Two weeks ago I posted an entry titled Wall Street’s Bullish Bias. Take another look at that blog to get an appreciation for how Wall Street characterizes government and central bank rescue attempts. We’ll evaluate the effectiveness of those efforts in a future blog post.

Since writing that piece, I came across some additional Wall Street research from a reputable source that demonstrates how far the Street is willing to twist news to provide it with a bullish conclusion. The earlier article listed 14 “Positives” that the research contended were starting to dominate. Prominent among the “Positives” were government stimulus efforts. Now comes news that federal outlays have declined by almost 3% year-over-year–obviously a decrease in direct stimulus. If stimulus is good, this would seem to be a negative. Not so according to the recent research piece. The decrease is characterized as positive because it is good for the deficit.

In a similar vein, the same research piece reported that total government spending (state, local and federal) declined year-over-year in the fourth quarter. Since a decrease in government outlays diminishes GDP, one would expect this to be viewed as a negative. Again, not so. This reduction in government spending was spun positively as “making room” for private GDP to increase.

On a role, this same study took on unemployment. Along with housing, unemployment has been the most vexing problem facing our economy. In the worst unemployment crisis since the Great Depression of the 1930s, every job is precious, and government goes out of its way to trumpet any new jobs it has “created.” This research piece reported that since early 2010, total government employment has declined by 500,000. That is truly unfortunate for those who lost the jobs, but even that dire statistic was cast in a positive light as “making room for private employment to increase.” One might logically make that argument if government employment were depriving private employers of needed candidates. With almost four job seekers for every private job opening, however, such an interpretation is ludicrous.

While it’s clear that intelligent, informed people can disagree on interpretations of data, Wall Street is remarkably consistent. When reading any piece of Street research, never lose sight of Wall Street’s primary job – to sell product.

Since the greater than 20% stock market decline in last year’s third quarter, the excellent research staff at ISI has chronicled almost 100 stimulative policy initiatives by governments and central banks around the world. That coordinated effort to reverse the worldwide economic slowdown has succeeded in halting the stock market’s decline and in boosting prices back to the levels prior to last year’s market collapse.

Earlier this week ISI reported that for the first time ever the world’s five largest central banks were simultaneously conducting aggressive easing operations. In addition to our own Fed’s zero interest rate policy and willingness to buy bonds with no liquid market, the European Central Bank has launched its Longer-Term Refinancing Operations and has made virtually unlimited amounts of money available to European banks for three years at a mere 1%. The People’s Bank of China has just pledged ongoing Eurozone support and is expected to continue domestic stimulus. Although not directly involved in Eurozone operations, the Bank of England and Bank of Japan have both committed to additional aggressive quantitative easing.

Such widespread coordinated rescue efforts were unknown during 2008’s near collapse of the global financial system. Recent central bank actions appear to support legendary hedge fund guru George Soros’ contention that the current financial crisis is even more dangerous than that of 2008. According to Bloomberg, Soros characterizes this as the most difficult situation he’s seen in his career. Soros says that it’s more important to survive this crisis than to get rich.

It appears that the world’s central banks are in agreement that the global debt crisis is so severe that they will do what they must to ward off the normal corrective forces of recession. Recent actions are analogous to betting the ranch. All other resources have been spent. They have been forced into the ironic attempt to solve a problem of excessive debt by issuing far more debt.

So far the willingness of central banks to pump massive streams of new money into the system has elicited good feelings and rising stock prices. And there is no way to know how long such positive feelings will remain. However, unless the central banks are able to prevent recessions indefinitely (an unrealistic proposition), eventual economic slowdowns will spotlight the folly of would-be central planners who will be held responsible for the even more intractable levels of debt that we or our children and grandchildren will face in the years ahead. The mature economies of Europe, the United States and Japan have no realistic prospect of growing their way out this debt morass. The critical questions facing investors are how long central banks can defer the pain, how much they will inflate the debt bubble and on whom the inevitable defaults will fall.

In 2011, most of the world’s equity investors suffered. Although business conditions have continued to slow on most continents, the majority of world equity markets have turned the tide and started 2012 on a strong note. As typically happens, perception of the news brightens after markets rise. Earlier this week the excellent researchers at ISI offered a litany of “Positives Starting to Dominate.” Notwithstanding the quality of their research, these points typify the bullish bias of the Wall Street establishment rather than portray an accurate rendering of underlying business fundamentals.

