Having returned from a lovely holiday with my bride on the Gulf of Mexico – where the Florida beaches look as pristine, the seafood is as delicious, and the best hotels are as splendid as they were before the oil spill – it’s time to turn our attention to the investment outlook for the new year. This will be a longer post than usual, but hopefully will reward the reader’s patience.
This is not a set of predictions, as I am not in the predicting business; we’ll leave that for others – and there are plenty who have taken up the task. This is a survey of the macro landscape at the start of the year, where we try to identify some portfolio strategies that give us the best probability of market-beating returns. Let’s start with some of the economic background.
The Economic Picture
As we look at US policy, we have monetary and fiscal accommodation in abundance. The Fed has promised, and is delivering, monetary easing through a program of Treasury bond purchases…and of course its near zero discount rate policy. Fiscal policy is also easing as the administration has responded to the mid-term elections by turning its focus to the economy and reaching out to business leaders, but conditions are already improving as evidenced by the Philly Fed and Chicago PMI indexes.
The President and Congressional Democrats, seeing they had little chance of passing further stimulus on the spending side, joined with Republicans to get it done on the tax side. Not only do we not face tax increases in 2011, we even have a slight tax cut for wage earners. The severely damaged banking system is being nursed back to health. Here we have one of our basic principles to guide us: don’t fight the Fed (or the government).
Looking to the real US economy, we can see that the persistence of easing policy has begun to produce results in some key areas. Unemployment, a major concern of policy makers – especially the elected variety – remains well above target levels but has stabilized. We have enough data points showing improvement that we can begin to talk about the success of policy in this area – see here and here for data with a couple of differing perspectives. It will be a long climb out of this hole, but we have no evidence to suggest that the trend will not continue in 2011. Improving employment should lead to improving consumer confidence, which is bullish for corporate earnings and should help to stabilize residential real estate.
Earnings have rebounded strongly in reaction to policy moves, as we have seen a V shaped recovery in both earnings and share prices. Standard & Poors are forecasting a 13% year over year increase in S&P 500 earnings for 2011 – certainly well short of 2010’s robust increase, but respectable in any case. Note that the sector with the strongest forecast is basic materials. This is a theme we will return to shortly.
The residential real estate market is where the US economy is showing little sign of improvement, and commercial real estate is only marginally better. After showing signs of life in the first half of 2010, price and demand were weak in the second half. These are economic headwinds to be sure; it only makes sense as these markets were the proximate cause of the financial crisis, but there is a silver lining – they are also helping to keep inflationary pressures in check.
Speaking of inflation, by most standard measures the core rate remains low , with forecast probabilities keeping it in the low single digits. Certainly the official inflation calculation and methodology is somewhat controversial, and we will get to that when we look at commodities, but leaving it aside for a moment, the consensus is that there is and will continue to be some inflation, and indeed we are seeing fewer references to deflation (outside real estate) and a double dip recession. Barring some new crisis – always a possibility – we appear to be out of those woods.
The Financial Markets Picture
Having set the economic backdrop, let’s turn to the markets. First we consider equities and our favored benchmark, the S&P 500. After posting a 23% price return in 2009, the index gained 12.78% in 2010 ( a total return of 15% with dividends). There has been some commentary to the effect that we are due for an off year, but I have not seen any compelling data to make a case for that scenario.
Standard & Poors projected 2011 earnings for the index are $94.80, giving an earnings yield of 7.5% – well above the yields not only on 10 year Treasuries, but on investment grade corporate bonds as well. Turning the equation around, it gives us a very reasonable forward P/E ratio of $13.27. Barring any widespread miss in actual earnings, this should set up for another year of gains in the S&P 500. In the short term, stocks do look extended and could be due for an early pullback (we will return to our regular shorter term analysis starting next week), but given the growth outlook a normal equity allocation still looks like the way to go in 2011.
Turning to bonds, we were bullish during much of 2010 before turning bearish in early October, and it was a rewarding position. This was however a technical call, not a long term macro call. Real yields at the longer end of the curve had simply become too low. The market has pushed them up, and given the forecast of 1 – 1.5% inflation for 2011, they still may have some way to go, but I cannot agree with some of the more sensationalist bond bears (for example Elliott Wave International).
