Market View - January 2012

“US Closes 2011 With Record $15.22 Trillion In Debt, Officially At 100.3% Debt/GDP, $14 Billion From Breaching Debt Ceiling”, is a headline taken from the website of Zero Hedge, while just as depressingly the front page of the last edition of the FT last year (31st December) advised us “$6.3 trillion wiped off markets in 2011” as global stock markets fell 12.1% over the year resulting in total capitalisation dropping to $45.7 trillion.

Seemingly we begin this New Year as we ended the last one, with financial headlines and newswires focusing upon the debt woes of either America or the Euro-zone, or alternatively the threat of a hard landing in some of the major emerging market economies such as China. The performance of global equities in 2011 could have been a lot worse however, were it not for the recovery over the last quarter as the S&P 500 rose around 14% from its October lows to the end of December, to finish the year flat in nominal terms, while the FTSE 100 in the UK which also had a rollercoaster year, ended down 5.6% and the FTSE EuroTop 100 in Europe declined almost 10%!

Even Germany suffered heavily (despite their economy showing robust strength), with the DAX down 15% for the year, led by the fall in bank shares (Commerzbank fell 70%!), while Japanese stocks also fared badly as the Nikkei 225 fell more than 17%. It was emerging market shares that bore the brunt of the flight to safety, as the MSCI EM index declined more than 20%. China and India the two largest emerging economies continued to generate impressive GDP growth during the year, but this did not stop their stock markets being amongst the worst performers for 2011, with the Hang Seng falling almost 20%, the Shanghai Composite almost 22%, and the Indian BSE Sensex losing almost a quarter of its value (making 2011 its second worst year on record).

Some of the best places to have been invested during 2011 were undoubtedly in UK gilts (up 17%), German Bunds (which rose 10%) and US Treasuries (also up around 10%), while gold continued its long bull market climbing almost 9%, although some of its bullish lustre will undoubtedly have been dulled by its strong pullback in performance from late summer when its price reached $1900 an ounce before closing the year at just $1531! The primary catalyst for the performance of most capital markets in 2011 was the ongoing euro-zone debt crisis which despite several supposed rescue summits during the course of the year continued to worsen with seemingly no practical realistic solution in sight!

One of the most popular historic methods of trying to determine whether stocks are cheap or not is to analyse the price to earnings (P/E) ratio. Traditionally has entailed taking the current price of the index in question and dividing it by the average of the reported earnings of the constituent stocks over the past twelve months. For the S&P 500 in the US which closed the year at 1257.60 (having extraordinarily closed at 1257.64 on the last day of 2010) this gives a current PE ratio of 13.8, which compares favourably to the index’s average ratio (from data over more than a hundred years) of around 15.

However during times of extreme volatility (for example at the height of the post Lehman crisis, the PE registered at 123.7!), the traditional twelve month trailing (TTM PE) ratio can lag the index to the extent of being meaningless. This resulted in legendary value investor Benjamin Graham (whom Warren Buffett modelled himself on) introducing the original cyclically adjusted Price Earnings ratio following the 1929 crash and which in recent years has been refined by Yale professor Robert Shiller using a ten year average of real, inflation adjusted earnings (PE10) which coincidentally tracks pretty closely the real inflation adjusted price of the S&P 500 index.

The bad news is that the US market’s current PE10 ratio of 20.5 is significantly higher than the 16.4 historic average (again using data since 1874). This ratio is also used extensively by the highly regarded market strategist Russell Napier in his bestselling book, “Anatomy of the Bear”; the subject of the book’s subtitle “Wall Street’s Four Big Bottoms” occurred in 1921, 1932, 1942, and 1982 when the PE10 ratio in each case had fallen into single figures, which is most instructive when we consider than even at the bottom of the post Lehman bear market (when the S&P500 index fell to 676 in March 2009), the ratio did not fall below 13.3!

In light of this depressing background, it would be very easy to conclude that 2012 is likely to be just as disappointing, but according to the latest edition of The Economist newspaper’s Buttonwood section (Ever hopeful), “Investors approach 2012 with cautious optimism”. The article suggests that Europe may already be in recession and the region’s politicians have not yet come up with a solution to the sovereign debt crisis, but 2011 was such a dismal year for European equities that many investors must hope that the bad news is already in the price”

The article also reminds us that the biggest fundamental problem that the investing optimists must be wary of remains the threat of anaemic growth continuing despite the best efforts of the central banks and government policymakers to tease the global economy back to health! The Economist article concludes more positively with the statement that “This does not mean that investors cannot make money, but it does mean that buy and hold is not necessarily a winning strategy”

We are also cautiously optimistic on the outlook for 2012, especially for global equities which remain our preferred asset class, but acknowledge that as in the past few years, risk adjusted returns will not come easily, and investors will need to be careful of the many pitfalls that likely lie in wait. Accordingly we look forward with anticipation to the inevitable opportunities that 2012 will provide for us.

From all of us as Ash-Ridge Asset Management, we would like to wish you a Happy and Prosperous New Year!