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January 2012 Investor Letter

Dear Investors,

I’m not sure that the change of a calendar year holds as much significance to any other profession as it does to the professional investor.  Investors are by practice intensely aware of cyclicality and the elapse of time, and so the start of a new calendar year represents a well-deserved milepost to catch a quick breath and take stock of the year behind and the year to come.


The year behind was as wild as it gets for one in which the S&P 500 was effectively flat.  The S&P finished the year down 0.0028% despite plenty of volatility.  At one point the index was down over 11% for the year, but the best 4th quarter since 1999 saved a flat end.  All the noise of the market masked a pretty strong year for US companies, which are on pace to grow earnings by 14% vs. 2010.  This is a great sign for the year ahead because as earnings have grown stocks have gotten cheaper.  Valuation is the single most important factor in forecasting future returns and as of now stocks are extremely cheap.  Analysts are predicting that corporate earnings will grow another 10% this year, which means that the S&P 500 finished 2011 selling at a little over 11x forward earnings.  In comparison, the index sold for 44x earnings in 1999.  Although the market has been flat for the last decade, this discrepancy in valuation should show that the environment has changed a lot.  Given the current valuation, I would not be at all surprised to see a double digit return from the S&P this year.


Despite favorable valuation and my own optimism, there are certainly reasons why the coming year could be just as difficult a year as the last one was.  For one, Europe is still a concern.  Last month I wrote that until the European Central Bank prints money without restraint, it’s unlikely that the Eurozone will exit the headlines.  In December there were signs that the ECB is ready to do this, but it has done so in such a convoluted way, that I’m not sure the market fully recognizes it. 


The second area of concern in 2012 was also the biggest area of surprise in 2011: the US Treasury market.  Despite the fact that the US government lost its AAA credit rating in August, the 30-year US Treasury bond was the best performing asset of the year.  It returned a staggering 31% as interest rates fell from 4.5% to 3%.  I do not expect a similar performance in 2012, but to be fair I didn’t expect such a performance in 2011 either.  If anything, 2011 reinforced that US treasury bonds are dangerously overvalued.  Unfortunately it’s hard for me to see how this can be remedied without creating some turbulence in equity markets. 


Still, it’s tough to say whether 2012 will be the year that the bond market finally wakes up or if that’s further down the line.  Given that 2012 is an election year, it is actually likely that rates won’t rise as politicians do what they can to maintain a stimulative environment.  Eventually the US government will have to stop running trillion dollar deficits, but given congressional gridlock, they may wait until the bond market forces them to act.  However, unlike the late 90s it’s not the equity markets that are the focus of concern, it’s the debt markets.  This means that equities should fare better than debt when this eventually comes to pass.  So, while I remain positive on investing in US equities, there are areas of concern, which is why we will continue to hold higher levels of cash and some gold as we wait for the horizon to clear. 


Scott Krisiloff, CFA
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