Lena Press and A. Lynn Phillips assisted with the analysis for this report.

Transcription

1 The Economy in Review: 2011 By G. Michael Phillips, Ph.D. James Chong, Ph.D. William Jennings, Ph.D. Contact: Lena Press and A. Lynn Phillips assisted with the analysis for this report.

2 Table of Contents 1. Introduction: Investment Risk From the Economy in The New Risk and Return Trade-off: High Risk, Low Returns; Low Risk, Higher Returns 3. Which Key Economic Events of 2011 Most Impacted Market Volatility? 4. Drilling Down: Status of the Economy by Quarter 5. Looking Ahead 6. Some Sample Economy-Tuned Investments 7. Conclusion Appendix: Key Economic Variables From Before the Meltdown to Now

3 Introduction: Investment Risk From the Economy in 2011 What a distressing year for investors! The first six weeks of 2011 demonstrated solid gains, were followed by about six months of flat performance, but then were followed by a large drop, another two months of flat performance, a month of recovery, and finished with fairly flat returns for the rest of the year. Since 2008, there s been little talk of an election year rally. Will 2012 look the same? Better? Worse? Nobody knows. But there are some lessons from 2011 that can be applied now to improve the odds that 2012 will be a more successful year for investors. This report will begin by reviewing the economic events that shaped market volatility in We will first look at which key events impacted the market, and which ones impacted little more than the headlines. We then will look at a different view of the changing economy, showing how key economic variables changed over the course of Next, we ll review the 2011 performance of the Dow 30 stocks identified a year ago as being most suited for the general economy. Last, we ll identify several Dow 30 stocks which currently seem the best suited to the 2012 economy. The New Risk and Return Trade-off: High Risk, Low Returns; Low Risk, Higher Returns. In looking at two potential investments offering the same expected return, economic theory (and, perhaps, common sense) mandates that the safer of the two would be preferred. Similarly, if there are

4 two potential investments, one with markedly more chance of loss than another, one would require greater potential return in order to make the riskier investment worthwhile. This positive relation between expected risk and the expected rate of return is a fundamental result of economics. However, it doesn t tell the whole story. After the final bells are rung and the ledger boards are tallied, there is a tendency for greater volatility to be associated with lower expected returns. This is a fascinating difference between traditional theory and reality: the first says that more volatility should be pursued in order to achieve greater returns, whereas the second says that volatility should be minimized for maximum returns. Since risk is generally a bad thing, and realized return is a good thing, the optimal strategy will be to reduce risk and therefore maximize return. This would result in a win-win portfolio, with lower volatility and also higher expected returns. Unfortunately, many investors are in the opposite lose-lose position right now, being swamped by excess risk and correspondingly disappointing returns. This past year saw huge amounts of market volatility. In the short run, overall market volatility is measured by the VIX index, which reflects the implied standard deviation of S&P 500 options. The following chart shows historical values of the VIX for the past few years. The VIX and SPX were highly correlated as seen in the following chart of 2011 data. The value of the VIX is along the horizontal axis, with the value of the SPX index along the vertical. The chart shows that as the level of volatility increases in the marketplace, the corresponding S&P 500 value declines. To the extent that the value of the S&P 500 is a present value of future cash flows from its constituent companies, anything which raises the discount rate would tend to lower the present value. One of the key parts of a discount rate is the risk premium. The VIX is positively related to the risk premium in the marketplace and so, as VIX increases, there is a tendency for stock values--and corresponding index values--to decline.

5 Which Key Economic Events of 2011 Most Impacted Market Volatility? The headlines and conference talk this past year were dominated by international turmoil. Natural disasters, the Arab Spring, and a plethora of sovereign debt crises added to the overall angst. However, not all of the most obvious economic disturbances had major impacts on market volatility. The following chart shows key economic events mapped against values of the CBOE s VIX index, the socalled market anxiety index. From this chart, several events associated with large changes in VIX can be identified. In February, violence in Libya prompted increasing energy prices and a corresponding increase in market volatility. In March, the Japanese earthquake and tsunami caused a short-term spike in volatility. From May through the middle of July, the VIX was turbulent but generally hovered around the same levels that it began the year with. In the beginning of August, the possibility of a U.S. government default and the corresponding downgrading of U.S. treasury instruments compounded with the growing possibility of European bank defaults caused the VIX to reach the same levels as in May, 2010, when the Senate passed the initial financial reform legislation. (Even so, the market volatility was only about half of what it was in fall 2008 at the darkest days of the market meltdown.)

