For the last few years I have participated in two different "year ahead" preview articles -- one for The Bespoke Investment Group and one for Seeking Alpha. These are both excellent resources -- each valuable because of the specific approach taken.
Last week I suggested that readers join me in checking out the ideas of the Bespoke panel. If you have not done so, it is still an excellent and timely idea.
I know that many readers do not click through to the links. With this in mind, I am repeating the text of my responses here at "A Dash." These reflect my current thinking on many issues covered recently in other articles, and will be the basis for continuing work.
For your convenience
Below is the full 2012 Bespoke Roundtable Q&A with Jeff Miller of A Dash of Insight.
1) Looking back on 2011, what were your best and worst calls?
Thanks again for inviting me to participate. The questions are excellent, so I always learn something just by formulating my own answers. You also have a great roster of participants, and I learn from their wisdom. I know from the comments that readers of my blog also appreciate the work you do in producing this Roundtable.
Turning to my own results, my best calls were sticking with Apple, trading drilling stocks in a timely fashion, and accurately predicting earnings on most of my holdings.
My worst calls were in the medical device area, where earnings remain solid, but fear of policy changes is overwhelming. Even though I was underweight financial stocks, the correct weighting would have been zero!
Overall, my worst prediction was that the market would gradually accept the evidence of better earnings and an improving economy. I was right on the facts, but wrong on the reaction.
2) What surprised you the most about financial markets in 2011?
I was most surprised about the persistence of highly-correlated trading based on the headline of the day. We all know that this will eventually end, and I expected that to happen last year. The risk on, risk off, simplification underscores the irrelevance of most actual data.
One lesson for us was the increased emphasis on yield. It caused us to develop a new program for yield-oriented investors. By combining solid dividends with covered calls, we created a strong, income-oriented investment program.
3) The S&P 500 hit its bull market highs in April 2011. Which will happen first? Will we first take out the April highs or have we entered a new bear market (a decline of 20% from the highs)?
We almost had the decline already! In October we were down 19.4% on an intra-day basis. Right now it is a good question since we are about 9% off of the highs. I expect us to take out the highs in the first half of 2012.
4) Depending on your answer to question 3, how long do you expect the bull or bear to last?
At least through 2012. The biggest concerns come from things that most people are not already worrying about. Everyone is closely monitoring the economy and Europe, for example. North Korea is a wild card. Middle East tension and concern over nuclear weapons in Iran could generate a spike in oil prices.
To summarize, some shock to the economy is the biggest worry in 2012. Barring that, a bull market will end when Fed policy sends interest rates significantly higher, probably not until 2013 at least.
5) How should an investor with average risk tolerance be positioned for the year ahead?
I appreciate the careful wording of your question. Most investors are freaking out, over-reacting to headlines. The big market swings induce plenty of fear. If you think (incorrectly in my opinion) that your upside in stocks is only 8% for the year, why deal with a market that often moves 2-3% in a day.
Most investors are not honest with themselves about risk. Even in a good market year it is typical to have a 15% drawdown at some point.
In my approach the first and most important question for the investor is not what they hope to gain, but what level of risk is appropriate.
With this in mind, positions should be about 30% smaller than normal because of the current risk level. I use the St. Louis Financial Stress Index as an objective means of determining actual risk. It is not a forecast of the stock market. My research found that a level of 1.1 in this index was the start of a trigger range. This level was briefly exceeded a couple of months ago. The index has pulled back into the .8 range, but not enough to give an "all clear."
6) How do you see the European sovereign debt crisis playing out in 2012?
This is the biggest current issue and the best source for profit by getting it right. There is an overwhelming consensus that this is an inevitable disaster. Merely questioning this and raising alternative possibilities leads to a chorus of people questioning your sanity!
This is a very crowded trade: short the euro, long bonds, long puts, short US financials, 100% out of the stock market for investors, and short for many hedge funds.
I have a resource page linking to more detailed coverage (http://oldprof.typepad.com/a_dash_of_insight/european-debt-crisis.html), so this is just a summary of conclusions. Check out the link to see the argument.
There will be a problem with European sovereign debt for a long time, a period measured in years. Merkel has said that it is a marathon. The market is treating it as a sprint!
At a dinner in October I surprised some blogging colleagues when I told them that we would no longer be worried about this issue in eight months: June or July. Today's news reports that Mark Mobius just said something similar.
What is taking place is a process of negotiation and compromise that will gradually involve many different programs and participants. The final result will be a combination of bailouts, leverage, ECB bond buying, investments from sovereign wealth funds and China, austerity, economic growth, and maybe even the departure of one or more eurozone members.
Not one of these things, but all of them. Democratic governments move slowly, trying to figure out what works. They will do more of what is working and less of what does not. The partial moves, disparaged as "kicking the can" by the average talking head, actually provide some useful time.
There will be no trumpet sound ringing when it is over, just as there is no gong sounding right now. The Europe story will gradually fade, and people will notice that it no longer dominates the news.
7) How bullish or bearish are you on the following markets: The US, Europe, Developed Asia, China, Emerging Markets?
There are many good investments, but the US has an advantage on a risk adjusted basis. I own many stocks with substantial global exposure. I like China better than the general emerging market theme.
8) What do you believe is the contrarian call on equities right now?
My measure of sentiment is the P/E multiple on forward earnings, especially as compared to interest rates or inflation expectations. This tells you what those with assets are really doing as opposed to what they are saying.
By that metric, sentiment is more negative than it was at the 2009 bottom.
9) How confident are you that US companies can live up to current consensus earnings expectations?
I have a contrarian take on earnings forecasts: I find them to be of some value! No one else does. I share the popular skepticism about "buy" and "hold" ratings, but I find the earnings forecasts to be helpful.
Most observers will tell you that earnings estimates are too optimistic. The same people will tell you that the bar is too low at the time companies report. Well you cannot have it both ways. If these statements are both true, then at some point in time, earnings forecasts must have been reasonably accurate. My research shows that the one year forecast period is very good, incorrect only when there is a recession. http://oldprof.typepad.com/a_dash_of_insight/2010/10/profiting-from-forward-earnings-estimates.html.