The holiday season is a great time to catch up with family in a joyous and festive environment. Coming from a small farming community, I had the good fortune of being a member of the large families that are customary in rural settings. Large, loud and boisterous gatherings are always a fixture over the holiday season. My wife’s family is comprised of 7 sisters and 1 brother, which generally means the men are left to fend for ourselves while the sisters cluster together (a happy situation for all involved). The seven in-laws and lone brother have different family backgrounds and we all work in a wide range of industries resulting in varied and different view-points. Usually our conversations are centered on children, sports, vacations and everyday life. Rarely do we have discussion concerning investments and money but that changed this year. This year produced earnest discussions on the market outlook for 2012 and possible strategies for our investment portfolios.
During the past few months I have noticed a shift in the conversations that I am hearing during business meetings but more importantly at social gatherings. Everyone I meet on the street is concerned and anxious about the upcoming year for the markets. Given my 18 years of trading experience in investment banks and hedge funds on Wall Street, I am viewed as a reliable, honest and knowledgeable source of information. The conversations either start with quotes heard from some government official or personal financial advisor who has stated that the economy has turned around and that 2012 will mark the return of the equity bull market. People are naturally skeptical, and rightfully so given the forecasts, and seek out my opinion and advice.
In the past, I avoided giving investment advice to family or friends for two reasons. Family and friends enjoy razzing me for my rare market miscalls at every gathering. Even when I reference the famous George Soros quote, “It is not whether you are right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong,” they remain undaunted in their reminders. Since trading is my profession, my advice has a very technical slant. Discussions with me generally include a plethora of economic indicators that the general public does not have access to or concern themselves with. My views leave them with a dazed look and they end up more confused than before. Over time, I decided it was best not to mix business with social or family gatherings and stopped providing advice. This year I broke my rule. I just could not bear to see family and friends lose more money in the equity markets after everyone’s crippling losses in 2008.
2012 is not the year the bull returns to the equity markets. To consider market growth, we need to contemplate what drives a booming economy. It is not government spending, nor housing sales, nor the unemployment rate and it is certainly not some government official pontificating from their pulpit in Washington. In my opinion, there is only one economic number to tell you if the economy is recovering and whether the equity markets will begin sustainable growth this year. You need to look at personal consumption, or in other words, how much the average person is spending.
Other economic numbers are important; but without strong consumer spending, a long term bull market is just not possible. Members of Government will argue convincingly that government spending has a positive effect and it will indeed spur and grow the economy. For long term sustainable growth to occur, this is simply not true. Consumers’ spending of goods and services is a true measure of long term economic growth because consumption accounts for 70% of the economy. This high correlation level requires consumption for a market rebound. If there is minimal or no consumption increase, then the economy will falter. One might disagree with my rationale, but you cannot argue that the U.S. Government is not in a strong position to further spend its way into economy growth and thus create a bull market.
By the end of 2011, the US Debt level topped out larger than the U.S. GDP. The debt to GDP is now approximately 102%. In comparison, Greece and Italy have Debt to GDP levels of 116% and 118%. As we are all aware, Greece and Italy are facing major troubles with their debt. Clearly the U.S. government is not in a position to float its economy for any length of time. This leaves consumer spending as the only route that will bring the return of the bull market.
Now that we have ruled out Government spending to foster a bull market, we need to consider what drives consumer spending. The obvious answer is salaries and/or wealth effect. A wealth effect occurs when a consumer receives a gain on assets. The most common wealth effects, excluding a tax cut, are stock gains or a rise in residential house values. In either scenario, when the consumer experiences a gain they take profit or take a loan against the gain in order to spend money.
Without consulting any current economic numbers as proof, I feel confident stating that the average consumer has not experienced a wealth effect in the past year. Most consumers have not recouped their losses from the 2008 market crash let alone have a position to report gains. With regards to housing prices, we are still waiting for the final 2011 numbers. However, falling short of a miracle in December, the nationwide healthy housing market will show a modest down for 2011. The healthy housing market does not include the distressed housing market which reports numbers far worse that a modest down. It is extremely optimistic to say that any wealth effect for 2012 will be minimal at best.
Without any wealth effect expected, let us look at salaries. Salaries can be broken down into two areas; the number of people employed (the generation of a salary) and the average annual salary actually earned. We are still recording very high levels of unemployment. According to the U.S. Bureau of Labor Statistics, although some growth has occurred we remain at 8.5% unemployment and have a total of 13.1 million people searching for work (United States Department of Labor, 2012). In comparison, the unemployment rates during the bull run of the early 2000s maintained levels between 4 and 6%. Looking further into today’s numbers, the Bureau reports there is another 8.1 million currently in part time positions that would prefer full time employment but are unable to find full time work. Basically 14% of our working population is not able to consume anywhere near what we would need to support strong economic growth. By evaluating employment numbers in their simplest form, it appears that a tremendous amount of jobs need to be created before we see a shift in personal consumption that will foster a long term bull market.
There is one final factor we should consider and that is exploring the possibility of the employed receiving large salary increases. The Bureau of Labor Statistics has reported that in 2011 the average worker's salary had the steepest decline since the 1980s (when adjusted for inflation) which is logical given the current levels of unemployment. Until we see the unemployment rate drop, the available labor supply will be great enough to offset the need for salary increases. Again, we can conclude that a large increase in consumption as a result of salary increases will not occur in 2012.
When you combine limited government ability to stimulate the economy and no wealth effect or salary increases evident to increase consumption, one is hard pressed to say 2012 will be a banner year for equities. Until we see large decreases in the unemployment numbers or substantial inflation adjusted salary increases, the impetus for a solid long lasting bull run does not exist.
If I am wrong about the market, it will be minimal. As stated, the impetus and numbers for a long-term bull run are not there. I admit that there is room for very modest gains in the equity markets but they will come with great uncertainty and volatility. I would rather miss a modest year of a bull run and have my money secure in a bank rather than going through gut wrenching market swings and periods of uncertainty. It is much easier to sit on the sidelines until the consumption signs leave little doubt that the markets are poised for a bull run. After all, the average bull market lasts approximately 4 years. As a trader, I quickly learned to decipher a smart trade versus the risky ones. If I am wrong and you miss the first year of a bull run, the missed gains are worth the peace of mind you have and you will sleep better at night.
With interest rates at relative lows, the question arises about what to do with your investments. Taking George Soros’ quote from above, you should limit your downside potential. In 2012, this results in not investing in the equity market. You should focus on paying down debt and keeping your money accessible for future opportunities by purchasing short term interest bearing products for a modest yet safe return.
If you still want equity performance then I would suggest putting a portion of your money into a managed futures fund. A well run managed futures fund will diversify its holdings across some of the latest systematic strategies and look to capture profits by taking advantage of short term trending and turbulent markets. These funds use algorithms to capture short term trends, volatility and downward movements. In short, they buy and sell the market many times over a short period of time rather than using a buy and hold strategy that mutual funds employ. These funds could provide handsome returns in markets such as the one that 2012 will bring. However, before any managed futures fund is purchased, proper due diligence of the fund should be undertaken by yourself or your financial advisor.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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