Market Outlook for 2012

If one were to look back at the final results for the year, one would conclude the markets offered stagnant and somber results in a lackluster and boring fashion. Witnessing the Dow Jones Industrial average up 5.5%, the S&P 500 producing zero percent gains and the NASDAQ showing a 2.7% decline does little to stimulate the much adored “I had a great year” conversation. But to call the annual journey lackluster and boring couldn’t be further from the truth.

In fact, when analyzing market data for the Dow Jones Industrial Average back to 1928, of the 83 years in question, 2011 ranked 15th on the most volatile list. We define volatility and constructed this list by taking the historical range of daily returns in 120 day increments for the index. The European debt crisis, which is far from over, will go down in history as wreaking havoc on the US equity markets.

In fact, using market volatility as a gauge, equity investors have aligned this crisis amid calamities such as the 1987 crash, the Great Depression, the 2008 banking debacle, Pearl Harbor and WWII, The Asian Crisis of 1997, the flash crash of 1962 and the Russian bond default of 1998.

The point of this observation is not to promote apprehension and uneasiness when it comes to investing; it is to demonstrate the wonderment of our free market system and the fortitude of the United States of America. In every one of these historical instances, catastrophic circumstances did not lead to an end of an era but made us stronger as we recovered. US equity markets, while excessively volatile did manage to go on and trade higher.

It is for that reason that logic trumps emotion when devising our market strategy for 2012. Tactically speaking, our strategy has been one of relative bullishness since the beginning of October. Strategically, we remain cautious but our optimism grows. By laying out our 2012 investment thesis, this narrative will allow us to further elaborate on our style of investment and how we intend to guide our investors towards stellar investment opportunities and returns.

Our Tactical Outlook

When speaking of our tactical strategy, we allude to our shorter-­term plan of action (one to three months) within our longer-term plan of action (one to three years). When crafting our tactical strategy, our thesis revolves around our proprietary behavioral model.

Our Behavioral Indicator attempts to capture human trading emotions mathematically. It combines years of data from various indicators and aggregates it into an easy to understand model that assists in the investment decision making process. Our indicator encapsulates the put/call ratio, the volatility index, pricing and volume analysis, new high/lows and point and figure analysis to report the daily scores used in making decisions.

Our indicator will score within one of five basic Market Cycles. These cycles include “Extreme Euphoria”, “Greed”, Rational Market”, “Fear”, and “Extreme Panic”. Depending on where we are in the market cycle determines how aggressive our portfolio structure. Typically, the best time to aggressively buy US equities are when we are rising out of Extreme Panic. The best time to be conservative is when we are falling from Extreme Euphoria.

Delving further in the interpretation, our models comprise of two lines. The first is the “Trigger Line”. This line tracks the general movements of the market and provides us with a “heads up” that a time to act is approaching. The second line is the “Trend Line” and provides us with the actual actionable entry or exit into the market.

The trigger line bottomed in the extreme panic zone and started higher on October 4th this year. The trend line turned higher soon after and we decided to increase our long exposure aggressively on October 12th.

While the strategy worked well for us in the month of October, we overstayed our "risk on" position when in early November the trigger line started lower. By November 14th the trend line was headed lower and an investor should have decreased his long bias in favor of a more defensive stance.

On December 6th, the trend line started higher once again.

We continue to have a long bias in place and expect the market to continue higher through January. Our tactical stance will change once the slope of our trend line heads lower.

Bottom Line: We believe the US equity markets will continue to move higher through January and we continue to deploy a bullish portfolio framework. Once the behavioral model slopes negatively, we will take profits and assume a more defensive stance.

Our Strategic Outlook

Fundamentally, the US stock market is undervalued and quickly approaching a buy point that will start a long­term rally. We are confidently making this call based on the fundamental research we have calculated and analyzed.

Our fundamental model encompasses several valuation metrics in an attempt to arrive at a fair value for the US indices. The key elements within our fundamental model focus on:

1 ­ The twelve-­month forward earnings yield for the S&P 500 (which is the inverse of the twelve-month forward P/E ratio).

2 ­ Expected earnings growth over the coming twelve months.

3 ­ Yield differential against the ten­year treasury yield to attempt to capture security rotation.

We have been tracking this model for over fifteen years and it has produced significant market directional opportunities. Unlike our behavioral model that seeks out more shorter-term directional movements in order to

capitalize on excess returns through tactical portfolio rebalancing, our fundamental model provides information on larger secular shifts in the US equity markets and directs our strategic positioning.

