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Market Commentary - December 31, 2011

Posted by: STEVE ARNETT

Posted on: January 13, 2012

2011 Year In Review

Most of the year we experienced high volatility in the stock market, with the S&P 500 Index down as much as 12.6% by October and the EAFE index (international) down 21% by October. At this point in the year the US was downgraded from AAA to AA and fears of severe problems in euro-denominated countries reached a climax. Both indices rallied to finish the year significantly higher with a 2.11% annual return for the S&P 500 and (12.14%) annual return for the EAFE. The best performing asset classes were US Treasuries on the bond side and large US dividend stocks on the equity side. "Flight to quality" was the theme during a period of volatility and panic among investors much like we saw in 2008.

The Dollar

We anticipated the dollar to weaken as more debt was added to the US government; however, the dollar strengthened in 2011 which created a headwind for international investments. Long-term we believe the dollar will weaken which should serve to add return to international investments.

International Stocks and Bonds

While we expect volatility to continue for the foreseeable future, we are optimistic about the opportunities for long term investors owning international stocks and bonds. Patience will pay off as many international companies were oversold in the panic and our managers picked up bargains. The same held true in the international bond market as quality bonds were over discounted yet fundamentals remained unchanged for bonds in countries where GDP and currency remained strong.

Valuations

We are seeing extremely attractive valuations in domestic, international, and emerging market stocks. Compared to historical averages, price to earnings ratios (P/E) are very low with international stocks trading cheapest versus historical averages.

Index	Current P/E	10 Year Avg.
S&P 500 (US)	11.8	14.6
EAFE (International)	10.2	13.4
Emerging Markets	9.4	10.9

Looking Through the Windshield Instead of the Rear View Mirror

We strongly believe the economic growth for the future will come from emerging markets. The international markets have taken a beating in 2011 with the EAFE index down 12.14% versus the S&P’s increase of 2.11%. Our exposure to internationals has certainly negatively impacted our performance for 2011, but we think long term we will be handsomely rewarded. The sheer population numbers in places like China and India mean that the smallest improvement in their standards of living results in enormous consumption dollars. The crisis with the PIIGS (see our in depth explanation on page 2) resulted in almost all international markets declining despite the underlying values and/or potential for growth. We increased our allocation to internationals in 2011 and remain confident that was a prudent change. And despite the extremely volatile market, when looking long term, there are great equity valuations as demonstrated by the current P/E ratios relative to historic numbers.

Greece Deconstructed: A Primer

In the Beginning

Recognizing that some type of European economic union and a single currency would put them in a far better position to grow symbiotically and make them more globally competitive, in 1992 several very heterogeneous European countries signed the Maastricht Treaty. This created the Eurozone which would operate under a single currency known as the euro and would represent the largest trading bloc in the world, made up of two distinct groups. The first group included Germany, France, the Netherlands, Belgium and Austria, all of which have enjoyed historically stable economies and are referred to as the EU. For this group, the real benefit of the union was the ability to increase their global exports. The other group was made up of Portugal, Ireland, Italy, Greece and Spain, now known as the PIIGS. This group was far more focused on the service side of business.

Pigs Get Fat, PIIGS Get Slaughtered

Of the two groups, the PIIGS looked like they had financially gained the most with the least amount of effort. For example, their association with the EU immediately created a self-confidence that came in the form of lower inflation and interest rates. Prior to the treaty, they had an inflation rate of over 9% as compared to 3% for the EU. The yield on their 10 year treasury was over 12% as compared to 9%, respectively. So just for showing up, the PIIGS not only enjoyed a more stable inflation rate, they had access to funds at a lower cost which in turn drove up domestic demand. This emboldened investors, consumers and the government to increase their spending fueled by readily available access to debt. Over time the PIIGS experienced rapid wage inflation and more rigidity in the labor market which caused them to be much less productive and much less able to compete globally with the Chinas and the USs of the world. However, things still appeared to be okay because of their stability and growth domestically, especially in the housing market. The governments loved this opportunity to spend as though there was no tomorrow and even though they didn't have the cash they could simply issue more bonds that other governments, banks and investors were all too happy to buy. Since the bonds were considered sovereign debt, when banks bought them it had no effect on their risk profiles when regulators looked at their holdings; otherwise, there would be capital restrictions that would apply. So the PIIGS experienced a windfall when they came under the euro umbrella and gave no consideration to being competitive -- they had no reason to, at least at that moment.

Counting the Cost

Then the financial crisis hit in 2008 and all bets were off. The PIIGS were faced not only with rapidly decreasing demand but with increasing expenses and the loss of productivity that made them less competitive globally. Typically, when a country has lost competitiveness, it lets its currency depreciate, making exports cheaper and imports more expensive. But as Eurozone member countries there is no such opportunity for the PIIGS. If they decide to remain members they must become more competitive by cutting costs like benefits and pay. According to our global bond manager Dr. Michael Hasenstab:

The cost for a major country, such as Germany, Italy or Spain, to exit the Eurozone would be horrific. The cost of staying, although politically noisy, is far less than the cost of exit. For instance, German industry would be uncompetitive overnight if Germany left the Eurozone. The new German mark could appreciate significantly and the export sector could be decimated, which may cause massive job losses and wealth losses throughout the economy. Additionally, Germany has a lot of investments and assets in the rest of Europe denominated in euros whose value would likely be slashed dramatically if the German mark appreciated relative to those currencies.

Although belaboring and messy, it’s in everyone’s best interest, including the US and China, for Europe to fix its problems through financial stabilizing mechanisms and reform. We saw a commitment from politicians in Europe during the second half of 2011 in this direction and we anticipate further action towards resolution.