What a strange, strange year it has been. We would have preferred it to be dull, less “interesting times.” There were so many anomalous or unforecastable events muddying the economic waters, it seems incredible that financial markets in broadly general terms did as well as they did. With the final December surge U.S. stock markets ended little changed for 2011 versus 2010.  The Dow Jones Industrial Average, comprised of the suddenly in vogue dividend-paying, large-cap names, outperformed the modest gain of S&P 500 Average while the NASDAQ Index finished off about 1%. Amazingly, the Dow swung at least 100 points (from open to close) in 100 trading days last year, which indicates that volatility is here to stay and that it takes strong conviction – and a strong stomach – to stick to investment horizons of several years. The fourth quarter witnessed a good October performance followed by a rotten November and a final rally in the month of December. As dyed-in-the-wool value investors who have been through many market cycles over the past 25-30 years, we feel fortunate to have navigated through the minefield. Despite ongoing concerns and risks, we continue to see opportunities for investment in U.S. stocks.

Speaking of world markets, however, the schism(s) in the European Union captured much of the market’s attention over the last year and at times seemed to have turned fixed income markets into a trading casino for sovereign bonds. Most proposed solutions have appeared to us to be more like band aids rather than the surgery needed to correct the failed economic models of the many European “entitlement” states. Rumors flew, protests turned violent, governments realigned, and a general fear that the EU and the Euro might not survive generated trouble for many investors sometimes on a day to day basis. As a result, austerity forced upon the weaker countries has led to the likelihood of a downturn in European economic activity for 2012. While we believe the EU will not crumble nor the Euro goes belly up, it is going to take many years and heroic cooperative efforts to avoid a disastrous scenario for worldwide economic growth.

Consequently, there was no solace in the hoped-for diversification benefit in foreign stock markets in 2011. With cracks appearing in the economic momentum of China, many emerging markets experienced sharp declines of 15% or more. And guess what! Even that stalwart of Europe, Germany, had its DAX drop nearly 15%. Only the “safe havens” of U.S. Treasury bonds (and German government bonds) performed well in a world full of turmoil.

The stock market environment wasn’t any better beyond Europe. We agree with Goldman Sachs, (although we confess to only having read the headline), that the era of the BRIC’s, a term it coined a decade ago, may be starting to ebb. It would have been useful, however, for investors in those countries to have received the call at the beginning of last year. In approximate terms during 2011, Brazil was down 25%, Russia was down 29%, India was down 40% and China was down 20%. We will refrain from mentioning Greece’s returns and will only state that they made all other returns look downright satisfactory. Goldman’s shift in position is likely much more fundamental in nature than we give it credit for, yet it always surprises us how often poor returns are the source of and precede downgrades, be it of economies or companies, rather than the other way around. So being up or down a few percent, as was the case for most U.S. indexes, was a desirable relative outcome.

And so, perhaps the most unlikely event of the year was the significant out performance of 10-30 year U.S. Treasury securities, which rose in a range of roughly 15-30% in value in the face of the historic downgrade of the country’s financial health from AAA to AA !  Yes, we understand that the alternatives were not particularly palatable but it was still unusual to witness this slightly dowdy contestant win the beauty contest after being roundly booed by the judges.

The consensus forecast for the domestic economy looked pretty good going into 2011 as tax cuts were extended to the end of 2012. But disappointment soon set in as the Japanese tsunami damaged U.S. supply chains, unemployment increased for a time, the housing market continued to fray and the Fed’s monetary programs appeared to have little effect on consumer demand or corporate profits. Corporate fiscal health continued to rise but expansion/modernization plans were shelved as uncertainty rose, in large part created by an intransigence and brinksmanship of all branches of the U.S. Government. With the “rules of the game” sure to be on the table during this contentious election year, inertia prevailed. The expiration of recent tax cuts, the new rules of financial industry regulation and the eventual cuts in government spending will once again dominate headlines as Congress weaves its way into a crucial Presidential election. 

Consensus forecasts are usually wrong but forecasting “surprises” are essentially useless for investment horizons longer than a week. Our assessment of current investor attitudes is that most people are not expecting a strong recovery in 2012 in response to the many problems facing much of the world simultaneously, and these are reflected in current stock valuations. The issues we now face seem to lack the definitive responses by policymakers which were largely accepted prior to the debacles of 2008-9. This increase in uncertainty around a battered worldwide banking system, domestic labor and housing markets, and the right monetary and fiscal policies to be pursued has soured many investors on financial market opportunities.

However, we believe general pessimism does not tell the entire story. Elections in the U.S. will have a definite affect on domestic fiscal policy once the smoke clears in the “new” Congress and there is at least some opportunity for improvements in tax and spending legislation. It is hoped that such compromise legislation allows more positive activity on the part of corporations and consumers. Job creation is at the top of everyone’s list and it is likely that the monthly numbers will trend upward as the year progresses. Passage of free trade legislation has improved the outlook for our exports and the negative influences of the series of natural and man made disasters should also ebb. The strength in the dollar and in longer term Treasuries makes the U.S. a much better investment alternative than the struggles of European nations and the weakening in heretofore rapidly growing economies such as India. Fiscal policy will continue to dominate the economic outlook as the Federal Reserve basically continues its expansionary, low interest rate course of action.

One of the great challenges facing world economic growth is further ordered deleveraging of government and consumer balance sheets, similar to what the corporate sector has accomplished. The mutual dependence of the banking system and government financing issues complicates matters. Perhaps more importantly in the U.S., is the reluctance of both public and private policy makers to implement a plan to correct the severe damage caused by the housing bust which has put so many homeowners “underwater” on their mortgages. A viable write-down and new repayment schedule would have a very positive effect, in our opinion, on both the labor situation as well as the consumer’s ability to spend. We believe that as long as the banking system remains unhealthy, Western economies will not fully recover. Another challenge lies in the domestic energy plan regarding alternative fuels and oil imports. The outlook for “normal” oil prices in 2012 varies widely but a more reasonable natural gas development and oil export program could be one of those positive surprises that change the longer term investment outlook.

Our scenario forecasting outlook calls for resumption of GDP growth, albeit not to previous recovery rates.  The impact of changes as a result of the election is the major wild card and could have a very positive impact on the outlook for 2013. We continue to believe that over time equity markets will offer better returns than bonds, further near-term flight to safety notwithstanding. We are actively managing our clients’ portfolios toward those industries and companies which offer the highest quality at attractive prices with diversification as a risk dampening tool.

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