What Last Year’s Stock Market Says about 2012

Day to day, the stock market may feel like a roller-coaster, but in fact the U.S. is experiencing stagnation with a very, very faint upward trend.

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Jin Lee/Bloomberg via Getty Images

A trader works on the floor of the New York Stock Exchange, where the Standard & Poor's Index was virtually unchanged for the year.

If you asked most investors about 2011, they would probably tell you that it was a year of extreme economic uncertainty, marked by fears of recession and a currency crisis in Europe. Risks were high and stock prices were volatile. That’s perfectly true if you look at day-to-day swings. But look at the year in its entirety, and you see a different picture.

Overall, in fact, very little happened. Europe didn’t solve the euro currency crisis. The U.S. economy didn’t rebound. The S&P 500 closed 2011 almost exactly where it began the year, and the Dow crept up a scant 5%. The economy grew for the 10th quarter in a row but real GDP was less than 2% above year-earlier levels. Today’s economy may feel like a roller-coaster, but in reality the U.S. is barely going for a ride; it’s more accurate to say it is experiencing stagnation with a very, very faint upward trend.

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Of course, that doesn’t mean all stocks performed equally. Shares offering above-average dividend yields outperformed the rest of the market by five percentage points, on average. At the same time, growth stocks outpaced value stocks by a similar amount. Those two trends may seem contradictory, since value stocks typically pay higher yields than growth stocks do. But essentially, the U.S. stock market was showing some optimism about future growth at the same time that many investors were searching for worthwhile yields.

The quest for yield in the stock market was largely the result of the exceptionally low interest rates available on bonds. Indeed, yields on 10-year Treasuries declined from 3.9% in 2010 to 1.9% by the end of 2011. As I discussed last week, three factors caused this sharp drop: the Fed’s attempts to bolster the economy by pumping lots of money into the system; depressed demand for borrowing; and a flight to safety by institutional investors moving out of the euro and into the U.S. dollar.

Indeed, the flood of incoming hot money boosted the dollar by 9% in the second half of the year. Simultaneously, the euro fell to a 17-month low. Gold performed even better than the dollar, rising about 10% in 2011, for its 11th annual gain. Toward the end of the year, however, gold started weakening on fears that austerity in Europe would lead to a global recession.

Looking at the major stock market sectors, we see that financials were the biggest losers, down 20%. The euro crisis continues to pose a threat of big losses for banks all around the world. The other big loser in 2011 was the basic materials sector (i.e., natural resources apart from energy), down 13%. A global slowdown, including faltering growth in China, is reducing the demand for raw materials.

The sectors that were up 10% or more for the year included: electric utilities, 15%; consumer staples, 11%; and health care, 10%. All three are basically defensive and recession-resistant. In addition, many stocks in these groups offer dividend yields above 3%.

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Three sectors were nearly flat for the year – discretionary consumer items, energy and technology. All three groups are sensitive to economic growth. So the fact that they were static reflects the current level of economic activity – or inactivity.

Take all these trends together, and you have a fairly clear picture of where the U.S. currently stands economically and what the issues are for 2012. We have been out of recession for a long time and are on track to recovery, although not making much progress. So far, growth has been minimal – far too little to bring unemployment down to normal levels.

The U.S. is also benefiting from uncertainty in other countries. Inflows of hot money should keep bond yields unnaturally low for a while. At some point, however, those inflows could taper off. And that, in turn, could produce a sharp rise in rates and sizable losses in the bond market.

Stock investors continue to worry about the stability of banks and other financial institutions. They are also worried about a double-dip recession. As a result, stock buyers are cautious about investing for growth and still favor recession-resistant stocks that offer generous yields.

The big question for 2012 is whether investors become confident enough to begin moving out of defensive stocks and into more aggressive growth choices. There would be a good case for that, if you consider the U.S. economy in isolation. But two interconnected risks exist that argue against such a move at this time. First, there is a significant chance that the euro will come apart or that some members will leave the Eurozone. That would likely send a shock wave through the banking system and probably batter the stock market for three to six months.

Second, if Europe does manage to keep the common currency intact, it will be at the cost of brutal austerity policies that would likely cause and prolong a recession in Europe. Consider also that China’s economy has slowed and that there are political risks, such as conflict with Iran, and the possibility of a global slowdown is substantial. Until those dangers pass, conservative investors are probably smart to focus on defensive choices and continue to favor top-quality stocks that offer high yields.