Russell Investments Blog

Our market expectations for 2012 were best described as modest. When looking at the fundamental valuations of equities at the end of last year, Russell believed there was an opportunity for higher returns in 2012 if the market were to use stock fundamentals to price stocks. That was, and is, a big “if” in our minds. If the market continues to be more concerned about Europe than fundamentals, we believed that modesty would be the best policy.

Which brings us to January. The returns we saw in January brought us much of what we forecasted for the entire year. Many clients have noted this and have asked if this meant we would see a flat market for the remainder of the year, or if we would raise our year-end S&P 500™ forecast from the 1,300 level we started the year with. This is a very fair, simple and straight forward question. Hopefully, my response here will be fair and straight forward. Unfortunately, it will not be simple.

The challenge with simple forecasts for the S&P 500 is that the rationale behind them is more important that the number. But if you’re like me, you generally remember the number more than what was said before and after the number. A number is not capable of supporting subtext, but the creation of that number is all about the subtext. In a massive over-simplification of our 2012 forecast we were, and are, basically saying “stocks prices are cheap and will likely go higher if Europe does not get in the way.” Now that they have gone higher, the question is will they go even higher or will Europe “get in the way” as it has so often over the last two years?

Clearly the market has been less concerned about Europe for the last four months, as evidenced by very strong equity performance. Is there a good reason for that optimism? The short answer is yes. From July through November, the crisis had two major areas of threat: liquidity and solvency. The last two months have been characterized by slow, meaningful progress on the issues in Europe. December brought major action by policy makers and central banks to provide enough liquidity to lower the immediate threats that a general lack of liquidity were creating for the market. January brought real progress in addressing the fundamental solvency issue.

For the last two years we have said that the solution to the Eurocrises would have three major components – essentially a three-legged stool. We think it is useful to view the January developments in Europe from that point of view.

Leg 1: Increasing the firepower available to support countries

• In the short term this means increasing the size of the “kitty”, via expansion of the European Financial Stability Facility (EFSF), European Stability Mechanism (ESM) contributions and accelerated implementation, International Monetary Fund (IMF) facilities and other support.
• The European Central Bank’s Long-Term Refinancing Operation (LRTO), which amounts to opening the discount window for three-year loans to banks at 1 percent interest. In our opinion, this significantly decreases the risk of a Lehman-type event among European banks in 2012.
• At the recent European leadership summit the treaty language establishing the ESM and making it operational by mid 2012 (not 2013 as originally discussed) has been finalized and awaits signature. Probably in the neighborhood of 500 billion Euros.
• The IMF has also called for its members to contribute more to its own firewalls
• In the short term this means increasing the size of the “kitty”, via EFSF expansion

Russell’s conclusion: As long as Italy and Spain don’t need to tap these resources, the monies available are adequate for Greece, Portugal, Ireland, and Cyprus.

Leg 2: Dealing with de-facto insolvencies

• The PSI (banks) negotiations continue as it relates to the “haircut”, or capital loss, that holders of Greek debt and are likely to conclude by mid February.
• Russell conclusion: a haircut is inevitable and an unmanaged market default of Greek debt is viewed as too risky by policy makers so a deal is likely, but will be the result of tortuous negotiations that will continue to ebb and flow. It should be noted that some bondholders view an open market default as preferable for them given their exposure to credit default swaps.

Leg 3: Creating greater fiscal discipline and integration

• The summit managed to place governments in a fiscal straight jacket going forward.
• Russell conclusion: a necessary result of successfully addressing the current flaws in the Euro, but one that is generally unpopular with many voters in individual countries. Agreeing to greater fiscal integration is agreeing to reduce the sovereignty of individual nations and that is almost always very unpopular.

We think these moves to meaningfully increase the giant pot of money available to address this issue and towards greater fiscal integration and discipline are real steps forward, but many challenges and questions remain.

• What if Spain and Italy need to tap into the giant pot of money? If that happens, “we’re gonna need a bigger boat.”
• What if the negotiations on the haircut that bondholders will take on Greek debt fail to reach a solution and an open market default of Greek debt occurs?
• What if the economic slowdown, recession, in Europe meaningfully changes the austerity and reform initiatives in place in the peripheral nations?

Like I said, subtext.

With real progress in the last two months we are more confident that equity returns will be positive and perhaps even robust in 2012, but real questions remain. That increase in confidence is leading us to slightly overweight equities in many of our Enhanced Asset Allocation (EAA) model portfolios but with the understanding that there will continue to be volatility in the position throughout 2012. But Russell is making sure our clients understand that if they make that move their success will have a great deal to do with their time horizon. If they have a short term horizon, they will have to be nimble. If they have a longer-term horizon they will need to be resilient. Of course, forecasting the markets is never certain, but we believe that overweighting equities now will prove to be a good move in the future. We also believe that even if that proves out, the journey will be painful.

I would suggest that for most of our clients, the best move may be to stick with their strategic weight in equities and fixed income. If they are currently underweight equities, consider buying more to get to their planned weight, consider an overweight but be honest with yourself about your ability to weather the “bad news” cycle about Europe that is almost inevitably going to come.

With regard to the S&P 500 target, we are leaving it at 1,300 for now. The clarity has improved around Europe but real questions remain, and revising that number up sends a message that is too blunt in our minds. Perhaps a better way of thinking of that forecast is that we are expecting the S&P to be at least at 1,300 by year’s end.