2012 investment outlook

I don’t know why I feel the need to do an outlook post. I don’t pay any attention to market forecasts. I don’t invest in indexes. So, why the need for an outlook post? Well, over the years I have to come to the opinion that it is quite helpful to your investment results to know at a very broad level if you’re investing with a head wind or with a tail wind. For me this affects my broad allocation to cash versus risk investments and also helps me determine how much risk to take in my trading account. The upside to investment outlooks is that on a long term horizon they don’t change that often. With that said lets jump in to my thoughts on 2012.

For 2012 my outlook on equity markets remains almost exactly the same as last year. Last year I wrote;

As far as the macro environment goes, it mainly drives my asset allocation decisions. And those decisions are strongly colored by my contrarian nature. Today I find markets in general over valued world wide based on historical relationships with emerging markets being frothier than developed ones. And more importantly I think there are more risks to the downside than surprises to the upside. In that light in the new year I have raised my cash position to about 40% of my portfolio. I think there is a good probability that 2011 will give me a chance to put that cash to work. But maybe not. Who knows?

That turned out to be a pretty good positioning for the rest of the year. In 2012 I’m pretty much of the same opinion with some slight differences. Stock markets are generally over valued still but this time European and emerging markets less so with their dismal performances in 2011. I also think there are still more downside risks than upside opportunities. This time let me provide some backup data.

The US stock market is over valued based on long term valuation metrics. The chart below shows 4 popular stock market valuation metrics. They all show the US market about 30% over valued. For more info see here. Dshort updates these metrics frequently.

Historically, markets tend to go from periods of high valuation to periods of low valuation. This has been true since 1900. Since 2000 the US markets have been range bound to put it optimistically. See the chart below. The chart is a bit old but gets the point across.

Notice the length of prior range bound markets. Based on history we still have a few years to go of range bound markets and could very likely see lower valuations. Bull markets do not start from high valuations. That does not mean that in the short term the market will not go higher. It sure can. But there is sure not a tail wind for higher stock prices.

The downside risk is that this is really not a range bound market but a true bear market, last seen in the great depression. See chart above. What makes today’s macro environment different from every market except the great depression is that we are in a period of deleveraging. The last time this happened in the US was in the 1930s. The chart below says it all. See here for source. Steve Keen’s blog is quite good and worth reading.

A similar picture can be painted world wide not just in the US. The point is that a big part of economic growth in the last decades came from expanding credit and debt levels. That is most likely over now and the deleveraging that is on going and likely to continue is providing a headwind to economic growth, earnings, risk appetites, and investment returns. I do believe the US and the world is much better equipped to handle this new deleveraging and thus I land in the range bound market camp as opposed to the bear camp. There are pockets of good value in markets but those can be easily derailed by the global macro forces very quickly.

With this 2012 outlook in mind my investment positioning remains focused primarily on capital preservation, income and dividend investing, and high levels of cash. I remain focused on dividend payers, certain fixed income investments, and on finding good trading setups. Investing in today’s environment is full of headwinds. Better to sit out most of the storm and wait for better weather.