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Below is the macro-outlook from our annual report to our investors.

S&P500 (SPY) earnings yields (7%) versus 10-year Treasury yields (2%) make the U.S. stock market quite cheap. Europe, (9%) versus (2% to 3%), is even cheaper. Some say that these interest rates are fabricated by Fed policy, and the natural rate is higher. But the Keynesian bottom line is that there is a lot of excess capacity in the global economy today, so that inflation is not a risk in most developed countries. Monetarists argue that out-of-control government money printing to finance their debt is inflationary and should lead to higher interest rates, based on the theory that MV=PQ (M: money supply, V: velocity of money, P: prices, Q: quantity, with V and Q being constant over the long run, so that rising money supply leads to rising prices). But are velocity and quantity constant? The U.S. has tripled its monetary base since 2008, and we still are not seeing any inflationary effects.

Corporate operating margins peaked in Q3 and are near record-high levels. But we could be at higher sustainable operating margins today than in the past due to technology (e.g. cloud computing benefits), low wages, and restructurings. Alain Rossman, in discussing the cheap yet valuable resources available to his startup Klip using such services as Amazon’s (AMZN) Mechanical Turk labor marketplace stated “You can achieve 10 times more now with 10 times fewer people and 10 times less capital. This is unbelievable. This is the golden age of startups, and I hope America and everyone else takes advantage of it.” Corporate America also gets it, and is in the early days of saving money hand-over-fist from outsourcing certain activities to the “cloud”.

We have had U.S. sovereign credit downgrades, a euro Crisis with risk of huge global defaults, and even decelerated earnings growth in the second half of 2011 thrown at the U.S. stocks, but the resilient U.S. stock market ended the year roughly unchanged from one year ago. European stock markets were hit much harder, and were down in the double-digits during 2011. If the European authorities and its European Financial Stability Facility take actions to alleviate Euro risk such as were taken in late December 2011 (resulting in Italian sovereign yields falling from 6% to 3%), then we can expect a short-term risk-relief rally in Europe and other markets.

Over the next twelve months, the biggest issue is the duration of the economic slowdown that began in 2H 2011, and its impact on corporate earnings. Is it only a mid-cycle blip or a full-blown recession? At least in the US, it appears not to be a full-blown recession judging from recent employment data and retail sales (albeit with heavy price promotions).

But what kind of recovery is the U.S. experiencing? Many regions (excluding Washington DC and Silicon Valley) and sectors like construction and manufacturing are not recovering at all. So, when will this recovery become more broad-based? The answer is not anytime soon. The current U.S. savings rate of 3.5% is the lowest since 2007. Consumer debt is currently at a two-year high. Recent jobs created were mostly low-paying jobs like retail, temporary services, and leisure/hospitality. The middle-class is suffering from the skyrocketing cost of maintaining their social status and perceived affluence pathway. Referred to as the toil index by economist Robert Frank, it tracks the number of hours a median earner must work each month to earn the implicit rent for a median-priced house. The toil index rose from a postwar low of 41 hours a month in 1970 to more than 100 hours in 2005 (aided by dual-working households). Although it has fallen since the housing bubble burst, the middle-class squeeze persists. Thus, although the U.S. may not be in a full-blown recession, it certainly does not feel like an economic recovery. Anecdotally, people now appear to appreciate the things they have, and are making do with less.

Ironically, this economic backdrop is not bearish for the stock market. Frugality by consumers and U.S. corporations (many with large net cash balances) is a virtue not a vice. A low-growth, productivity-led recovery with little inflationary pressure is bullish for stock markets. Moreover, the stock market is cheap today, especially in comparison to bonds or cash. It would take a major earnings decline to derail this bull market, which is unlikely. The next twelve months could see a double-digit rise in stock markets in the U.S. and Asia, driven not by earnings growth, but by rising valuations. Europe is a wild card, with a lot more upside, but also more downside, depending on macro-political factors. But if I were to take a bet, I would side with a bullish surprise for European stocks which is not reflected in today’s stock prices.

MACRO INDICATORS

Economic Trends (score 0–10 per trend)

Score

Score

Comments

Jan-12

Jul-11

Consumer

7

3

US job growth and retail sales picking up, Europe flattening, Asian consumption boom continues.

Industrial Orders

3

7

Indus prod fell in Nov in U.S. & EU, 78% U.S. capacity utilization is below 80% long-term average, – leaves room for more growth.

Supply & Demand Conditions

4

2

DRAM prices bottomed-out in November, and stabilized in Dec. NAND flash MLC recently declined 5% on average in 2H Dec. Semi inventories are lean, but waiting for end-demand to pick up.

Capital Markets

Interest rate Outlook

4

5

Euro uncertainty creates higher risk premiums in Asian and Latin American debt. European sovereign yields declined in late December following indirect support from EU authorities. U.S. Treasury bond yields benefitted from euro-related flight to quality. But how much lower than 2% can they go? Short rates are now near-zero in Europe as well as the U.S. U.K. looks dodgy, with inflation near 5%, and a weak economy despite stimulus.

Bond - Earnings Yields (30 points)

27

22

S&P 500 earnings yld of 7% minus 10-yr Treasury yld of 2% creates above –norm 5% yld gap. Europe earnings yld of 9% versus core sovereign yields of 2% to 3% are even cheaper.

Derivative of change in Earnings Forecasts

3

2

Tech EPS trended down in 2H 2011, especially semis. Big questions is this a mid-cycle inventory correction, or a longer cyclical downturn. Certain niches like social internet, cloud computing & smart phones continue to do well.

Technical

Crossover of 50 & 200-day moving averages

6

4

Recent rally moved up the 50-day moving average closer to the 200-day moving average, but still below.

Exogenous Factors

Sovereign Credit Crises

2

2

We are in unprecedented times. Investors may not appreciate the full ramifications of the pending sovereign debt crisis.

Final Score (0 – 100)

56

47

Up from 47 in July, 47 one year ago, and 49 eighteen months ago.

Beyond 2012, our major worry is the bloated balance sheets of leading developed world countries. Governments of the U.S., Japan, U.K., and parts of Continental Europe are simply spending more money than they have. Political gridlock in face of huge fiscal deficits is a ticking time bomb, but apparently with a very slow fuse. At the end of the day, there are three outcomes. The positive outcome is having economic growth provide the resources to pay off the debt, of course combined with reasonable fiscal policies. A second outcome is to inflate your way out of the debt problem, putting a damper on the liquidity-driven rallies we have become accustomed to. The third and most painful outcome would be deflation and default, which the Fed and certain European counterparts are working so hard to avoid. Initially, the stock market would crash, but this catharsis could lay the foundation for a longer-term bull market.

Our final litmus test is to take what the market gives us. In the second half of 2011, we started paying up for certain high-growth stocks during market dips. In the first half, we were only shorting.

Source: Stock Market Outlook For 2012 And Beyond