Thursday, January 5, 2012

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.


Bill said...

The only thing I'll quibble with you about is the heading of this post. It should be "2011 Review."

McKibbinUSA said...

Nicely and honestly reported, yes...

William said...

I have been a bit concerned that Schaeffer's Investors Intelligence poll quickly turned bullish after its October lows when Bulls were down to 34.4% and Bears up to 46.4%. The past three weeks Bulls have risen to about 50% and Bears have fallen to around 30%. At their peak last March Bulls were at 57.5% and Bears were less than 20%.

But Lipper US Fund Flows paint a different picture: net outflows of $23 Billion last September, inflows of $4 Billion in October, outflows of $13 Billion in November and thus far for December outflows of $6 Billion.

Thus investors actions over the past 3 to 4 months have been pretty negative. I am reassured that they aren't acting overly bullish.

Benjamin Cole said...

Congrats to Scott Grannis, not only for reasonably accurate forecasting in a very choppy market, but honestly assessing performance at year end. Most guys remember only their successes---good for self-esteem, but not technically accurate.

One correx: The Fed is not being "easy." The Fed has been passively tightening the money supply.

If you believe the Fed is "easy" then you also believe the Bank of Japan is "easy."

Low interest rates alone do not mean "easy," nor does a haphazard and irresolute program of QE. That only means "less tight."

The Fed will "ease" when it defines a nominal GDP target, and then lowers interest rates and conducts QE and wipes out interest on reserves until the economy hits the Fed's announced nominal GDP growth targets.

The Fed is actually shrinking the money supply as we speak---extending the recession. It is a disaster, and we are seeing deflation re-emerge as a result.

I recommend to Scott Grannis and all others this:

There is a growing number of conservative econ bloggers coming to the Market Monetarism movement. Welcome aboard all, whatever your political stripe, I say.

It is not about being GOP or Dem, it is about what works.

Pragmatic Investor said...

Good, at least you answered the call, although you massaged some of the conclusions. I don't know how you can say housing is recovering when housing price is at multi-year low and housing starts hasn't broken out of the 2010 range. And commodity prices are clearly down for the year. One commodity doesn't make it a whole market.

As for investment returns, as you disclaimed a year ago, you were short Treasuries, which is consistent with your view of rising interest rates. That one position pretty much guaranteed you would have a losing year.

Squire said...

I had a feeling Benjamin would bring us to somewhere with his posts.

Divisia, or Market Monetarism (MM?), reminds me of Modern Monetary Theory (MMT). The main argument MMT’ers made in support of MMT is that you don’t understand it. I said made, in the past tense, because MMT dropped off the face of the earth.

I suspect the goal of MM is to justify more money, debt, credit money, deficit spending or whatever to stimulate the economy, just like MMT. It seems nobody except those who call themselves Austrians want to form capital as a way to eventually grow the economy.

Is there a comprehensive article written by someone who understands MM enough to explain it to the non-cognoscenti? Benjamin?

Benjamin Cole said...
This comment has been removed by the author.
Benjamin Cole said...


Actually, Market Monetarism is accessible, and there is a not bad Wikipedia entry on it.

In a nutshell, you target nominal GDP growth through a transparent and explicit monetary policy.

In today's world, the Fed would say, "We are targeting 7.5 percent nominal growth in GDP, and we will buy $100 billion a month in bonds, keep interest rates where they are, and limit interest on reserves until we get to that growth level for three quarters running, Then we will re-assess, and publicly reveal the next course of action."

(I am short-handing much).

There is not threat of "hyper-inflation" as the upper limit targeted would be 7.5 percent. Obviously, with the USA economy currently in deflation (see latest two CPI readings, or declining unit labor costs, or declining real estate values, or a Dow Jones at 1999 levels) the threat is not inflation.

People have been braying about inflation so much they have not recognized the true modern threat to the USA economy and that is Japan-itis.

To be honest, yes Market Monetarists do call for mild inflation to handle something called sticky wages.

I advocate mild inflation now to help deleverage the economy and reflate real estate values (loans are made in nominal dollars). In Japan real estate values have fallen for 20 years counting, resulting in ever-worse bank balance sheets.

What you have now is "theo-monetarism."

Theo-monetarism, as practiced, is resulting in recessionary deflations, and a Japan-like economy.

Japan has an extremely strong yen. japan has had 15 percent deflation in the last 20 years. Japan's manufacturing output has fallen 20 percent in that time period, while stock and equity markets cratered by 80 percent.

You call that theo-monetarism. A faith that tight money works, despite abundant empirical evidence to the contrary.

L.A. said...

Benjamin, Any other recommended articles/links on Market Monetarism? The Wikipedia article sparked my interest.

Pedro30854 said...

Readers of "Fooled by Randomness" would appreciate the folly of prediction and the role that chance plays on the outcome. Whilst entertaining, the result matters little. I don't know how many predictive articles I've read containing overwhelming arguments backed by indisputable facts that turn out differently. That being said, I always enjoy Scott's commentary as his presentation of measurable trends is a welcome relief from the biased garbage reported by the mainstream media!