2012 Performance: Why Stocks Rallied
While the performance of the S&P 500 in 2012 was "middle of the pack" in terms of annual rankings (40th out of 85 years since 1928), this result exceeded the expectations of many analysts, including myself. In this article I will address three questions:
1. What were the causes of S&P 500 performance in 2012?
2. Where did my own forecast go wrong?
3. What would I do differently?
Causes of S&P 500 performance in 2012
The first step in understanding why stocks rallied in 2012, it is essential to understand that the reasons typically cited by bullish pundits at the beginning of 2012 turned out to be completely wrong. Most bullish analysts predicted that stocks would rise in 2012 for reasons such as: 1) Europe's economy would do better than expected; 2) Europe didn't matter much to the US anyway; 3) US earnings would be surprisingly strong; 4) Stocks were cheap; 5) Investors would switch en masse from bonds to stocks; 6) Central bank policies would provoke "reflation"; 7) Central bank excess liquidity would flow into stocks. Those who made these predictions (about 90% of all bulls) were like golfers that shanked a shot off a tree trunk but found that the wayward ball landed on the green. Their score on that hole might seem good, but their true performance was terrible.
Stocks don't rise or fall for no reason at all. So what were the factors that drove stock price performance in 2012? I believe there were three main factors that worked together: A Binary set-up, relief that the worst did not transpire in Europe, and risk-averse asset allocations going into and throughout most of 2012.
1. Binary set-up. At the beginning of 2012 stocks were poised smack dab in the middle of a wide range of possible outcomes. PEs were very near the historical mean, and the views of stock market commentators were sharply divided. Given precarious economic and financial conditions around the world, a negative outcome of the European crisis would likely have triggered a loss of 250 or more points on the S&P 500 relative to where they started the year (1258). On the other hand, a 250 point rise in the S&P would hardly be far-fetched in a positive fundamental scenario since this would still have placed PEs within the "normal" range of historical valuations.
As it turned out, the most negative scenarios feared by investors did not materialize. But the positive scenarios hoped for by bulls did not materialize either. So the binary set-up cannot in and of itself explain 2012 stock market gains.
2. Relief that the worst did not occur in Europe. There is a difference between what people rationally expect and what they subconsciously fear. And often that which people subconsciously fear can behaviorally override what they rationally/consciously expect. The published (i.e. "conscious") consensus expectations at the beginning and throughout 2012 was that Europe would manage to muddle through their problems somehow. However, there was an underlying fear that disaster might occur - probably intensified by the still vivid memories of 2008-2009. When this "outlier" event did not occur, market participants felt relief.
3. Risk-averse equity allocations. Again, it is one thing to say that Europe will muddle through and the US will be fine. It is another thing to risk your money on that assumption when there is a real risk that disaster could, in fact, occur. Thus, despite the "muddle through" consensus and middle-of-the-road valuations at the beginning of 2012, it seems that the equity allocations of institutional and individual investors were actually quite cautious. As a result, when macro outcomes were merely slightly disappointing rather than catastrophic, many institutional and individual investors rushed to cover their underweight, hedges and/or short positions.
The price action in 2012 followed the pattern of a classic "short-covering" rally: First, there were big percentage price moves on relatively low volume. Second, prices in 2012 tended to spike on positive macro news whereas price response was more muted in reaction to negative news.
In sum, the market was underweight/short/hedged for much of 2012, and this was a key driver of positive returns in 2012, in the absence of supporting fundamentals.
Where Did My Own Forecast Go Wrong?
I first became bearish in July of 2011 when the S&P 500 was at around 1340. A subsequent 20% decline in the S&P 500 and proxy ETFs such as (SPY) affirmed that this call was correct. I remained bearish despite a snap-back rally in September-October 2011, and on October 27 of 2011, with the S&P 500 at 1285, I reiterated my bearish stance. At that time I acknowledged that further upside was possible/likely but predicted that by late April of 2012 stock prices would peak and commence another bear market cycle. From December 2011 through January of 2012 I published a series of essays in which I detailed the predictions that supported my forecast and asset allocation strategy.
In late August 2012, I acknowledged that my S&P 500 forecast was wrong and since that time, I have no longer been predicting a bear market and have said several times since then that from a tactical (short-term) asset allocation point of view the path of least resistance for stocks is up. However, I have emphasized that from a strategic or long-term point of view, returns on equity investments are likely to be substantially sub-par in historical terms.
So where did my forecast go wrong in the period between October 20011 and August of 2012?
I did not fail to see the binary set-up nor the fact that stocks such as Apple (AAPL), Intel (INTC) or Microsoft (MSFT) would probably rally sharply if the situation in Europe were resolved in a relative benign fashion. I specifically wrote about that. Thus, the failure of my forecast came in predicting that the crisis in Europe would intensify.
