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A look at the stock market in 2012

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It’s been quite a year, one of violent swings but no real trend. We seem to be in a time where everything happens faster and faster. Lots of books 10-20 years ago warned us of this. This year was supposed to be better. Among the four years of the presidential term, the third has historically been the best-performing one for stocks. Yet, the total return for the S&P 500, which includes dividends, is barely positive. A small rise in prices between now and December would qualify as a win for the presidential cycle in the history books, but it wouldn’t be much consolation for investors.


A big reason why U.S. stocks have veered away from their historical pattern is Congress. Incumbent presidents use the third year of their term to push through economic stimulus in hopes of getting the electorate on their side. This year, as you know, stimulus took a backseat to fiscal austerity and political theater. Even passing the extension to the payroll tax holiday has morphed into a game of politics.

Everything seems to be correlated in the markets. Things that used to be uncorrelated now often move the same. There are not any reliable places to hide.

The most likely prediction? My expectation is that 2012 will offer more of the same, with ups and downs driven by three major factors: Europe, China, and the U.S. economy. Let’s take these one by one.

Europe:

The sovereign debt crisis in the eurozone remains at the epicenter of the financial markets, and until we get to the end game it is difficult to see a reason why this would change.

There are two main but connected issues in Europe. The one making all of the headlines is the sovereign debt crisis. Simply put, the countries in southern Europe have taken on too much debt; like a boat in deep water they face sinking without the help of others. These countries also are not competitive and cannot grow their way out of that debt by paying it off. And they cannot print their own money and inflate their way out. (Pay the bondholders with a lessor valued currency.) The austerity imposed on them by the northern countries that have better finances may be making things worse because it is deflationary and economies will contract. It’s difficult to reduce your debt to GDP when the GDP is shrinking.

The other issue concerns Europe’s banks, many of which are undercapitalized and overleveraged. Europe’s banks are getting hit from two sides. They are facing stricter imposed capital reserves and banks have lost some of their funding as people are weary of placing their money in them. This also makes selling short term bonds to institutional investors harder. So these banks need to raise capital or sell assets in a down market to bring their leverage down. Since leaders in the IMF EU have not embraced a Tarp like program as we in the US did they have been selling assets, and perhaps selling assets was at least in part responsible for the recent severe sell off in risk assets: Stocks bonds, treasuries, commodities, real estate; all to raise capital. By some Wall Street estimates, Europe’s banks need to shed between $2.6 trillion and $3.9 trillion worth of assets. This makes for a lot of selling and no so much buying which contributes to an already bleak economic picture.

A best case scenario may be a complete fiscal integration, more like the United States where a central fiscal authority like our Federal Reserve Board has the power to tax and create laws, as well as to issue bonds. It would have duo mandate to fight inflation as they already do but also deflation and promote employment. A problem with the euro when it was launched over 10 years ago was that it created a monetary union without a fiscal union, and full fiscal integration would finally correct that shortcoming.

A worst case scenario is if Europe went through a messy divorce with countries exiting the EU, resulting in a breakup of the euro. This could be weaker members leaving or perhaps even the stronger countries leaving like Germany. Policymakers know this would be a disaster and a sport of symbiotic realtionships or game theory seems to be at work.

For 2012 the most likely scenario may be just more of the same and a muddle through approach.

A look at China and the US for next year will be published in the enxt article.

Trade with a plan.

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