After each of ISI’s “positives,” I’ll offer what I consider to be a more relevant counter-balance from the perspective of investors rather than short-term traders.

• Housing starting to recover. While some measures of decline are improving, prices continue to fall and huge numbers of foreclosures remain a fact of life. It will take years for the housing market to return to conditions that existed before the bubble.
• Labor market improving. This is a celebration of direction over level. At 8.3% unemployed, the labor market is only slightly better than its worst status since the Great Depression of the 1930s. The government’s U6 measure, combining both unemployment and unintended underemployment is above 15%. Additionally, a large number outside those measures have given up hope of finding a job and have left the labor force entirely.
• Credit expansion unfolding. This is due more to the unprecedented creation of money from world central banks than from any greater willingness to lend by bankers, who are still licking their wounds from their mindless expansion of credit over the prior decade. Applause for credit expansion must also be questioned while we are still trying to recover from an unprecedented debt crisis.
• Low dollar. While a cheap dollar does improve profit potential for exporters, no country today wants too strong a currency, and currency wars with unpredictable negative consequences are a very real possibility. It’s also hard to believe that the U.S. will long maintain its historic economic supremacy with a weak currency.
• Low rates. While low rates clearly benefit the housing market and businesses financing operations or expansion, low rates penalize savers and pension plans. Furthermore, with central bankers artificially lowering rates and keeping them down for years, unintended negative consequences could be numerous and severe.
• Pent-up demand. We hope there’s pent-up demand, because consumers have bought far less in recent years than had become customary before the bubble burst. It is certainly possible that personal deleveraging is continuing, however, as people realize that they had run up unsustainable debt levels before economic conditions deteriorated. With unemployment still extremely high and the fear of unemployment a real concern for many, the willingness to spend may be markedly diminished in the years ahead.
• U.S. manufacturing renaissance. It has been encouraging to see manufacturing statistics and manufacturing employment improving over the past several months. After years of ceding our manufacturing dominance to the rest of the world, however, we need far more evidence to call this improvement a sustainable trend.
• U.S. energy sector booming. As with manufacturing, it’s certainly welcome to see this industry improving. The durability of that improvement, however, will undoubtedly be determined by the success or failure of efforts to reignite world economic growth.
• Double-dip fears minimal so far this year. How strong a positive is it when we’re celebrating the reduced potential for a serious negative? It’s damning with faint praise at best. And with Europe falling into recession, this potential must refer only to the U.S.
• Inflation receding around the world. Receding inflation is testimony to weakening worldwide business conditions despite the huge monetary expansion being conducted by most major central banks. Ironically, our Federal Reserve is afraid of inflation receding too much, possibly leaving us with deflation, a condition Fed Chairman Bernanke has vowed to combat.
• Europe financial strains have eased. Really? Why are heads of state and central bankers meeting daily for weeks on end to ward off the dangers of sovereign default? The pledge of unlimited supplies of new money to endangered banks for almost any quality collateral has eased the liquidity crisis, certainly not the solvency crisis.
• Liquidity is building in the world economy. No question liquidity has improved. That’s what happens when central banks hand out newly created money. And many corporations have improved their liquidity by lengthening the average maturity of their debt. It is perhaps instructive to remember that when you or I borrow from a bank, we may have more cash in our pocket, but we still have to pay it back, and we have to pay interest while the loan is outstanding. Improved liquidity may only buy time for entities with intractable solvency problems.
• There have been 83 stimulative policy initiatives announced around the world over the past 5 months. Why have governments and central banks done that? Because business conditions are so bad.
• The Fed has rates on hold at zero and is doing Operation Twist. See the prior comment.
• ECB is scheduled to further expand its balance sheet on February 29 by as much as 1 trillion euros. Ditto again. Moreover, do you suppose that bond buyers might start to worry about the value of the currency in which they are supposed to be repaid? Perhaps that concern helps to explain why the price of gold has exploded upward, a situation that central bankers and other proponents of fiat money hate to see.
• There are no particular problems at the moment such as Japan disasters, Thailand floods, supply-chain disruptions, gasoline price spikes, and debt ceiling crises. Thankfully, although seasonally adjusted gasoline prices are up by almost 30 cents over the past two months, and we know we will soon again be wrestling with our own need to reduce deficit spending. Unfortunately, natural disasters happen all the time, and when any nation, company or individual is excessively leveraged, risks of bad outcomes are far more likely. The world and its institutions have never before been so dangerously overleveraged.

