Thu, 20 Dec 2012
2012 shows the importance of paying attention to valuations amid the doom-and-gloom headlines.
Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.
Jason Stipp: I'm Jason Stipp for Morningstar.
2012 was an interesting study in how things don't always turn out as anticipated. So what are some of the big lessons from the year that was? Here to offer his insights is Sanibel Captiva Investment Advisers' President Pat Dorsey.
Pat, thanks for being here.
Pat Dorsey: Always a pleasure, Jason.
Stipp: So let's rewind back to the beginning of 2012. We had headlines about doom and gloom in Europe. We were starting to get worried about some of the emerging markets. Things here at home: unemployment was still very high. We had a lot of issues about the stalling economy …
Dorsey: We had an election coming up, and God forbid, a Democrat was in the election, too ...
Stipp: It didn't look like a great environment for investors. But when you look at the numbers here at the end of the year, there is a disconnect.
Dorsey: Yes. Last I checked, S&P is up about 17% [year to date] just before Christmas here. And I think that's a wonderful indication for people that, first of all, when the talk is of doom and gloom, that's probably when you need to be putting money to work.
And secondly, a lot of times, what's in the headlines is already discounted into stock prices.
Stipp: So let's tick off some of these. So you mentioned the S&P up about 16%.
Dorsey: Despite [the fact that] unemployment is still over 7%, it's incredible. But corporate profits keep doing reasonably well, and critically, the S&P started the year at about 12 times earnings.
Stipp: What about Europe? It's still an area of concern. There are still worries, it's calmed down recently. How did those markets do?
Dorsey: Well, that's frightening when you talk about rewinding to the beginning of the year. Remember when "Grexit" was a part of people's actual vocabulary, this Greek exit from the euro. Depending on which European index you look at, you are up between 18% and 22%. The DAX, which is the German equity index, is up 30% year-to-date.
Basically, yes, Europe was a worry. There are still very long-term tensions between basically fiscal sovereignty and a shared currency. Those tensions have not been resolved. There are still high levels of debt in Spain, high levels of debt in Italy, but at the end of the day, when you're buying Europe, you are not buying Spain, you are not buying Greece, you are not buying Italy, you are buying companies. And some of those companies will do well and some won't do well. But at the beginning of the year, they were all priced to go out of business.
Stipp: Emerging markets, we were really worried about a hard landing in China.
Stipp: There are still concerns in China. Emerging markets performance this year?
Dorsey: Up 16%, 18%, about there. China slowed down to 7.5% [GDP] growth, which yes, is lower than 10%, but I can think of a lot of countries that would kill for 7.5% growth.
There seems to be a real recognition in China that the capex-led model--let's build eight new steel plants this year--is not sustainable. Hence, you are seeing some attempts to change that economy to more consumption-driven. That's going to be a long path. That's going to be a difficult one. There are some worries over asset bubbles there with some of the securities being sold by banks to investors that they think are guaranteed, but are not guaranteed.
But again, at the end of the day, what really matters more than anything else is, what's the actual growth rate of the economy? And at a 7.5% growth rate, you are consuming a fair amount of stuff. You are importing a lot of stuff. People are buying more KFC from Yum Brands, and equity investors do OK.
Stipp: Let's talk about some of the safer assets. So, at the beginning at 2012, you might've been inclined to look at gold because of all of the uncertainty that was out there. How would you have done?
Dorsey: Flat. Maybe 5%, I think, depending on the day of the week that we are looking at. And again, the point there is that you are looking at this supposed hedge over uncertainty and worries. But I always say, the end-of-the-world trade only works once, and the day that it works, you probably are not going to be worried about your gold position. You probably will have other things on your mind. And so, in this case, it turned out that owning great businesses with pricing power was something of a better hedge than owning a yellow metal that doesn't do much for you.
Stipp: We've also seen investors, and this is really a conundrum, continue to pour money into fixed income. We've been saying for a long time, fixed income has got really a lot of headwinds against it, but it also did very well in 2012.
Dorsey: Yes. High-yield was up only somewhat less than the S&P this year. High yield was up 15%-16%, somewhere in that neighborhood.
Even if you owned investment-grade, you did fairly well. We saw record bond issuance this year. Investment-grade bond issuance was up 50% in 2012 over 2011.
So certainly, if you'd made what I would call a rational bet at the end of the year  to lighten up on your bonds, you would have regretted that. And I have certainly been wrong in thinking that bonds were about to roll over.
The question, though, you need to ask yourself if you are still owning a lot of high-yield or owning a lot of long-duration bonds is, "Do you feel lucky, punk?" Because you are kind of living borrowed time at this point. So don't get lulled into a false sense of security with the performance of the past year.
Stipp: So let's step back a little bit and try to pull out some key takeaways from what we've learned from the past year.
So it sounds like one of them you are saying is, the market can behave somewhat irrationally for extended periods of time. It doesn't always do exactly what you would expect it to do in a short period of time.
Dorsey: Well, certainly not in a short period of time and certainly, I would think, let's call the performance of bonds this year a little bit irrational, right.
However, the thing to bear in mind is that markets don't tend to move based on what you see in the headlines. The headlines are full of Company X is growing at this rate, Country B has this amount of debt, inflation is here, GDP is there.
The single variable that explains a decent proportion of equity returns over time is the price you pay for the equities that you purchase, and frankly P/E ratios don't make for good news stories.
Stipp: And what about this idea of recency bias, looking at what things have done in the recent past. If you were going to rewind to the very beginning of 2102, and use some of the performance trends you'd been seeing, also a big mistake for you.
Dorsey: Exactly. And I think this is just human nature. You take the current state of the world and project it out into the future. It's 2007, home prices will always go up; it's 2010, my gold position will keep going to insane amounts of dollars per ounce. Or fears of a double-dip recession, fears of a hard landing in China, that will continue to persist. But the world usually reverts back to a longer-run mean, and that mean is not shrinking by 5% every year.
Stipp: So looking to 2013, if we didn't want to be beholden to recency bias, you mentioned fixed income as one you really shouldn't expect to continue on that trend forever. What are some others? As far as that 15%-16% performance in the S&P? What should my expectations be for stocks?
Dorsey: It's a gift. You've got 16% returns of S&P, and we got phenomenal returns over the past three years. Again projecting those out in the future doesn't make a whole lot of sense.
Given your starting valuation today, call it 14 times, maybe 13 on the S&P 500 depending on whose numbers you'd like to use, and given pretty muted profit growth next year--let's be honest, the U.S. economy is not going to grow gangbusters next year. Global growth is probably going to be in, call it, the 3.5% range, because Europe's still flat on its back. Emerging markets are still doing well.
I think it's reasonable to expect a nice mid- to high-single-digits rate of return on your equities. That's about in line with the long-run averages, so it would shock me really if we had a materially negative year next year. That seems unlikely, given where rates are and where price/earnings ratios are, but it would also shock me if we had another 16% year. I'd like to be shocked by that, but it would shock me.
Stipp: Pat, I'm sure we'll sit here a year from now and talk about what the market was in 2013. But thanks for helping us get some perspective, take a look back and pull some excellent insights from the year that was.
Dorsey: Thanks, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.