Let us concentrate on where my predictions regarding Europe went wrong. First, I forecasted that Spain's fiscal problems would turn out to be much worse than expected. Second, while I have been of the view that Germany would probably act to save the Eurozone, I forecasted that Germany would drag its feet and that real economic and financial damage would be done in the interim. Third, I posited that by early 2012, the Spanish economy had reached a "point of no return" in which even aggressive ECB action would fail to prevent major damage to the real economy there and to the Eurozone as a whole. Therefore, it was my view that the cost of a bailout of Spain was becoming so high as to be extremely precarious economically and politically.
The first part of my prediction undeniably came true: The fiscal problems in Spain turned out to be much worse than anybody was expected in January 2012.
The second part of my prediction also came about 90% true. Germany, hemmed, hawed, bullied, cajoled, railroaded and procrastinated to an alarming degree. Indeed, to this very day, outside of the unprecedented actions undertaken by the European Central Bank (ECB), the EU has been incapable of taking any truly significant measures to support Spain and the other PIIGS (asides from Greece) due to German foot-dragging. However, I say that this part of the prediction was only 90% materialized because the other 10% can be assigned to what Germany did not do: The Germans did not ultimately try to stop Mario Draghi from taking unprecedented measures to bail out Spain (by promising unlimited purchases of their bonds). Germany did provide the sole dissenting vote within the ECB regarding this decision, but the German government did not substantively undermine the decision and may have even supported it in private. Furthermore, Germany ultimately compromised enough on the Greek situation to enable the Hellenic nation to remain in the Eurozone (although there can be no question that massive economic damage was done to Greece and Europe as a whole due to the failure of the Greeks and Germans to take decisive actions earlier).
It was the third part of my prediction that went somewhat awry. My experience with similar crises around the world had led me to expect a steep contraction in Spanish GDP as consumers and business people curtailed spending and as the payment system seized up. In the end, the Spanish economy proved more resilient than I had expected. Whereas my best-case scenario for Spain was a GDP contraction of 2% - and I thought it could become much worse - Spanish GDP actually registered a contraction of around 1.4%. This resilience was key as it made obviated the need for the Germans to make truly hard decisions regarding a Spanish bailout.
Why did the Spanish economy hold up relatively well? First, Mario Draghi stemmed the fears of Spanish default by making unprecedented (and potentially unconstitutional) promises to monetize Spanish debt in unlimited quantity. Second, and just as importantly, Spanish consumers and businessmen were able to maintain calm just long enough to avert a crisis in the real economy. While I was not surprised by the former, I did not expect the latter.
Why did business and consumer spending not collapse under the simultaneous weight of a seized up financial system and fiscal austerity? ECB actions were less important in this respect than widely assumed, and so the answers lay elsewhere. While I cannot address this issue fully in this essay, I believe that the efficiency of the Spanish welfare state combined with idiosyncrasies of the culture in that nation were differentiating factors and combined to prevent the sort of collapses in spending that were witnessed in other nations that have faced a similar predicament.
I fully acknowledge that my prediction of a very steep recession in Spain was wrong. Does that mean that the bulls were "right?" How many bulls do you know made a detailed case on why the Spanish economy would prove to be very resilient? I personally do not know any such bulls. For the most part, bulls merely assumed this, despite no knowledge or understanding of the situation there, or comprehension of the importance of the Spanish situation the rest of Europe as a whole. You cannot be right about something you do not even understand.
Would I Do Anything Different?
It is said that hindsight is 20/20. But is it? Imagine that you became friends with an alien creature from another galaxy that had the ability to travel through time. On October 27, 2011, with the S&P at 1285 you struck up a conversation with your time-traveling alien friend regarding the future, specifically about events that would transpire on earth between that very moment and December 31, 2012. Your time-traveling friend was able to provide you with the following information regarding events during that time-frame:
1. The European rescue plan that was announced in late October designed to erect a "firewall" around the PIIGS outside of Greece will fail miserably. Specifically, the EFSF plan to create a 2 trillion euro fund made up of bonds backed by partial guarantees from EZ nations never even got off the ground.
2. Numerous plans to rescue Greece and prevent sovereign default will fail. Indeed, private investors will be forced to take massive haircuts of over 80% on their Greek bond holdings by early 2012. However, not even that will not be enough as the Greek government will again be facing default by August of 2012 and a Greek exit from the Euro will generally be perceived at that time as the most likely outcome.
3. There will be a massive run on European banks and many will be taken to the brink of collapse. The situation becomes so bad that the ECB is forced to rescue the European banks in December of 2011 through an unprecedented funding program called LTRO.
4. Despite the LTRO, the Spanish banking system will continue on a downward spiral and by June of 2012 will require a 100 billion euro bailout to avert total collapse.
