IF

2011 turned out to be a breather year for the US stock market after two years of rallying off the 2009 low. Despite the S&P 500 closing modestly higher, the year was notable for price volatility. After rising strongly into May, the market fell almost 20% to its October low only to rise again by year-end. Geopolitical and macroeconomic concerns made 2011 a particularly hard market to weather.

As we enter the New Year, the outlook for the market looks to be influenced by these same global concerns. We might as well call 2012 the year of “IF.” For example, what happens:

IF there is a run on the European banking system and the Euro collapses and the contagion spreads to US banks? IF world growth slows, Europe goes into recession and China’s economy has a hard landing? IF there is a violent confrontation with Iran and oil goes to $200/bbl and gasoline to $5/gal? IF a Republican or Democrat is elected president in November? IF US political gridlock continues, and issues of pressing national importance continue to be ignored?

These are geopolitical, macro-economic issues. We readily admit that we don’t know how they will play out in 2012. There will be surprises to be sure. And nobody can presume to claim that they know how the interaction of events will play out. To a large extent, investors are in the hands of the gods when it comes to the big picture. Some would say that the market is unable to discount what it can’t anticipate. Therein lies the risk for investors.

Economic reports suggest that the US economy has so far been insulated from the troubles in Europe. The economy seems to be improving though at a modest pace. The current momentum should carry the economy higher in the first half of 2012. China continues to grow strongly though India struggles with high inflation and a weak currency. Brazil is cooling having shown 0% growth in the third quarter of 2011 while Russia is experiencing political challenges and capital flight.

While macro issues will strongly influence market returns, the situation at the micro level offers cause for optimism. You have heard this from us before but the facts remain: Earnings for many corporations remain strong though growth will probably moderate. Balance sheets for a wide variety of companies are robust with lots of cash and relatively low debt. Valuations are low. The price/earning ratio (forward earnings) of the S&P 500 is about 13 compared with a historical average over 16. The S&P 500 index dividend yield is 2% with a good chance of rising further as companies return more of their profits to shareholders. This compares favorably with yields under 2% on five year, investment grade corporate bonds and 2% inflation. For the long-term, equities seem to offer the best value among asset classes.

Short-term, the risk/return outlook facing equity investors is asymmetrical: upside potential of maybe 10% if we muddle through vs. 20-30% downside in the event of an overwhelming crisis. Our strategy has been to maintain cash balances above typical levels to cushion against unforeseen shocks. Nonetheless, on weakness, we intend to commit funds to stocks with low valuations that can produce fundamental improvement in operations in spite of a difficult macro environment.

While investors may find themselves discouraged by the macro environment, we are encouraged by the low valuation of potential investments. Many large-capitalization stocks such as WalMart, Microsoft and General Electric seem poised to move higher in price after a decade of disappointing performance. We are excited by the potential of investments in the oil and gas industry, which is experiencing boom times here in North America. After a dismal 2011 during which many foreign markets substantially underperformed those in the US, it may now be the time to increase exposure overseas.

2012 will be a year of threatening political and macroeconomic developments counterbalanced by low valuations and strong corporate performance on the micro level. It may well be “three yards and a cloud of dust” as football great Woody Hayes described the game, as opposing forces push and pull against each other. Volatility, at times, is to be expected. Though the crystal ball continues to be cloudy, we see reason to be optimistic.

All of us at P.R.Herzig & Co wish our clients and friends a Healthy, Prosperous and Happy New Year.

Tom Herzig

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