title for a 2011 year-end entry

31 Dec

Another year has passed, while a new one begins. Each annual turn is often a time of reflection as well as prediction. In keeping with that tradition, today’s entry will comprise some of the former, but mostly the latter, and some of neither.

The S&P 500 ends the year up about 15%, the Nasdaq about 17% and the Dow 11%. From where I stand, that’s a banner year, especially considering that average annual returns are more like 8-9% and long-term expected returns from today’s levels look to be under 6%. (Thus we can say this one year’s returns represent two years’ expected.) Commodities and other risky assets also had a great year. Bonds and stocks, both foreign and domestic, performed well. Commodities, in some cases, knocked it out of the park (think cotton, up 90%). Gold rose about 30%, oil 13%. Housing prices did not do so well, however, and the economy limped along.

So 2010 looked good for the markets. Does that have any relation to a 2011? As we have to disclose often, past performance is not necessarily an indicator of future results. Still, the two are often related. Specifically, past performance can be a contrary indicator of future results. As the saying goes, if something can’t continue, it won’t. I am optimistic about the future overall, but I see several areas that appear stretched and where future results may not be as robust as the recent past.

Today we learned that that Groupon accepted about $500 million of a $1 billion funding round. This is a two-year old company is an industry that doesn’t have a lot of barriers to entry. Sure, they were the first, but their margins are artificially high and their labor-intensive strategy depends a lot on street-level salespeople. There is a lot of panache here; Groupon is cool and retailers want to be associated with them – now. But “cool” is ephemeral and in business competition does not lay down just because you’re bigger. Especially when the business model is so easily copied and the space nascent. Competitor LivingSocial has received investment from Amazon and it’s not a stretch to believe my favorite online retailer could move into that market. Yet Groupon is raising a billion dollars. To me, it’s unbelievable and is probably a sign of too-heady times in the private markets.

Meanwhile, the commodities rose still has its bloom on the ever-present investment thesis of increasing consumerism in emerging markets. I think there could be several surprises on the “emerging” front in the new year that will surprise a lot of the gung-ho investors in this space. I speak specifically about gold and rare-earth metals here, but I get the feeling that a lot of the agricultural commodities have run up too high (and so have some of the ag-related stocks). A thesis that makes sense at a price does not make sense at any price.

Oil seems fairly priced to me at present.

As for stocks, a previous post pretty well elucidates my thoughts here. Bonds are something I’ve also recently written at length about and my feelings here haven’t changed a whole lot. I think surprises to the downside on bonds and stocks await. Put premiums are low as markets near their recent highs amid high levels of investor bullishness. This tends to be the case near market peaks.

Are there any bubbles (other than in the use of the word “bubble”)? I think there is one in concerns over our fiscal and monetary situation. That is a funny thing to say because I, too, am concerned. It just seems to me that “everyone” is concerned about these two things and so they are probably somewhat overblown. Such things have a way of working themselves out. While it’s often felt that the good folks in Washington live in a different world, I’m not convinced they won’t take care of these problems. A year ago, I wouldn’t have dreamed Obama would break his campaign promises by passing a law that was largely deferential to Republicans. But it doesn’t take much to change Washington’s mind and/or direction these days and our problems will not just get worse in a linear fashion. However, fiscal and monetary issues should lead investors to plan for contingencies, protecting from downside deviation.

The solutions aren’t linear, either. Think protection from phase transitions, or more popularly, tipping points. Securities trading below intrinsic value. Healthy balance sheets. Excess cash. Opportunistic management teams with flexible operating philosophies. Don’t try and time the market, but be ready to pounce when Mr. Market turns manic.

Most of the economic data coming out is noisy. The bottom line is the economy isn’t going gangbusters and I’d expect that activity would remain at a similar pace. Of course, that’s the easiest expectation. Unemployment just can’t come down as fast as we’d all like without some significant retraining and job creation in other sectors. It’s a structural issue which will take years to resolve. At the same time, corporate profit margins are well above their historic highs.

2010 was a fantastic year, personally as well as professionally. Each day is a chance to learn something new and I’d like to think I was able to do so. I hope 2011, despite its being an odd year, holds similar promise. Happy New Year.


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