The New Year is already here!  And this time around I've somehow managed to complete my annual musings before February!  Let's get right into it, as I'm much more excited about 2012's outlook than I was about 2011's.

Overview

2011 was characterized by the dichotomy of strong corporate profits alongside disappointing US economic growth.  Our forecast failed to anticipate the four biggest events of the year: the Japanese Tsunami, the Arab Spring, the European Sovereign Debt crisis, as well as US Treasury yields dropping to all time lows.  We did however get some of the little stuff right…

We forecast a 2011 stock market range on the S&P of 1100 to 1350.  This proved to be bang on.  Given my expectation of volatility, I did not target a specific number for year end, but the average of our range was 1225; a bit low, but a lot closer than consensus forecasts above 1400.  Pending final numbers, it appears real US GDP only grew about 2% (as we forecast vs. a consensus outlook of 3.5%) while inflation rose 3-3.5% (as we forecast vs. consensus projections below 2%).  We were premature in expecting a serious break in gold prices, which did not occur until fall.  My prediction that Gold prices would fall below the level of the S&P 500 appears to still be a few months off.

In some ways, 2012 is likely to provide a mirror image of 2011.  Profits are likely to disappoint despite a big improvement in US economic growth.  In a world where the market reacts fast and violently, none of us can wait for me to flesh out all the important details.  Here’s a quick summary of what I expect in 2012: 

Although strong US economic numbers dispelled some of the prevailing gloom at year end, it appears much of the recent improvement may be due to what has (so far) been unseasonable mild winter weather.

THE GLOBAL ECONOMIC OUTLOOK

Europe...

...Is in recession and will remain so for some time while the Euro zone addresses complex fiscal and sovereignty issues.  However, they will ultimately fix them, as it is in their interest to do so, and in aggregate they have the wherewithal.  At the risk of oversimplifying, financial disasters have two key components, liquidity and solvency.  Crises are always the result of a shortage of liquidity; i.e. when current obligations exceed cash on hand.  Ending or preventing crises requires the debtor’s ability to quickly and sufficiently obtain cash to pay the obligations.  In the case of governments and banking systems, crisis alleviation depends on having available both funding mechanisms and a political will to use them.  In October we pondered that, “the upcoming European summit meeting will put on a few more band-aids, fix some small portion of the problem, and kick the can down the road”. Since then the ECB has arranged a very big band-aid: 3 year low interest loans to European banks upon request.   These loans radically reduce the risk of a near term liquidity event in Europe.

Once a crisis is averted, the longer-term question is one of solvency; do the assets of the debtor exceed the liabilities?  In the case of governments, assets include their ability to generate tax revenue.  When the assets are insufficient, (think Fannie Mae, GM, AIG and Greece) creditors will suffer a loss unless someone else bails them out.  Contrary to popular perception, the US bailout a couple years ago hardly bailed out the owners of banks (stockholders of Citi, BofA, GM, and AIG got crushed) but actually bailed out the creditors (i.e. Goldman Sachs and pension funds) as well as senior management.  

Although Greece is insolvent, and rising interest costs may drag Italy to the brink, the European Union as a whole is actually more solvent than the US.  Total European debt is less than 80% of GDP vs. 100% in the US.  The key difference between these two economies is that European debtors owe the majority of the debt to European creditors.  Any sacrifice suffered by one results in a benefit to the other.  They are arguing over how to divide up the pie, but governments from Athens to Zurich (I know Switzerland isn’t in the EU) also realize the only way everyone loses is if delay destroys the pie.  Europe is in recession but the Euro will survive.  Most likely even Greece will remain as part of the Euro zone.  Clearly the adjustment in Greece would be easier if they had their own currency, but they don’t.  At this point in time the only thing worse than remaining in the Euro for Greece would be the destruction of the Greek banking system that would result from conversion back to the Drachma.

China and Emerging Markets

These economies will slow significantly and some (like India) will also fall into recession.  They are very leveraged to global growth and therefore a lot more vulnerable to recession than is currently appreciated.