Is the glass half full or half empty? It largely depends upon what one chooses to look at. Do the listed “positives” foretell steadily improving world economic business conditions? Can governments and central banks print their way to wealth and prosperity? If so, why not do it all the time? Notwithstanding the possibility of central bank largesse creating periodic bursts of enthusiasm, current economic and monetary dangers are severe and the future very uncertain.

No time to write, so I’ll post again next week.

By interesting coincidence, the S&P 500 began 2011 at 1257, exactly where it began 2012.  Last year stock prices rose strongly into February on positive investor sentiment, exactly as prices have this year.  Prices reached the peak of that rally last February at about 1345.  They spent the rest of the year working their way back to 1257.  Today the S&P 500 closed at 1345.  All analogs eventually break down.  It will be interesting to see how long this one tracks last year.

Enjoy the Super Bowl.

A timely rally in the last two weeks of the year and enormous amounts of Federal Reserve stimulus enabled major U. S. equity indexes to escape the fate that befell virtually the entire rest of the world. By interesting coincidence, the S&P 500 closed 2011 at 1257, exactly where it closed 2010. A small dividend resulted in the S&P providing a positive return in contrast to the average U. S. stock’s decline of 6% for the year. Even that loss was far better than the damage done worldwide. The Dow Jones World Index (excluding the U.S.) lost 16.3%. Against such a difficult backdrop, our client returns in the low single digits were at least a minor victory. This result marks the twenty-fifth time in its twenty-six year history that our controlled-risk/flexible allocation process has earned positive returns. We lost a perfect record in 2008, when clients’ portfolios lost a fraction of one percent with the S&P 500 down 37%.

Despite the many trillions of dollars of wealth wiped out in 2011, world governments and central banks warded off the danger of systemic collapse with a flood of newly created money. While reliquifying banks in greatest danger, the lending countries involved (including the U.S.) greatly weakened their own balance sheets. Debt downgrades were commonplace around the world. As downgrades proliferated, governments increasingly denigrated the ratings services. Notwithstanding their checkered history through the subprime mortgage debacle, the ratings services are merely pointing out the obvious: Financial stability has deteriorated dangerously as countries throughout the world attempt to counter the logical consequences of excessive debt. The most important question facing investors again in 2012 is whether or not that debt peril can still be controlled.

The record amount of stimulus provided by the Federal Reserve has kept the U. S. from falling into the recession that is apparently beginning to grip the Eurozone. There is discussion of yet another round of stimulus. While corporate profits were strong in 2011, and analysts are forecasting another year of profit growth in 2012, year-ahead forecasts are being ratcheted down by a great many companies currently announcing their fourth quarter results. Productivity remains strong, which is great for corporate profits, but a negative for employment. While improving slightly, the nation’s unemployment problem remains severe. Interest rates have declined to historic lows, which lowers business costs but penalizes savers, and the Fed has pledged to keep short rates near zero at least through mid-2013. If all other global factors remain static, U. S. stock prices are not unreasonable, with valuations in the aggregate high but not as extreme as they have been through most of the past decade and a half.

Unfortunately, it is highly unlikely that conditions around the world will remain as they are. Leading indicators for Europe and the major Asian countries are declining. China’s economy, the engine of growth for much of the world, is slowing. Its stock market, down by more than 60% from its 2007 peak, is screaming loudly that something is not as sanguine as the bullish government statistics proclaim.

The most immediate problems lie in Europe, where bankruptcy is pending in Greece. No one seriously believes that Greece can survive without a succession of sizeable bailouts from stronger European neighbors and possibly China and the International Monetary Fund. It is completely unknown whether or not the political will is sufficiently widespread to generate such a rescue. If Greece or another fragile European nation should default, the consequences are unpredictable. Banks that hold the defaulted bonds could in turn fail, setting off a domino effect which could expand far beyond Europe. Billionaire hedge fund pioneer George Soros has characterized the current crisis as more severe than that of 2008, which would have led to a worldwide financial collapse but for history’s greatest-ever government bailout.

