Market Comment Q4 2011

Originally Published January 8, 2012

Perspective

The market has posted a positive quarter. Autum 2011 was another volatile period marked buy a fixation on Europe and the seemingly unending problems of the inflexible Euro currency. For the Year 2011 markets in the US finished nearly even, but global investments have suffered. Massive flows of assets continued to pour into bonds. Interest rates are near all time lows.

Pervasive Negativity

Since the bottom of the market in March 2009, there has been persistent and growing fear of a return to crisis and chaos in the global banking system. Numerous measures of the US economy have shown significant improvement - Unemployment and industrial production have begun to improve and inflation has remained tame. These positive numbers have done little to curb the ongoing sentiment of negativity.

This group psychology reminds me of the 1990's market environment; in the reverse. In the 90's, few were focused on risk or dark visions of the future for investors. Many were interested in stock tips and stories of riches that were apparently attainable to anyone willing to make an effort to invest.

As the stock market convulsed after August of 2000, real estate took center stage as Americans were convinced that home ownership could be an ever growing source of wealth. These times of extreme optimism now look distant and irrational.  Most investors seem to feel that those days are over and safety of principal should be the focus of portfolio strategy.

Universal sentiment of the investing public creates many "crowded trades". This has driven money to gold, bank deposits and US government securities. Running with this herd will likely cause great pain for many. The more negative the "common wisdom" becomes, it shall likely be proved wrong.

Surprises

The group psychology of fear is very powerful. Near zero interest rates are buffering many from simply exiting all market based instruments until that Holy Grail of a time when "Things Look Better".

When things do begin to look better, the markets will have already rebounded. The surprises that will occur in this environment are like to be of the positive variety - due to the fact that anyone can see how bad it is. It reminds me of a saying of my Father, "it is what it is, until it isn't".

Where will the surprises come from? Here are a few possibilities:

Natural Gas Boom

Despite serious concern about environmental impact, the production via hydraulic fracturing technology in the US has created a massive supply of natural gas energy that has driven the price ($/MMBtu) to below $3 from over $15 less than four years ago. I expect the impact of this to be massive. The entire transportation sector of the US economy could be on the cusp of a reconstruction cycle.

Housing Value(s)

Karl Case, a professor emeritus of economics at Wellesley College, was quoted recently in the New York Times; "People thought home prices would never go down...Now people think they will never go up". "Housing starts are at a 60-year low and they've been there for three years. That's unheard-of." When investors give up, there is no sellers left. That is when prices are near the bottom.

Printing Press

Jonathan Laing writes in Barron's 2-2-2012

"European officials seem, after months of dithering, to finally be coming to grips with the crisis euro zone. A plan came the week before Christmas when the European Central Bank granted some $630 billion in three-year loans to banks across the European Union and likewise loosened collateral requirements on a subsequent round of liquidity facilities dubbed the Long Term Repo Operation."

What this may signal is that Europe may be at a early stage in a monetary buffer to the trend of panic that consumed the EU and most of the world in the second half of 2011. The attempts at political solutions have resulted in confusion and votes of no-confidence by the market.

Printing of money is a scary proposition, but the alternatives of long term shrinking of government budgets around the world may be a much worse scenario in the middle and long run. QE1 and QE2 have been managed without much negative fallout in the US and Europe may now be able to bridge the current weakness with ECB lending until growth can emerge and create more flexibility.

Toxic Politics

The Presidential election year is now staring the market in the eye. With the acrimony and disfunction of 2011 still clear in voter memories, there is hope for rationality, truth and mathematical reality to have some role in the legislation and leadership of the USA. The reality is that it probably cannot get much worse so once again I look for some surprises on the positive side.

The markets have been stalled for much of the last eleven years. This is very unusual relative to the history of the modern market. Within the near term, say the next 36 months, we are likely to see a reversion to more historically normal market returns. It will no means be easy, but the rewards for patience and discipline should be significant.