Despite apocalyptic predictions from the ancient Mayans, not to mention teetering on the brink of a Fiscal Cliff, we have survived into 2013! 2012 was a very memorable year on many fronts: unprecedented actions were taken to keep the Euro Zone intact, ever-popular social media site Facebook launched an ill-received Initial Public Offering, the US won a record setting 46 gold medals in the London Summer Olympics, and Barack Obama was elected to a second term, remaining our Nation’s 44th President. Unfortunately, a few tragedies scar deeply in our memories, including Superstorm Sandy that pummeled parts of New York and New Jersey and a shooting rampage at an elementary school in Newtown, CT. With all of these headlines flashing across our screens, the financial markets marched on and on, and up and up, helping to make up the ground we lost in the weak performance of 2011.
US Stock Market Performance
Coming off of a lackluster -0.003% performance in 2011 as measured by the S&P 500 index, investors were cautious but hopeful that the economy would pick up steam and take share prices with it. While many individual investors were scared off by the late summer carnage the year prior, those brave enough to stay invested in 2012 were rewarded with a handsome 13.4% return, the best since 2009. Few would have guessed we would finish the year so well back in the early summer. Fears that Spain and Italy would default on their sovereign debt coupled with weakening domestic data caused the market to tailspin 10% from their April highs. Have no fear, our brave Federal Reserve Chairman Ben Bernanke always comes to the rescue! Along with his trusty sidekick, European Central Bank President Mario Draghi, Bernanke fired up the printing presses and launched stimulus programs of unprecedented scale. These were designed to keep interest rates low, encourage individuals and corporations (and governments) to borrow and spend, and to calm nervous investors that the Euro Zone would avert implosion. For the near term at least, this strategy worked extremely well. Fears subsided, US GDP growth kicked into a higher gear, and stocks zoomed over 14% in less than four months! Election season proved a bit rocky, culminated by a 313 point drop in the Dow Jones Industrial Average the day after President Obama won a second term. Stocks teetered through the finish line with the looming December 31st fiscal cliff deadline, but never suffered the significant free fall that many had feared. Small cap stocks typically exhibit amplified performance relative to their larger counterparts, mainly due to their higher sensitivity to market cycles and greater risk. This year was no different ith small cap stocks besting large caps by clocking in at a very healthy 16.7% return.
International Stock Market Performance
In late spring, things looked very bleak in Europe. Citizens swarmed their local banks, demanding all their deposits returned to them in scenes reminiscent of our Great Depression. If a country were to exit the Euro Zone, their currency would revert to their pre-euro denomination and see significant devaluation instantly. Borrowing rates for Spain and Italy were skyrocketing to unsustainable levels and Germany was resisting calls for a bailout. The MSCI EAFE index of international developed countries plummeted almost 17% during this two month period. While few investors had the stomach to purchase European stocks around this time, hindsight shows us that it would have been an ideal entry point. International stocks finished the remainder of the year up 22% from those lows. For 2012 as a whole, the developed international markets of Europe, Japan and Australia finished up 15.0%. Emerging market stocks in countries such as China, South Korea and Brazil hugged their developed counterparts tightly throughout the year, and then edged slightly ahead at the end to finish up 16.5% in 2012.
Bond Market Performance
For the last few years, economists and investment managers alike have been fearful that interest rates had sunk too low and were poised to spike, inflicting pain and carnage to an asset class known for low volatility and safety. 2012 was not to be that year, as interest rates remained at historic lows. No data point is more indicative of this than the record low yield of 1.404% on a 10-year Treasury Bond reached on July 24th. A conservative investor with a portfolio of US Treasury Bonds would have received a modest 2.0% return for the 2012 year. Taking on a slightly higher amount of risk through municipal bonds would have boosted the total return to 6.8%, despite the fact that interest on municipal bonds is free from federal taxation. An investor willing to lend her money to corporations as opposed to governmental entities was rewarded with a total return of 9.8%, on par with even the loftiest expectations for a stock-like return.
Alternative Investment Performance
The so-called smartest investors came off a year of significant underperformance in 2011 with a thud. Hedge funds are an asset class where investment managers have significant flexibility to place bets for or against any type of security. However, their inability to accurately predict market movements resulted in a mediocre 3% gain through November, compared with 18% for the S&P 500 over that time frame. The S&P 500 has now outperformed its hedge fund rival for ten straight years, with the exception of 2008 when both fell sharply. Gold finished in positive territory for its twelfth consecutive year. Its closing price of $1,676/oz was 6% higher than the start of the year. Oil also moved higher for a fourth straight year, rising a modest 3.5% and setting a record for the highest average daily price of over $111/barrel. The biggest loser of the year was Arabica coffee, falling nearly 40%.
State of the Economy
Despite many of the risks mentioned above, including a Greek exit from the euro and US potentially falling off a fiscal cliff, most key economic indicators improved throughout the year and many currently paint a relatively optimistic picture. Third quarter Gross Domestic Product, the most recent time period available, clocked in at a 3.1% annual growth rate, up from 1.3% in the second quarter. The unemployment rate dipped to 7.7% through November, the lowest level in four years. Home prices rose 0.7% in October, marketing the ninth straight price increase nationwide. Additionally, new single-family home sales accelerated in November to the fastest pace in 2 ½ years. All of these figures point to a recovering economy.
Outlook for 2013
As with the beginning of any other year, we sit at the beginning of 2013 with a list of strengths and challenges for the global economy. At the top of the former list sits central banks’ efforts to bring the cost of money down to encourage growth. Coupled with corporate cash flows at multi-decade highs, low government and household debt service and rapidly increasing emerging markets consumption, there are many reasons the stock market could continue to march higher toward the peaks set in October 2007. Challenges to this forecast include a looming US debt ceiling and spending cut debate, expiration of a 2% payroll tax holiday for US workers, high sovereign debt levels in developed countries including the US, Iranian nuclear enrichment, and fading growth benefits from the stimulus efforts. Reaching a fiscal cliff agreement at the 11th hour is by no means a resounding victory in US politics. The upper bracket tax hikes make only a small dent in our national deficit, and Federal debt is headed to levels only exceeded during World War II.
Stock market gains are driven by three factors: 1) corporate earnings growth, 2) the multiple that an investor pays for a dollar of earnings, and 3) dividend payouts. Top economists predict that 2013 will be a very strong year for earnings growth for US companies, at 10% growth compared to around 6% that 2012 will likely show when finally tallied. The Price/Earnings multiple currently stands at a relatively average level of 12.7x and may modestly add or detract to stock performance throughout the year based on investor sentiment. Dividend payout ratios are near all-time lows, but dividend growth rates are the highest in six decades. All told, economists across the board are predicting high single digit returns for the market in 2013.
On the bond front, investors should be a little more cautious. Owners of bonds and bond mutual funds earn a return in two ways, through interest received and through changes in the prices of the bonds. The interest received is always a positive return, but the price can rise or fall. Over the past few decades, declining interest rates have led to surging bond prices, creating a strong positive environment for bond investors. Going forward, if an investor desires to lend her money to the US government for 10 years, she will be rewarded with a 1.86% return before taxes. Thirty years will offer a 3.07% return. Meanwhile, if interest rates begin to rise from these historically low levels, the prices of bonds and bond
mutual funds will decline, possibly negating the positive yield.