The debt crisis that we began to warn about in the late-1990s is coming ever closer to its denouement. We can’t know whether we will experience sovereign defaults in the year ahead or whether governments will again succeed in “kicking the can down the road” for a while longer. Which course unfolds will have a huge influence on equity potential in 2012. The hope for the world’s markets is that governments and central banks will again provide the needed rescue money. While it could work, such an expectation is hardly a sound basis on which to make investment decisions.

When we made the case in the late-1990s that stocks were about to enter a long weak cycle in which equity profits would be scarce, we wrote that such cycles over the past 200 years have on average lasted about a decade and a half. Our caution at the time was that this one might last even longer because the excesses built up in the prior long strong cycle were more severe than any before. More debt than ever before had accumulated relative to the size of the economy, and valuations had soared far above any others in history. Notwithstanding strong stock market returns in 2009 and 2010, the performance record for stocks century-to-date is weak, as indicated in the table below.

Annualized Returns for the S & P 500
For the Periods Beginning in the Following Years
Through December 31, 2011
Barely more than one-half of one percent per year has been made in stocks since the beginning of the century. We are pleased that our clients’ portfolios have grown by more than 65% over that time before fees, which vary by portfolio size. There have been two powerful rallies in the long weak cycle that began in 2000. The first, from 2003 to 2007, convinced many investors and analysts that the bear market from 2000 to 2003 was a stand-alone event and that the bull market that began two decades or more earlier was back in force. Over the past three years, rising stock prices have again convinced many investors and analysts that the worst is behind us and that a new long-term bull market has begun. At the very least, the advance has been durable enough that turning bullish at the right time could have made money. It is instructive to note, however, that very few investors who profited in the 2003 to 2007 rally were astute enough to retain those profits through the 2007 to 2009 decline. Since we consider it unlikely that the long weak cycle has ended, we believe that it is similarly unlikely that beneficiaries of the rally that began in 2009 will ultimately retain those gains. While valuations have declined somewhat from their extremes, the underlying debt situation has worsened. Over the past two centuries, equity markets have never begun a new long strong cycle in the absence of ultra-cheap valuations and with debt levels still at excessive levels. It is improbable that historical precedent will be broken in the current instance unless governments and central banks abandon the fight against debts and simply print so much money that inflation minimizes the debt burden. Because that action could become the long-term solution, we have begun to build a position in gold that would benefit from significant inflation, unlikely as inflation looks at present.

Many investors typically choose to put their money in the asset class that has most recently performed best. Even with interest rates beginning 2011 at extremely low levels, the Federal Reserve’s move to buy bonds directly and push rates even lower led to good bond returns over the full year. Because bonds have also marginally outperformed stocks over the past 30 years, there is an increasing tendency to move money into fixed income securities to sidestep the volatility that has plagued stocks in recent years.

High quality bonds could perform well in 2012 if we experience a recession or other deflationary or disinflationary event, which would probably be bad for stocks. If rates remain stable, a ten-year U.S. Treasury note will return about 2%, its current interest rate. If the economy strengthens, interest rates will likely rise and bond prices fall. Should debt begin to fail around the world, interest rates on secure bonds could plummet and prices rise. Because of default risk, lower quality bonds could conversely see interest rates soar and prices collapse.

While we believe that the ultimate resolution of the debt crisis will involve significant levels of money printing and substantial inflation, we would be surprised to see that unfold over the next year or two. More likely, it will come further down the line. We consider a disinflationary–even deflationary–environment more likely in the short run, which would be best for top quality bonds. With yields so low, however, the reward for being right about bonds in the year ahead is relatively small. Should yields rise for any reason, however, even top quality bonds could lose money this year and for several years ahead. When bond yields began their last long rising phase, even unmanaged Treasury bills outperformed bond total returns for more than four decades from the early-1940s to the early-1980s. Although we anticipate the likelihood of a disinflationary environment this year, we are not recommending bonds because the reward for being right about bonds is significantly less than the penalty for being wrong. Even if investors should profit in bonds this year, they will only retain those profits if they eventually make a timely sell decision before aggressive money printing promotes significant inflation. From current interest rate levels, the odds are against bondholders over a multi-year time frame.

