The economy in 2011 started well enough, but then GDP growth slowed sharply and the unemployment rate ticked higher. A tsunami and a major nuclear event hit Japan. The "Arab Spring" began toppling governments in Northern Africa. Politicians in Washington went to war over the debt ceiling. Standard & Poor’s downgraded US Treasury debt, while Europe started to fall apart financially. The Super Committee failed to reach any kind of agreement on deficit reduction.
Domestic stocks experienced a “flash crash” in May and a major (16%) correction, mostly in July and August. But by the end of a frustrating year that saw a remarkable series of crises and heightened market volatility, the stock market has held up remarkably well, with the S&P 500 returning 2% in 2011 (all from dividends given that the price was flat), small domestic stocks falling -4%, and international stocks losing -12% (established markets) and -18% (emerging markets).
Given flat to down stock prices and growing earnings and dividends, stock valuations have improved and stocks appear more interesting now than they did a year ago. On the other hand, risk remains elevated as serious problems persist. In Europe, a near-term implosion may have been averted but much still needs to be done about government deficits and about the financial health of European banks. Long term economic solutions remain elusive and the risks of a European economic slump in 2012 are growing, with global implications. Meanwhile, questions are increasing regarding China's ability to dampen inflation without triggering recession. Though few seem to notice, we're increasingly concerned about looming debt problems in Japan, whose debt relative to GDP is over 200% (for perspective, debt to GDP is about 140% for Greece). Geopolitical risk is particularly high relative to Iran given new sanctions and threats of retaliation. Politics continues to create uncertainty with elections looming, an ever growing list of temporary measures, and a changing regulatory environment. And already high political risk is amplified given the fact that the effective federal tax rate on dividends is set to nearly triple for many clients beginning next January, absent any new changes.
Bonds were 2011’s best performing asset class, and the 10-year Treasury note saw its yield go from about 3.5% at the start of the year to under 2% now, leaving prospective future returns from bonds quite anemic while raising potential intermediate term risk in bonds to much higher than normal. In alternatives, your gold positions were again your best performers, even after a late year correction. And in real estate, the best opportunities still appear to be in select private opportunities.
In all, 2011 was a frustrating year for investors, but we’re pleased that it was not worse, given the parade of crises we reviewed. We’re encouraged by better valuations even as we remain defensive given our view about the elevated level of risks that persist.