First Impressions of 2012:
First Impressions of 2012
If you believe that first impressions are important, January sure was exciting. The S&P 500 started the year by gaining 4% in January on the back of strong earnings results, reassurance from the Fed that they will continue to do what it takes to support economic growth, and convincing rhetoric coming from Europe. All of our main themes for 2012: Europe, the U.S. Economy, Corporate Earnings, and the Fed's Zero Interest Rate Policy have had developments this month.
Since Thanksgiving, the S&P 500 has experienced an extraordinary rally, appreciating over 13%. Impressive, indeed. However, it's worth noting that we experienced an almost identical rally in the end of 2010 through January of last year. Interestingly, from Thanksgiving 2010 to the beginning of February 2011, the S&P 500 rallied 12.9% before finishing 2011 6% lower as European worries kept a lid on equity valuations.
While there has been plenty of good news lately to start to feel bullish, the black cloud that is the European debt crisis still hovers above the market with the potential to rain on the parade. Coming into 2012 we believed, for better or worse, developments in Europe would be the #1 near term catalyst for markets, and we've yet to see anything that tempts us to waiver from that stance. We have coined a new acronym for the countries with looming debt issues. Rather than PIGS, we're going to refer to Greece, America, Portugal & Spain as the GAPS. As in, fiscal gaps, budget gaps and uncertainty gaps that, until filled with meaningful and truly beneficial reform, will continue to impede sustainable long-term growth.
So here's the progress report on what Euro zone leaders have been up to recently: All but two of the Euro zone countries agreed to implement tighter budget disciplines on Euro members that are intended to prevent catastrophic situations caused by excessive government spending via government debt buildup. However, the penalties for violating the new debt/GDP and deficit restrictions appear to consist mainly of more fines that do nothing to help a country that is already in a dire situation, i.e. Spain & Portugal. Meanwhile, here's an example that helps depict how dire things have become in Spain, who continues to release alarming statistics that indicate their economic situation is transitioning from bad to horrible.
In Athens, negotiations between Greece and their bondholders have been ongoing, and are expected to conclude at the end of this week. The recent rally in the markets indicates that expectations are for an agreement to be reached that benefits Greece and puts them in position to qualify for their second round of bailout funds from other European nations due in March. It appears the fate of Greece presently relies on bondholders taking a "voluntary" haircut, (which is still technically a default), on the existing debt outstanding. But in the real world, these reductions in bond values are about as voluntary as an "offer you can't refuse" from Don Corleone. If there is no agreement, Greece would likely be back on the path towards a more traditional default, which we assume would be disastrous and could leave some bondholders with next to nothing.
In January, interest rates moved in two different directions across Europe. Portugal saw rates on their 10 year debt surpass 15% this month, while Italy and Germany continue to see their rates decline. Portugal and Spain are still major concerns going forward, considering conversations on how to resolve problems with their debts and economies have yet to get serious. We expect all of these things to continue to be a major headwind for stock prices until more action is implemented.
Bringing things back overseas, U.S. economic data has been underwhelming, but just good enough to squash talks of another recession. Q4 GDP came in lighter than expected at a mediocre 2.8%, indicating the economy continues to move along at a sluggish pace. It also looks like we're going to once again run a Federal Budget Deficit north of $1 trillion this year. However, corporate earnings have mostly been positive. Of the 204 companies in the S&P 500 that have reported earnings this quarter, 60% beat consensus estimates, 12% were in-line, and 28% were below the average estimate. With relative valuations much lower than this same time last year, it's far more likely that stocks will rally should we continue to see solid earnings performance.
Data Source: money.cnn.com
Another positive catalyst came from Fed Chief Ben Bernanke as he expanded the time horizon for 0% interest rate policy out to 2014, which is nice, but hardly anything to get too excited over. More importantly, he also suggested that the Fed stands ready to continue purchasing investment securities and adding investments to the Fed balance sheet should they deem those actions necessary. In other words, any doubts that another round of quantitative easing would be available should be eliminated. The debate on the actual effectiveness the quantitative measures have had, or will have, on long term economic growth and inflation is ongoing. However, we can't ignore that stock rallies have coincided with the previous announcements and implementations of these measures. We would expect another round of quantitative easing to have the same effect on stock prices again.
As the year progresses, we will be closely monitoring the fiscal and monetary issues surrounding the 'GAPS.' Inevitably, Europe will need to enact measures that will both contain bond yields and support government budgets, without seriously hindering economic growth and sending the Euro zone economy into a major recession. We are definitely encouraged that corporate earnings have been strong. If you combine the consistently positive earnings results and optimistic corporate outlooks with valuations that are lower than a year ago, stocks most likely have lower downside risk at this point relative to last year. Finally, it's necessary to reiterate that any form of quantitative easing, from the U.S. Central Bank or abroad, would provide enough fuel to send the markets higher, even if only temporarily.
2012 is off to a quick start but we feel that now is not the time to relax and get comfortable. The lack of volatility this month will most likely prove to be short-lived, and we're anticipating that the remainder of the year will prove to be a much bumpier ride.
*The S&P 500 and other indices are unmanaged and cannot be invested in directly. Past performance is not a guarantee of future returns. All financial figures have been pulled from Morningstar.
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