Despite an economic recovery weak by historical standards, the uncertainty of election year politics, a government seeming at times paralyzed by a pending fiscal cliff and long-term federal debt crisis, a 10-year war in Afghanistan, and widespread belief that the best days of the U.S. are behind us, the stock market, as measured by the Standard & Poor’s 500 total return, gained 16% in 2012.
Reflecting pervasive pessimism, the stock market in the last quarter of 2012 showed a fractional loss, with the 4Q 2012 total return on the Standard & Poor’s 500 a loss of four-tenths of 1%.
To put the year in proper financial perspective, it must be viewed from the historic depths of the financial crisis of 2008.
So deep was the meltdown in the economy, financial institutions, regulatory framework, consumer sentiment, and investment markets that the recovery that began in 2009 is understandably slower and scarier than past recoveries. But ample evidence shows a recovery remains intact.
The five-year performance of the Standard & Poor’s 500, an indicator of blue-chip stock performance, turned positive this past quarter. Stocks have come back from the post-financial crisis lows in stair-step pattern.
Underscoring the wisdom of staying broadly diversified, most major asset classes showed positive returns in 2012. As if to show the folly of making investment decisions based on short-term results, only five of the 12 major asset classes tracked by Fritz Meyer Economic Research showed a positive return in 4Q2012, while 10 of the 12 major asset classes were in positive territory for the 12-month period ended December 31, 2012.
Notable in the final quarter of 2012 was the strength in the euro, which had been pushed lower for most of the year as the Eurozone crisis raised doubts about the future of the Old World.
The flip side was weakness in the U.S. dollar, gold, and commodities. Gold, which so many market-timers and doomsayers talked up as it soared to new all-time highs again and again in recent years, plunged 5.7% in 4Q2012. Inflation fears remained dormant despite the Federal Reserve’s easy monetary policy, which has kept interest rates near all-time lows in an effort to stimulate the economy and promote business lending and investment.
A big winner for the quarter were high-yield “junk” bonds, as investors seeking yield bid up prices of below-investment bonds. While the slowly improving economy reduced the credit risk posed by junk bonds, the credit risk on these bonds and their default rate must be carefully considered in seeking their yield.
While bears foolish enough to try to predict the broad stock market’s next move up or down probably missed the unexpectedly strong performance in U.S. stocks in 2012 and the gains in an assortment of other core asset classes, last year’s investment performance for portfolios diversified across a broad swath of asset classes was good and, depending on your risk profile and goals, may indeed have been very good.
Real estate investments, so badly battered in the mortgage debt crisis in the U.S. that sent ripples throughout the globe, shot up by 18.4%. That was the one asset class that outperformed U.S. blue chips in 2012.
While past performance is never a guarantee of future results, the fortunes of commodities and crude oil, which had soared after the financial crisis, were reversed in 2012. As the economy grew only slowly and inflation remained benign, investors who had stuck with asset classes out of favor in 2008 were rewarded in 2012.
The reversal in fortunes for some asset classes was also evident in U.S. industry sectors in the fourth quarter of 2012. Financial services stocks continued to lead, while technology stocks and telecom lagged.
In a hopeful sign, consumer discretionary, industrials and materials—the sectors considered most sensitive to an improving economic outlook—posted gains in the 4Q2012.
The one-year period that ended December 31, 2012 showed a stock market that seemed to know a recovery was under way, even as the economy was growing anemically.
Financial services, the industry disgraced and blamed in many quarters for its role in the financial crisis, came roaring back to gain 26% in 2012. Financials was the sector least expected by Wall Street to outperform in strategists’ forecasts at the start of 2012.
Defensive utilities lagged, as low interest rates made the yield stocks less attractive.
Diversifying U.S. stocks based on their market capitalization provided little difference in performance in 2012, as mid-caps narrowly edged out small- and large-caps in that 12-month period. But it was a different story over the 10-years that ended at the close of 2012. Mid- and small-caps have beaten large-caps by a wide margin over the past decade.
Diversification across stock markets globally showed a similar pattern, with the 2012 difference in return across four different global stock benchmarks appearing to be minor.
A $1 investment at the start of 2012 in the 1000 largest publicly-held U.S. companies was worth $1.15 at the end of the year, while a $1 investment over the same period in emerging markets or European equities was worth $1.20 at the end of the year. A benchmark of Asian stocks excluding Japan in 2012 led the global stock-gain race, with a $1 investment growing at the end of the year to $1.23. It’s notable that the strong U.S. stock market performance was the laggard among these global benchmarks.
The differences among global stock markets becomes much clearer when examined over the 10-year period that ended December 31, 2012. A $1 investment in emerging country stocks increased nearly fivefold in value and the laggard among these four global stock benchmarks was the U.S. stock market, which over the same 10-year period did not quite double.
For 2012, stocks posted strong returns across the globe. The Eurozone’s 16% gain (not including dividends reinvested) was the biggest surprise. At the start of 2012, with Europe teetering, it seemed an unlikely region to stage a stock rally.
A look at U.S. stock benchmarks versus major global markets shows the importance of diversifying across different styles and market-capitalizations of U.S. stocks as well as global markets.