We enter 2012 with great fragility in the world economy and great uncertainty in world markets. Should governments and central banks fail to maintain investor confidence, the possibility exists for waterfall price declines. That prospect poses great danger to traditionally allocated stock and bond portfolios, but it presents the potential for great buying opportunities at far lower prices for investors properly anticipating such an outcome. That scenario need not unfold this year, but the unraveling of the Eurozone could precipitate it. Stay alert!

Bailing out the overextended remains the headline of the week. Will bondholders come to an agreement on restructuring Greek debt? Will Greece receive the proposed bailout that allows a rollover of the debt coming due March 20? Are Portugal and others lining up behind Greece to negotiate further bailouts?

The International Monetary Fund (IMF) announced this week that it will seek an additional $500 billion from its members to fortify its bailout war chest. The United States, which provides 17% of IMF funding, quickly declined to contribute. Hooray! Finally, someone rejecting the concept that we must bail out bankers and other bad decision-makers at all cost. Perhaps this is the first in a succession of actions needed to eliminate moral hazard. Companies, governments and investors must be allowed to fail when they make fatally flawed decisions. If, instead, they are bailed out, others are encouraged to repeat the risk-taking, hoping for a big reward if successful, and comforted in the assurance that major losses will be covered if a bailout becomes necessary.

The inequity is obvious. At the investor level, the risk-taker can win big if the risk is rewarded. On the other hand, if the market penalizes the risk, but the loss is covered by a bailout, the taxpayer eats the loss.

Now we read headlines out of Europe claiming that austerity required to pay back some of the debt load should not be pursued to the extent that it jeopardizes growth. In other words, don’t let the difficult get in the way of the desired. If reducing debt becomes uncomfortable, add a little more debt to promote desired growth. Unfortunately, at current debt levels in many countries, there is no realistic way that they can grow their way out of the hole. The hole just keeps getting deeper because of the cost of servicing the existing debt.

Meanwhile in our country we hear that the Fed is seriously considering QE3, another attempt to promote growth by adding to the debt load. Some speculate that the Fed will again try to prop up the housing market by buying more mortgage-backed bonds, as they have done in earlier quantitative easing episodes. Besides again promoting moral hazard, that behavior would penalize investment managers such as ourselves, who correctly forecast the losses that would flow from the irrational overleveraging in real estate. Investors who blindly chased yield in low-quality real estate investments were rewarded with high returns when that sector was soaring. Without Federal Reserve support, many of those investors would have given up those gains and more in lost principal when real estate prices collapsed. Instead, they were bailed out and received their principal back in addition to the high yield. Managers like us, who avoided such securities because of the correctly perceived danger, settled for lower yields in securities that survived the downturn without government rescue.

Today investors face a similar quandary. Far more asset types–even whole countries–are threatened by excessive debt. Should investors settle for lower returns from investments that will survive inevitable debt implosions in the years ahead? Should they invest more aggressively, betting that the world’s governments and central banks will be willing and able to prevent destructive debt collapses? Or should they acknowledge the long-term debt danger but invest more aggressively anyway with confidence that they will successfully time their exit from risk before serious damage is done? A sobering consideration was voiced recently by former Federal Reserve Governor Bill Poole, who said that the United States is just a few years behind Greece when you look at the numbers. In choosing a path, investors need to assess their ability to withstand losses, should governments and central banks fail to solve the debt dilemma or if investors’ timing is less than precise.

The financial market’s focus remains on Europe.  The financial press directed its attention today to the rumored Standard & Poor’s downgrades of European sovereign debt, confirmed late in the day.  Most European nations have now been downgraded, and the downgrades have reached Europe’s core with France and Austria losing their prized AAA rating.  A few nations, including giant Italy, were dropped two notches.  At the most fragile end, Portugal joined Greece, as S&P downgraded Portugal to junk with a negative outlook.

Markets reacted calmly.  Since the potential for such downgrades was announced several weeks ago, the markets have apparently had an opportunity to factor them in and adjust.