We are close to getting significant buy signals from the fundamental model. In fact, 4Q11 is only the fourth time since we started tracking this model in 1985 that we received an “Extreme Panic” reading.

The first three times occurred in November and December of 2008 and March of 2009. Analysts are forecasting the components of the S&P 500 index to report an aggregate $106.70 in the coming twelve months putting theearnings yield at 8.5% (or 11.8 twelve-month forward P/E ratio). Expected calendarized earnings growth for

the index is 12.5%, tracking below the average 18% and the anemic ten-year treasury yield has been tracking

around 2% for several weeks.

By taking these measures into account, our belief is that the market has already priced in much of the current and expected market turmoil that has been reported over the last several weeks.

When interpreting the fundamental model, one needs to wait for the trigger line (thin blue line) to fall below

zero and buy when the trend line (thick orange line) starts to head higher.

As can be seen we are below the zero line and the trigger line has turned higher. This puts us on alert that we

are approaching market bottoms and will increase our long exposure more aggressively when the trend line

heads higher. When following these rules of engagement, our fundamental model has picked points in the

market when the US equity indices have gone on to return 28% on average in the following year.

We are extremely energized by the opportunity the market will offer us once we have confirmation in the

fundamental model. Our anticipation that it will happen sometime in the first half of the year, possibly after one more pull-­back for the S&P500.

Bottom Line: This year will offer investors one of the best buying opportunities seen in years. The trick is to attempt to time it in such a way that protects investors from what may be a continued volatile stock market.

Taking a closer look at the historical market calls that our fundamental model has provided, one can see the lucrative opportunities presented. There have been six other buy signals since 1985 not including the one we are receiving today.

1 - Displays our fundamental model in the mid fourth quarter of 1988. Our trigger line alerted us to a potential

opportunity in November 1988 and we received the actual buy signal in March 1989. The S&P 500 went on to

rally 25% from those levels over the next year.

2 ­ - Shows our fundamental model in the fourth quarter of 1990. The trigger line gave us the signal to be on

watch in October 1990. The buy signal came relatively quickly in December of the same year. The S&P 500

moved higher by 29% in the following year.

3 - Came in December 1994. As the exhibit shows, the buy signal ultimately arrived almost a year later in

October 1995. The S&P 500 moved aggressively higher over the next year and a half producing returns in excess of 35%.

4 - September 2002 is when we obtained the next fundamental trigger indication. As seen in the exhibit, the

buy signal arrived in October 2003, over a year later. By January 2005, the S&P 500 had rallied close to 20%.

5 - Shows our fundamental model in the final quarter of 2005. The trigger line gave us the heads up in

October and the trend line gave us the buy signal by July 2006. Within a year’s time the S&P 500 ran 20%.

6 - Trigger comes in December 2008.. The trend line though kept us out of the market until May 2009. Upon

the buy signal the S&P 500 went on to return an astonishing 37%.

7 - We expect to see the S&P 500 to return in excess of 20% in the next twelve months.

Risks To Our Thesis

There are several factors in our opinion that point to superior returns ahead. That said, proper risk management begs the question, “what if”. There are a few “what if” questions that should be addressed and more

importantly, if these events were to happen, how would we acknowledge these risks and what actions would have to be taken. While the number of risks that can affect the market are inexhaustible, there are primarily

three risks that we envision have the possibility of spoiling our market thesis. These risks include but are

certainly not limited to the European debt crisis; 4Q11 earnings season; and foreign affairs, particularly as it

relates to the Middle East. We will discuss each in detail.

European Debt Crisis

The euro zone debt debacle has, for the most part been center stage and the root of most of the market

volatility in 2011. This will most likely continue into 2012, especially with numerous sovereign debt offerings

coming in 1Q12. The lugubrious European economy points toward recession and one needs to wonder how

that will affect our frail recovery here.

The European Commission’s economic sentiment indicator fell in December for a 10th straight month while

unemployment continues to hit fresh highs. Economists are now projecting GDP contraction for the euro­zone in the fourth quarter of 2011 as well as for the first quarter of 2012, officially marking a recession.

A recession in Europe, along with a new found mandate of fiscal austerity by several nations will exacerbate

the hardship and inability for most nations that are fiscally challenged to find their way out of trouble. A nation

that abruptly exits the common currency or the EU will definitely have a major negative impact on the equity markets as will a default by one or more southern European nations.

