Shaping a Portfolio for 2012: mid-year review

2012 strategy

The year is half over.  It’s time to look at the basic portfolio strategy put in place on January 1st, see how well it did and make mid-course corrections.

The relevant Strategy posts are:  Shaping a Portfolio for 2012:  general, and putting the pieces together.

In brief, I thought:

–plus 10% for the year would be a good performance for the S&P 500

–volatility would be high, caused by the evolution of the EU financial/identity crisis, with Europe possibly following Japan down the road to ultimate economic and stock market irrelevance

–emphasis should be on the US, where broadening and deepening of economic recovery would make it important to emphasize technology, domestically-oriented companies and WMT customers rather than TIF clients.


How has that worked out so far?

Overall the strategy has been a reasonable guide.  Through July 3rd, the S&P is up 9%, making it a star among world equity markets.  WMT is up 18%; TIF is down 19%.

where I was wrong

Volatility has been greater than I’d expected.  I would have preferred daily fluctuations around a more or less steadily rising trend.  Whe we got instead was a sharp advance through March, an equally sharp fall through early June, and then a bounceback.

The EU may not be such a lost cause as I had expected.  In January I thought that the EU-as-the-new-Japan was both the most prudent course to plan for and the most likely outcome, given the immense power of the status quo.  I now think there’s hope for a better future for the EU, although decline-into-irrelevance is probably still the most prudent planning stance.  The difference?  I’m tempted to add one or two more EU-listed stocks to complement the IHG I already own.  I haven’t started looking yet, so I have no idea which names.  The general idea, however, would be to have companies domiciled in the EU but with much of their business elsewhere.

Emerging markets in general, and China in particular, have been weaker than I’d expected. Emerging markets are normally boom or bust affairs.  This time around, it’s taking these economies longer than I’d thought to reach an even keel after the boom of a couple of years ago.  Their next day in the sun may not dawn until 2013.  The result may be weaker commodities prices until then.  Another plus for consumers worldwide.

The effects of GDP weakness elsewhere has taken a greater toll on US industrial growth than I had figured.  The current slowdown in the US has to be the most important development I didn’t anticipate.

where to from here?

My thoughts are more in the category of fine-tuning rather than a complete overhaul.

–the S&P 500 has already achieved my admittedly conservative objective for the full year.  I think this means it’s time to become somewhat more defensive.  To move significantly higher from here, investors have to be able to envision reasonable earnings growth coming in 2013.

For now, the election (no one in Washing ton seem to me to be up for the task of addressing the current economic challenges the US faces–but this is usually the case) and the “fiscal cliff”  (the idea that currently-mandated spending cuts and tax increases will clip 4% from next year’s GDP, sending the country back into recession) stand in the way of imagining a happy outcome.

–This means that beneficiaries of innovation and structural change–traditional growth stocks–will likely be the second-half winners.  I’ve begun to think that the major cellular operators in the US, especially VZ, are particularly interesting.

–dividend-paying stocks continue to look attractive to me, despite their being expensive relative to recent history.  High current yield isn’t enough, however.  Dividend growth is an increasingly important issue, since simple bond-like high yielders have long ago been picked over.

–I’ve also begun to look at REITS that concentrate on major cities in the US, as a supplement to the hotels I’ve been advocating for some time.  The idea is that cities like New York and San Francisco are hubs of tech innovation.  They also draw considerable buying interest from foreigners  And their own economies are on the rise again.  I own SLG.  It has some warts, though–mainly its dependence on the finance industry tenants–so this one has a handle-with-care label on it.

Shaping a portfolio for 2012 (VI): putting the pieces together

my equity strategy for 2012

two caveats:  

–I’m looking at equities as a US-oriented individual investor with a global outlook.  My portfolio will be keyed off the S&P 500.

–I think there’s a chance that the EU is the new Japan.

