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Investment Resolutions for 2012

2011 was a year of volatile markets which produced an unchanged S&P 500 and a 5.5 percent gain in the Dow Jones Industrial Average.  While equities experienced a roller coaster ride, US government bonds maintained their upward momentum from 2010.  Both the 10-year and 30-year US Treasuries appreciated by close to 25 percent over the past year as European turmoil caused investors to continue to flock to the safety of Treasury bonds.  Gold, on fears of both inflation and deflation, rose by approximately 11 percent, and West Texas Intermediate crude oil rose close to 7 percent to over $100 per barrel.[i]  Worldwide, stocks lost 5 percent while bonds returned 5.5 percent judging by two benchmarks, the MSCI World Index and Barclays Capital Global Aggregate Float Adjusted bond index.[ii]  As a result, the U.S. markets were some of the best performing financial markets in the world in 2011.  Despite this outperformance, many retail investors became disenchanted with the constant volatility in U.S. stocks.  Yet, with the European and US fiscal crises unresolved, with slowing growth in China, and with problems brewing in the Middle East with Iran, 2012 appears to be another year that is poised to be driven by macroeconomic and political events.  In spite of the apparent uncertainty, there are a few resolutions that each person should attempt to maintain in the new year.

I will continue to invest the majority of my portfolio in the United States.

The U.S.’ federal gross debt recently passed 100 percent of GDP.  Partisan gridlock remains a major problem in Washington.  GDP growth is forecast to only be approximately 2.5 percent in the first quarter of the year.  Despite these worries, the U.S. remains the best place in which to invest.  According to the Federal Reserve, household debt has fallen in 13 consecutive quarters and corporations hold record levels of cash with which they can use to withstand any exogenous shocks to the economy, to hire new employees, or to increase their capital expenditures[iii].  Secondly, the US dollar Index, which tracks the value of the dollar against a broad basket of other currencies, including the euro and the yen, rose by 1.3 percent in 2011.[iv]  This was the second consecutive year that the index’s return was positive as investors continued to look towards the safety of the U.S. dollar and U.S. Treasuries during these volatile times.  Finally, the S&P 500 Index trades at 14.98 times trailing twelve-month earnings.  Although this is higher than the P/E ratio of the European stock market, the S&P 500 is cheaper than the 20 times earnings that it traded at over the past two decades.  Moreover, the U.S. should probably remain the best option for investors looking for shelter from Europe.  A recession in Europe will affect the U.S. though: in 2010 22.5 percent, or $412 billion worth, of U.S. exports in goods and services went to the European Union.[v]  Also, during the stock markets downturns of 2011 the correlation between all stocks neared 100 percent, i.e. when the European stock markets declined the U.S. stock market declined as well.  However, the European stock markets declines were larger, and therefore the S&P 500 outperformed every country’s stock market in the Euro Zone besides Ireland.  In an interview in November, Warren Buffett commented on the prospect of selling stock if further problems in Europe occur: “If you own a good business locally in Omaha and somebody says Italy's got problems tomorrow, do you sell your—do you sell your business? Do you sell your apartment house? No. But for some reason, people think if they own wonderful businesses indirectly through stocks, they've got to make a decision every five minutes…I'm going to own those businesses for years just like I would own a farm or an apartment house and they'll be all kinds of events and there'll be all kinds of uncertainties and in the end, what will really count is how that business or farm or apartment house does over the years...and I can't time the buying and selling of it.”[vi] Furthermore, concerns regarding the effect of a European slowdown caused the stock markets in many emerging markets, including China and Brazil, to decline significantly in 2011.  Since a large portion of China and Brazil’s exports flow to Europe and since their exports account for a higher percentage of their economies, these emerging markets are more susceptible to a recession in Europe.  As a result, the United States may be one of the safer places to continue to invest in 2012.

I will keep a small portion of my portfolio in cash.

During the past year the Dow Jones Industrial Average passed the 12000 mark 25 times.  Similarly, the S&P 500 was range bound

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throughout the year and ended only 0.04 percent from where it started the year.  The stock market appeared to play Jekll and Hyde for much of the year.  In the third quarter it dropped 14 percent, but in the fourth quarter it rose 11 percent.  As was the case for much of the past decade, it paid off to have some cash set aside for times during which the financial markets were falling.  This plays into Warren Buffett’s main motto of “Be greedy when others are fearful.”  History tells us that corrections (declines of 10 percent or more) occur every couple of years, and bear markets (declines of 20 percent or more) occur every 5-6 years.  Severe bear markets (declines of 30 percent of more) have occurred 7 times since the the 1929-1932 stock market plummet.  In Peter Lynch’s 1990 Bestseller Beating the Street, he wrote: “If you had the courage to add another $1000 every time the market dropped 10 percent or more (this had happened 31 times in 52 years), your $83,000 investment would now be worth $6,295,000.”[viii]  Consequently, it helps to have some cash – about 3-5 percent of your portfolio - on the sidelines in order to take advantage of the times when hiccups occur in the markets.  By sticking to a disciplined approach, such as investing $1000 every time the overall stock market declined by 10 percent, this eliminates the difficulty of making a judgment call about the relative value of the stock market.  Over the short term, the stock market might continue to fall and cause unrealized losses, but in the long term this strategy has historically been a successful way to use any short term dips in your favor.         