One small sign of encouragement is the fact that the euro has hit a sixteen month low against the US dollar

trading roughly $1.27. Over the course of last year, it has been highly unlikely to see both the US dollar and the US equity markets move in the same direction, but for the past week or so, the US stock market, buoyed by

improving domestic economic conditions, has trended higher despite the weaker euro.

One or two weeks a trend does not make, but perhaps it’s a sign that our fortunes will not be tied to every flash headline that emerges from across the pond.

Our hopes are for a clear and uncompromising solution that will not only curtail the panic stricken volatility that the markets of all instruments have had to suffer, but offer long-term stability that can be a model for other

nations that may face similar circumstances. We are in agreement that there needs to be concrete and serious preconditions before the real work starts. Countries that have become addicted to overspending need to first

admit there is a problem and commit to serious reform, even if it means taking a subservient role to a larger

fiscal authority. In lock step with this commitment on the part of European leaders, the ECB must take a more

active role immediately without violating their charter to support those European nations that face budget

shortfalls. This can be done by working directly with the IMF. The global economy will be willing to bear some of the liability if it is shown that those countries with fiscal problems have taken serious steps towards fiscal

reform.

Once this phase is complete and the markets are stabilized, then there needs to be serious conversation about centralized fiscal policy. This may take changes in EU and ECB law, but in the end it will be necessary to avoid

another crisis. While we are not on the centralized regulation camp, if the intention is to continue to entertain a single currency and centralized monetary policy, then centralized fiscal policy is in order. Creating a mechanism whereby a central fiscal entity can approve and support an individual nation’s budgetary needs and growth initiatives will restore confidence in the European economic model.

Having a complete handle on the budgetary needs of member nations, a single euro­bond can be issued at attractive rates. With reduced cost of capital to support fiscal reform, this will give

Europe the time it needs to restructure and regroup while putting pro­-growth initiates in place.

One can hope that these measures are being taken seriously and the markets are pressing the

eurozone for results. Given the yields for various European countries, credit default spreads and the brutal

beating the equity markets are taking, leaders in Europe are under extreme pressure to get something done

immediately.

If European leaders choose to prolong in finding painful but productive solutions, expect continued volatility up until the point where there is an actual default and/or departure from the common currency by one or more

nations. This will drive stocks lower. Fortunately our portfolio can be rebalanced and restructured very nimbly

at JSK Partners and we are prepared to protect assets in the event this doomsday scenario actually happens.

Bottom Line: We forecast a very profitable 2012 with robust returns but are well aware of the external risks that pose a threat to our thesis. More importantly, we are prepared with alternate investment views should the worst come to fruition.

4Q11 Earnings Season

Earnings season kicks off this week with Alcoa (that has already managed expectations lower) reporting on January 9th. Analysts are expecting 4Q11 year-over-year earnings growth in the 6% range for the S&P 500.

One detail that hasn’t gone unnoticed is the deterioration of that quarterly forecast over the past several

months as analysts have been ratcheting down their quarterly earnings expectations. Analysts were looking for 4Q11 earnings growth as high as 14% in early September. With the global economy teetering on the edge of

recession, one needs to scrutinize how these companies are reporting but more importantly how they will be

guiding for the New Year and managing record cash levels that has been accumulated since the 2008 rout.

Should earnings season produce prosaic results, we could be in for a softening in the current rally that started

in early October 2011. Given the amount of negative guidance to date, we anticipate another strong, albeit

managed earnings season. When valuing the S&P 500, we tend to look beyond the quarter to quarter swings

and focus our efforts on the longer-­term calendarized earnings expectations for the index.

Indeed we have witnessed similar degradation in earnings trends as analysts have lowered their twelve­month outlook by $1.30 or almost 2% from $108.10 in early September to $106.10 as of last Friday. This decline

in forecasted earnings is significant because it resembles the trends we found in late 2007 as we entered a

recession amid the housing collapse. Looking at the trends today, if the European crisis is not contained and

the global economy suffers a similar “Lehman Event”, corporate earnings forecasts will follow a similar

trajectory as found in figure 8.

Based on current earnings expectations, we estimate the S&P 500 in undervalued by 12% to 20% depending on which time series one uses. A marked decline in earnings expectations will disrupt this time series and our

investment thesis will need to be addressed.

Bottom Line: Based on our assumption that we are not heading for a recession in the US and we will avoid a profits slowdown of the 2008 magnitude, we are convinced 2012 will offer substantial investment opportunities. Should we see further and accelerated destruction of corporate earnings power, we will need to readdress our thesis and prepare to take a more defensive stance as the year progresses.

