By Rodric E. Cummins, CFA , Senior Vice President and Chief Investment Officer
Surprisingly good economic data in the fourth quarter rescued the U.S. stock market from what was otherwise shaping up to be a very disappointing year for investors. Macro-economic and political uncertainties drove the capital markets, obscuring the very positive bottom-up results of individual companies and dampening investors’ appetite for risky assets.
The high levels of volatility that we’ve experienced since the beginning of the financial crisis have continued. In fact, when you tally the most volatile days in the U.S. stock market over the past 50 years, 37% of those days have occurred since the beginning of 2007. With performance concentrated in short bursts of returns, investors needed to be fully invested in well-diversified portfolios in 2011 to make money. Those that did avoided the possibility of very damaging results from attempts at market timing.
Bond investments played an important role in diversified portfolios in 2011 as interest rates fell sharply. Bonds led all major asset classes with a return of 7.84%, as measured by the Barclays Capital Aggregate Bond Index. Investments considered being safe havens did exceptionally well as evidenced by the 30-year U.S. Treasury bond that returned 35.60% for the year. The S&P 500® Index, after gaining nearly 12% in the final quarter, ended the year almost exactly where it started. With the dividend yield, the index returned 2.11% in 2011, well below what most had hoped for after an exceptional year in 2010. U.S. stock returns were meager but they were significantly better than those abroad as foreign stock markets fell under the pressures of the debt crisis in Europe; China’s effort to slow economic growth; and the concerns that a slow global economy could threaten export-driven emerging market economies. Stocks in international markets returned -13.71% for the year (MSCI AC World Index Ex- U.S.).
For four years running, the central economic and political story has remained global deleveraging. This deleveraging is the unwinding of excessive debt amassed across decades of over spending by individuals, companies and governments. Debt reduction is achieved in the opposite manner in which it is acquired, typically leading to long periods of reduced spending (or slow growth) as financial resources are directed to reducing debt levels. As we have stated before, we believe we are in an extended period constrained by deleveraging and one marked by slow, below-capacity, economic growth.
Households and corporations are coping well with the forces of deleveraging. While household debt still remains high, it is trending down, and the financial strength of U.S. corporations has rarely been as strong as it is today. Households and corporations are on the path to building a foundation that makes for a much more sustainable long-term economic recovery. Unfortunately, the government sector has not been as responsive. The limitation of central governments to match the demands of the capital markets with timely solutions has been painfully exposed through political impasses in the U.S. and Europe. This lack of resolve has created noticeable apprehension among investors, and rightfully so. Risk assets such as stocks are highly dependent on the future growth of the economy, so investors are keenly focused on the global economy’s well-being and policymakers’ ability to navigate debt reduction while smartly managing normal business cycles.
In the face of these challenges, it’s important to recognize that the U.S. and global economies are massive, diverse and very adaptive. The U.S. economy is maintaining a slow, but growing trajectory; job conditions are slowly improving; corporate earnings are at record levels; and corporate success stories abound across virtually all non-financial sectors. The resiliency of the capital markets has been impressive, especially considering the challenging environment over the past 12 months that has included natural disasters, supply disruptions, oil price shocks, sovereign debt downgrades, and political impasses. Even in the midst of these headwinds, the U.S. equity markets posted a third consecutive year of positive capital market returns in 2011.
As we move into a new year, the dominant theme remains the economic and political uncertainties which make for a very fragile market environment. With economic growth highly dependent on the actions of policymakers, particularly in Europe, central government’s decision-making is key and election year results are important. These conditions will almost surely result in higher than normal market volatility and a wider range of possible outcomes for investors.
Investors can prepare for this market environment by being mindful of three simple principles.
First, investors should focus on long-term objectives while expecting continued high levels of volatility. A well-diversified global portfolio that is properly aligned with your investment objectives, your risk tolerance and your time horizon provides the confidence that you need to stay with your financial plans in turbulent times.
Secondly, in a market environment with a wide range of possible outcomes, that well-constructed portfolio should contain strategies designed for both upside capture and downside protection. This likely means a diversified mix of stocks and bonds, again within the context of your personal objectives, risk tolerance and time horizon.
Finally, investors need realistic expectations about expected returns. As deleveraging likely constrains economic growth, investors should be prepared for an extended period of below normal returns. This may require increasing savings rates to offset lower future capital market returns.
All indices are unmanaged and not available for direct investment. Index performance assumes no taxes, transaction costs, fees or expenses. This update is prepared for general information only and it is not to be reproduced.