Perhaps just an interesting coincidence, but a rumor floated this morning on CNBC that the Federal Reserve is seriously considering QE3.  That prospect served to remind investors worldwide that governments and central banks remain alert to the problems and stand ready to bend every effort toward avoiding economic downturns that would penalize banks, individuals and other entities that made the mistake of excessive leverage.  The Fed stands poised to once again attempt solving problems brought on by too much debt by creating even more debt.

A potentially more important news story emerging this morning was the apparent breakdown of the latest talks regarding the restructuring of Greek debt.  Before today, there had arisen some level of confidence that bondholders would accept a negotiated price reduction or–“haircut”–of perhaps 50%, and that Greek debt could be restructured on a “voluntary” basis.  If such a reduction of principal value were “voluntary,” no credit default event would be triggered, and the writers of insurance against bond defaults would not have to pay.  Of course, to contend that the acceptance of any such “haircut” would be “voluntary” is pure fiction, but such intellectual contortions are necessary to ward off the potentially calamitous repercussions that could flow from a credit default event.  The breakdown of today’s talks reduces the likelihood of an orderly Greek default.

While the financial consequences to counterparties who wrote credit default swaps are unknown, according to banking analysts, they are potentially severe.  Investors don’t know which financial institutions would be exposed to losses from a disorderly Greek default.

Last weekend, hedge fund pioneer George Soros warned that the current European crisis is more dangerous than the 2008 crisis that, but for the greatest government intervention in history, nearly led to the breakdown of the world financial system. Chinese officials voiced the same alarm a month earlier.  Soros indicated that a breakup of the euro, which could follow a disorderly Greek default, could precipitate a collapse of the European Union, which could in turn have “catastrophic consequences” for the global financial system.

Since the next rollover of Greek debt is not until March 20, it is likely that negotiations will continue for several more weeks.  Those discussions, however, are no safeguard against investors starting to handicap in advance the odds of a “voluntary” agreement.  Spanish and Italian debt was brought to market today relatively successfully.  Huge volumes of debt are scheduled to come to market throughout Europe over the next several months.  If potential buyers become wary that Greece’s problems will lead to a Eurozone breakup, they may boycott those auctions.  Destructive contagion could spread rapidly even in advance of a formal default.

Our markets experienced no violent reaction to today’s negotiations breakdown.  Just a few months ago, the morning news from Europe moved U.S. equity markets by hundreds of points day after day.  Minor changes in investor confidence could again precipitate such volatility.  As we head into a long weekend in the U.S., there is added time for events or rumors of events in Europe to again reach a boiling point.

This is not simply traditional market volatility.  Debt is threatening the world financial system.  Governments and central banks may again successfully “kick the can down the road,” as long as they can maintain investor confidence. But that can’t be guaranteed.  Governor of the Bank of England, Mervyn King recently said: “The crisis in the euro area is one of solvency and not liquidity.  And the interconnectedness of major banks means that banking systems, and hence economies, around the world are all affected.”  If investors start to focus on solvency–and Greek default could force that–the return of capital will become far more critical than the return on capital.

Although not very precise short-term tools, valuations are the best long-term determinants of stock market direction.  Valuations become particularly helpful forecasters when they reach either positive or negative extremes.

Throughout the past very difficult year for the equity markets, analysts have repeatedly predicted rising stock prices.  The most common justification, despite the worsening European debt crisis, has been that stocks are cheap.  In other words, they argue that valuations are extremely low.  As we turn the calendar to 2012, let us take a closer look at the valuation argument.

By far the most commonly quoted measure of value is the price-to-earnings multiple (P/E).  According to Standard & Poor’s, which is the source of all of the data in this post, using Generally Accepted Accounting Principles (GAAP), the trailing 12-month P/E ratio of the S&P 500 at year-end was 14.0.  That is below the 17.0 average going back to 1926, but it is far from cheap.  Before equity valuations went into the stratosphere beginning in the mid-1990s, the long-term P/E average was between 14 and 15.  When S&P 500 earnings went negative briefly in 2009, the effect was to artificially lift the eight and a half decade long P/E average.  That unique episode distorts history.

