It’s Tuesday in Europe, and they’re short on cash.  Sound familiar?  It should, as this has been going on now for almost four years.  In this environment, we find ourselves discussing low interest rates, job uncertainty, political dysfunction and how to cope with lifestyle adjustments never contemplated during the years of leveraged living.    There’s no going back to the “good old days”, so the sooner new strategies are in place, the better.

Moving into 2012, the economic and political issues are pretty clear.  The outcomes are not, and consequently, investors remain both skeptical and apprehensive.  The traumatic stress of the 2008/9 market meltdown is still with us, and like a homeowner bracing for a hurricane, the storm shutters are up and everyone’s hiding in the hall bathroom.  If we should experience a disorderly resolution to the European debt crisis, no one can say it comes as a surprise.  So, let’s look beyond the “event” for a moment, clarify our perspective and commit to moving forward.

A year ago, Europe represented an investment risk, and analysts were calling for the US economy to grow about 3%.  Corporate earnings were on the rise.  In reality, Europe turned into the dominant investment issue of the year, while US GDP stalled in the first quarter, and though it improved as the year progressed, it will likely come in at only 1.8% for 2011. Not enough to call it growth.

As the above chart shows, corporate earnings hit a new all-time high. But, the US stock market ended the year right where it began with the S&P 500 Index up 0.04 points or 2.11%, counting dividends.  For the year, mid-cap stocks declined and small company stocks were relatively flat at +1%.

Foreign stocks closed down -12% while the emerging market index declined -18%.

The upside surprise came from US and municipal government bonds.  The Fed’s QE2 and operation “twist”, coupled with fears of a euro collapse and a flight to perceived safety sent government bond prices soaring and yields to historic lows.  The BarCap Aggregate Bond Index, with its heavy weighting in US government bonds, gained 7.8% in a year that was supposed to be a good one for stocks.

2012: Europe the US and China
In their book This Time is Different, Reinhart and Rogoff define debt intolerance as “a syndrome in which weak institutional structures and a problematic political system make external borrowing a tempting device for governments to employ to avoid hard decisions about spending and taxing”.  Greece has spent more than half the years since 1800 in default.  Should anyone be surprised that it’s in the same place again?

Notably, as the debt issues worsened in the peripheral European countries, the government leaders were replaced with “technocrats” rather than politicians.  We’ll take that as a positive.

In the fourth quarter, uncertainty surrounding bank exposure to European sovereign debt raised concerns of a credit freeze similar to that of 2008/9 and the Lehman Brothers collapse.  On December 21st, the European Central Bank (ECB) loaned more than $640 billion to European banks to reduce the risk of a financial system melt down.  While the move reduced the risk of contagion, it didn’t address the issue of too much sovereign debt.  That problem and a European recession will be with us in 2012.

Here in the USA elected officials argued over budget deficits, failed to “go big” on a debt deal, gave up our AAA credit rating and punted on a debt reduction plan via the special “super committee”.  Still without a real budget, Congress avoided government shutdowns by passing continuing spending resolutions.  The US government has now run deficits exceeding $1 trillion a year for the past three years, borrowing heavily from the Federal Reserve, China and Japan.  Consumer sentiment dropped to its lowest level in 30 years (excepting November 2008), the president’s approval rating hit a term low of 40% and Congress saw its dismal approval rating sink to an all-time low of about 10%.

It will be a long and difficult process to reach a political consensus on the role of government, debt and entitlements.  Nevertheless, it is one that we must both embrace and endure.

Despite all that, the economy managed to add about 140,000 jobs per month (2.9 million since March 2010) while GDP growth actually improved as the year wore on.  A strategist at JP Morgan said it best when he wrote that “in the battle between the forces of political headwinds and the power of the US private sector economy, the economy has shown thus far to be the better bet”.


The key takeaway on stock valuation is that in 2011 earnings grew while prices did not.  Even though we expect
earnings growth to contract somewhat in light of a European recession, US stocks have become even more affordable.  The chart below highlights the relationship between price/earnings ratios and equity returns.  Another strategist noted that only 20% of the time in the past quarter century has the multiple been this low…time to rebalance.

China is now the world’s second largest economy and the biggest contributor to global growth.  The International Monetary Fund (IMF) estimates that over the next several years, China will account for about 30% of world GDP growth per year while the US will contribute about 15%.  This has important implications for international investing and emerging economies.  With the emerging market index off more than 18% in 2011, and price/earnings multiples lower than the US market, this asset class once again appears attractive.

Strategically, we want to maintain our focus on income while selectively rebalancing toward specific equity classes like blue chip and dividend paying stocks.  We reduced our international exposure in August and November of last year, and have maintained cash cushions to temper market volatility.

In 2012 we intend to manage risk through the continued use of structured notes while seeking equity like returns in asset classes like high yield bonds.  We will continue to build our energy sector allocations into core portfolio holdings and will look closely at large cap growth companies, the most undervalued equity asset class going into 2012.

In closing, we would like to emphasize that 2008 gave us the end of the credit driven lifestyle.  Everyone has been affected in one way or another.  The game has changed.  Consumers are reducing or eliminating debt, increasing savings and evaluating large purchase decisions.  We are in a deflationary environment where income and steady earnings are the way to measure success.

Here’s to a healthy and prosperous New Year.

Watermark Update
As is our custom, we will be sending out year-end tax reports toward the end of January.  You will receive your 1099’s from our custodians, Schwab and TD Ameritrade by mid February.  Unlike previous years, the custodians must now report realized gains and losses on these forms.  This year, you’ll see stock transactions and in subsequent years the forms will include mutual funds, fixed income and eventually, all other transactions.  We have been working with TD and Schwab to be certain that they have the proper figures.  Please be sure and give us a call if you have questions on the new format.

Please welcome Lyle Brandt to Watermark.  Lyle worked with us in the late 1990s before founding his firm, Peak Capital Management.  We are pleased to tell you that he and his clients are once again part of the Watermark family.  He brings more than thirty years of experience and expertise to our staff.

We would also like to let you know that we will soon forward our updated regulatory documents as required by the SEC.  Significant changes include the move to our new offices in San Ramon, the addition of Lyle, and our asset growth to more than $180 million under management.

As always, we value the trust and confidence you have placed in our firm.

Mark Miller  Eric Lai  John Wenzel  Lyle Brandt