I will decrease my reliance on US Treasury bonds.

Over the past couple of years, a popular prediction in the investment world has been that the Federal Reserve’s easy monetary policies will cause investors to demand higher interest rates on Treasuries because of increased inflationary expectations.  This trade has been the undoing of a number of hedge funds and investment firms as they chose to bet against Treasuries.  In contrast, the 10-year Treasury and the 30-year Treasury rallied by 25 percent, in part caused by the Federal Reserve’s announcement that it would keep the Fed Funds rate close to 0 percent until at least mid-2013.  As a result, the yield on the 10-year Treasury is at 1.89 percent, lower than the 2.2 percent inflation rate calculated by the Bureau of Labor Statistics for the month of November.[ix]  Therefore, the inflation-adjusted yield on all Treasuries, except for the 30-year Treasury bond, is currently negative.[x]  Despite the 30-year Treasury currently yielding a positive real rate, the duration on the bond is 19.34.[xi]  This means that if the interest rate on the 30-year Treasury rises by one percent, then an investor would lose 19.34 percent of his investment.  With interest rates currently at historic lows, an investor would be playing with fire if he or she invested any significant amount of money in Treasuries.  Instead, investors may want to consider filling out their fixed-income portion of their portfolios with individual investment grade corporate bonds or an index that tracks the performance of high-yield bonds.  For many highly rated investment grade securities, their bonds, similar to Treasuries, have been bid up to historic levels, and as a result their yields are at historic lows.  For example, as of January 2012 there are four companies that Standard & Poor’s rates as AAA: Automatic Data Processing, Exxon Mobil, Johnson & Johnson, and Microsoft.  All of Johnson & Johnson’s bonds that mature within the next 10 years all yield less than 3 percent.[xii]  Even Google, which sits on almost $40 billion in cash, issued approximately $3 billion worth of bonds in 2011 to take advantage of the low corporate interest rates.  The value in corporate bonds now lies in those bonds that are rated below the top ratings.  This means bonds rated A and BBB by S&P.  In this area, investors can discover companies with solid cash flows, but with their bonds still yielding approximately 5-6 percent.  Second, investors should wade into an index that tracks the performance of high-yield bonds.  By buying an index that holds a basket of high yield bonds, this provides the investor with diversification in case any of the corporations default on their bonds.  Currently, the default rate for companies whose bonds are rated lower than investment grade (i.e. junk bonds) is less than one percent.  The historic default rate on junk bonds is over 5 percent.[xiii]  Typically, this would suggest that the spread between the yields on junk bonds and Treasuries are severely tightening.  Instead, this has not been the case.

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As demonstrated by the chart above, the spread between the 10-year Treasury bond and the average junk bond is over 600 basis points (6 percent) because jitters over Europe continue to avert the attention of investors away from the underlying fundamentals.  As a result, investors can continue to receive high yields from junk bonds despite the underlying companies performing well – or at least not defaulting on their debt - in the current economic environment.

I will rebalance my portfolio at the appropriate time to make sure that it does not contain only stocks at their 52-week highs.   

Over the past two decades various academic studies have attempted to examine the correlation between past stock performances and future stock performances.  From the studies a common conclusion generated regarding stocks that have just hit their 52-week high was that there was a positive serial correlation between recent past performance and the next 6-month future performance of a stock and a negative serial correlation between recent past performance and the 6-18 month future performance of a stock.[xv]  Translation: a stock that had just reached its 52-week high historically has appreciated in value over the following 6 months, but then declined in value between the following 6 and 18 months.  In order to adequately receive the benefits of both momentum stocks (those stocks trading near 52-week highs) and value stocks (those stocks not trading near 52-week highs and trading at low multiples relative to their earnings), an investor should routinely monitor his or her portfolio in order to obtain a satisfactory balance between the two types of stocks.  In this way, investors can be hedged in case the historical performance of momentum and value stocks breaks down (unless of course both types of stocks fall in tandem as was the case in 2008  Yet, investors can also take solace in one other fact: in the past nine years, the total return, including the reinvestment of dividends, of the S&P 500 was positive in eight of those years).

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As the chart above indicates, healthcare, utilities, and consumer staples were the best performing sectors of 2011, while financials and materials were the worst performing sectors of 2011.  Does this mean that investors should rebalance their portfolios to include financials and materials?  For select individuals this strategy could be appropriate.  By focusing on large companies with strong balance sheets and sustainable dividends, investors could potentially be entering stocks at attractive valuations.  For example, JP Morgan Chase and Freeport McMoran are two industry-leading companies with strong balance sheets and dividend yields of over 2.5 percent, but both of their stocks were hit hard in 2011 because of the macroeconomic events in Europe and China.  By buying the stocks of the best companies in these sectors, investors can buy stocks that have been pulled down by the overall sector weakness.  By keeping an eye out for companies that fit this profile, investors could possibly reap the benefits of any long-term appreciation in these stocks.  Furthermore, by locking in profits for some stocks that have performed well over the past year, investors can transition from past winners to past losers without having to add any additional capital to their accounts. 

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Article Archives : 2012 and 2011