2011 review

My predictions for last year produced mixed results (7 out of 12 right or mixed, and 5 out of 12 wrong), but on balance they were handsomely rewarded from an investor's perspective.

The economy will grow by 4% or more in 2011. Wrong. Through the third quarter of 2011, real GDP grew at an annualized 1.2% pace, and given current expectations for growth in the fourth quarter, the year-end tally will probably be 1.7%. One reason for the shortfall in growth was the Japanese tsunami, of course, which disrupted economies all over the world. The biggest reason, however, was the flareup of concerns over sovereign debt defaults in the Eurozone, a prospect that sent tremors through global financial markets and capital fleeing to the safety of Treasuries. The tsunami was an act of God, but sovereign debt problems were well known at the end of 2010, so I can't claim to have been blindsided by that—I simply didn't think the situation would escalate to the degree it did.


Inflation will trend slowly higher. Right. All measures of inflation moved higher over the course of the year. On a year-over-year basis, the CPI rose from 1.5% to 3.4%; the PCE deflator rose from 1.4% to 2.5%; and the GDP deflator rose from 1.6% to 2.4%. A popular inflation-adjusted bond portfolio (TIP) enjoyed a total return of 13.2%. 


The Fed will raise rates sooner than the market expects. Wrong. For the past three years I have consistently underestimated the Fed's willingness to embrace monetary ease, and at the same time I have underestimated the world's demand for dollar liquidity. In retrospect, I would say that the Fed did the right thing by keeping rates low and pursuing quantitative easing, even though I thought they were making a mistake by doing so. This is one mistake I'm not too sorry to have made, even though it led me to be too optimistic regarding the potential returns to equity investing.


The housing market will be showing signs of life by the end of the year. Right. Housing starts turned up over the course of the year, rising some 30% from their year-end 2010 level. Activity remains extremely depressed, of course, but on the margin construction activity is definitely improving. Moreover, the decline in housing prices has slowed overall, and in some areas prices appear to be firming.


Interest rates on Treasury bills, notes and bonds would be higher than the market expects. Wrong. This prediction was driven by my Fed and GDP forecasts, which were also wrong. Treasury yields fell to levels not seen since the Great Depression, as weak growth and fears of a Eurozone financial collapse drove safe-haven demand to unprecedented levels and convinced the Fed that they needed to pursue an aggressively accommodative policy. A diversified portfolio of Treasury Notes and Bonds returned 9.8% last year.


MBS spreads are likely to widen over the course of the year. Right (but for the wrong reason). I thought that mortgage rates would be driven higher as Treasury yields rose, but as it turned out mortgage rates fell by less than Treasury yields. However, as I suspected they would, mortgages delivered a decent return of 6.1% for the year despite wider spreads.


Credit spreads are likely to decline gradually over the course of the year. Wrong. Credit spreads widened mainly because Treasury yields collapsed, and also because of fears of a Eurozone-sparked financial crisis that could lead to a global slump. Despite wider spreads, however, corporate bonds were a profitable investment. Investment grade bonds returned 7.5% for the year, while high-yield debt returned 4.4%. One popular high-yield fund (HYG) enjoyed a 6.7% return.


Equity prices are likely to register gains of 10-15% next year. Wrong (but not terribly). The S&P 500 produced a total return of 2%, the Dow 8.4%, and the NASDAQ -0.8%. However, Apple, my favorite and highly recommended stock, posted an impressive return of 26% last year.


Commodity prices will continue to work their way higher over the course of the year. Mixed. The CRB Spot Index of non-energy commodities fell by 7.4% last year, but oil prices rose by 8.2%.


Emerging market economies are likely to do somewhat better than industrialized economies. Mixed. On average, emerging market economies grew by more than industrialized economies (China, for example, most likely grew by at least 8%), but due to declining commodity prices and fears that a Eurozone financial collapse could prove highly contagious, emerging market equities suffered. On the other hand, according to JP Morgan, emerging market debt delivered a return of 8.1%.


Gold will probably move higher. Right. Gold prices rose 10% last year, but along the way they suffered a 20% correction. This reinforced my belief that the potential volatility of gold prices was very high, making gold an extremely speculative investment. 


The dollar is likely to move higher against most major currencies, and hold relatively steady against emerging market and commodity currencies. Mixed. Against a basket of major currencies, the dollar rose by 1.5% last year. It rose against the Euro and the Canadian dollar, was basically flat against the pound and the Aussie dollar, and fell by 5% against the yen. Meanwhile, the dollar rose against most emerging market currencies. 


On an absolute return basis, a portfolio holding almost any reasonable mix of long positions in dollar-denominated equities, commodities, corporate, high-yield, and emerging market bonds, mortgages, and TIPS—all consistent with my forecasts—would have enjoyed a return substantially in excess of the return on cash. Avoiding cash, in other words, was a very rewarding experience. Despite my mixed forecast record, I don't feel bad at all about the results.