The last two years' liquidity-driven charge higher seems likely to give way to a bull market driven by fundamentals.
Third bull market years rarely show extreme returns—up or down.
While fundamentals are good, they're also more widely appreciated—requiring more homework by investors to achieve good results.
Over the past two years, we've frequently written that the sharp, sentiment- and liquidity-driven initial charge higher would eventually yield to a bull market driven by fundamentals, entailing changing leadership among categories of stocks. In our view, 2011 likely holds this shift.
What's more, 2011 likely features more muted results for broad stock market indexes. Historically, bull market third years (March starts year three) are typically up a little or down a little. Occasionally up big, but never down huge. Our view is 2011 is an up-a-little year—akin to 1960, 1977, 1994, and 2005. Make no mistake: 2011 can be a perfectly good year. But it's also likely a year requiring much more homework for investors to dig deep below the market's surface to identify underappreciated opportunities favored by strong fundamentals. This year, we expect those anticipating big returns from broad, index-level decisions to meet with frustration. Yet it's a year that will frustrate the bears too—2011 will be an equal-opportunity antagonist.
For the last four years or so, investor success has been predicated on getting high-level decisions (whether or not to be in stocks) correct. In 2008's massive bear market, sector, country, and stock-specific decisions didn't contribute much to portfolio direction—the asset allocation decision drove results. The same was true in 2007 and in the huge global rally of this bull market's first two years. Those who didn't buy into rampant economic hypochondria and remained in stocks in 2009 and 2010 likely saw huge positive results. In those two years, sector, industry, and country returns were near uniform in direction—up big. Sure, economically sensitive areas led the recovery, but most stock categories did fairly well—meaning country, sector, industry, and specific stock selections didn't matter as much. A high-level example: From the March 9, 2009 bear market bottom through 2010's close, the US-specific S&P 500 rose +93.1%, the global MSCI World +93.3%, and the all-foreign MSCI EAFE +92.0%.* Eerily similar, and up big! To make 2011 a good year, we feel it'll require making correct tactical decisions that go beyond a surface-level, risk-on or risk-off strategy. Decisions at the sector, country, sub-industry, and company level will gradually gain in importance.
Still, some investors remain pessimistic and anticipate the worst. But fundamentally, stocks generally remain quite attractive relative to low-yielding fixed income and cash alternatives. And economically, growth and expansion seem poised to continue for the world and US—the Emerging Markets-led economic boom lives on. Because of other important drivers like global political gridlock, a new bear market seems the least probable outcome for the year. But as we've also said, while future economic growth, gridlock, and strong equity market fundamentals are important factors, they don't perfectly translate into equity market returns. It is not solely fundamentals one must assess—but also how widely the investing public appreciates these factors. Here, an important shift has occurred.
The past two years' dire pessimism still exists, but its subscribers are fewer in number. An optimistic group, driven by reflection on 2009 and 2010's above-average stock market gains, has grown to counterbalance the pessimists. While people feeling better might seem positive, it also ratchets up economic and stock market expectations—making upside surprise harder to achieve. We're left with two groups: The still-dour, who continue their exhaustive hunt for the fabled second shoe, and the new optimists, who struggle to control their greed. The middle is nearly bare.
The stock market has an uncanny ability to do what few expect. The dominance of groups expecting extremes (one way or the other) makes big up or big down results unlikely. More likely is a tug-of-war, with volatile ups and downs along the way to seemingly validate either group's view. But we feel hindsight will ultimately show 2011 was a year of rotation to fundamentals regaining primacy—a not uncommon pause that refreshes within a broader bull market.