Q4 2011

Risk aversion was the driver of positive investment performance in 2011 with the Barclay’s Bond Aggregate (the broadest fixed income index) returning 5.6%.  The S&P 500 index returned 2.1% with dividend payments comprising the entire return for the year.  The best performing sectors were Utilities (14.9%), Consumer Staples (10.5%) and Health Care (10.2%).  There was a wide dispersion of sector performance in 2011 with Financials and Materials losing 18.4% and 11.6% respectively.  Avoiding companies that employ leverage and have historically erratic earnings was the key to a better than average return for the year.1

The 10 year Treasury note started 2012 with the lowest yield on record for the last 130 years.  To put this in historical perspective, 130 years encompasses two world wars and the Great Depression.  The question to ask as an intelligent investor must be, “Why would someone be willing to accept less than a 2% annual return every year for the next 10 years?  Are the alternatives really that bad and is the investment landscape really that bleak?”  The only reasonable conclusion is that fear is the strongest force driving investment decisions today.2

The European Monetary Union was put to the test in 2011 and barely managed to hold together with Greece and Italy tottering on the verge of default while Germany and France tried to improvise solutions ad hoc.  The outcome of the European Union fiasco is unknown and far from being resolved.  The only credible long-term solutions involve a common Euro bond or a debt restructuring by Greece, Italy and perhaps all of the more indebted members of the currency union.  Europe serves as a cautionary tale to any nation that voluntarily gives up its currency sovereignty; only agree to do so if your debts are assumed or forgiven.

The United States economy moves into 2012 with a number of positive economic trends that should bolster growth (albeit at an anemic pace) should they continue.  The private sector is hiring again, consumer spending is rebounding and the housing market seems to be finding a bottom in terms of price declines.  Corporate earnings gained another 16% year over year on top of the 40% gains in 2010, leaving corporate balance sheets with a wide moat of liquidity. 3 The biggest financial institutions in the U.S. will continue to be hamstrung by their size and by a lack of trust, providing us with a continued reason to avoid owning the common stocks of those companies.  In contrast, the resiliency of the highest quality stocks is nothing short of amazing considering all the factors that were working against them in 2011.  Valuations were compressed despite a double-digit increase in earnings and dividends, largely due to market participants shifting billions of dollars from their equity mutual funds into fixed income.  As the venerable Jim Grant recently observed, “Mr. Market has a tendency to switch the labels on the risky and safe assets when no one is paying attention.” 4

Sources:  1 – Standard & Poor’s: standardandpoors.com, 2 – United States Treasury: ustreas.gov, 3 – U.S. Bureau of Economic Analysis: bea.gov, 4 – Grant’s Interest Rate Observer: grantspub.com

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