Fourth Quarter 2012 Letter to Clients

As we consider the year that has just concluded, the predominant theme for 2012 seems to have been “The Year of Gloom & Doom.”

For much of the year, the U.S. economy teetered between recession and slow growth. Concerns over the Eurozone economies continued unabated. The election season proved to be perhaps the most contentious ever. All in all the headlines were downright depressing. (Though, on the bright side, the Mayans proved to be poor apocalypse predictors.)

So, with all the negativity that we were confronted with in the media on a daily basis, it’s no surprise that stocks struggled in 2012, with the S&P 500 index generating a return of…um… 16.00%.

Wait…how’s that?

Sixteen percent?

You read correctly. Despite all of the pervasive negativity in the news cycle in 2012, stocks apparently failed to get the memo. Not only did stocks, in reality, not struggle, they enjoyed substantial gains. And yet it is interesting how many people believe that 2012 was a down year for stocks. If you watched the cable news networks for any length of time during the year, who could blame them?

We made the point recently that the old adage “stocks climb a wall of worry” was among the truest ever spoken, and that adage was proven true yet again this past year. But 2012 taught us some other lessons as well, so let us pause for a moment and consider what they might be:

Lesson 1: Stock investing is about owning companies, not countries: While most observers have been focusing on the fate of nations, primarily our own, corporations are busy fanning out around the globe in search of opportunity. And they are finding it.

Developing economies are surging as technology is leading many of the world’s previously downtrodden areas into a new era of prosperity. And that same technology is enabling the world’s great companies to move nimbly into these areas of opportunity that previously didn’t exist.

Thus, although American companies are certainly affected by the fate of their domestic economy, they are not bound by it. The continued growth in the stock price of these companies in the face of an uncertain economic future at home is a reflection of this reality.

Lesson 2: The Death of Asset Allocation Was Greatly Exaggerated: It was in this space exactly a year ago that we were defending the virtues of asset allocation despite the fact that Blue Chip stocks trounced nearly every other asset class in the world in 2011. The pain for diversified investors was particularly acute because the Dow posted a gain for the year of 8.38% while most other equity asset classes experienced losses.

Right on cue, the media began rolling out its “Diversification is Dead” stories, and Wall Street began rolling out its “Dogs of the Dow” strategies (last seen being offered circa 1997), asserting that U.S. large stocks were the only “safe” equities in this volatile environment.

And so, predictably, we saw a complete reversal of the Dow’s performance in 2012, from top of the pack to bottom of the pack:

There is no environment more challenging for diversified investors than when Blue Chip stocks are leading the market, because it is easy to become convinced that diversification does nothing but diminish returns compared to what was there for the taking if we had just bought the Dow (or S&P). But as we saw during the entire decade of the 2000s, Blue Chips can also trail the rest of the market for years at a time. Remember, then, that Blue Chips are just an equity asset class like all others, and diversification is about hedging the long-term risk that comes from concentration in any one asset class.

Lesson 3: Investors chasing hot stocks continue to learn hard lessons: For the first nine months of the year, Apple was the darling stock of investors around the world. From January through mid-September, the world’s favorite tech company gained an astonishing 67%. By comparison, the S&P 500 index for the same time gained a comparatively paltry 15%.

Not surprisingly, investors flocked to Apple stock in droves, wanting to get in on some of the action. Unfortunately for them, the stock peaked in September and plunged during the last three months of the year. From mid-September through the end of December – much to the chagrin of the late-arrivers – Apple plunged nearly 25%. Though it finished 2012 with a respectable 27% gain, those investors who piled into Apple late in the year experienced hefty losses.

Unfortunately, this type of “rearview investing” is more the norm than the exception. Investors find it impossible to resist the allure of a stock (or fund) that has posted market-beating returns that are there for the taking. Usually, however, it ends up more like Charlie Brown trying to kick the football only to have Lucy, yet again, snatch the ball away right when he arrives.

Lesson 4: The media’s spin cycle only has one setting – “Fear”: During the financial panic in the fall of 2008, the media’s favorite narrative was a running count of how much money investors had “lost” during the crisis. (That these investors only lost money if they sold their holdings was seldom pointed out as this did not make for exciting reading.) The news shows loved to talk about how the selloff had “wiped out X trillion dollars from Americans’ net worth”.

Today, we sit with the Dow in the 13,300 range, more than double its level from the lowest depths of the crisis. So where, we ask, are all the news stories pointing out how the bull market has “added X trillion dollars to Americans’ net worth” these past 48 months? If we had all those articles focusing on how much investors lost during the hard times, why aren’t we seeing commensurate stories today about how much investors have made in the good times?

The sad truth is that such news doesn’t sell. Only fear sells. Fear gets people to watch. Fear gets people to read. So that is what the media focuses on. This isn’t news to any of us, least of all the media. But it’s good perspective to keep in mind during the next period of market volatility that, sooner or later, will surely come. The media has no interest in a balanced, calm, long-term perspective. It has only one purpose – to hold your eyeballs as long as possible so it can charge the highest advertising rates possible.