Q4 2011 Summary and 2012 Outlook

I know, I know, I have been quiet.  But for good reason.  The market is behaving like a roller coaster and investors have indigestion from the volatility.  Talking heads only add to it.  My September 12, 2011 call for a significant easing off the investment accelerator pedal has felt right, wrong and anywhere in-between so many times I should feel dizzy.  That day I said “The market may be giving a signal that a sharp drop is ahead and risky assets could drop 1.5-3x more than the broad market.”  We have had three valleys, two peaks and lots of up and down in little more than three months.  Europe and the global banks underperformed at first, but are now outperforming other sectors and countries.  One bright spot has been my gold call: “Another theory is that gold is reflecting future relative dollar strength to a basket of global currencies.  Either way, it probably makes sense to get out of its way.”  Avoiding it or being short one of the gold ETFs has been profitable and offset pain elsewhere.  The issue at hand is what to do now and we shall get to that.

While the broad US stock market will end 2011 darn near flat to up a little, most investments that outperformed in the bounce since the bear market bottom performed poorly.  Emerging markets and developed markets outside the US fell 15-20%. Europe and its euro currency were the worst offenders.  Technology stocks lagged the broad market.  The volatility since August has been so potent I heard a man in his sixties complain about it to a clerk at my local grocery store.  Buy and hold investors with a mostly US-focused portfolio have done just fine so far, but the traders among us are just about ready to throw up.  Hedge funds are feeling the pain the most as they are whipsawed from low to high, to subsequent low, to the next high.  They are at the mercy of psychology and trend-following no less than the average investor/trader.

If you followed my advice, you should have ~25% cash to burn at this point.  Stop day trading (you know who you are) and add a bit to those broad, large and small cap US index funds you own and keep your now reduced exposure to emerging markets and non-US developed markets in case a bounce happens.  As I said in September, “Poor stock market performance in the fourth year of a President’s term is rare as can be.”  Please don’t think for a second the volatility is over.  A plausible scenario for 2012 is a W shaped year with one or two shocks causing steep drops in the first and second quarters, followed by a nice rally into the election and an overall 10-20% S&P 500 return.  I expect the market to trick us into believing 2012 is like awful 2008, an anomaly for a fourth year in the election cycle, at least a few times in the near future.  But 2012 will buck the trend because stocks hate the uncertainty that goes along with legislation which creates winners and losers.  Losers hate losing more than winners like winning – this keeps stocks from rising when the prospect of big legislative change is at hand.  Election years like 2012 yield little in the way of change and President Obama has no real competition at this point.  Regardless of your political leanings, Romney is no more a contender for President than John Kerry two elections ago. Fourth years for lame ducks are even better historically.  There is good reason to believe Obama is essentially a  lame duck to his own second term, especially if you watched the Republican debates so far.

Europe could throw a monkey wrench into our plans for a good year and help create a W chart, but the US should continue to do better than foreign markets if for no other reason than the strength of the US Dollar.  Our economy is also recovering nicely from the recession, but not fantastically.  Beating expectations is a win even if your wallet doesn’t feel as high and mighty as it did in 2005-06.  Hedge funders like SAC Capital are even betting on a real estate stock rebound in 2012 which seems a tad premature.  Tech stocks should gain leadership once again as risk appetites return, but don’t bet on that in the first half of next year.  A strengthening USD should keep gold prices falling as speculators exit their long-held positions to lock in profits.  If some brainy solution to European banks’ sovereign debt problems arises out of the blue, we could see things reverse with the US lagging again and gold moving up.  Until then, maintain an 80-90% allocation to stocks with the remainder short gold or in cash.

Good Luck and Happy New Year!!!