The United States

The US will enjoy a temporary return to its role as the locomotive of the global economy.  The US banking system is once again functional; Fed policy remains accommodative; the housing recovery will emerge; and despite some reduction in exports, unemployment will fall faster than anyone expects.  This fantasy can continue to play out as long as the rest of the world is willing to loan us money at ridiculously low interest rates.  The massive overhang of debt will impair US growth for many years to come.  It will not however prevent the US economy from growing much faster in 2012 than it did in 2011.  I expect 2012 real GDP to grow faster than 3% despite the drag of a global slowdown.  Although pundits argue the recent decline in the unemployment rate is based primarily on discouraged would-be workers dropping out of the labor force, I believe these fears are overstated.  I suspect we will discover most of those dropouts are laid off government workers who collected unemployment until those benefits ran out then applied for their pensions.   The combination of aging baby boomers and declining immigration is creating a permanent reduction in the work force.  Private sector boomers may be working longer than they planned a few years ago, but the number retiring will continue to increase every year for the next decade.  US unemployment will drop more than anyone expects in 2012 (to 7.5%).  Although not a problem for the next year or two, demand for a shrinking work force will create upward pressure on wages and downward pressure on corporate profit margins for years.

For the last couple of years the major bright spots in the US economy were the rapid growth in exports and soaring profits generated by foreign subsidiaries of US corporations, both enhanced by the declining value of the US dollar.  It’s time to kiss those days goodbye.  The world outside of the US is sinking into recession.  No other outcome is possible in Europe.  Even China appears at risk.  Chinese growth has slowed in response to efforts by the central bank to control inflation and end the property bubble.  Official statistics indicate reduced inflation, but many analysts argue that actual inflation in China is almost double the official rate.  The big problems are the shadow banking system and the overdependence on massive, politically-driven Chinese construction projects that are unrelated to actual demand.  Some argue that the Chinese bubble is about to burst, but China’s massive accumulation of foreign reserves should enable the government to provide a cushion against the most negative effects.  At least so far, Japan has resisted the massive inflation that will be ultimately required to deal with their government debt.  The developing world is heavily dependent on exports to growing major economies.   It is hard to envision how a best-case scenario of slow growth in the US, UK, and Japan can overcome the combined negative effects of a Chinese slowdown and a European recession on global growth.   The risk of course is that the global slowdown tips the others back into recession.

THE INVESTMENT OUTLOOK

Currencies

Investment dollars will flow into the US in response to the improved US economic growth, contrasted with diminished growth prospects elsewhere.  This will push the US dollar higher.  An appreciating dollar will suppress inflation, exports, commodity prices and US corporate profits.  Conversely it will increase P/E ratios, consumer purchasing power, and overseas investment opportunities.

Bonds and Interest Rates

I have been very wrong about the direction of interest rates and US TBond prices for the last two years. That won’t stop me from once again predicting a sharp rise in long-term rates by the end of 2012.  The TBond market is poised for disaster over the next few years.  The improving economy and the prospect of re-emergent inflation will set the stage for a less accommodative Fed once the election passes and we head into 2013.  Indeed, once the Fed begins to act, their response will likely be swift and violent.  The only safe place in the bond market remains High Yield and Bank Loan funds (like Fidelity’s FFRHX – the largest position in our managed portfolios for the last few years). Despite falling interest rates that resulted in a disappointing 2011, FFRHX still gained almost 2%.  High quality municipal bonds now appear secure but only if you plan on holding them to maturity.  The same cannot be said of muni-bond funds that may be forced to sell bonds prior to maturity due to investor redemptions. 

