On January 4, 2011, I sent out a document titled, “Marek’s 11 Things to Worry about in 2011.” It was a list I created for myself of what to consider while investing, and I wanted to share it with friends and colleagues. Over the course of the past year, while the awareness of the issues has heightened significantly, the actual list itself hasn’t changed much for 2012. Below is the original document with today’s commentary (in bold). I think this year it’s important to remain mindful of the risks, but also identify opportunities driven by other investors’ fear.
Marek’s 11 Things to Worry about in 2011
1. Europe – Greece and Ireland are struggling. Portugal, Spain, and Italy are next. The problem is solvency, not liquidity. More bailouts? Restructuring? Changes in the Euro-zone? This, of course, ended up dominating the headlines for most of the year and continues to be a major concern.
2. Commodity Prices – Many commodities have appreciated tremendously in 2010, including corn, oil, and sugar. This will have its effect on the global economy eventually. They didn’t get many headlines, but commodities were one of the worst performing assets classes in 2011. While oil and gold performed well, the Dow Jones-UBS Commodities Index was down 13%. As for the impact on the world economy, it must be a factor but I haven’t seen much data on the details.
3. US Government Balance Sheet – Federal debt is high and continues to grow despite rock bottom interest rates, while taxes are being cut. Many municipalities, states, and cities are struggling to remain solvent due to high debt and declining tax rolls. At some point this irresponsible behavior will catch up to the US. Federal balance sheet and budget problems surfaced on several occasions and will continue to do so- this problem isn’t going away anytime soon. On the other hand, municipalities held up much better than many had prognosticated, including Meredith Whitney who had a well-publicized blunder.
4. US Unemployment – Unemployment remains stubbornly high and there is little sign of material improvements coming anytime soon. This impacts consumer spending, economic growth, and government benefit spending. Unemployment stayed over 9% for the majority of the year, and only very recently dipped a bit. The labor participation rate, the number of people employed relative to the population, and other related metrics, all show a population that is shifting towards permanent unemployment (which isn’t captured in the headline rate).
5. China – People are in awe of China, its growth, and its prospects. But historically China has had its booms and busts, and it hasn’t always delivered on its potential. The biggest concerns are a possible real estate bubble and inflation. “Housing prices in the U.S. peaked at 6.4 times average annual earnings this decade. In Beijing, the figure is 22 times.”*. Given the recent global focus on China, a major correction in its real estate market will likely be felt by investors everywhere. Inflation is soaring and the government is raising interest rates, but will likely need to take more drastic action. China was one of the worst performing equity markets in the world last year, down around 20%. Economic challenges are getting more attention and 2012 will tell whether the government can engineer a "soft landing."
6. Japan – Japanese debt now stands at 200% of GDP**. Japan has an aging population, and growth is nonexistent. Judgment day is coming.
7. Interest Rates – They have nowhere to go but up. It is unclear how the markets and the economy will respond once the process of raising rates begins. Investors have piled into government, corporate, and high yield bonds in 2010 and enjoyed substantial gains. These gains will be pressured when rates start to rise, which will likely impact other markets. I was blatantly wrong on this one. Rates went down and then down some more on treasuries and mortgages. I’ll go out on a limb and repeat my assertion that rates have nowhere to go but up at this point.
8. US Housing – Mortgage rates are rising (most recently from 4.2% to 4.8%), foreclosure inventory is high and rising, prices are dropping (1.3% in October alone), unemployment is high, and many homeowners are underwater. Nothing good to say here other than some markets are starting to look cheap. Last year was a difficult year in housing and several of the major builders are under heavy debt. However, things are starting to turn in the market and this may be one of the big positive surprises in 2012.
9. Economic Growth – Troubles in Europe and cuts in government spending will negatively impact European growth, which will in turn hurt the rest of the world. This one held true, in retrospect was obvious, and will continue.
10. Banks – Unclear whether the banking crisis is really over. Financial results of the banks are lackluster, and every time things look up there is a new issue, like the mortgage “robo-signing”. Financials were one of the worst performing sectors in the US and abroad last year. This also might be an area of positive surprise in 2012. I believe the US banks are much better positioned than anytime in the past decade with leverage ratios the lowest in 20 years*** and very conservative lending criteria. In addition, financial stocks are very cheap, mostly trading at a large discount to tangible book value. On the other hand, European banks might continue to suffer for a while. Nevertheless, as you may have read, Catalus recently announced expansion to the Continent.
11. War – The Koreas aren’t playing nice. Iran is a wildcard. Russia has been aggressive in places like Georgia. Any decent sized war or attack will have its implications globally. Nothing major in 2011, but rumblings in the Middle East are growing and the risks remain.
Bonus! The Unknown – Who knew that AIG was selling naked CDS en-mass in the 2000’s? I didn’t, I thought it was an insurance company. You don’t know what you don’t know. We’ll see what we don’t know in 2011. My favorite!
* Wall Street Journal, ** Central Intelligence Agency (CIA), *** Goldman Sachs