5. The Spanish economy will contract sharply. Furthermore, throughout 2012, Spain will systematically violate fiscal commitments signed in prior months. Spain will essentially be shut out of private bond markets by July of 2012 and yields on 10Y Spanish debt will rise substantially above 7.0%.
6. Due to resistance from Germany and other northern European states, there will be no Eurobonds in 2012, and it will be admitted by all parties that there will be no possibility of issuing Eurobonds for the foreseeable future.
7. Due to resistance from Germany and other northern European states, there will be no banking license granted to the EFSF or ESM. Furthermore, the ECB will announce that it will refuse to provide funding to such a body even if a banking license is granted.
8. Spanish and Italian financial markets will experience horrific declines. Bond yields will rise substantially above the levels that they were at on October 27th 2011, or even December 31, 2011. Spanish and Italian stock indices will decline more than 20% below levels that they were at on October 27th 2012. By April of 2012, stocks will be substantially down for the year.
9. After October 27, 2011, the prices of most global commodities will decline by more than 20%. Global commodities prices will be down on a year-to-date basis for virtually the entirety of 2012.
10. The economic and financial situation in Europe will get so bad that by September 2012 the ECB will be forced to announce an unprecedented rescue of Spain, consisting of unlimited purchases of that nation's debt. Furthermore, Spain's banking system will come to the brink of collapse and will have to be rescued with a 100 billion Euro fund to capitalize its banks.
11. US economic growth will slow during 2012 with YoY GDP growth dipping below 2.0% in the second quarter and actually turning negative in the fourth quarter. The deterioration in the US economy will become so alarming that by September of 2012 the Fed will be forced to undertake unprecedented measures to stabilize the US economy. The first estimate of fourth quarter 2012 US GDP will report a slight contraction.
12. S&P 500 YoY earnings growth slow substantially in the second quarter of 2012 and will be flat to negative by the third quarter of 2012.
13. The US 10Y Treasury yield will fall below 1.40% by July of 2012 - by far the lowest in US history.
Now, suppose that after having this conversation with your alien time-traveling friend you had the opportunity between October 27 of 2011 and December 31, 2011, to make investment allocations. The time horizon for the investment would be until December 31, 2012. What would you do?
Assuming that all of this foresight was available, can it be considered to have been a mistake to have suggested conservative equity allocations at the beginning of 2012?
I made quite a few predictions in 2012 that came true. However, I made some key predictions - particularly regarding a sharp decline in the Spanish economy and contagion to the rest of Europe - that did not come true. The extent to which I was wrong in my predictions regarding Spain Europe could be debated, considering how close to the brink Europe came, but the fact that those predictions ultimately turned out to be wrong cannot be doubted. And as a result, my forecast of the evolution of the S&P 500 turned out to be wrong.
Was my conservative asset allocation strategy for 2012, which I announced in December of 2011 wrong? No. And here investors need to understand a critical distinction.
Good investing fundamentally consists of weighing rewards against risks. In the absence of extraordinary prospective rewards that could compensate the extraordinary risks that even in retrospect were undeniably present, large allocations to equities simply were not warranted in early 2012.
I think that a conservative asset allocation was the right investment call at the beginning of 2012. Nobody lost any money if they adopted this strategy, although this did not turn out to be the most profitable possible strategy, in hindsight. Even passive and/or blind investments in index ETFs such as (DIA) and (QQQ) turned out to be more profitable.
I make no apologies for suggesting that investors focus on preserving capital rather than risk large losses in exchange for relatively modest gains.
Do I regret anything? Yes. In retrospect, I wish I had made greater efforts in my writings to distinguish asset allocation strategies for absolute return versus relative return investors. My analysis has been directed almost entirely at absolute return investing. For those who prefer (or perhaps need) to focus on relative returns, I would have suggested other asset allocation strategies.
In sum, the substance of my forecasts was more accurate than the majority of forecasts made by bullish analysts in 2012. Yet, my asset allocation suggestions merely led to capital preservation - as opposed to the middle of the road total return for the S&P 500 registered in 2012. When dealing with probabilistic scenarios, these things happen. Bad golfers that shank their golf shots will sometimes land the ball closer to the pin than players that hit the ball with good form.
Because successful investing is a matter assessing the probability of uncertain outcomes along with their associated risks and rewards, better decisions are not always more profitable than worse decisions. Long-term success is largely a matter of understanding the difference. Confronted by the massive risks faced by investors at the beginning of 2012 versus a prospective 16% total return (actually registered in 2012), I would suggest implementation of a conservative asset allocation strategy every time.
But last year is last year's news. In my next essay I will focus on the prospects for 2013 and my suggested asset allocation strategy.