. But 2012 has brought the U.S. stock market back into positive territory, with a 3% cumulative return for the five years 2008-2012. We’re above break-even.
I begin with a review of the lessons learned in 2012 around the globe and then extend the perspective to the longer-term history of U.S. markets over the past 87 years. My goal is to arm you for thoughtful investment decisions.
The year 2012 in review
I’ll review the year by analyzing what has worked and what has not. I begin with risk and reward for sectors and styles and then drill down further by examining the cross-sections of styles and sectors, using heat maps to identify trends.
U.S. stock market
I begin with an analysis of the risks and rewards in 2012, as shown in the following chart, and add my outlook for 2013. The total U.S. stock market returned 16% in 2012, matching the S&P 500’s return. In the following, I show total market results for 5,000 companies rather than just the S&P 500’s 500 companies.
Next I look at style-sector cross-sections to hone in on what is hot and what is not. The following heat map provides insights for both quantitative and fundamental investors. The cells show performance in 2012. For example, the cell in the upper left corner, reading 13.9%, says that large value (LGVL) stocks in the consumer staples (STAP) sector earned 13.9% in 2012.
Many quantitative managers employ momentum in their models. See the bibliography at the end of this commentary for articles that describe the exploitation of momentum effects. Fundamental managers use heat maps as clues to segments of the market that are worth exploring, for both momentum and reversals. A heat map shows shades of green for “good,” which in this case is good performance relative to the total market. By contrast, shades of red are bad, indicating underperformance. Yellow is neutral. The idea is to focus on the dark greens and dark reds for clues on momentum and reversals. Can we expect more of the same in 2013, or an inflection point?
As you can see, there are 81 cells of interest (either dark green or dark red), with key observations as follows:
I also examine the cross-sections of styles-sectors-countries in the following heat maps.
Key observations are as follows:
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Winners
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Losers
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Financial stocks in all styles and countries. Like the U.S., this is a reversal that I doubt will continue.
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Japan , especially energy and utilities, precipitated by their nuclear disaster. Despite the setbacks, the long suffering in Japan has positioned it as a value play – a bargain. See chart below. I expect better relative performance in 2013. .
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Smaller companies in the UK, especially financials and consumer discretionary. Market leadership is likely to turn to countries less affected by the economic crisis, like Australia, Latin America and Emerging Markets.
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Energy & Material stocks across the board. Infrastructure spending in 2013 will reverse this trend. I think infrastructure spending will increase.
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As in the U.S. analysis above, we can review the biggest, best and worst performing stocks in the EAFE index, as shown in the next table. Unlike the U.S., there are no clear sector patterns.
In the remainder of this report, I provide a longer term 87-year history of stocks, bonds, T-bills and inflation.
The 87-year history of the U.S. capital markets
The following table shows the history of risk and return for stocks (S&P 500), bonds (Citigroup high grade), T-bills and inflation. There are many lessons in this table, so it’s worth your time and effort to review these results. For example, here are a few of the lessons:
- T-bills paid less than inflation in 2012, earning 0.08% in a 1.43% inflationary environment. We paid the government to use their mattress.
- Bonds were more “efficient,” delivering more returns per unit of risk than stocks in the first 43 years, but they have been about as efficient in the most recent 44 years. The Sharpe ratio for bonds is .56 versus .38 for stocks in the first 43 years, but the Sharpe ratio for both is about the same in the more recent 44 years, at .25 for stocks and .29 for bonds.
- The past decade has been the second worst for stocks across the past eight consecutive 10-year periods. The decade 1963-1972 was slightly worse.
- Average inflation in the past 44 years has been about 2.5 times that of the previous 43 years: 1.65% in 1926-1968 versus 4.38% in 1969-2012.
- Long-term high-grade corporate bonds fared very well in the last three years, which is surprising in light of low interest rates. America has benefitted from confidence in the U.S. dollar, resulting in material decreases in interest rates. It’s a “Limbo” market: How low can you go? (The “Limbo” is a dance contest where participants attempt to pass below an extended pole that is progressively lowered.)
Market History For Periods Ending December
Additional perspective is provided by the following histograms of stock and bond returns.
87 Year Return History of Long-Term Corporate Bonds 1926-2012
Appendix: Articles on Momentum Investing
- George, Thomas and Hwang, Chuan-Yang. The 52-Week High and Momentum Investing. The Journal of Finance • vol. lix, no. 5 • October 2004 Link1
- Sapp, Travis and Tiwari, Ashish . Does Stock Return Momentum Explain the “Smart Money” Effect? Article first published online: 27 Nov 2005 Link2
- Wikipedia. Momentum InvestingLink3
Ronald Surz is President of PPCA Inc. and its Target Date Solutions subsidiary, both in San Clemente, CA. He is also Vice President of eVestment in Marietta, GA. Ron can be reached at (949)488-8339 or [email protected]. Comments welcome.
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