6 The next big decline in market volatility began in early October, when the Federal Reserve announced operation twist in which it sold bonds of 3-year remaining maturity or less and purchased bonds of 6-years to 30-years remaining maturity; the goal of this approximate $400 billion transaction was to lower longer term rates, stabilize short term rates, and make equity investments relatively more attractive. Volatility dropped during the first two weeks of October but then remained flat but choppy until Thanksgiving week at which point there began a strong decline. Even so, the VIX ended the year about 50% higher than it began (23.4 vs ).

7 Drilling Down: Economic Changes 1st Quarter 2011 Another way to assess changes in the economy is to examine an economic profile of eighteen key MacroRisk factors at the time period of interest. The chart shows how far away each factor is from its historical average, expressed in standard deviation units. (Statisticians would call these measurements z-scores.) Most of the time, random fluctuation would cause a factor to be within two standard deviations of its historical mean. The first chart compares the economy s MacroRisk profile at the beginning of 2011 to its profile at the beginning of the 2nd quarter of The largest change between 1/2011 and 4/2011 was the increased value for Monetary Base, which is the part of the money supply directly controlled by the Federal Reserve System. Along with this ramping up of the money supply, the CPI increased, as did auto sales. The unemployment rate was somewhat lower, a good sign, but housing starts also declined, a bad sign. There was also a noticeable increase in the Euro exchange rate though not statistically significant. Similarly, there was a sharp decline in the Tokyo stock exchange index following the earthquake and tsunami, returning the index to November, 2010, values. However, this move was not statistically significant given past fluctuations. Generally, except for the movement in the monetary base, the economy was similar to the previous quarter s conditions.

8 Drilling Down: Economic Changes 2nd Quarter 2011 From 4/1 to 7/1, it became clear that the recovery s pace was slow. There was an increase in the unemployment rate, with a corresponding decrease in new durable goods orders and auto sales. With the world s focus on Europe s sovereign debt crisis, the Euro exchange rate continued to rise through April but began a steady decline through the rest of the year. Overall, however, the economy was relatively unchanged in second quarter. Drilling Down: Economic Changes 3rd Quarter 2011 The third quarter of 2011 saw significant economic changes. While the next chart shows the dramatic differences from 7/1 through 10/1, the discussion will be given on a month to month basis.

9 July was the time of sovereign debt crisis. Greece received billions in financial aid from other EEU countries, the bond ratings services continued to downgrade various European debt, and the United States federal debt burden became front page news. Overall, prices continued to rise, orders for new durable goods continued to fall, and money was flowing into the bond markets which caused yields to continue to fall. In August, American politicians passed several measures to begin to control the U.S. debt burden, the U.S. debt rating was downgraded by S&P, and there was continued concern about European debt. The FTSE 100, a measure of European stocks, fell. The Tokyo stock exchange index, a measure of Asian activity, fell. There was also a substantial drop in the yield curve.

10 September began to show signs of a thawing in the economy. The yield curve continued to fall, but the CPI was stable. Housing starts increased significantly and the Federal Reserve slowed money supply growth, as shown by the decrease in the monetary base. Drilling Down: Economic Changes 4th Quarter 2011 In the fourth quarter, the Federal Reserve s $400 billion Operation Twist began. In this operation, longer term treasury securities were purchased, while at the same time, shorter term treasury securities were sold. The stated goal was to raise short term yields while lowering longer term yields. The yield on 20 year (constant maturity) treasuries fell from 4.56% to 2.57%. The impact on shorter term securities was not as clear. For example, the yield on 1 year (constant maturity) treasuries fell from 0.29% to 0.12%. The Federal Reserve also started lowering the monetary base, which moderated CPI growth. At the same time, M2 continued to expand, reflecting some thawing in the loan markets.

11 Drilling Down: Economic Changes 2011 Comparing the end of 2011 to its beginning shows two very different economies. The beginning of the year saw gold rising dramatically, the European markets climbing, prices rising, and interest rates trending up. By the end of the year, there were major declines in international variables (FTSE, Euro exchange rate, Tokyo Stock Exchange index), significant increases in housing starts, and a continued, though small, lowering of unemployment rates.

12 For comparison, here is the top level comparison of economic conditions in 1/2008 to those in 12/2011. As shown above, in 2008, gold was soaring; by the end of 2011, gold was down from its highest values. In early 2008, as now, long term rates were below their expected range. In 2008, the Euro was strengthening relative to the dollar. By the end of 2011, the Euro was weakening. In 2008, housing starts were declining. While they are still close to their bottom value, the end of 2011 has seen a mild improvement in housing starts. In 2008, unemployment was starting to rise, energy prices were up, and orders for new durable goods were down compared to the expected ranges. These are reversed now, suggesting that some parts of the economy may be turning around. Even so, looking at the individual series shows that the current values of many key variables (e.g., housing starts, unemployment, short term rates) are still fairly flat when compared to their historical values.

