Preparing for 2012's Coin Toss
Heads: The European Central Bank (ECB) is given the mandate to act as the lender of last resort and print Euros, thus kicking the proverbial can down the road. The eurozone is stabilized and further recession is temporarily avoided. Financial liquidity expands as the Fed continues its "accommodative" policy; low interest rates and corporate stock buybacks fuel upward pressure for global equities.
- or -
Tails: Europe fails to fund the critically over-leveraged governments sparking a messy unraveling of the crisis, contagion forcefully spreads and tightening financial conditions impairs growth in a meaningful way. Spooked investors could spark a run on stocks that would make 2008 look like a walk in the park.
The inherent nature of a coin toss scenario is that after enough flips, a "tails" will eventually land. Unfortunately, the sovereign debt crisis in Europe has escalated to a point of no return and is now playing this dangerous game every week/month. The simple facts of the problem facing European countries today render the inevitability of "tails" a mathematical certainty; there are no two-sided coins in this game. One of the most thoughtful and influential investors in the world, Mohamed El-Erian, CEO and co-chief investment officer of Pimco, recently wrote rather alarmingly, "It is critical for the welfare of billions around the world that Europe get its act together now."
As leaders across the Atlantic attempt to postpone the day of reckoning (or "rig" the game), the storm clouds are gathering. The interconnectedness of global activity will serve to further destabilize the global financial system, as the waves of the crisis will surely reach our shores during a fragile, yet gradual recovery. While some corporations are meeting conservative earnings expectations, profits have mostly been engineered through cost cutting measures (i.e. workforce reductions). News of an improving unemployment rate would seem contradictory, however further examination reveals discouraged workers "who have not attempted to find employment in the last four weeks" are "no longer counted" as unemployed. Moreover, the delicate and questionable strength of the domestic economy will struggle trying to weather Europe's formidable debt crisis hurricane.
The stock market has been willing to accept the concept of deferral for now, but the uncertainty surrounding the months and years ahead presents an extremely challenging investment environment for the buy and hold investor. The year ahead will almost certainly be an opportunity isolated market. Whether via stock picking, sector selection or deeply discounted closed-end exchange-traded funds (ETFs), investment gains in 2012 will be garnered as a result of rigorous digging; uncovering select opportunities where reward far outweighs risk. We are continuously scouring through an inventory of targeted vehicles across various specialty categories including royalty trusts, pipeline companies, master limited partnerships, high dividend paying blue-chip stocks, real estate investment trusts and enhanced income focused ETFs for potential additions to client portfolios.
In 2011, we generated positive returns while maintaining a much lower risk profile as volatility plagued most sectors leaving them flat or negative for the year. (See our 'Market Insight' for details.) Sidestepping international market declines of +20% proved vital in our effort to shelter principal values. These upswings and downdrafts are likely to persist in 2012 as fiscal imbalances throughout the developed world continue to be identified and debated but not resolved. While a range of outcomes are conceivable in 2012, an escalation of the European debt crisis poses the most significant threat. Therefore, we continue to favor strategies that provide income and equity-like returns over time via much lower risk levels. Looking ahead, the prudent path towards long-term investment returns will include insulating portfolios against the brewing storm in the near-term, keeping some "dry powder" to buy assets that go "on sale" when it's pouring, followed by a transition into an asset allocation that will profit when brighter, sunny skies re-emerge in the years to come.
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