Markets in 2012: Déjà vu or the Contrarian View?

Brett Hammond, Senior Economist

Brett HammondNow is an ideal time to review the previous year’s market movements and try to project what lies ahead in the coming year. Our view is that there won’t be dramatic changes in market performance from 2011 to 2012, although the unresolved debt situation in the eurozone injects uncertainty into all forecasts. Given the modest performance of stocks in recent years, investors may be inclined to stay on the sidelines or increase their allocations to bonds. However, contrarian investment strategies are often the most financially rewarding over the long term (just ask Warren Buffett), which is why some investors should consider buying stocks now, when prices are low, and hold them to realize potential long-term gains.

The starting point for any market discussion is the economic climate. We expect the U.S. economic growth rate in 2012 will be about 3%, which is better than last year, but still not great. While increased hiring in the private sector is underway, this is partially offset by contraction of public sector payrolls, with a net gain in December of about 200,000 new jobs (not enough to make much of a dent in overall unemployment). In the first 11 months of 2011, local governments eliminated 180,000 jobs and state governments 70,000, according to The Economist. At the federal level, the Pentagon’s recent announcement that it intends to reduce defense spending by $450 billion over 10 years could also have a negative impact on economic growth.

Key Drivers of Higher U.S. Growth

Yet, there are a few factors that could spark higher growth in the U.S. economy, including a comprehensive solution to the eurozone debt crisis; a U.S. federal government initiative focused on providing financial assistance to the states; or higher-than-expected growth in Asia (China and India, in particular), which would stimulate demand for U.S. goods and services.

On the other hand, there are also scenarios that could stifle U.S. economic growth such as: continued uncertainty in the eurozone and/or a collapse of the euro; austerity measures imposed by Washington; an economic downturn in Asia; or Iran shutting the Strait of Hormuz, which is the passageway for nearly 20% of the world’s oil.

In the U.S. markets, we expect that returns in fixed income will decline in 2012, with the exception of high-yield and emerging market bonds. Last year, Treasury bonds rallied, with an index of long-dated Treasuries rising nearly 30% (the index’s best performance since 1995). Even with lower returns, however, we believe Treasuries will still be viewed as a safe port in the storm in 2012, given the expected volatility in Europe.

On the equity side of the U.S. markets, we don’t see significant change ahead (the Dow was up 5% last year and the S&P 500 index was flat). U.S. companies will benefit from an improving U.S. economy, but will be hurt by difficult conditions for European-based revenues. Volatility will continue, reflecting uncertainty about Europe as well as lack of Washington economic policy leadership. We expect markets in the eurozone, which declined 15.7% in 2011, to perform somewhat better this year.

Among S&P 500 companies, overall earnings growth this year should be about the same as last year, though some sectors have a brighter outlook. Domestically focused companies should also perform a bit better, while multinationals will likely tick down, given the poor economic climate in Europe and the ripple effects throughout the world.

Look for moderately strong performance within sectors that produce steady cash flow, such as consumer staples and utilities, which have performed well even amid the economic slowdown. The retail sector’s outlook is less favorable, given consumers’ unease about spending, and the discretionary profile of products sold by retail-focused companies.

Getting the Housing Market off the Ground

In our view, single-family owned residential housing is another sector that may under-perform in 2012. While there has been some modest growth in the number of housing starts, the housing market is still hamstrung by the large number of mortgages that are underwater (meaning the home is worth less than the value of the mortgage) and the large number of homes that are sitting idle following foreclosure proceedings. With no comprehensive solutions being advanced from Washington to work through the backlog of these properties, residential construction will continue to be weak, as will the overall housing market.

The financial aspects of a weak housing market, increased capital and other regulatory requirements, and knock-on effects from Europe will continue to weigh on the financial services sector, limiting investors’ interest in many of these stocks.

Taking a Contrarian View

For investors, we believe 2012 is an opportunity to boost one’s exposure to equities. After a decade of being mostly beaten down, price-to-earnings ratios are low (this is the price of a stock divided by its earnings per share). U.S. stocks sell for 14 times earnings – the average over the past two decades for the S&P 500 index was 20. The truly contrarian position is to stay in stocks for the long term – riding out the inevitable volatility and resisting the popular temptation to try to time the market, jumping in and jumping out based on short-term movements.

Continuing with the contrarian theme, investors can find attractive opportunities in one segment of the real-estate market – multi-family housing. This market continues to perform well as home ownership is less affordable (and less appealing) for struggling consumers. That drives vacancy rates down and rents up – boosting the position of companies owning and operating multi-family housing units. Of course, multi-family housing should be seen as just one asset in a diversified portfolio. Like other real estate investments, multi-family housing is relatively illiquid. Other risks include rising or falling interest rates and dramatic changes in other macroeconomic conditions, such as unemployment rates. These can all affect the relative attractiveness of the asset class. With stocks unpopular, and thus available at historically low prices, we believe that a diversified allocation presents an opportunity for disciplined investors to achieve strong long-term gains.