A Reflection in the 11th Hour

01/07/2013 10:00 am EST


John Stephenson

President and CEO, Stephenson & Company

If how we end the year is any indication of how the next one will begin, we're looking at more political grudge matches that work less for the economy and more for the politicians, with the economy—and citizens—paying the biggest price for the spectacle, notes John Stephenson of Strategic Investor.

The damage to the cult of equities from the force-fed housing booms on both sides of the Atlantic, the dot.com crash, the bailouts of Wall Street, and the ongoing political gridlock in Washington and Brussels has been immense.

Despite solid gains this year for the S&P 500 and for the Nikkei—which boasted a 23% return for the year, its best return since 2005—investors are running scared. Investors have flocked to the relative safety of bonds, which on a cumulative basis have outperformed US stocks for over 31 years. Even shell-shocked pension funds are fleeing to bonds on central bank promises of sustained short-term rates of zero.

Not only are investors shunning stocks, but correlations between stocks are high, suggesting that the return for stock picking is minimal. The KCJ Index, which measures the expected average correlation of price returns between S&P 500 components, confirms that correlations are way above normal.

Because of the tighter than normal correlations not only between individual stocks but between markets, investors have adopted a broad-based approach toward securities, selling or buying index futures and ETFs rather than trying to cherry pick the individual market constituents with the best fundamentals. Increasingly this macro madness has had commodities, bonds, and stocks acting as a single trade—risk on, or risk off—buy commodities, stocks, and bonds or sell them all.

But that isn’t how markets are supposed to work. Risk assets such as stocks and real estate are supposed to deliver higher returns than risk-free assets to encourage capitalist managers and investors to invest risk capital in businesses.

Without the reasonable potential for better risk-adjusted returns from stock investing, a key tenant of capitalism itself has been impaired. Thankfully, capitalism or stock investing isn’t dead yet, and the risk-return balance will shift away from bonds and toward stocks in 2013.

The Fed is likely to remain accommodative through early 2015, providing a powerful tailwind for stocks and bonds. Recent jobless claims declined to 343,000, near their lowest level in five years, which if sustained should see the Fed reaching its 6.5% unemployment rate target by the second half of 2014.

The bond bull market still has legs, but it will eventually come crashing to an end as the Fed starts tightening. But for now, bond investors can relax.

Apple (AAPL), the most talked-about company in 2012, had a breathtaking ascent and a spectacular belly flop to end the year. Still, the company managed to post a nearly 26% gain over the year, but the year-end swoon ushered in an onslaught of pessimism about the outlook for America’s most dynamic company.

As I argued recently on CNBC, the stock is suddenly a cheap call on the future of Silicon Valley . If you truly believe that Apple is rotting, then perhaps investors should rethink their current complacency about the sustained competitive dynamism of US tech stocks. But for me, I’m a buyer of Apple at these levels.

US housing will help solidify confidence on Main Street, as attractive affordability and low inventories point to a sustained recovery in housing activity in 2013. Fueled by low interest rates and rising consumer confidence, US housing starts in October hit a four-year high, with new home construction up a hefty 42% from a year earlier. Already, homebuilders such as PulteGroup (PHM) have been on the move, returning a staggering 178.9% in 2012.

Global economic growth in 2013 should exceed the growth in 2012, but the pace is unlikely to be strong enough to significantly lift commodities. Stocks should outperform bonds in 2013, as long term yields rise toward 2% and corporate profits expand in the 5% to 7% range.

My gameplan for the start of the year is to be positioned for pro-growth conditions, overweighting equities over bonds and favoring cyclicals over defensives for the start of the year. The year ahead will likely be choppy, but correlations will start to drop and stock picking will be rewarded as the cliff becomes a thing of the past.

Read more from John Stephenson here...

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