Market Outlook: 2011 Year-End Commentary

The Economy

If the stock market was our only barometer for assessing the health of the economy, we would likely conclude the economy fell back into recession during the second half of 2011.  Fortunately, we have other instruments to measure the state of our economy.  Here are some:

• Gross Domestic Product: Despite a stumble in the third quarter this year, GDP rose almost 2% on an annualized basis.  Consensus forecast for the fourth quarter is for a rise of nearly 3%.
• Unemployment: The national jobless rate fell from 9.5% in July to 8.5% by year-end.
• Consumer Price Index (CPI): Inflation finished the year with an annual increase of 3% but the pace of inflation was actually decelerating in the second half of the year.
• Corporate Profits:  The average profit for the 30 companies composing the Dow Jones Industrial rose nearly 15% during the past year.

These rudimentary readings suggest our economy, although weak and wounded, is clearly on the mend.  There must have been other factors affecting the stock market.  One peek into any financial website, multinational corporate earnings report or even an old-fashioned newspaper would unearth the biggest concern – Euroland.  More than a decade after many European countries banded together to form a single currency (the “euro”) and a single economic zone (the “European Union”, aka the “euro zone”), that band is being stretched thin.  During the past 10 years, many of the financially weaker countries, upon entry into the European Union, took advantage of cheaper borrowing rates the euro had created for them and borrowed more money than they could afford to pay back once a recession hit.  That recession arrived in 2008 and these countries have been scrambling ever since.  Disciplinary measures need to be put into place to work out these bad debts, but no one country, government, board or other body within the European Union seems to have the singular authority to direct a remedy.  The financial world has begun to question the wisdom of creating the euro from a region with such proud but disparate cultures.  And here at home, the housing crisis seemed to have actually gotten worse.  No recovery is in sight for this deep, dark cesspool of bad mortgages and foreclosures.  Further straining markets, the mighty Chinese economic engine displayed signs of slowing during the second half of the year.  Maintaining growth at double digit rates in China will test the resolve of the people leading this latest Asian miracle in capitalism.

The Markets

By summer of 2011, equity markets throughout the world contracted because of fears of a breakup of the euro, the only other currency with as much global reach as the U.S. dollar.  Bond yields lowered even further at the prospect of the euro crisis slowing future global growth.  After such a deep recession and so much financial turmoil, the values paid for stocks and bonds in 2011 show little premium for the prospects for future economic growth.  Today, stocks trade at considerably lower multiples on earnings, and bonds yields show little, if any, premium for future expected inflation.  Typically, some inflation is a by-product of economic growth, so for yields on 10 Year U.S. Treasuries to have fallen below 2% reflects a glum outlook for economic expansion.  Commodity prices descended in concert with equity markets this past summer as Europe’s debt crisis and China’s economic evolution issues threatened to untrack world growth

Stocks

While earnings for many public companies continued to grow, these generally good reports could not appease investors’ worries about the European deficit crisis.  Not surprisingly, international stocks faired especially badly in second half of the year.  The standard benchmark for international stocks, the MSCI EAFE Index, was down more than 16% during the last six months of the year.  The S&P 500 Index fell 3.7% for the same period.

Bonds

Despite vast predictions of the end of the everlasting bull market in bonds, yields continued to creep lower in the summer and fall of 2011, providing even more price appreciation for bond patrons.  In fact, bonds were the best performing asset class for not only the second half of the year but for all of 2011.  The Barclays Aggregate Bond Index gained 3.4% during the final six months of the 2011.  U.S. Treasuries remained the investment of choice for safety despite the downgrading of U.S. debt by Standard & Poor’s during the summer.

Commodity Futures

The S&P GSCI Commodity Index dropped 3.8% during the second half of 2011. Industrial metals and agriculture sectors helped lead commodities lower.  What a difference a year makes.  In 2010, industrial metal values rose more than 16% and aggregate agriculture commodities prices soared almost 35%.  Once agriculture prices spike that much, amplified plantings (supply) are sure to follow.  Increased farming of such commodities as wheat, cotton and soybeans took root and prices fell back.  While overall energy prices moved little in the second half of 2011, natural gas prices continued their relentless march lower. Extracting seemingly unending amounts of natural gas from rocky layers within the Appalachian Mountains has forced natural gas prices to crater.  Despite natural gas prices having already fallen more than 90% in the five years leading up to the summer of 2011, prices slumped another 40% in the last six months of 2011.  Now that is a bear market!

Real Estate

The domestic housing markets remained depressed throughout much of the country.  As a result, as much as a third of all homeowners with mortgages owe more on their homes than their houses are worth.  That is a recipe for more foreclosures, which puts even more pressure on housing prices.  Fortunately, borrowing costs remain very low.  Securitized commercial real estate prices also fell in the second half of the year but were tempered by the relatively high yields these produce.  The National Association of Real Estate Investment Trusts Index slipped 2.4% during the back half of 2011.