Thursday, January 19, 2012

Markets Update – Perspective

In 1979, Business Week ran a notorious and compelling article pronouncing “The Death of Equities.” By the end of the 1970’s, investors had experienced an awful decade for stock returns. As the Dow Jones Industrial Average sat 20% below its all-time high – reached just six years earlier in 1973 – investors grew disillusioned with stocks. High inflation had further destroyed real investor wealth, and optimism was low.

In hindsight, 1979 was an incredible buying opportunity. Valuations were very low and the U.S. was about to embark on 20 years of strong growth. The stock market ended up returning 18% in 1979 and stocks gained 2,500% over the 20 years after Business Week ran that melancholic story. There are certainly many differences between now and the 1970’s, and there are some similarities. We wouldn’t be so bold as to predict a 2,500% return through 2030, but we certainly feel that investors are overly pessimistic about the future return potential of their stock investments.

Investing in 2011 didn’t help to encourage optimism in the future, especially for diversified investors who were whipsawed by alternating psychologies. Erratic emotions were sometimes displayed from one day to the next, as we saw in early August when the Dow Jones Industrial Average moved up and down about 5% for several consecutive days. These outsized moves continued for much of August and September before rebounding in October and stabilizing for most of November and December.

In the end, the S&P 500 actually made a nominal positive return for the year, but that was a standout compared to many investment segments. Some sectors of the market that we view as having very positive long-term prospects were the worst performers in 2011. For instance, we view emerging markets favorably going forward, but these markets suffered losses in excess of 20% in some cases in 2011. Natural resource and commodity stocks were also poor performers, even though gold prices moved significantly higher and oil ended the year close to $100/barrel, about where it started the year.

U.S. Treasury bonds did very well throughout 2011 as investors looked for security in an uncertain environment. The European debt saga, the tsunami in Japan, the Arab Spring and our own domestic tussle over the debt ceiling all led to amplified volatility in the financial markets as investors reached for the safety of U.S. government bonds. Despite the continued strength in U.S. Treasury bonds during 2011, we are not inspired to put a significant weighting towards low-yielding investments that seem likely to produce negative returns after adjusting for inflation in the long run.

We expect that some of the volatility is here to stay as issues like the European debt situation, as well as the elections in the U.S., are likely to affect the markets during 2012. We are still working through an economy that is trying to deleverage from the housing crisis. Bank debts and real estate losses have, in effect, been transferred from private to public hands. There is never a perfect historical precedent to follow, but the financial markets are indicating that there are a wide variety of possible future economic outcomes and that outlook changes – at times significantly – on a daily basis.

The 2012 year has started out with a remarkably positive tone as the S&P 500 has already advanced 4% just a few weeks into the New Year. Many of the worst performing sectors in 2011 have been the market leaders in 2012. Examples include the financials, emerging markets, smaller cap and growth companies which have all done better than the broad large cap indexes this year, reversing the trend in 2011.

Stocks have been buoyed by positive jobs data early this year, as the economy created 200,000 jobs in December. The unemployment rate moved lower to 8.5% and the jobless claims have generally been trending down at consistently below 400,000 in recent weeks. Of course, just a few weeks into the New Year is a very short sample to hang your hat on. We are well aware that the first several months of 2011 were filled with comparatively positive data compared to what developed over the second half of the year. That being said, with earnings high and interest rates low, we are encouraged.

At Rollins Financial, we have increased our holdings in income-producing stocks and corporate bonds, which tend to be somewhat more stable in the face of volatile equity markets. We are trying to balance allocations with those sectors with the greatest investment potential, and therefore, exhibit more volatility with more defensive and income-producing positions. Our objective for each investor is to find the right mix and offset some of the higher volatility positions with more defensive and non-correlated assets, which will hopefully reduce some of the instability of a portfolio. Should the year provide opportunities to reallocate to either a more defensive or offensive position, we are able to do so with a balanced approach.

The future is always uncertain and that uncertainty is a significant reason why investors expect stocks to provide higher long-term investment returns. It is our belief that stock prices are currently reflecting much of the uncertainty, and therefore, are providing good value to patient investors. The S&P 500 is currently trading at about 12 times this year’s expected earnings, which is below the long-term average of 15 to 20 times earnings.

Bonds and cash provide more certainty, but in most cases, don’t appear priced to provide generous long-term returns. The historically low interest rates paid by CDs and government bonds serve as a good incentive to take on additional risk and invest additional capital in equity positions. This should push stock prices higher, so long as the economy can grow, even if the pace of growth is lower than what we have been accustomed to in the 1980s and 90s.

Thank you again for visiting the Rollins Financial Blog. We hope this update has been useful to you, and as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Eddie Wilcox

Partner and Financial Adviser
Rollins Financial, Inc.

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