Reading the financial press or watching financial television, you have likely heard P/Es reported below 14.  Because forecasters work hard to bolster their case, they employ other measures than trailing 12-month GAAP earnings, which used to be the industry standard.  Now more analysts choose to use operating earnings, which eliminate non-recurring items.  Some cynics refer to operating earnings as “everything but the bad stuff.”  Another common method of reducing the P/E is to use forecasted earnings, rather than trailing 12-month results, which have always been the standard.  Because analysts tend to be perpetual optimists, actual earnings over the decades typically fall short of forecasts.  All that notwithstanding, stocks trading at 14 times earnings are only slightly undervalued compared to median P/Es since 1926.

Analysts run into far more inconvenient truths, however, when they examine other commonly employed measures of value.  But for the valuation extremes for most of the period since the mid-1990s, price-to-dividends, price-to-book value, price-to-sales and price-to-cash flow look expensive, not cheap, when compared to their valuation readings going back over many decades.

Another way to measure the value of stocks is to see how high investors have bid prices of all domestic stocks relative to the size of the U.S economy.  Ned Davis Research computes the value of domestic stocks at 96% of current GDP.  While that is below the extreme readings of the past decade and a half, it is above all preceding periods.  By comparison, even the most extreme reading before the crash of 1929 was only 87%.

Because it is common to weight recent experience more heavily than that from more distant years, it is understandable that today’s analysts view current valuations as cheap.  They are, in fact, far cheaper than are those that have characterized the past decade and a half.  The fatal flaw in such reasoning, however, is that those valuations, unique in U.S. history, distort sound analysis.  We know in retrospect that stocks bought at those extreme valuations have produced, at best, virtually flat returns.  Most equities purchased at those extremes have produced losses.  To describe stocks today as cheap relative to such unprecedented levels is to damn them with faint praise.  If we properly disregard such extreme valuations, investors should realize that, apart from P/E, which is slightly below average, all commonly used valuation measures are closer to their all-time highs than to levels from which major advances have been launched.  Stocks are not cheap.

The S&P 500, the investment community’s most widely-watched index, fell in the last few minutes of today’s trading session to close the year at 1257.60.  It closed 2010 at 1257.64.  We finished a year marked by surging corporate profits, mega-doses of government stimulus, plummeting treasury bond yields, headline-grabbing bankruptcies of American Airlines and MF Global, ongoing armed conflicts, overthrows of Middle Eastern governments, violent protests in Europe, “Occupy” protests here at home, unresolved housing and unemployment problems, our AAA credit rating diminished, politicians who can’t craft a compromise, and European banks and countries on the edge of bankruptcy.  All that action notwithstanding, the S&P 500 closed the year virtually unchanged.  Beyond the S&P, the Dow Jones Industrials and Utilities tacked on gains, while the Dow Transports, Nasdaq Composite, New York Stock Exchange Composite, Mid-caps, Small-caps and the most inclusive Dow Jones Total U.S. Stock Market Index all showed losses.  Overseas the carnage was more significant, with both emerging and developed markets falling.  All but a very few countries experienced declines ranging from about 15% to 40%.  Not a happy year for equity holders.

We enter 2012 with hope but with far more questions than answers.  Let me list a few:

• Will recently improving employment, manufacturing and consumer confidence statistics continue into the new year as government stimulus and tax incentives wind down?
• Will housing prices halt their declines in 2012?
• Can we make a meaningful dent in the overhang of homes for sale?
• With Real Disposable Personal Income now declining, will the U.S. consumer continue to cut his/her savings rate in order to maintain spending?
• Can U.S. corporations continue to grow earnings in an environment of weak housing and massive unemployment?
• Will our major political parties reverse the trend of moving farther away from common ground?
• Will Occupy Wall Street simply mark the beginning of growing social unrest?

Europe and the Euro were the dominant financial stories in 2011.  With their multiple problems still unsolved, these are likely to remain the primary themes at least through much of 2012.  That probability raises additional questions.

• Can the Eurozone escape a serious recession despite rapidly declining economic indicators?
• Can several European countries roll over massive amounts of debt coming due in 2012 at rates that will not worsen already serious debt conditions?
• Can the Eurozone hold together?
• Will more European countries introduce austerity programs sufficient to meet Eurozone standards without sinking their economies?
• Will the European Central Bank need to obtain a changed mandate to print its way out of the worsening debt crisis?

