Despite the numerous and oft-touted risks, government follies, and frequent calls for recession by well-known prognosticators, the world did not end and equity markets did not decline in 2012. In fact, quite the opposite occurred; economies improved and equities returned the highest amount since 2009. Not even fixed income securities declined. If 2012 were a fairy tale, undoubtedly the year told the story of Cinderella.
For the year, the S&P 500 returned 16.0% (including dividends) and the Barclays U.S. Aggregate Bond Index returned 4.2%.
We are proud to say that we performed well in both an absolute and relative sense in 2012. Black Cypress equity portfolios were up over 18.5% in 2012, outperforming broad markets by 2.6% with less volatility. In fact, the year transpired largely as we expected.
From our December 2011 letter, Well-Positioned (dated January 17, 2012):
“In our fixed income positioning, we should experience positive returns–in both absolute and relative terms–if rates are flat or rise.”
U.S. Treasuries and high quality bond rates were roughly flat in 2012. Our fixed income securities returned over 7.0%, besting the Barclays Aggregate by 3.0%. We were able to achieve this out-sized return with less duration due to our exposure to non-Treasury markets and therefore credit risk.
“While the market has risen over 14% since September of last year …our portfolio still has an 18.5% implied return.”
During 2012, our equity portfolios rose almost exactly 18.5%. That was certainly a call we are happy to have gotten right, but we do not expect to be that precisely right again. Though, we are proud to say we have compounded capital at almost 18.0% per year since inception.
As we have noted in the past, we should do well on both a relative and absolute basis when markets are down, flat, or moderately up. However, when markets surge from pricey levels like they did in 2012, we should be expected to underperform on a relative basis. While this is our expectation of the way our portfolios will behave in various market environments due to the structure of our strategy, it is only an expectation. It was not the case in 2012, as we outperformed the S&P 500 by 2.6% despite its double digit gain.
We urge you to not expect the same from indices over the next several years. Mid-single digit returns, at most, is likely in our opinion, as asset returns leave us wanting. There are a few reasons for caution.
For one, current valuation levels lower expected returns. Estimates for S&P 500 earnings per share (EPS) for 2012 hover around $87. At today’s closing price of 1,472.12, the S&P 500 is trading for 16.9x trailing earnings. Of course, the market’s P/E must be put into context. And for today’s P/E, the context makes the valuation look worse.
Profit margins are near peak so multiples trading above the long-term average on record EPS don’t inspire cheapness. If we had a 17 multiple on recession-level earnings, then we could get excited. But an above average P/E on the highest earnings ever? Not so much. Last year’s return was due almost entirely to multiple expansion; nominal earnings growth was essentially flat and negative if adjusted for inflation. This change in the growth rate of profits is troubling.
Since March of last year, EPS have been declining on both a nominal and real basis. Analysts are expecting $100.71 in EPS for next year, but the past two quarters’ earnings actually declined. Will earnings grow almost 16% next year, as analysts expect, when sales growth rates have fallen for four straight quarters and grew just 3% in 2012? It isn’t without possibility, but it does imply that profit margins will surge above 9.0% in 2013, a level that has never been reached.
Fixed income is in an even more precarious position. Government rates hover just above all-time lows. Credit spreads have narrowed and absolute yields are rock bottom. Yields on the most risky debt have plummeted thanks to Fed policy and as well as current low default rates due to lush liquidity available to finance each and every debt offering at lower and lower yields. Junk bonds for instance, which returned over 14% in 2012, now yield just 6.0%, the lowest rate ever.
It was certainly a Cinderella story in 2012, but we can’t help but think that the clock is about to strike midnight and our glorious horse-drawn carriage will turn back into a pumpkin pulled by mice.
Rich equity and bond prices are not the only reason for tempering asset return expectations. Fiscal policy is about to become a drag on growth. We do not yet know how large a drag because not even tax policy has clarity. While Republicans and Democrats voted for what will now be known as Obama’s tax cuts, Democrats have recently stated their desire for additional revenue. Spending cuts were absent from the fiscal cliff deal and a battle looms in March over sequestration, the debt ceiling, and how to reduce the deficit. The one known, however, is that austerity–in some amount–is coming to the U.S. in 2013 to dampen growth.
We wrote in last year’s letter,
“None of the data is overly strong, but enough so to make us still believe the U.S. economy will continue to “muddle through” over the next year.“
Although several prominent economists and equity managers made calls for a recession, the economy did in fact muddle through, growing approximately 2.0% in 2012.
On the bright side, the U.S. economy has much improved. Housing, once a major drag on growth, has seen price increases and building volumes surge. Auto sales are also recovering, employment continues to make gains, and measures of income have started to grow again. Gasoline and natural gas prices should remain moderate over the coming years, as the U.S. energy production resurgence continues. Banks are better capitalized and are lending again. These, coupled with loose Fed policy, should help to offset some of the fiscal tightening and keep the economy growing, albeit slowly, in 2013.
These positives won’t likely lead to a banner year, but more moderate returns. Not quite the story book ending we may want, but if the slipper fits…
To our partners: thank you for the opportunity and privilege to serve you another year!