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2011 Year In Review: Economy & Markets

January 6, 2012

(Reprinted from the February 2012 edition of the Bath Country Journal.)

by Kevin Kroskey, CFP, MBA

Major World Indices Ranked

Investors entered 2011 with hopes that the world economy would continue recovering from a long and painful deleveraging process. Equity markets had posted two straight years of positive performance, central banks remained committed to pro-growth monetary policy, and major developed nations were focused on reducing debt.

By mid-year, however, optimism faded as troubling events around the world dominated headlines. The devastating earthquake and tsunami in Japan, political unrest in the Middle East, rising oil prices, a US credit downgrade, and an escalating debt crisis in Europe weighed heavily on markets. As stock market volatility returned to global financial crisis levels, investors faced a major test to their discipline.

Economic signals continued to be mixed in 2011. Favorable US news included strong corporate profits and dividends, substantial levels of cash on corporate balance sheets, and low interest rates and inflation. Pessimists could point to the longstanding jobless trend, slumping home prices, worrisome levels of government debt, and political gridlock.

Although emerging economies showed resilience, investors were concerned that another recession in Europe would impact its trading partners in emerging economies—and particularly in China, where high inflation and a manufacturing slowdown threatened to send its previously fast-growing economy into recession.

Investment Overview

Most global equity investors experienced negative returns in 2011, and investors in US equities had to endure a heavy dose of uncertainty for their modest gains. The S&P 500 returned 2.11% for the year and reflected this volatility by closing up or down over 2% on thirty-five days in 2011, compared to twenty-two days in 2010. By contrast, the index did not have a single day with a 2% or more movement in 2005, and only two days in 2006.

Higher correlations among individual stocks and between asset classes can also be observed. In 2011, there were sixty-nine days in which 90% of the S&P 500 stocks moved in the same direction, which is more than the combined total for 2008 and 2009. Higher correlations are common during periods of uncertainty, as macroeconomic forces overshadow the impact of a company’s business fundamentals on its stock price.

Despite strong returns in the fourth quarter, developed and emerging markets logged negative returns, with forty of the forty-five countries posting losses. Developed international markets, represented by the MSCI World ex-USA Index, returned ­12.2% and the MSCI Emerging Markets Index returned ­18.4% for the year.

The US dollar fluctuated but finished about 3% above where it started against most developed-market currencies. It sharply appreciated against the main emerging market currencies. This relative strength negatively impacted dollar-denominated returns of emerging market equities. The euro remained stable during the year even as analysts began predicting the dissolution of the currency zone.

Large caps generally outperformed small caps around the world. Value stocks underperformed growth stocks in the US, but mostly outperformed growth among emerging markets and had mixed results in developed markets. Longer term government securities including Treasury Inflation Protected Securities performed exceptionally well in the fixed income arena.  Real estate securities in the US had strong positive returns and international REITs had sharply negative returns but still managed to have good performance relative to other international asset classes.

Prudent, globally-diversified investors must remember that portfolio results may have underperformed the more commonly reported S&P 500 and Dow Jones Industrial Average, since these were the top performing equity asset classes in 2011. As Nobel Laureate Merton Miller was famously quoted, “Diversification is your buddy.” Forsaking it is not a wise decision and being cognizant of its effects—pro and con—is necessary.

Looking Forward

Jeremy Siegel who is one of the most credible of financial academics recently commented, “The equity premium today, which is the difference in expected return on stocks and bonds, is more than twice its historical average. The historical average has been 3% to 4%, and right now the expected return on stocks after inflation is around 8%. For bonds, returns are about zero for the 10-year.”

While nobody knows the forthcoming twists and turns of the markets or the timing of them, it is very unlikely that bonds will outperform stocks over the next decade. These expectations need to be incorporated into portfolio allocations while being careful to manage overall risk and volatility.

 

Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs. Prior columns can be obtained by visiting www.TrueWealthDesign.com/bathjournal

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