Two decades ago, faced with a choice of preserving a traditional way of life or beginning a painful reorienting of priorities that would stimulate economic growth, the forces of the status quo in Japan overwhelmed those of progress.  Japan’s economy has since stagnated.  Its stock market, once the largest in the world, is now a backwater.  Its leading companies, other than auto firms, have been surpassed by foreign rivals.  Global investors don’t bother with Tokyo stocks.

Something similar could easily happen with the EU.  Bad for people who live there; not such a big deal for everyone else.  For investors, the EU would become a special situations market.  Portfolio managers would be on the lookout for unique, counter-culture firms, or for international giants who would be European only by accident of listing.   There’d still be the possibility, however, that such stocks would be held back by the general economic malaise andnot perform as well as they would if listed elsewhere.

That’s a worry for the future. My main concern for the present is the transition from superstar securities market to irrelevance.

That process didn’t go smoothly inside Japan, but it had relatively few negative effects on the rest of the world.  Japan was a single country, relatively isolated, and whose banks and government were funded by Japanese citizens.

In contrast, there’s some possibility that if the EU–a bunch of different countries, all dependent on outsiders to keep their financial systems afloat– chooses the Japanese route, the bumps in the road will have considerable negative effects for the rest of us.

How to protect yourself against these possible bumps?

I think this is an asset allocation issue–you protect yourself by having a smaller allocation to equities and a larger one to other asset classes, especially cash.

My equity strategy doesn’t consider that European financial woes might send temporary shockwaves across the rest of the globe.

(Two other points on Europe:  although investors outside the US seem to me to continue to be especially fearful, securities markets have been discounting Eurozone problems for over a year, and increasingly so over the past six months.  Also, I think the worst nightmare of the markets–another “Lehman moment”–is an unlikely outcome.  Even if the failure of a key financial player in Europe were to happen, the world already has a blueprint for action to prevent global trade from grinding to a halt.)

up 10%?

I’d characterize good performance for 2012 as being up 10%.  In looking at an individual stock, my first question is how it will deliver at least that return.  For what it’s worth, I expect stock markets will be volatile throughout the year and that the bulk of the year’s return will come in the second half.

what I’m doing

1.  Three years ago, with the US as ground zero of the financial crisis, it was clear that the US would be growing more slowly than the rest of the world.  So the right thing to do was to avoid stocks that were focus on the domestic economy and heavily overweight those that, while US-based, have the bulk of their profits elsewhere.

That worked exceptionally well until several months ago.   But it’s no longer the right thing to do, in my opinion.  Why not?

–Nothing works forever.  Stocks get expensive, and relative growth rates in the world change.

–Today, economic recovery in the US is broadening and many Americans have gotten excessive debt under control.  The housing market appears to be bottoming after almost five years.  Yes, recovery is slow and unemployment is high.  But changes on the margin are positive and that’s what counts.

–In contrast, Europe is in the midst of a crisis where the outcome is certain only to be one of various shades of ugly.  Emerging markets, while still generally growing more quickly than the developed world, are struggling with overheating.

It seems to me that consumer businesses that address a broad base of American customers and industrial makers of durables and of manufacturing equipment are the place to be.

2.  Market attention is also shifting again–correctly, I think–to larger, more mature companies.

Part of this is that American income-oriented investors are continuing to buy dividend-paying stocks.  Yes, this process isn’t new.  It’s been going on for two years.   And, yes, it’s scary that the trend has hit the newspapers.  But these slow growers are also reasonable ways to play the gradual bounceback of the fortunes of the average American.  And the Fed is likely to keep interest rates artificially low on fixed income for at least the next year.

Not exciting stuff, but investing is about making money–not about glitz.

3.  Not every consumer stock will be a winner.  Over the past couple of years, the clear winners were the luxury retailers and the dollar stores–the consumer bookends of the very affluent and the very not-affluent.  We’re now in a period, I think, of average Americans beginning to spend more freely. So the bookends are not the place to be.  I find it hard to figure out the net result of trading up and having too much bricks-and-mortar retail capacity, however.