13 Looking Ahead This report is not attempting to provide economic forecasts. (A great resource for that purpose is the Philadelphia Federal Reserve Bank s Survey of Professional Forecasters. A recent copy of the forecast given by these professionals is available at However, there are some economic measures that may help shed some light on what to expect in the coming year. We begin with several measures of economic sentiment and utilization. Using the MacroRisk Analytics economic factor search tool, we created the table below. The first several entries compare various measures of consumer confidence and economic sentiment at the end of 2011 to their values at the beginning of the year. While the assessment of future bad conditions was only 91.8% of the 1/2011 value, suggesting maybe some improvement, all the other measures were substantially reduced. Perhaps most disturbing are the measures of people s assessments of current conditions to conditions six months from now, and to conditions six months ago. Approximately half as many people at the end of 2011 thought that current conditions were better than conditions were six months ago, as thought that at the beginning of Similarly, only two thirds of the number of respondents who said at the beginning of 2011 that they expected better business conditions 6 months hence said the same at the end of The second part of that table compares various measures of U.S. capacity and capacity utilization. Capacity refers to the physical infrastructure necessary for producing goods and services. Utilization of this capacity is how much of this capacity is actually being used. The measures given below suggest that there may have been some small increases in capacity utilization in 2011, but that overall the current utilization is not much different than at the beginning of the year (e.g. the capacity utilization index is about 1% higher than a year ago). The projected utilization is for a decline in capacity utilization (e.g. expected capacity utilization index is 73.3% of a year ago). This is consistent with a weak recovery that could extend through the 2012 year.

14 On the other hand, current economic conditions, as measured by the MacroRisk economic climate ratings, are somewhat more positive. These positive conditions have not yet had their full impact on businesses and households and so it isn t surprising that they haven t yet shown up in the confidence, utilization, and sentiment measures. Using the current economic profile, a series of common indexes and ETFs for different asset classes were analyzed. Unlike last year, when REITs and Commodities were viewed as 5 star economic climates, this year there are no categories rates as 5 star. Half of the indexes had a 4 star economic climate rating. Three had 2 star and two had 3 star economic climate ratings. In general, if an investor is otherwise neutral between sectors, then that investor will likely choose to invest more in those sectors that have better economic climates--there is predicted to be less economic headwind from the current economic conditions for those sectors. The current economic climate suggests that it is probably a good time to be investing a bit more in equities, real estate, and commodities, and a bit less in bonds and gold.

15 Some Sample Economy-tuned Investments A year ago in our economic outlook, we identified several Dow 30 stocks that had desirable characteristics for the then prevailing conditions. Stocks included in the equally weighted portfolio included CAT, DIS, IBM, KO, MCD, and XOM. The following shows how that portfolio compared to the Dow 30 index over the subsequent year: As shown, the annual return was almost 3 times that of the overall Dow, with similar volatility. Using data from the end of 2011, a similar set of Dow 30 stocks was identified as being particularly tuned to current conditions. These stocks are T, KO, KFT, MCD, PG, and VZ. (Our approach for identifying these stocks was discussed in the November, 2011, T3 Newsletter.) Conclusion So, what did we learn in 2011? While traders may get in and out of the market before key economic events impact their investments, and while some may be able to guess tomorrow s headlines and buy appropriately, investors need to create portfolios that are less sensitive to the changing economy. Purchase decisions to capitalize on January s headlines may lead to poor portfolio composition in June, and to stress for clients and advisors alike. Instead of playing current events roulette, investors who create low-risk portfolios that can withstand whatever unexpected happenings may occur in the economy can end the year with fewer worries. By reducing exposure to the broader collection of risks facing investors as opposed to traders, investors may be able to move from the lose lose situation of high volatility and low returns to the win win situation of lower (or at least the same) volatility and higher returns. (An example of this strategy at work is shown in the Dow stocks portfolio graphed above.)

16 We hope that by taking the lessons of 2011 to heart, investors can construct portfolios that are tuned to economic conditions, have reduced exposure to risk, and have a successful * * * * MacroRisk Analytics provides powerful cloud-based tools to help financial planners and investment professionals address each of the issues discussed here. For further information please contact Phil Hahn, Director of Marketing, at or info@macrorisk.com.

17 Appendix: Key Economic Variables From Before the Meltdown to Now The following 18 charts show the evolution of each of the MacroRisk factors from before the 2008 crash through 12/2011.

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