Commodities

Unlike a year ago, when the global economy was still expanding, the global economic growth, excluding the US, is now clearly slowing.  While it is theoretically possible that stronger US growth will take up some of the slack, the increased purchasing power of the dollar will offset much of the potential price gain from that source.  This trend, which began before mid-year 2011, will resume later in 2012.  A critical element of commodity prices is the rapidly expanding glut of petroleum. For the first time in over 60 years, the US is not only a net exporter of energy, but also a net exporter of petroleum products thanks to shale-sourced oil & gas.  To some degree the long term potential for glut is mitigated by new aversion to nuclear power following the Japanese disaster.  In the short-term there is some risk that the uncertainty created by the recent uprisings in North Africa and the Middle East may cause energy prices to spike early in the year.  However over the next decade any rise in energy prices will be severely constrained.   This biggest risk of a sharp rise in commodity prices comes from a weather related shortage in agricultural commodities.  That development would aggravate what I expect to be a shocking slowdown in the Chinese economy.  The central bank of China may have no choice but to resume printing money even as stagflation grips their economy.

Similarly, gold prices, which remained disconnected from the emerging bear market in commodities until September, have now entered a bear market of their own.  After the recent 20% decline from $1900/oz to near $1550/oz, a bear market rally to around $1700s/oz. appears likely.  I suspect this recovery will be a prelude to further decline to at least $1400.  This forecast directly contrasts a recent Bloomberg poll of traders who on average expect gold prices to rise above $2100 in 2012.

US Inflation

Despite an uptick in 2011 (that we predicted almost exactly) and fears generated by the actions of the Federal Reserve, US consumer price inflation has not taken off.  Barring a simultaneous weather related spike in agricultural prices combined with a new oil crisis in the Middle East, consumer price inflation is likely to moderate in 2012.   It appears the Fed may be (at least temporarily) on the verge of success in shifting inflation from consumer to asset prices.  I expect US CPI to drop back around 2% this year, while home prices move higher and stocks soar.

Home Prices

For the last couple of years my forecasts of flat housing prices appeared pessimistic compared to a general consensus of moderate recovery.  In retrospect my forecasts proved to be optimistic.  After years of over-optimism, the consensus has been beaten down and now at best expects prices to bottom, with most observers expecting further declines.  At the risk of once again being premature, I expect housing prices to begin to recover in 2012.  The combination of price cuts, low mortgage rates and rising rents make the case for affordability compelling.  Years of minimal homebuilding have largely offset the still large but shrinking inventory of properties in various states of foreclosure.  As prices rise (even a little) negative equity will be reduced, shrinking the potential shadow inventory of foreclosures.  Mortgage rates are now so low that affordability will remain high even as rates move higher.  Furthermore, a growing US economy will generate more jobs in 2012 than it did last year, increasing fundamental demand.  The demographics of an aging baby-boom population remain a long-term impediment to the market in single family homes, but it will take higher prices to draw that inventory out so it should not be a big problem this year.  Don’t plan on home prices to rise fast enough to start a new career flipping houses; the gains will build gradually over time.  This is however an opportunity to add the benefit of leverage with low cost financing to the solid returns of an already positive cash flow.  The most attractive investment opportunities appear to be in the townhouse and condominium markets.  This is the result of extremely depressed prices combined with very favourable demographics trends.  Those of us living in McMansions will only participate minimally in any recovery.

The US Stock Market

The stock market rally that developed in the last quarter of 2011 is likely to continue into early January.  Recent US economic reports have contributed to market optimism, but they are still on shaky ground. From where I sit, the glass is already half full and still filling… although I expect it to spring a few leaks before the investing world figures that out.  Let’s look at those leaks before getting into why I am optimistic about US stocks in 2012:

It is disturbing that the gains in domestic economic activity have reflected a falling savings rate rather than rising incomes.  Unless incomes start to keep pace with spending, these gains are not sustainable.  The good news though is that recent payroll data do suggest income gains are on the way.  I suspect a lot of recent consumer spending has been driven by unseasonably favourable weather from what (so far) has been the driest winter in 140 years, so retail sales may slow significantly when winter arrives.