For perspective, have a look at the following 25 year chart of the yield on the benchmark 10 year US Treasury note. It remains firmly in a falling trend. While my position to begin 2011 is where it ended 2010 – bearish and short, my expectation is that we will return during the year to a normal allocation to bonds in those portfolios where bonds are appropriate. If the 10 year yield breaks 4% – just above the top of the trend line, then we may be looking at a secular Treasury bond bear.
Now we turn to commodities, and this is where things get really interesting. The CRB index rose more than 17% in 2010, besting the 15% total return of the S&P 500, and finished with a flourish, gaining nearly 10% in December. We have to ask ourselves, in the real world, how do we reconcile a 17% gain in commodity prices with 1% core inflation? Aside from the usual questions about official statistical methodology, this presents an interesting quandary for investors. Either commodities have gotten ahead of the economic fundamentals, or inflation is poised to jump. Which could it be?
For clues, we can turn to the global macro environment, and specifically to China, a major driver of commodity demand. Chinese authorities moved to tighten policy fairly aggressively in 2010 to head off inflation, with a series of bank reserve increases, reduced lending quotas, and the Christmas day rate hike. Our favorite analyst of the Chinese economy, Michael Pettis, is on record as calling for a high single digit growth rate in 2011, but sees 3-5% beyond this year.
If this forecast proves accurate, along with slow and steady growth in the US and elsewhere, we should see continuing gains in 2011, but they are likely to be more modest. Given 6-7% GDP growth in emerging economies and 2-3% in the developed world, it may be difficult to see another year of commodity gains in the 17% range, but the trend is up. Here we can apply another of our basic principles: don’t fight the trend.
I still hesitate to recommend commodities, even in the easy to use ETF form, because many investors don’t understand them well enough. We mentioned above the upbeat forecast for basic materials stocks, which are leveraged to commodity prices; along with energy stocks, that may be a safer way for more conservative investors to play this theme in 2011.
Finally we have to mention currencies, specifically the US Dollar. There is quite a lot of commentary out there, but let’s keep in mind the economic fundamentals of the Dollar. The 25 year chart below is a good place to start. One thing that jumps out at me, and frustrates foreign policy makers and central bankers, is the remarkable volatility of the reserve currency. Note how the index fell along with bond yields during the 1980s, rose with the stock market boom of the 90s as foreign investors poured in, and fell again when they fled after the 2000-01 bear market and Fed easing, finally bottoming after the 2008 crash.
In the last few years volatility in the Dollar index has been contracting, and the currency is stabilizing as the US begins to address some of its excesses. To be sure, it is stability at a low level, but as interest rates come back to more normal levels, and sustainable growth returns (instead of a succession of asset bubbles) the US Dollar should benefit. For US investors, Dollar stability could mean more stable inflation, bond yields, commodity and asset prices, and corporate earnings. That may strike some as an overly rosy scenario, but the chart speaks for itself.
Some Final Considerations
There are a number of risks, as always, to this outlook. To borrow a useful phrase from Donald Rumsfeld – for which he was unfortunately ridiculed – there are known unknowns and unknown unknowns. We can’t say anything in advance about the latter, but do need to consider a few of the former, because they could significantly impact the investment outlook.
1. The euro situation. This is the most threatening unknown in my opinion. The euro outlook and sovereign debt problems of some of its members are extremely delicate, and will require courage and a willingness to deal will unpleasant realities on all sides to resolve favorably. I am skeptical but hopeful that eurozone policy makers will be up to the task. If they really make a mess of it, the results would upend our outlook.
2. Acceleration in commodity price inflation. I do not expect this for the reasons already stated, but if it does happen it will also change the outlook significantly.
3. New troubles in the banking sector – something we don’t already know about.
4. Trouble in the Middle East or the Korean Peninsula.. This is a perennial concern and with US and other foreign troops still on the ground in Iraq and Afghanistan, trouble is possible; Pakistan is particularly worrisome. Trouble in this region could spell trouble in the markets, at least in the short term.
My outlook for 2011 is constructive for stocks (although I do think there is a good probability for a pullback early in the year), in particular for materials and energy stocks, and for money center banks, which could also outperform but carry significant risk.
My outlook for Treasury and investment grade bonds is negative to begin the year, but will become more constructive as yields rise toward levels consistent with the economic outlook. I am more positive on high yield bonds. Finally, commodities should continue to perform well for alert traders.