The United States is faced with an equally problematic debt dilemma, although less imminent.  We have so far been spared European-type pain, because the world remains willing–even eager–to fund our massive deficits.  Whether or not we begin to experience Europe’s problems depends upon the sustainability of investor confidence.  The reality is that we can never pay for all our past promises with a dollar possessing anything like its current value.

• Will our politicians cobble together a debt reduction plan to sufficiently placate rating agencies in order to keep the U.S debt rating from being lowered further?
• Will the Federal Reserve resort to some form of QE3?
• Will we begin to renege on some past promises, either domestic or international, to keep budgets from exploding?
• Will we ultimately resort to dramatically rapid money printing?
• Will foreign sources continue to buy U.S. debt at historically low interest rates despite our huge deficits?
• Will gold prices rise for the twelfth consecutive year if investors fear the inevitability of massive money printing?

Many bullish investors argue that, despite growing debt problems in the developed world, the emerging economies will provide the engine of growth that will keep the world financially steady.  That prospect raises some difficult-to-answer questions.

• Why did the world’s emerging country stock markets significantly underperform those of the developed world in 2011?
• Why did the stock market of China, the economic giant of the emerging countries, fall precipitously in 2011?  Why is it down by almost two-thirds over the past four years?
• The most powerful influences on markets often flow from events that are totally unanticipated. What currently unforeseeable events, good or bad, will unfold in 2012?

With so many open questions facing investors in the coming year, we will remain extremely flexible and ready to adapt to the unfolding story.

As we close 2011, we wish you and your families a new year filled with good health, happiness, peace and prosperity.

Last week’s blog post about Mission adding gold to client portfolios elicited a few questions and comments. Among others, there were questions about the relative attractiveness of bullion, exchange-traded funds or gold mining stocks.

For the purpose of our purchase, which is to hedge against the probability of money printing, bullion is the best pure play. Gold is heavy, however, and presents the problem of storage and possibly also of transport. For our purposes, investing in physical gold for large numbers of individual clients would be impractical.

While investing in the common stocks of mining companies would be an easy alternative, mining stocks do not always move in concert with the price of gold. Often, the direction of the overall stock market has a greater influence on gold stocks than does the direction of gold’s price. While mining stocks pay a dividend, unlike the metal itself, that dividend yield is typically below the already low average yield of most common stocks. Despite the fact that gold’s price has risen for a decade, the stocks have been far less consistent. Most major gold stocks are trading below their levels of four to six or more years ago. In fact, giant Newmont is trading barely above its price in early 1994. Periodically gold stocks do very well, but they are not as consistent a hedge against the perils of the printing press as is gold itself.

The exchange-traded fund GLD presents the best combination of direct correlation to the price of gold and ease of ongoing ownership for large numbers of investors. It’s not perfect. In an extreme market disruption, access to the value of the asset could be temporarily compromised, as would be the case with any tradable security. It does not, however, suffer the inconveniences of storage and transportability, which burden physical gold.

A separate question was why we bought now and not years ago. As longstanding readers of our commentaries and attendees at our seminars know, I have long been an advocate of individuals owning some gold. I have characterized such ownership in those communications as more an insurance policy than an investment. Its purpose has been to protect against unpredictable and dangerous economic, political or monetary events.

What has changed our thinking about adding gold positions to client portfolios is the growing belief that we are now faced with predictable and dangerous events. Over the past six months there has been clear evidence in this country and Europe that governmental and monetary authorities are unwilling to take meaningful actions to deal with our respective debt crises. Europe’s unwillingness has precipitated the dramatic rise in sovereign bond yields in recent months. While we still maintain that the timing of the ultimate resolution of these crises is highly uncertain, it looks increasingly likely that the resolution will have to involve large quantities of newly printed money. Because such heavy printing could be ramped up at any time, we decided that it would be worth initiating gold exposure now in case such printing should begin very soon. As indicated in last week’s post, we plan to build our position if gold prices correct further in the weeks, months or quarters ahead.

In the meantime, we wish our readers a merry Christmas and happy Hanukkah and a peaceful, relaxing holiday season.