What on Earth is going on?
Financial markets in the year 2011 did almost precisely opposite that which everyone had expected. Should we be surprised?
Interest rates, which had reached historic lows by the end of 2010 and were expected to rise, fell even further.
Despite continued weakness in the U.S. economy, a mountain of debt, and persistent unemployment, the U.S. Dollar gained strength.
Despite superior growth and better balance sheets (and partially due to the strong Dollar), foreign equity markets (especially emerging markets) significantly under-performed the U.S. equity market (which was itself flat).
Fear, uncertainty, and confusion among the gamblers who trade in and out of markets hoping to make a quick buck.
Worries over the fate of the European Union and banks holding the sovereign debt of wobbling European governments spooked these traders, who shed risk by moving money out of foreign securities and into U.S. Treasuries. But, did they do this in a deliberate and methodical fashion? No. Markets gyrated hundreds of points up and down daily, in no way reflecting fundamental values.
Meanwhile, more far-sighted investors positioned themselves for a longer horizon over which more likely scenarios might be envisioned. Like us, Bill Gross, founder and lead manager of the largest and most successful bond fund family in the world (PIMCO) positioned his flagship fund for rising interest rates and growing inflation.
Did he guess wrong, or was he just a tad early? Interest rates are still at historic lows, and closing in on that magic zero, below which they will surely never stay. If any bet on interest rates can be judged sane, it is surely that they will rise, eventually. Additionally, in pursuing monetary policy intended to stimulate the U.S. economy, the Treasury keeps printing more money, which certainly risks weakening the Dollar and stimulating inflation. Likewise, contrary to recent market weakness, growth in emerging markets continues to outpace the developed world.
So what is the sane, emotionally detached investor to do? Well, keep our heads for starters; and not try to predict what will happen over the short term. There are certain longer term risks for which we can prepare and position our portfolios to withstand. The risk of inflation can be addressed through the use of inflation-protected bonds and the ownership through stocks in companies that own natural resources. The risk of rising interest rates (which translates into falling bond values) can be countered with floating rate bonds and shortened maturities. A weakening Dollar can be offset by owning foreign securities and currencies.
There are also opportunities to be exploited. Warren Buffet is fond of reminding folks that the best time to invest is when everyone else is frightened to death. And, then there is the old adage that the market “climbs a wall of worry.” If fear gripped the markets in 2011, perhaps greed will reverse them in 2012. No one knows, and we should not care. Our horizon extends out over years and, for some, decades. Positioning our portfolios to serve us over those horizons should be our guide.