In the fourth quarter of 2012, China surged as economic momentum bottomed and growth appeared to be picking up. China’s ability to stave off recession and maintain strong growth rates heartened global stock investors after predictions earlier in 2012 for a sharp slowdown in China. China’s ability to move from being totally dependent on foreigners buying its goods to growing a middle class and transforming the nation into a consumer-driven economy remains a challenge.
The S&P 500 declined by 1% in 4Q2012, having run up to the year’s peak in September before the fiscal cliff fears and election worries increased uncertainty and widespread doubt about the government’s ability to tackle structural budget deficits.
The big news of the fourth quarter and for much of 2012 was the fiscal cliff and ongoing crisis over the U.S. government’s deficit. Thanks to a last-minute deal in the Senate, a crisis in confidence was for the time being averted and President Barack Obama signed the American Taxpayer Relief Act of 2012 (ATRA), a sweeping tax reform package that renewed tax breaks for most individuals and businesses and avoided automatic spending cuts to a plethora of government programs.
Under ATRA, income tax rates were hiked on high-income earners. A new 39.6% rate applies to singles with $400,000 or more of adjusted gross income and joint-filers with $450,000 or more of income. In addition, ATRA modifies the 15% capital gains tax rate applied to taxpayers in the 25% to 39.6% income tax brackets and adds a new 20% capital gains tax rate to those in the 39.6% tax bracket. In addition, those subject to the 20% tax rate on gains will also be subject to the 3.8% surtax on investment income above $200,000 (single filers) and $250,000 (joint filers). So the top capital gains rate is actually 23.8% for those in the 39.6% tax bracket beginning in 2013.
What does this mean to economic growth? The accompanying slide shows the history of tax rates versus economic growth over the past 73 years. While supply-siders contend that tax cuts have spurred economic growth, and have pointed to Reagan-era and George W. Bush income and capital gain tax cuts to make their case, the slide suggests only a weak negative correlation between cap gains cuts and economic growth. Conversely, it seems unlikely that the Obama tax hike will stall the weak but steady economic expansion under way for over three years.
While the recovery has been hampered by weak jobs reports, the employment situation is always a lagging indicator of economic activity. While jobs numbers month to month are closely followed in the media, employment reports are extremely volatile. As the accompanying chart illustrates, while the recovery in job formation has been less than desired given the magnitude of the contraction, it’s not too different from the last recovery.
Coming out of the past two recessions, employment recoveries have been characterized by choppiness month to month. It’s wise not to expect a straight-line improvement in employment reports. Historically, there have even been periods in which job formation has stood still or actually declined even as the economy remained in expansion mode.
A promising sign in the U.S. recovery from the global financial crisis has been the steady rise in housing starts since 2011. The progress in housing starts for the past two years, illustrated in this chart, has told a story emblematic of the slow progress of the recovery from the depths of mortgage debt crisis. Since mid-2010, almost every positive monthly report on housing starts is followed by a flat or slightly lower report. So the news on housing appears to be very mixed. However, if you take a step back and look at the overall trend since 2010, it’s been very positive.
Despite a down month in the housing start figures for the month of November, strong back-to-back housing-start reports beginning in August spiked higher for September and October. The Mortgage Bankers Association is forecasting steady growth in housing starts.
Despite the positive picture drawn by data on housing starts, jobs, auto sales, and personal income as well as the resolution of the fiscal cliff, it’s important to note that the recovery remains weak by historical standards and a full restoration for America, while likely, is by no means a certainty – a point made by the Conference Board with its release of the December 2012 Index of Leading Economic Indicators: “The indicators reflect an economy that remains weak in the face of strong domestic and international headwinds, as it faces a looming fiscal cliff. Growth will likely be slow through the early months of 2013.”
Regarding the stock market, this one chart best illustrates how stock prices are driven by earnings and how, at the beginning of 2013, analysts expected higher earnings to drive stock prices higher going forward.
The green line representing stock prices, for the most part, follows the purple line representing corporate earnings. You can see how, during the seven years leading up to the tech bubble, the period from 1994 to 2000, the correlation of stock prices with earnings broke down. Along these same lines, you can see that ever since the stock price collapse in 2007 and 2008 corporate earnings have grown at a faster pace than the prices of stocks in the S&P 500 stock index. That’s because, after the drubbing stock investors took in 2008, they are reluctant to bet on stocks again even though earnings have been coming through.
Moreover, the purple stars illustrate how Wall Street analysts were projecting continued growth in corporate earnings in 2013 and 2014. If Wall Street analysts are correct and the purple line trends higher through the end of 2014, then the green line, based on the historical trend, seems highly likely to be dragged higher by up-trending profits in American companies.
Meanwhile, the consensus forecast, based on data from The Wall Street Journal’s survey of 50 leading economists, calls for continued expansion of the American economy in the five quarters immediately ahead.
And, finally, the Organization for Economic Cooperation and Development’s December 2012 Economic Outlook for the world economy forecasts European economic growth flat-lining in 2013 and picking up in 2014. OECD expects accelerating growth in every other region. The world is looking positive.