21/12/2011: Still unfinished business

Looking at 2011 through the rear-view mirror, we need to acknowledge that it has been quite a formidable year. It started with the “Arab Spring” and ended – there is still another week to go – with the passing of Kim Jong Il, the North Korean leader.
In between, there were many extreme events of both the “Black Swan” type, such as the Fukushima disaster, and the politically self-inflicted type, such as the US debt ceiling debate and the five last chance summits to resolve the euro crisis.
All this made 2011 a challenging year for the markets. Many equity indices, especially in Europe, are significantly down from 2010, and volatility is almost back at levels last seen during the financial crisis of 2008. There doesn’t seem to be any end in sight.
It can be quite revealing to take a glimpse at what we wrote a year ago, so I pulled up the text, I wrote in 2010, “Unfinished business,” and was rather surprised that its first paragraph is still a perfect fit a year later, adjusting the outlook horizon accordingly: “With a week to go until New Year’s Eve, 2010 ends with many unresolved problems that will continue to affect the first part of 2011… The most obvious is the European sovereign debt crisis, or, as we prefer to call it, the crisis of the euro.
So far, European leaders have failed to address the underlying problem of the crisis: To really function as a currency area, the Eurozone simply needs much more economic, fiscal and social integration.
Instead, they have focused on reshuffling and guaranteeing governments’ debts with ever more complex schemes. Despite these band-aids, the debts refuse to disappear… Hence, we expect the crisis of the euro to continue making headlines in the first months of 2011.”
I continued by acknowledging the US debt problems, which are also still unsolved and are likely to remain unsolved in 2012, a presidential election year. I concluded with China’s struggle with its inflation issues. At least this last point has been dealt with in 2011, to the extent that now it is the Chinese growth outlook that worries many market participants.
Despite all the challenges that prevailed in late 2010, I thought 2011 would be a transition year, with at least a decent performance in the equity markets, since stocks had been fairly valued and in some cases even cheap.
I was proven wrong. Indeed, even technical analysts indicated that 2011 should be an outstanding year for equity markets, being the third year of a US presidential term. Since World War II, this period has delivered a 16% performance on average on the S&P 500, compared with 5% in the first year, 4% in the second, and 7% in the fourth. So much for inferring patterns without enough data points.
This is why we enter 2012 in a very cautious and conservative mood. Although equities are now even more attractively valued than in late 2010, we learned from 2011 that a state of unfinished business is not a healthy environment for aggressive investing.