Without question, the financial markets yielded better in 2012 than what most had believed possible at the beginning of the calendar year. At that time, embroiled in a U.S. Presidential election and ongoing turmoil in the Middle East, many analysts would have been happy if we simply avoided catastrophe.
Despite ruinous consequences of Greek financial restructuring and uninspiring rhetoric coming from global central banks, the markets gave us reason to hope that the nadir of bear market capitulation might have come and gone.
The reason I begin this year’s message with a quite simplistic retrospective is that at no other time in the last decade has it been quite as instructive to look backwards as it might be to prognosticate going forwards. The likely scenarios we might expect to unfold in 2013 are really the compelling appendices to the storylines of the past four years. Without a back-story, this coming year really has no self-sustaining narrative.
The reason for these anomalies lies with the diminished role of the consumer worldwide, and his/her inability to muster either the cash or the confidence to turn around the disruptions of our current economic crisis. Still struggling with too much debt and no real income growth, consumers dragged down GDP to its lowest levels in decades, and held it down to a pace that exacerbates uncertainty surrounding forecasts and expectations.
And yet, with all of the turmoil and body blows the economy took in 2012, we enter 2013 with a muted sense of unrealized optimism. Several themes continue to resonate for the longer-term. Demographics, while different than a generation ago, are in our favor as it relates to investing and finding the next generation of capital gains providers. There is a plethora of opportunity in biotech, and almost no poor choices in the realm of agriculture, emerging markets, technology, and infrastructure remediation. As a result, I am seeing greater output from my proprietary analytics than anytime in the last half-decade. Expectations are rising about potential equity and sector performance.
Of course, irrespective of one’s expectations, it is always critical to maintain a prudent asset allocation balance in one’s portfolio. At the time of this writing, several uncertainties abound about whether we have begun a secular or cyclical recovery. Cycles evolve over time to become trends. That said, we have, indeed, experienced several short cycle recoveries in 2012, but whether they, in the aggregate, have sufficient strength to recalibrate a secular bear is another thing altogether. I do not think they have. But recalibration begins with a series of tests, and to that effect I think we are seeing early-stage progress.
There is a smaller chance that the bear sustains than existed before, making it more likely that we can generate positive alpha for portfolios in 2013.
The most likely scenario, in fact, is a shallowing of the downside influences (unemployment, inflation, fiscal tightening) and improvements in advancing economic statistics (capital expenditures, inventories, revenue). It should not be a surprise if economic activity accelerates during the coming year. Absent any exogenous shocks, I am prepared to trumpet for an optimistic economic outlook for this year.
Markets.
Globally and domestically, we are near or at significant inflection points in earnings reversals for Consumer Non-Cyclicals, Industrials, Financials, and Technology shares. Assuming we avoid fiscal backsliding, investors have reason to be positive about debt reduction and/or increases in disposable personal income. If household income rebounds, a big “if,” there might be an opportunity for the first signs of consumer expansion in a decade. As it is now, we have seen the best indicators since 2008. Expanding the workforce would be the most bullish economic indicator of all.
Across all regions, “hope for a better future” is the reason people keep trying. That hope is paying dividends in some emerging markets. The question is whether the “industrialized” nations can heighten prosperity for a vast array of their citizenry by creating new engines for opportunity. If alternative energy, bio pharmaceutical research, agribusiness, and brick-and-mortar infrastructure redevelopment can’t gain traction, it would not be for lack of trying or creativity.
While “emerging” sectors are poised for leadership, there is still enormous relative strength risk in mature companies that fail to adapt. There is very little progress in finding or supporting compromise positions between the “have’s” and the “have nots”. Banks continue to stumble over their dichotomous mission statement between being cultivators of global commerce or being profit-center equities. It’s almost certain that in their feeble efforts to generate profits, they will accept, and usually err on, the side of their equity holders before their customers.
All of my data indicate that while the pace of retrenching is picking up, we are still in a precarious position relative to historical rates of recovery. After all, the rupturous effects of Hurricane Sandy and the contentious tone of the election rhetoric tilt the axis of acceleration negatively. All told, the consumer is not yet fully back in the game, financially or psychologically. Therefore, the pace of growth, if any were to occur, will be well below its potential or our expectations. It is unlikely, the way the numbers are shaping up, that we can exacerbate the bear cycle, but an era of fiscal austerity has begun and we need to find a “new normal” of analytics that take into account the kind of earnings surprises that previously might have derailed the system entirely.
Strategy.
Thanks to this change in mindset and analysis, we might finally be able to see nascent signs of hope in the global economy. For example, fourth quarter (2012) spending and “optimism” improved from previous years, not enough to declare a bull economy but significant in numbers to allow for the first comparisons that reach a tolerable threshold of sustainability. As this momentum widens, it might exert influence upon a spectrum of economic sectors.
In this more optimistic scenario, legislators would be loathe to pass laws which punish the consumer psyche. There is a chance that fiscal and monetary policy could be catalysts for growth rather than impediments. A “grand bargain” saves both political parties from the wrath of consumers and, arguably, introduces more spending into an already tepid marketplace.
Following on that path, economic expansion produces more tax revenue, as well as accelerating employment and wages. This might be the moment for corporate “job creators” to put their money where their mouth is, and to release the trillions they have amassed while awaiting the outcome of our financial crisis. Given these possible outcomes, I am betting on the “right things” occurring, and positioning portfolios in (1) cyclical recovery (2) emerging, but consistent, earnings performers (3) infrastructure redevelopment and (4) demographic winners in biotechnology and agriculture.
While multiples have fallen, then risen, on news and exogenous events, equity valuations today are inexpensive in the long run. If anything, as bond yields have evaporated, the most compelling case for stocks is now. Owning bonds opens too much risk when/if rates start to rise.
Obviously, the caveat is to own equities in the right denomination to portfolio net worth, the right sectors, and using a consistent methodology for evaluation of purchase and sales. In other words, wholesale equity ownership is as foolish as avoiding stocks altogether.
A regimented metric, used consistently, is the most defensive way to play in an extremely aggressive and volatile pool. Historically, sector growth occurs in those equities which generate consistent earnings by knowing their customers, managing their balance sheet, and producing something of societal value in their community. While most conversation focuses upon “potential,” I prefer an ongoing association with sustainable valuations that span years, geography, and economic consequences.
Conclusion.
Most of us teeter on the edge of procrastination before succumbing to an irrational urge to act. The data today, however, posits a different suggestion. While many of us have already sat on the sideline assessing our anger and frustration over an economy run into the ground, modest reforms have occurred which offer an inflection point opportunity. The beginnings of our allocation movement are comparable to dipping one toe in the water.
Like it or not, we can maximize potential this year, not by avoiding the game but by playing it with cautious optimism. That seems to be the message of the embers we are leaving behind.
Asset Allocation:
Equity 36%/Fixed Income 29%/Cash 35%
Scotty C. George
(212) 624-1147
The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and it accuracy cannot be guaranteed. It is intended for private informational purposes only. Any opinions expressed are subject to change without notice. Du Pasquier Asset Management and its affiliated companies and/or individuals may from time to time own or have positions in the securities or contrary to the recommendation discussed herein.
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