A Great Year Ahead, Unless...

It’s a New Year and we’re back. Something about the solstice time of year seems to keep my Muse at bay, as if it goes off in search of days not so short, light not so muted, to where it won’t be reminded of just how many Christmas seasons have come and gone in my life time. The itch to hold forth on the prospects for the year ahead seem to have brought it back. Besides, 2011 was a beastly year for anyone practicing the craft of reconciling share price activity with the prospects of enterprises those shares represent, so much so as to make one wonder why we bother to even paying attention to such inexplicable nonsense. For those of us trying to produce an acceptable, risk-adjusted return, 2011 was heaped up with frustration. It was as if one set out swim across a river and after the exertion of many miles of both frantic dog paddling and effortless back stroking, all the while on the alert for (mostly) imaginary alligators, ended up exhausted at more or less the same place he started.

Can 2012 be much better? Based on the preponderance of knowable factors that tend to set the Market’s trend, it seems more likely than not. Of course, even a cursory look at how unpredictable so much of what made 2011 so interesting should remind us of the folly of presuming too much on the future. Those surprises included regime changes (or more specifically, fear of knock-off effects from disruptions to energy supplies) and acts of Nature which disrupted (and threatened unknowable further disruption) numerous, finely-tuned global supply chains (i.e., one of the strongest earthquakes ever recorded, the tsunami it produced, and that tsunami finding out a design defect in a backup system at a nuclear power plant, and extraordinary monsoon rains in Thailand.) These natural events probably had a bigger impact on global industry than the regime changes did, and they were certainly more substantive than that most histrionic of events that has been the European debt crisis. So before I spell out the factors that make me think that, absent surprises of the sort just reprised, the prevailing trend for share prices in 2012 is likely to be up, a few thoughts on the Crisis du jour are in order.

As previously noted in Musings, one of the lingering effects of the global financial panic a few years back is that it undid much of what was retarding the slow motion decay of that gaggle of erstwhile principalities we once called the Old World and still call Europe. A rising tide that once lifted even the leakiest of boats rushed out unexpectedly and exposed an awful lot of dry rot. Three years later it seems barely able to creep back in. What was marginally imprudent based on what seemed real in 2006, like the “right” to lavish vacations and early retirement, has been revealed as preposterous by a much harsher new light of day. A financial day of reckoning seems all but inevitable. However, what has come to matter more for investors than whatever the actual outcome ends up being (as if there will be an actually end point resolution to that decay that is older than Europe itself) is the narrative that has sprung up to describe it. 2011 was a year when mere constructs, the terminology of what at times seemed like an assiduously tended narrative, carried more weight than either the generally (albeit, modestly) encouraging economic recovery or the genuinely disruptive natural disasters that have since found their way down the Memory Hole.

The era when the day to day tone of the Market gets set by reactions to stories about “default”, “contagion” or “the next Lehman” is still with us, but like all narratives that are only tenuously tethered to reality, its days are numbered. These words are the minions of a concocted boogyman, meant to incite fear rather than to provide clarity. “Contagion” is a metaphor derived from medical science, as if the fleas from Greek debt are looking to bite the rats residing in the Bank of Italy. There is no comparing, in terms of uncertainty and surprise, what is taking place in Europe with what led up to the demise of Lehman Brothers. It’s like comparing the Little Ice Age with the Great Blizzard of 1888. The demise of Lehman, et al might have been years in the making, but the perfect storm formed like the proverbial thief in the night. (In early 2007, “derivatives” had been a scare word for so long that almost none of us paid them any more than lip service). The “never mind” on the Triple-A rating on nobody knew how much bank capital, the uncertainty around “mark to market” rules and how regulators would apply them, the emergence of “toxic” to describe assets that no one could know exactly what was they actually consisted of but have subsequently performed more or less as advertised, and even the exquisitely timed relaxation of market “uptick” rules, were all highly synergistic elements of a once in a generation bonfire.

There will be trouble in Europe, but nothing like what overtook the big banks in 2008. There will likely be “default”, but so what? Is that inherently awful? “Default” gets bandied about as if legions of creditors are about to be wiped out. Sometimes “wipe out” actually happens, as when the assets securing the liabilities are impossible to liquidate. Default is really nothing more than a formalization of a verdict the Market has already rendered. Debt issued at 100 but trading at 50 gets re-valued to 55% of original issue, or something like that. Then with its terms made more manageable for the debtor it ends up being worth 70 or more. For a preponderance of current debt holders, this falls somewhere between “not awful” and a good thing. It is quite likely that 2012 will see something like this happen in European debt. The lead up will be yet another series of frightening, “risk-off” days, but the outcome will manifest itself in a collective sigh of relief that nudges risk assets higher.

So absent unpredictable factors like well-placed (from mayhem’s point of view) 9.0 earthquakes or an Iranian sucker punch that ties up oil shipments for weeks or months, I favor the likelihood of strong positive returns from equities in 2012. The boogyman that has been the Euro crisis is probably losing his power to cow investors, but he will keep trying in 2012, and not without at least some short-lived effect. On the other side of the ledger, we have an economy that took some (mostly precautionary, fear driven) knocks during 2011 but kept on ticking and might even be picking up some momentum. A pathetic recovery to be sure, but a recovery nonetheless. If, over the course of 2012 it becomes apparent that 2013 will see a new Administration less antagonistic towards commercial success and obdurately ignorant of what drives prosperity, hiring, capital spending and M&A activity will likely return towards more normal levels. Even more encouraging, at this point in time, would be the Price Reality of US equities. It matter a lot that the Lost Decade for equities (the natural corrective to the Bubble that culminated with Y2K) has lingered on. And while we are coming up on three years since the bottom that was 3/9/09, it is not as if the Market has not repeatedly taken the trouble to purge excessively bullish spirits (that gruesome Q3 11 being the most recent). Fixed income investments have been marked up to where they cannot possibly meet the objectives of all but a very few investors, and commodities have already shown how unreliable a store of wealth they can be. Equities are undervalued relative to commercial prospects and historic norms, and under-owned relative to the needs of investors. Keep mayhem out of the picture, or contained in episodes of obviously finite duration, and stocks should go surprisingly higher in 2012.