4.  I still find IT attractive–e-commerce, social networking, cloud computing, mobile…are all important growth areas in all economies.  A big issue with the sector has been that the index is heavily tilted toward very mature companies.  In the current environment that may be a good thing.  I own a bunch of smaller companies.  INTC is my largest position.

5.  Europe is a place to avoid for now.  Yes, you can pick and choose among European-listed companies that have large exposure to the US or to emerging markets (I’ll confess to owning IHG).  But risks of a particularly unattractive outcome to the Greece-Italy situation are still higher than zero.  So why expose yourself to that possible downside if you can find comparable stocks at reasonable prices in the US?  If you’re going to buy Europe anyway, find something listed in the UK, Sweden or Switzerland rather than in the Eurozone.

6.  I think direct emerging market exposure of some type should be a continuing part of any equity portfolio.  Nevertheless, actively buying individual stocks in any of these countries (with the possible exception of Hong Kong) is financial suicide for just about everyone.  You might just as well burn the money in the street–at least you might get some entertainment value while your money goes up in smoke.

For what it’s worth, I own the Vanguard emerging markets index fund and a couple of the Matthews China-related mutual funds.

Shaping a portfolio for 2012 (V): the S&P 500 this year

4Q11 earnings season begins today

4Q11 earnings report season begins with AA after the close this afternoon.  According to theFinancial Times, Wall Street analysts are predicting that the companies in the S&P 500 will report another in a long line of quarters of year on year profit expansion, but at a rate under +10% for the first time since 2009.

There are four reasons for the weakening of the earnings comparisons:

–the € has weakened recently as the financial crisis in the Eurozone deepens.  That means a fall in the dollar value of profits earned by S&P 500 members in the EU.

–in response to Euro worries, wholesalers and retailers globally decided to reduce the amount of inventory they have on hand.  So they cancelled orders for merchandise that they would normally have bought from producers in 4Q.

–widespread flooding in Thailand led to hard disk drive and auto component shortages, meaning some products couldn’t be built and shipped

–economic growth in the emerging world continued to decelerate.

The component shortages and inventory shrinkage are temporary.  € weakness may be as well, depending on how the Eurozone crisis plays out.  If so, their main impact will be to transfer, say, 1% of yearly corporate earnings growth from 4Q11 into 2012.  As far as 4Q11 is concerned, however, the four together have probably been enough to offset all the positive effect on S&P earnings of a strengthening US economy.

According to the FT, S&P 500 earnings per share for full year 2011 will amount to $96.38, surpassing the previous for the index of $87, in 2007.  Given the sharp decline in reported earnings from financial companies since then, the 2011 figures document a huge rebound in performance by non-financials.

What about 2012?

The FT says the current consensus calls for eps of $106+ for the S&P this year, a gain of almost 11%.

My take is that that figure is really optimistic.  I also think that the analysts whose earnings estimates underlie this figure are assuming no negative impact on results from the financial crisis in Europe.  While that’s possible, I don’t should be one’s base case.

My assumptions are as follows:

base case

US (50% of S&P 500 earnings)       10% growth          = mild acceleration

Europe (25% of S&P 500 earnings)      5% decline          = significant deceleration

Emerging markets (25% of S&P 500 earnings)  15% growth          =significant deceleration

total          7.5% eps growth

optimistic case

US          +10%

Europe          +5%

Emerging markets          +15%

total          +10%

pessimistic case

US          +10%

Europe          -15%

Emerging markets          +10%

total          +4%.

Two observations:

–if I’m correct that some of the factors depressing 4Q11 eps are temporary, their reversal in 2012 should add a bit to 2012 S&P eps.

–in order for the pessimistic case to produce negative year on year eps for the S&P, European profits would have to fall by 30%.   While this is also possible, I don’t think it’s likely.

what about the multiple?

My pessimistic case yields eps for the S&P 500 of around 100.  The optimistic case generates eps of about $107 (i.e., the consensus).

If we apply the current market multiple of 13.5x to these numbers, we get an expected index level by mid-year of 1350 on my pessimistic view, 1450 or so if we’re optimistic.

