January 2012: Looking Ahead in 2012 - Assessment and Investment Strategy

January 6, 2012

Summary: In this quarter’s Commentary we review 2011, assess the current investment outlook, and discuss our investment strategy entering 2012.  A supplemental commentary (click here) provides important background information, “The European Financial Crisis Explained.”

2011: Volatility and Low Returns

The past year can be characterized as a year of volatile markets, unattractive investment options, and low returns -- not the type of year any of us welcomes or enjoys. The good news is that 2011 is behind us.   We are now a year closer to better times and higher returns. 

Volatility. The stock market was volatile last year.  Some days were “risk-on” and markets soared; while others were “risk-off” and markets plummeted. This volatility was the result of investors vacillating between fear and greed, reacting (over-reacting?) quickly and emphatically to slight tidbits of new data.  In fact, an individual piece of data rarely justifies buying or selling an investment or changing the direction of a solid investment plan.

Low Returns. Why were investment returns low?  There are two reasons: first, the world is awash with low interest rate money. Multi-trillion dollar programs of “quantitative easing” by the Federal Reserve has produced ultra-low interest rates and an investment environment of paltry returns. Just as scarcity increases prices, abundance lowers prices. Today, the supply of money is abundant, causing interest rates (the price of money) to remain at near-zero levels. Returns on other types of investments have followed.

Second, the economy remains in a slow growth mode, even two and a half years after the recession’s official end. Economic growth has been hobbled by a burdensome overhang of too much debt -- both private and government debt -- that continues to expand, making the problem worse, not better. Slow economic growth portends slow profit growth, a condition unfavorable to the stock market. 

Governments worldwide have been addressing the symptom of the problem (slow growth), but not the problem itself (too much debt).  Multi-trillion dollar programs of stimulus and quantitative easing have provided short-lived boosts to the economy (treating the symptom), -- meanwhile increasing government debt and making the problem (too much debt) even worse.

Looking Ahead to 2012

What should an investor do? Economies and financial markets never achieve a static state, but remain in a constant state of flux. Sometimes, like now, a host of factors point to danger ahead and a defensive, safety-minded portfolio is warranted.  At other times, markets are poised for generous returns and taking on more investment risk can be rewarding.  Confusing the two can be costly.  For patient investors, opportunity and the potential for significant profits always follow periods of poor returns.

Last August, Asset Allocation Advisors took action to put defensive measures in place for you, increasing the safety of your portfolio by reducing stock allocations and increasing cash reserves. Today, defensive and precautionary measures continue as the order of the day.

“The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”                                   Rudiger Dornbusch (MIT economist who was a professor to Mario Draghi, the new head of the European Central Bank.)

We believe that the looming European Financial Crisis (a crisis of unsustainable government debt and bank insolvencies) will have a heightened adverse impact on financial markets worldwide in the near future.  (For a more detailed overview of the European Financial Crisis, please click here.) We view European government debt growth as unsustainable and European bank insolvencies as near-certainties, and we have positioned portfolios accordingly.  Nonetheless, the timing of these events is difficult, at best, to predict.   Given the choice, we would rather be months early than a single day late in protecting you and your portfolio.

2012 Investment Strategy

Time and patience are required.  Investors cannot force or hurry an outcome. No one can foretell exactly when the crisis will erupt; nor can anyone predict the precise outcome.  Still, we believe that European developments will worsen in the coming months.  Defense is the order of the day. There is sufficient evidence now available to send prudent investors into a cautious mode.

Making Money. Successful investing sometimes entails a concerted effort to preserve capital and sometimes it requires aggressive tactics.  Waiting patiently is the hardest part of investing.  However, this is much preferred to ignoring risk, the easiest and most costly mistake in investing.

“The two most powerful warriors are time and patience.” --- Leo Tolstoy

Patient investors with defensive portfolios and ample cash reserves, like our clients’ managed portfolios, will be in a position to potentially capture outsized profits -- redeploying cash reserves and ramping up stock allocations (at low prices) after the crisis unfolds.  This is the strategy that can potentially lift portfolios to all-time record high levels.  We believe this opportunity draws closer each day. 

As your investment managers, our jobs are challenging and, at times, humbling. Thank you for the trust and confidence you have placed in us.  We wish you and your loved ones a healthy, happy and prosperous New Year! ***


Greg Schultz & Bruce

© Asset Allocation Advisors, Inc. 2012