Geopolitical Risks

There appears to be much unrest in the world these days. New leadership by a largely unknown young man in North Korea has the ability to rattle the markets as does the possibility of a new nuclear arms race in the

Middle East.

Iran has been sabre rattling these days as the US has imposed new sanctions against the rouge nation. Under

pressure from this country’s leaders, world nations are attempting to reduce the amount of oil they purchase

from Iran in order to tighten the noose around their already flimsy economy. South Korea and Japan, that

import 10% and 14% of their oil needs from Iran, respectively, have stated they are taking measures to find

alternative sources for their energy needs. China, which receives 22% of their imported oil from Iran, has already cut inbound oil due in large part to pricing disputes with Tehran. The European Union has stated they are

prepared to boycott oil imports from Iran starting next month. To the extent that it will affect their economic

recovery is largely unknown at this point.

All this because Iran, after years of trickery and deception, is building a nuclear weapon. This poses a major risk to our 2012 market thesis. Should Iran block the Strait of Hormuz, a scenario that many think is unlikely, then it will be considered an act of war and military engagement will ensue. In the end, 20% of the world’s oil passes

through the Strait of Hormuz, so conflict in that region will drive oil prices to new highs and jeopardize the US

economic recovery. To block this central oil passage would cripple the Iranian economy as well, so experts put a low probability on this actually happening, but crazier things have happened. Remember Japan’s 1940’s

answer to the US regarding the oil embargo.

There are those that are expecting all out military action in the weeks to come.

“Without much media attention, thousands of American troops are being deployed to Israel, and Iranian officials believe that this is the latest and most blatant warning that the US will soon be attacking Tehran.

Tensions between nations have been high in recent months and have only worsened in the weeks since early December when Iran hijacked and recovered an American drone aircraft. Many have speculated that a

back­-and­-forth between the two countries will soon escalate Iran and the US into an all­-out war, and that event might occur sooner than thought.

Under the Austere Challenge 12 drill scheduled for an undisclosed time during the next few weeks, the Israeli military will together with America host the largest­ever joint missile drill by the two countries. Following the installation of American troops near Iran’s neighboring Strait of Hormuz and the reinforcing of nearby nations with US weapons, Tehran authorities are considering this not a test but the start of something much bigger.” Thousands of US troops deploying to Israel – rt.com, 1/5/12.

"Prime Minister Benjamin Netanyahu and Defense Minister Ehud Barak are already reportedly making military contingency plans for taking out Iran's nukes.

The British Daily Mail's online edition for Wednesday quoted a "senior (British) foreign office figure" as saying, "We're expecting something as early as Christmas, or very early in the new year."" Investors Business Daily opinion, 11/11/11.

“In the meantime, Israel continues to reiterate that the prospect of a nuclear powered Iran would be “intolerable”. President Barack Obama has also stated formally that such an eventuality would be “unacceptable” to the United States. The fear in defence and intelligence circles is that Israel is preparing to launch air strikes on Iran’s heavy water reactor plant at Arak – due to become operational in 2012 –where weapons grade plutonium could, in theory, be produced.

Israel has acquired the necessary missiles and in-­flight refuelling technology to unilaterally launch such attacks. Specifically, the Israeli Air Force has been conducting long range live exercises involving F­15 and F­16 jets, refuelled by Boeing 707 and KC 130 aerial fuel tankers over distances of up to 2,000km –similar in length to the round trip flight to Iran’s nuclear sites. The Israelis have also acquired BLU­109 and BLU­113 “Bunker Buster” munitions –massive guided bomb units capable of penetrating up to 23 metres of soil to breach reinforced steel and concrete subterranean structures.

Such an attack would be sufficient to disrupt Iran’s nuclear programme but would have devastating repercussions throughout the region. Such an act would likely provoke all­out war between Iran and Israel –a war that would inevitably involve the US as one of Tel Aviv’s key allies. However, current diplomatic measures aimed at curbing Iran’s accelerated nuclear programme appear ineffective. Nor does there appear to be the prospect of internal regime change within Iran, despite the much­vaunted Arab Spring throughout the region.” Israel-­Iran tensions still key – Dr Tom Clonan, Irishtimes.com, 12/27/11.

Needless to say, this will have a negative impact on the market.

Bottom Line: Our investment thesis remains bullish and we anticipate one of the strongest years for market returns this year. Should geopolitical factors disrupt our sentiment, we will act forcefully to take a more defensive stance and preserve our clients’ capital.

Happy New Year.

Joseph S. Kalinowski, CFA