In other words, it’s reasonable to expect single digit gains for the S&P from today’s level based on 2012 earnings.  Add the current 2% dividend yield on the market to this and expected total return from owning US stocks appears more worthwhile, if not up to the standards of 2009-2010.  It’s certainly better than bonds.

What could move results outside this range of possible outcomes?

–good/bad sector and stock selection

–rise/fall in the multiple applied to the earnings (decreased uncertainty could move the multiple in a positive direction)

–severe economic problems in China (unlikely, in my view) or implosion in the Eurozone (a year ago, I would have said this was impossible.  I still rate an extremely unfavorable outcome as unlikely, but it’s no longer inconceivable).

That’s it for today.

Tomorrow:  putting the pieces of I though V together.

Shaping a portfolio for 2012 (IV): the US

US:  stocks vs. economy

It’s increasingly important in looking at the current US stock market, as it typically has been with almost every other national bourse, to distinguish between the health of the domestic economy and the prospects for the stocks listed there.

How so?

According to the best information from Standard & Poors (not every member of the S&P 500 chooses to break out revenues geographically), only 50% of the revenue generated by the 500 come from the US.  About 25% are sourced from Europe and the rest from emerging markets.

In today’s US, as has been the case for the last generation elsewhere, one of the first questions an investor should ask is whether economic growth inside the country will be better or worse than growth abroad.

So let’s look at the US economy.

the economy

the Great Recession

The domestic housing bubble began to collapse of its own weight in mid-2007.  The economy reached its nadir in mid-2009 and has been recovering since.


Three bumps in the road:

–the boost from spending deferred by companies and individuals during the down turn was exhausted in mid-2010 and the economy slowed somewhat.

–the Fukushima nuclear disaster disrupted industrial supply chains in March 2011.  That’s basically over.

–worries about a financial implosion of the EU that could send negative ripples globally caused companies worldwide to shrink inventories, starting in the summer.  That downward adjustment appears to have just ended.

Looking into 2012,

the economic situation in the US seems comparatively good:

–the housing market may finally be bottoming, in all but the areas worst affected by speculation, after almost five years of decline

–much of the excessive debt taken on by consumers during the bubble has been worked off during three years of restrained consumption

–employment is improving at a slow, but gradually increasing, rate

–real growth in the US will likely be around +3% for this year, which would make the country the best performer among the major developed economies.

Yes, the US faces longer-term problems:  substantial government debt, continuing government budget deficits, increasing competition from China and other emerging countries, the decades-long failure of either major political party to develop a policy agenda relevant for contemporary America.  There’s also the near-term question of fallout from potential economic/financial problems in Europe.

Still, relative to both its own experience over the past several years and prospects for the reset of the developed world. the US is looking pretty good.

the stock market

From a simple top-down perspective, I think market strategy is clear:

–there’s a clear case for overweighting the US vs. Europe or Japan.

One might also argue for overweighting the US vs the emerging world as well, since domestic earnings will likely be expanding at an accelerating rate while emerging markets’ profits, although growing faster, will be doing so at a decelerating rate–but I’m less confident that this is the right thing to do.

–one should emphasize domestic-oriented firms vs. international companies, especially those with exposure to the Eurozone

–manufacturers of industrial equipment and consumer durables should do relatively well

–expect consumers to continue the process, already begun, of trading back up to the higher-end brands they abandoned during the recession

–given that growth stock beneficiaries of structural change have been the biggest winners until the past few months, it’s possible that traditional business cycle-sensitive value stocks will have their day in the sun.

Nothing’s ever that easy, though. 

The internet, as wielder of the sword of creative destruction, continues to wreak havoc among bricks-and-mortar retailers and the strip malls they inhabit.

