A Great Year For Stocks Ahead?
October 6, 2011 by Daniel Zurbrügg
As I write this article, global financial markets and the world economy are at a crossroads; some people even believe it is a one-way street to an economic collapse, especially in the Western world.
Most major stock markets are down between 10 and 20 percent this year; and, even worse, most markets are trading below the levels we had 10 years ago. Generally, the past 10 years were a lost decade for most equity investors. But even for people who did not hold equities and put money into real estate instead, the past decade was a disaster, especially the past couple of years. It seems that only precious metals and bonds generated satisfactory returns.
(Long-term equity prices – The World Market Index)
Now that most Western economies are at risk of slipping back into recession, it is hard to convince anyone to put more money in stocks; yet there are several good arguments that now is the time to diversify globally and allocate more funds to stocks, especially after the events we all witnessed so far this year. Global equity markets were hit hard early in the year by events such as the flooding in Australia, the earthquakes in New Zealand and the nuclear disaster in Japan. During the summer months, the attention turned again to the sovereign debt problems in Europe and the United States.
It’s been a very volatile year for financial markets and equity markets in particular. However, the increasing uncertainty helped precious metals. Gold briefly touched $1,900 per ounce a few weeks ago. In the meantime, the price corrected to about $1,650 per ounce. Now, with the outlook for only very modest growth in Western markets (with a mild recession quite likely in a number of European countries) and high uncertainty regarding the sovereign debt problems in Europe and the United States, it is very hard to find a bright spot in markets and become more optimistic that 2012 will bring better returns for equity investors.
While the economic fundamentals are clearly very weak, a severe recession is probably not going to happen; but we have to get ready for a prolonged period with disappointing economic growth. However, economic fundamentals are one thing; the stock market is quite another. Therefore, despite the challenging outlook for the global economy, certain factors point to an improving outlook for global equity markets.
Here is why I believe that global stock market prices could rise significantly in the next 12 months:
- Valuation: Stock market valuation for most companies has come down significantly. This does not take into consideration that most companies are operating with a significantly higher efficiency, generating healthy profits in a time when economic activity is modest at best.
- General exposure to the stock market: Generally, private investors and institutional investors are holding very low equity exposures. The primary reason for this is that many got burned in the past decade, either by the bursting of the tech bubble some 10 years ago or by the very sharp, temporary sell-offs in 2008 or 2011.
- Relative attractiveness: With central banks printing record amounts of money, keeping funds in cash is a bad idea longer-term. What other options are there? Bonds? Interest rates are close to zero, so that’s not attractive either. Precious metals? This should be part of every investment portfolio, but buying more at elevated prices may be a bit risky. Real estate? Oh no, too much pain in the recent past; it’s too early to jump back into this market.
- Inflation protection: While inflation destroys the true value of savings and bond returns, stocks do adjust to an increase of inflation, at least to some extent. With the huge amount of liquidity being created by central banks, risks are increasing that we will see a prolonged period of inflation, similar to the 1970s.
- Increased payout ratios: There is a clear trend that dividends are becoming more important to investors again. Therefore, a growing number of companies are increasing their dividend payouts. Dividends used to be much more important in the old days and, after touching an all-time low a few years ago, the dividend yields are on the rise again.
- Relative pricing: Most major stock markets are still trading at levels seen 10 years ago. However, most companies are much leaner today, carrying lower levels of debt, and the size of the global markets has increased significantly in the past 10 years. This gives companies, which operate globally, new opportunities to sell their product and services. In view of this, today’s equity prices are offering compelling value.
- Higher growth in emerging markets: While economic growth in the U.S. and Europe will remain very disappointing in the near future, other markets are doing significantly better. China, India, Brazil and other emerging markets are showing a much more dynamic economic picture. We have to expect a temporary slowdown in emerging markets as well; but in the long run, capital will flow to markets that experience higher economic growth in the years ahead. Emerging markets will remain the growth engine for the world. We expect global gross domestic product growth to be around 3.5 percent in 2012. Despite the positive outlook for emerging markets, investors need to realize that volatility is typically higher than for Western markets and picking the right stocks is a more tricky exercise.
While we see an increasing chance for positive equity market returns in 2012, we remain cautious in the long run; and we are convinced that the time to buy and hold equity investments is over. Therefore, managing equity investments and investment portfolios in general will become much more challenging in coming years. Also, we think that certain sectors will still see disappointing returns even if the broader market outlook is improving — a good example being financial stocks, especially banks. Changing regulation and capital requirements will cause financial stocks to underperform in the near future.
For the coming weeks, we expect market volatility to remain high and stocks to continue to be under pressure, due to the uncertainty surrounding the European debt problem and the U.S. deficit problem. Although the market focus is on the European situation, we expect the U.S. crisis to become the dominating problem again. Most likely, this is going to happen once the European countries have reached an agreement on how to restructure Greece’s debt and/or to enlarge the European Stability Fund. An agreement would contain the problems for now and give European states much needed time to bring the finances in proper order.
On the other hand, there seems to be less progress in the United States in resolving the debt problem. The intense fight between the two main political parties has resulted in a deadlock, which is a very dangerous situation. One similarity between the European and the U.S. debt problems is that in the long run, spending cuts are not going to be enough. Also, the real value of future obligations needs to be reduced. This is most likely going to happen through increased levels of inflation in coming years.