musings on 2012

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2012?!?

Yes, you’re reading the year correctly–2012.

Why so soon?  Two reasons:

First, stock markets around the world seem to me to be laser-focused on the here-and-now.  As a general rule, any successful investor has to have a perverse streak–the fact that everyone is doing one thing is prima facie a reason to set out in a different direction.  Besides, focusing exclusively on today and tomorrow is playing the day traders’ game.  Great for passing the day, great for your broker–bad for your portfolio.  The edge, if there is any (the evidence is that day traders in the aggregate lose money), in this game is with the guy who has the most advanced trading software or the itchiest trigger finger or, in today’s world, is co-located with the marketmaker.

That’s not me.  I don’t think it should be you either.  We should be working smarter, not harder.

2.  Some people are beginning to argue that what we are now experiencing is not a simple correction in an ongoing bull market, but rather the first signs of a fundamental change in the direction of the market to the downside.

Their argument starts with two suppositions:

–turmoil in the Middle East will intensify, resulting in significantly higher oil prices.  This, in turn, will create a substantial headwind to world economic growth;

–the earthquake/tsunami/ nuclear power plant disaster in Japan will tip that country into recession (it wouldn’t take much, since Japan is barely growing). That, by itself, will have a negative effect on world growth.   In addition, supply chain disruption caused by damage to manufacturing plants in Japan will create added problems for industry internationally.

Together, the argument goes, these two forces are enough to cause a fragile world economy to slide back into recession.  Down world economy implies down world markets.

Could this be right?

my thoughts

it’s normally too soon to be worried…

Typically, the market begins to turn to earnings prospects for the following year in June or July of the current one.  Until summer, the market usually concentrates on the details of this year’s profit performance and doesn’t worry much about anything farther into the future.

…but these aren’t normal times…

2010, of course, was by no means normal.  Last year, investors refused to look any more than a month or two ahead until September or October.  Only when the positive evidence from corporate earnings reports became overwhelming did the market grudgingly begin to concede the possibility that 2011 might be an up year for company profits.

Once stocks began to move up, however, they didn’t stop until they had discounted everything positive that might happen in 2011.  Very unusual behavior, but the reason I had been expecting a correction.  It’s just too soon, for any market–but especially for one that has been so skittish, to begin to discount possible 2012 earnings gains.

The bears might cheerfully concede that that’s how the downturn began a month ago.  But, they would claim, the Middle East + Japan have turned a correction into something fundamentally different.

…so maybe a long glance ahead makes some sense

Another factor to consider:  we’ve just passed the second anniversary of the start of the bull market.  This is just an early warning indicator of the maturity of the advance. Some bull markets, like the one that began in 1992, have lasted far longer than two or three years.  But we can’t rule out the possibility of a market downturn in the easy way we could have in 2010.

So, contrary to the way things usually, maybe–just to be safe–it makes sense to take a guess at what 2012 might be like.

my yearend 2010 view

My base case for 2011 made at the end of last year:

–earnings of $100 for the S&P 500, which might be a little aggressive,

–a multiple of 14x, maybe 15x if we’re lucky,

= an index target of 1400-1500 for the S&P.

a rough guess for 1012?:

–eps growth of 10%-15%, as economies gradually return to normal and short-term interest rates begin to rise,

–a multiple of 13x-14x on those earnings,

= a target of 1430-1610 on the S&P.

If those guesses were anywhere near the mark, it would imply that 1012 would be an up year, but with the market rising less than 10%.

what’s changed since then?

How do Japan and the Middle East change these figures?  I don’t feel comfortable putting down precise numbers for either.  But I think it’s safe to say that the entire negative effect, both in Japan and elsewhere, of the earthquake will occur in 2011.  This means 2012 will benefit not only from the absence (we hope) of a comparable negative event, but also from the positive stimulus coming from reconstruction efforts around Sendai,.

Similarly, the negative effect of higher oil prices, provided they stay within a reasonable distance of the present level, will be felt throughout most of 2011.  Absent comparable increases again in 2012, the negative effects will fall out of year over year comparisons by next March.

Consumer pain will be felt most intensely in the US, where low energy taxes mean that the percentage increase in prices will be larger than elsewhere and where consumers use mind-boggling amounts of petroleum products.  But, on the other hand, the US consumer is showing surprising strength, and is in the best position today to withstand the negative effect of more expensive oil.

my conclusion

I find that these thoughts are pushing me toward a conclusion that’s different from what I’d expected. Japan may clip a percent or so off S&P 500 earnings growth this year, but will add a similar amount next.  Higher oil prices may shave another, say, 2%, from S&P earnings growth in 2011 but have little effect on the 2012 tally.

In other words, the Middle East and Japan will end up making the growth rate of 2012 earnings over 2011 results higher than it otherwise would have been.  An S&P level above 1400 may therefore prove hard to surpass in 2011, but one of 1550–a 10% gain–looks easier to achieve in 2012.  By slowing down and stretching out the pace of economic recovery, Japan and the Middle East may make it more probable that the rebound stretches well into 2012.