The question of whether the current high unemployment rate is cyclical or structural (I’m in the structural camp) is also relevant.  If you think high unemployment is cyclical–and that continuing economic growth mostly means the long-term unemployed gradually get their jobs back–buy WMT or DG.  If you think it’s structural–and that growth mostly means the currently employed get raises–buy TIF or JWN.  (Note: for the past six months, DG has been the clear winner, with WMT in second place.  Is this a counter-trend rally or the start of a new trend?  If the former, is it already mostly played out?)

Luckily, there’s no need for any investor to have a strong opinion about everything–or to act on everything he has an opinion about.  Instead, the secret to success is to understand what the issues are, but to locate a small number of things that you have the highest degree of confidence in to invest in.

Shaping a portfolio for 2012 (III): China


In assessing China, I think it’s important to distinguish carefully between the course of the mainland Chinese economy and the fortunes of China-related stocks.

the economy


The foremost goal of the Beijing government is to keep the ruling Communist Party in power.  This translates into the economic objective of avoiding possible social unrest by keeping employment high and unemployment low.  That’s quite a trick when you’re managing the transition from a rural, agriculture-based society to a more urban and manufacturing-oriented one.

In addition, China dedicated itself to creating a Western-style market-based economy in the late 1970s when it realized the country was too complex for central planning to work.  Again, hard to do when three-quarters of your industrial base was zombie-like state-owned corporations, when being a businessman was a felony and where citizens preferred to bury chuk kam gold trinkets in the back yard rather than use banks.

Complicating the situation further is the fact that high corporate or local/national government officials are Party officials whose chances for personal promotion are directly related to aggressively growing the areas they control, whether doing so makes long-term economic sense or not.


At the same time, all the mid-level national economic officials I’ve met–who actually implement policy–have been highly sophisticated, well-trained (mostly from the US or UK), competent and dedicated to creating healthy and balanced growth.

Given the large size of the Chinese economy and the paucity of tools to make economic policy, the best they’ve been able to do is to lurch between two extremes, overheating and stalling (the latter meaning unemployment is rising–a combination of new entrants to the labor force and layoffs)–and gradually lessen the amplitude of the cyclical swings.

where we are now

When the developed world appeared to be coming apart at the seams in 2008, China allowed a particularly strong domestic lurch to the upside.  For the past two years or so, Beijing has been trying to force an economic slowdown to rein in that expansionary impulse.

Policymakers have most recently been signalling their belief that slowdown has gone far enough and it’s time for faster expansion again.

China stocks

By and large, non-citizens can’t buy or sell stocks in the domestic market.  I’m not sure it makes much economic difference whether the local bourses go up or down.

Hong Kong is the natural market where the best and brightest of the mainland list their shares.

Over the past six months, Hong Kong stocks have sold off much more heavily than, say, the S&P 500, in response to worries about the Eurozone and potential global economic slowdown.  Since bottoming in early October, they’ve only rallied back in line with the S&P.  As I see it, so far there’s no anticipation of a better mainland economy this year in Hong Kong stock prices.  Many stocks there look cheap to me.

what to do

Personally, I think it’s important for all but the most risk-averse investors to have some exposure to the Chinese economy.

The most conservative way to do so is to hold companies listed in the US or Europe that have significant businesses in China.  Luxury goods retailers like LVMH, Tiffany or Coach are possibilities.  Casino companies like Wynn and Las Vegas Sands make all their money in Asia.

Discount brokers like Fidelity offer international trading services that allow foreigners to buy stocks in Hong Kong directly and cheaply.  Most investors will likely find it easier not to do research themselves, however, and buy an ETF or an actively managed mutual fund that specializes in Hong Kong or Greater China.

Price action in December and early January is often hard to read because of tax-related selling–losers in December, winners in early January.  Still, I’ve been a bit surprised that Hong Kong stocks haven’t done better than they have, given that the most recent economic news out of China, the EU and the US has virtually all been positive.

I don’t think this means that the positive case for the Chinese economy and for Hong Kong stocks is incorrect.  It may just take more time for negative emotion–from investors located in Europe, I think–to exhaust itself.  I’ve always thought that “buy on weakness” is pretty lame advice.  But it’s probably the right approach in this case.