January 1, 2012

In some of the most volatile global markets in recent years, the S&P 500 Index, after a spirited fourth quarter ascent, ended 2011 virtually unchanged from a year earlier.  U.S. investors may be disheartened at having had to suffer all this volatility with no upward progress in the broad markets to show for it, but the reality is that U.S. equity markets notched a solid performance in 2011 given the year’s numerous upheavals, which included the Japanese tsunami/earthquake/nuclear disaster, the Arab Spring, the U.S. sovereign credit rating downgrade and the European debt crisis.  In the tumult of 2011, the U.S. re-emerged as a relative safe-haven for nervous investors.

Money poured into the U.S. bond market and, to a lesser extent, the U.S. stock market as it fled Europe, Asia and Latin America.   The bottom line is that 2011 was a good year to be a U.S-focused investor—even if it did not feel like it.  Consider the following annual performance numbers for major global market indices in 2011:

U.S. S&P 500           Flat
U.K. FTSE 100        Down 5.6%
Germany DAX         Down 14.7%
France CAC-40       Down 17.0%
Japan Nikkei 22     Down 17.3%
Brazil Bovespa        Down 18.1%
China Shanghai     Down 21.7%
India Sensex           Down 24.6%

Here in the U.S., our grudging but resilient recovery continues, with economic data improving in recent months.  For the first time in a long while, things are starting to look incrementally better on the jobs front. In December the U.S. economy added 200,000 jobs and the unemployment rate fell to 8.5%, the lowest it has been since February 2009.  While bright light is not yet visible at the end of this long economic tunnel, all in all the situation is brightening.

Corporate America, unlike the rest of America, had a pretty good year.  Despite flat markets, earnings growth continued in 2011—and with earnings higher now but the market unchanged, stocks are cheaper today than they were one year ago.  As we enter 2012, the S&P 500 trades at only 11.6 times analysts’ consensus estimate for 2012 earnings.  To put this in perspective, the average price-to-earnings multiple of the U.S. stock market since 1871 has been around 15.  On top of relatively inexpensive stock prices, the financial strength of U.S. companies remains excellent.  And finally, relative to bonds, U.S. stocks have rarely looked so cheap.

The biggest risk for 2012 is the same one as in 2011: the euro-zone crisis.  While the European situation receded from the headlines during the holidays, it promises to come back in 2012.  Italian bond rates, as I write this, are above 7%, a level at which the Italian government will not be able to finance itself sustainably.  All told, countries in the euro-zone have to repay or rollover about €1.2 trillion in 2012.  With global investors increasingly skeptical of the euro-zone and the euro itself, who is going to buy all that debt and at what price?

Europe’s challenges are made more acute by the fact that the euro-zone does not have a straightforward rescue mechanism.  The European Central Bank (ECB) does not have the authority to conduct massive buying of government bonds of euro-zone members without a revision of its charter.  Thus, it has so far been ineffective in stanching the flight out of Greek, Italian and Spanish bonds.  The ECB has, however, extended generous loan terms to euro-zone banks, an action which has probably helped to stem the immediate crisis.  Still to come in 2012 is a credit crunch that promises to make life challenging for leveraged European companies or those that otherwise need ready access to reasonably priced credit.  As we saw here in the U.S. in the wake of the 2008 financial crisis, getting banks to lend money while they are trying to rebuild their balance sheets is no easy feat.

Longer term Europe faces a tough road.  Many economists expect a recession in 2012 even if a financial crisis is averted.  Many Europeans, who previously expected to be well-cared for by the state in ill health and retirement, are beginning to realize that the social contract with their governments they previously thought impervious is fraying badly.   They are awakening to the stark reality that they will have to bear much greater responsibility for their own financial lives.  As euro-zone governments enact cuts to save themselves, European citizens will probably be unable to avoid a deterioration in their confidence about the future.  Europe will be in a rut for some time to come.

U.S. markets seem to be hinting that investors, at least at the moment, do not expect Europe’s problems will become severe enough to derail our choppy recovery or to precipitate a global recession.  The U.S. has plenty of exposure to Europe—approximately 25% of our exports go to Europe—but the euro-zone problems, the slowing growth in Asia and Latin America and the shimmers of economic light here continue to bolster the case for why the U.S. will remain the destination of choice for global investors in 2012.

I welcome your comments and feedback.

Peter C. Thoms, CFA
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Tel: 619.435.1701
Email: thoms@orioncapitalmgmt.com

About the Author:
Peter C. Thoms, CFA, is the founder and managing member of Orion Capital Management LLC, an independent Registered Investment Advisor based in Coronado, California. The firm focuses on managing global investment accounts for institutional and private clients.

Disclosure:
This document is for informational purposes only. Nothing in this report is to be construed as a specific investment recommendation. This document does not constitute the provision of investment advice, which is only provided by Orion Capital Management LLC under a written investment advisory agreement and only in states in which Orion Capital Management LLC is registered or is exempt from registration requirements. Orion is not a tax advisor and does not provide tax advice. For tax advice individuals should consult their CPA.