Recent economic improvement and stock market gains reflect the re-emergence of consumer confidence and investor optimism.  At the end of summer, investor fears presaged an inevitable stock market rally.  For the last four months those fears were progressively reduced to mild scepticism as the market climbed the proverbial wall of worry.  Although not as bullish as last spring, investor sentiment has now turned positive, making stock prices vulnerable to a correction for the first time in months.  That vulnerability is appearing just at the moment when stock prices are facing a very big challenge.  Corporate profit margins are at record levels and are poised to disappoint.  US corporate tax collections fell in 2011, despite double digit gains in corporate profits.  Over 50% of S&P profits are generated outside the US; but the tax data implies that 100% of the increase in 2011 corporate profits may have been generated outside the US.   The emerging global slowdown will end that growth, and may even lead to a reduction in non-US profits.  The rising value of the dollar will amplify those effects.  These profit disappointments are likely to create a temporary (5-10%) correction in stock prices early in the year, before other more bullish factors overwhelm them.  Growing or even sustaining current profit levels will depend entirely on the US economic recovery.  The temporary shift toward US-centric growth will not only increase US employment, but will also raise US tax revenues. 

Given these headwinds to profit growth, readers will probably be shocked that I expect US stock prices to rise above the highs of last April (S&P 1363) in 2012 with a very real possibility of hitting new all time highs.  Last year, Bloomberg’s analyst consensus forecasted the S&P to end the year around 1400.  This year that forecast has been reduced to 1350.  The Wall Street Journal just published the 2012 year end consensus target at 1344. Like last year, I am reluctant to specify an exact year end target although the market did end close to the middle of our forecast range.  This year I expect the S&P 500 to range between 1150 to 1500. But unlike 2011, the S&P should end the year near the high end of the range.  Although I have capped the range at 1500, I would not be shocked if US stock prices reach a new all time high (pushing through 2007’s 1565) in 2012.

The core of my optimistic outlook is built on the expectation of disproportionate gains in the financial sector (which was one of the worst performers last year).  Banks will benefit tremendously from even a small improvement in home prices.  Those gains will allow US banks to reduce their reserves for loan losses, which in turn will bolster reported profits well beyond any actual gains.  Furthermore, the contraction of the European banking system will create an unprecedented lending opportunity for the well-capitalized US banking system.  Increased bank profits translate into higher capital ratios for banks, increasing their lending capacity.  US banks already started to offer more aggressive terms for commercial lending in 2011.  The combination of growing capital and low money costs will accelerate that trend in 2012.  The excess cash available for loans will even begin to spill over into slightly less restrictive terms on real estate lending.  The result is likely to be a virtuous circle of increased lending, rising asset values, an improving domestic economy, higher tax revenues, etc, etc, etc.   For the past few years, investors have conducted a massive reallocation of capital out of stocks into bond and money market funds.  As real estate and stock prices improve, while government deficits diminish, bond investors will grow impatient with returns locked in near zero.   Given the relatively low volume of stock trading, even a modest reallocation out of bonds into stocks will drive prices dramatically higher.  This is likely to create a bandwagon effect driving stock prices even higher.   

In the end, these stock market gains will be the unsustainable stepchild of rising investor optimism driving the price/earning ratios of stocks higher.   While low volume exaggerates the price effect of any movement in or out of the market, the demographic effect of retiring baby boomers will limit the amount of money that ultimately shifts out of bonds into stocks.    Furthermore the fleeting gains that I anticipate in 2012 are not likely to supported by long-term earnings growth as payroll gains recapture a bigger portion of GDP from corporate profits.  Ultimately this sets us up for a major market correction.  That unhappy story is inevitable, but it is a story for 2013 not 2012.

...

Recently at a forecasting breakfast, the keynote speaker (a very reputable economist) made a few remarks about the "experts" on CNBC who show up monthly or even weekly with predictions and no one ever checks their track record.  He said jokingly, "the great thing about being an economist is that no one ever checks your work."  One of the reasons I force myself through the process of these annual forecasts is that it forces me to check my work.  Especially in a year like 2011, where the market swung violently up and down, it is vitally important to be able to step back and assess the big picture.  Above I have outlined the big picture as I see it, and this provides the framework for our strategic plan.  Of course, we never invest according to an arbitrary 1-year time horizon, and we daily try to assess how the landscape has changed and tactically adjust accordingly.  Let's hope I get it mostly right again this year, as I am excited to enter 2012!

Clyde Kendzierski