Out with the Bold, In with the Few

“We’ll drink a cup of kindness yet, for auld lang syne” – Robert Burns

And that was that. After all the sturm und drang (we reckon it’s a good time for using German phrases) that saw the S&P fall 25% from its high in May to its low in October, the venerable index finished the year with a total change of four cents: 1,257.64 at the beginning, and 1,257.60 at the end. Along the way, beta bets were banished and safety names became the over-owned sector of choice.

The last week was much like the year – a little flutter higher at the beginning, a sag in the middle, and an end of period mark-up rally replete with quiet profit-taking in the waning moments. When Europe could stay off the radar, markets rose, and when it came back onscreen the ride would get bumpy.

As we enter 2012, the fourth calendar year since the crash (was it really that long ago?), predictions for the year cluster around three outlooks: another dreary sideways year like 2011 (similar to the rebuilding years of 1947-1948), an up year that starts with a European big-bang first before recovering, and last (and probably least) the old standby: next year equities should do great, and multiples will expand! It’s true that neutral years have been followed by double-digit gains several times in the last fifty years. We’ll let you choose.

Whatever your choice, at the moment the US economy is slowing. We’re not trying to alarm you, and we’re not hinting that it’s going into a recession. But it is slowing, and – in public, at least – the broad investment community has dialed itself up a menu of steady US growth on the horizon.

Last week the Chicago purchasing manager index put in a good report, but the Philadelphia Fed index of leading indicators weakened for a third month in a row, the Dallas and Kansas City Feds both reported weakening conditions, and business spending on capital goods has been falling (the special depreciation is running out). Spending seems set to replicate last year’s pattern: a boost for Christmas, and then consumers resume their careful ways (they did the same for Easter and back-to-school).

It’s not all that big of a deal, broadly speaking. The reality is that the economy has been pulsing up and down around a relatively stable, albeit sluggish path. But whenever it pulses up, the markets go ballistic and start talking up $150 oil and 1,500 on the S&P. Then when it pulses down, we hear about double-dips and deflation. There could be some downward attitude adjustments in store a few weeks from now, when earnings season begins again.

Whether or not our economy sustains what growth it has depends quite a bit on what happens with Europe. Does it muddle through, fall and rise, or collapse? The first is hoped for by the long crowd, the last by the shorts, and the middle is the consensus. There is no good way to handicap political decisions, but our outlook is that “muddling through” can’t be sustained. Between the deepening recession, the growing yields on sovereign debt and the inability of the unwieldy EU process to act sensibly except under the most urgent duress, it looks like crisis is fairly inevitable.

The “risk-on, risk-off” approach of 2011 is unlikely to change until equities can put on a sustained move that a) lasts more than two quarters; and b) is based upon concrete evidence of an improving economy. When that happens, money flow for investing will improve relative to money flow for trading. That doesn’t mean we can’t get a hot quarter or two – look at 2009 – but it does mean that the average investor is likely to feel frustrated for some time to come.

Next week brings the last two days of the Santa Claus period, spiced up by the ISM manufacturing report on Tuesday. The jobs report follows on Friday. Next year brings the likely denouement of the European debt crisis. If a genuine, all-together-now restructuring happens, then the day of reckoning for China’s property bubble gets to be postponed and equities would likely roar for some time afterwards. It would be a great opportunity to make money. If we get the acrimonious breakdown scenario instead, it won’t be the end of the world as we know it, but it will be a pretty grim period for equity investors, not to mention fixed income trading desks. It would be a great time to lose money.

We wish a Happy (and prosperous) New Year to our readers, and remind one and all that all US markets are closed on Monday, January 2nd.