The stock market, as measured by the Standard and Poor’s Five-hundred stock index, rallied strongly in the fourth quarter of 2011, finishing at 1258 with a gain of 11% for the quarter, but unchanged on the year. Stronger than expected US economic data drove the quarter’s rally, while political drama in the US and Europe served as dampers for the year in total. The ten-year US Treasury note finished the year at 1.87% down five basis points (hundredths of a percent) on the quarter and down 144 basis points on the year. Fear of a European financial meltdown drove investors to the perceived safe-haven of US Treasuries. Gold closed the year at $1,567 per ounce, down 3% on the quarter and up 10% on the year. Gold rose strongly as a hedge against a weaker US dollar in the first half of the year, but fell in the second half as investors sought safety from Europe in US dollars. Oil finished the year at $98.83 per barrel, up 25% on the quarter and 10% on the year benefitting from geo-political turmoil in the Middle East and the continuing motorization of Asia.
In the final quarter of 2011, the US economy began to show a quickening pulse rate. Economic data across the spectrum, from employment, to the consumer, to industrial production, to even residential real estate, came in stronger than economists had expected. This was reflected in higher US stock prices. The essential question for 2012 is whether or not this strength can be maintained. After four years of recession and mediocre growth, it is reasonable to expect acceleration in the economy as pent up demand, in automobiles for instance, begins to at long last break out. While job growth has been muted thus far, those with jobs are feeling more secure and are increasingly willing to spend. Residential real estate construction has finally emerged from record low levels, adding strength to the economy from a sector many had left for dead. Finally, US corporations continue to enjoy record levels of profitability. As the economy expands, corporations are in a strong position to increase hiring and investment, with over two trillion dollars of cash on their balance sheets.
Arrayed against an improving economy are several factors. First and foremost is the monetary crisis in Europe. Because the European Central Bank has resisted acting as a lender of last resort to euro zone countries, investors have put pressure on their sovereign debt, pushing up interest rates. For a highly indebted country such as Italy, this is dangerous. It cannot afford to indefinitely rollover its large debt at interest rates approaching 7%. (Comparable US interest rates have been closer to 2%.) If Italy were to default on its debt, it would be a catastrophe for the European financial system that would not spare the American economy. As it already stands, Europe is likely entering a recession, and will act as a drag on our own economic performance, seeing that Europe is our biggest trading partner. Thus far, European authorities have avoided a total collapse, but whether or not they can continue to keep matters from going over the edge remains in doubt.
Closer to home, our political system is seen by many as being critically dysfunctional. Almost every matter of fiscal policy is executed in a stopgap manner accompanied with partisan rancor and brinksmanship. Such an environment is not conducive to confidence and economic growth, as evidenced by the subdued growth in the third quarter that was coincident with the debt ceiling debacle. Fortunately, there is no major legislative matter facing the Congress for the first nine months of the year, apart from a full year extension of the payroll tax holiday, which will no doubt be another bruising battle early in the new year. After the November election, however, which we expect to be of the more vicious variety, major issues such as the Bush tax cuts, mandatory spending cuts stemming from the failure of the “Supercommittee,” and a further expansion of the debt ceiling are back on the agenda. If past behavior is any indicator, these will be highly contentious debates that could once again depress economic growth.
Lastly, geopolitics could play a major role in 2012. While the recent succession in North Korea with the death of Kim Jong Il has dominated international headlines, we believe that the new leader, Kim Jung-un, is largely a figurehead, and the same generals who were previously in charge are in charge now. We do not see any major change in North Korea’s intermittently belligerent posture toward South Korea. A greater risk, we believe, is presented by a possible American and/or Israeli strike against Iranian nuclear facilities. We do not think this a high probability event, yet the ramifications are potentially serious. Depending on how Iran chose to retaliate, a wider regional conflict could be triggered, and the price of crude oil would skyrocket. A dramatic increase in the price of oil would seriously dent American economic growth, if not push the economy back into recession. Given Israel’s limited ability to conduct a sustained, long-ranged aerial assault on a highly dispersed and fortified Iranian nuclear infrastructure, it is doubtful such a strike would be successful in seriously delaying the development of an Iranian nuclear weapon. That is why we do not see a lone Israeli strike as likely. Likewise, we think an American led strike is unlikely because of the potential for massive destabilization to the region and the global economy. We believe all diplomatic, economic, and covert avenues would have to be exhausted before such action were seriously considered.
This list is by no means exhaustive of the issues factoring into the market in 2012. A possible slowdown in the Chinese economy, continued high levels of indebtedness for the American consumer, and weakness in residential real estate are also issues that bear monitoring. This is a challenging environment for stocks, but the risks are well publicized and may to a large extent be discounted. Retail investors have been shunning stocks in favor of bonds going on four years, and this is a trend that may have run its course. At current interest rates, it is difficult to see a continuation in the total returns that bond investors have become accustomed to. With the likelihood of disappointment high for bond investors, stocks may be given another look after years in the wilderness. For 2012, we see the Standard and Poor’s Five-hundred trading in a range of 1150 to 1400. We believe stocks will have positive returns if the Europeans are able to prevent a full-blown financial collapse. The trend has been that they have always done just enough to avoid a collapse, so we are on balance, while remaining vigilant, confident that such a crisis can be avoided in the future.
For the second year running, we are pleased to have been named a Five-star Wealth Manger by Chicago Magazine. We appreciate your continued business and the trust you have placed in us. Do not hesitate to contact us with any questions or concerns you may have. We hope you have a healthy and prosperous new year.