Daily State of the Markets
Tuesday Morning – January 3, 2012

Good Morning and welcome back to the game. To say that 2011 was challenging for active managers (especially the second half) is likely the understatement of the year. Although active managers have outperformed the buy-and-hope crowd over the past twelve years by gi-normous amounts (lest we forget, the Lipper Growth Fund Index is down -28.44% from 12/31/1999 and the S&P 500 cash index is off -14.4% while even something as simple as a 15-month moving average produced gains of +103% over the same period), unfortunately 2011 was not a good year for anyone trying to actively manage the market’s ups and downs.

For example, while the Global Macro Hedge fund index, which incorporates global stock markets, commodities, bonds, and currencies, has been the clear leader since 1991 (according to HFRI), even this approach struggled to a loss of -8.5% in 2011. Next, according to HFRI, hedge funds had their third worst year on record as managers could not effectively manage 2011’s bucking bronco market. In addition, Goldman Sachs reports that 83% of Large Cap Growth Funds managers underperformed their benchmarks for the year.

However, let’s be clear about one thing; it is never okay to be “okay” with underperformance. While it is indeed “okay” to recognize that it was a tough environment (perhaps the toughest seen in 20 years), we must always be cognizant of the fact that markets change from time to time. Therefore, one of my biggest questions coming into 2012 isn’t whether or not a European bank will collapse at some point (likely), or if the EU will stay together (jury is out here), or if China will resurrect its growth phase (likely), or even if the U.S. economy will enter a recession (not likely). No, the biggest question on my mind is if what we’ve seen over the past five months in the market is the “new normal.”

Gun to the head, I do not believe that the news-driven, intensely volatile market environment will continue indefintely. Experience has taught me that the focus of the market has a tendency to change over time. And usually the change occurs right about the time that everyone in the game has things figured out. So, if you find yourself with a negative macro view due to the situation in Europe and the slowdown in China, you should recognize that this thesis is quite popular these days. In short, this means that should anything occur that runs contrary to this massively negative view, more than a few folks may be changing direction – and yes, all at the same time.

Of course, this does not necessarily mean that a negative macro view won’t be the way to go in 2012 (while the crowd is always wrong at both ends of a trend, they are right during the middle). In fact, our cycle work suggests that we may see another bear market in the middle of the year. No, the main point I’d like to make this morning is that the real key to 2012 will be the ability to be deal with whatever Ms. Market throws at us.

For example, if the bears make a comeback and the sky begins to fall again, investors had best have a way to play defense. While the buy-and-hope crowd wound up being successful in 2011, I’m guessing that based on the outflows seen at the mutual fund companies last year, more than a few folks gave up on the market at some point during the freakishly wild ride. And those that hung in there may throw in the towel if things start to get ugly again.

Next, if the highly volatile market continues, we better have a way to deal with it. Personally, I spent the vast majority of my week off from writing researching shorter-term trading strategies (so much for the “recharging the batteries” idea!). My goal was to identify a management strategy that would function well in the type of market we’ve seen since July of last year. And while I’m not sure this shorter-term method will be needed, I now have it at my disposal. Again, the key is to be flexible enough to adapt to whatever environment is presented.

Finally, if things such as low interest rates, strong earnings, and low inflation become the focal point, investors will need to be ready to run with the bulls. Remember, believe it or not, earnings are at record levels. Sure, the bears tell us this doesn’t matter. But, if the environment shifts – even a little – this might justify a surprising move the upside as valuation aren’t too bad right now.

What does this all of this mean for money management, you ask? For starters, it means we need to check our egos at the door each morning and forget about “being right.” Remember, this game is about “getting it right” – not about “being right.” It means that with volatility still high, we need to play “smaller” and more conservatively. And finally, in case my theme for this first trading day of 2012 remains elusive, I believe that 2012 will be about being flexible.

Turning to this morning… The better than expected PMI data from China and Europe pushed foreign markets significantly higher while the U.S. was closed. And with additional gains in both China and Europe today, it appears that the US will be playing catch up at the open. (However, we will be watching to see if traders use the early strength to lighten positions.)

On the Economic front… We’ll get a big report on the state of the U.S. manufacturing sector from the ISM at 10:00 am eastern as well as the update on construction spending.

Thought for the day… Choose to have a mind that is open to anything and everything…

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell…

  • Major Foreign Markets:
    • Australia: +1.08%
    • Shanghai: +1.19%
    • Hong Kong: +2.40%
    • Japan: +0.60%
    • France: -0.82%
    • Germany: +0.77%
    • Italy: +0.33%
    • Spain: -1.33%
    • London: +0.94%
  • Crude Oil Futures: +$2.19 to $101.02
  • Gold: +$20.60 to $1587.40
  • Dollar: higher against the Yen, lower vs. Euro and Pound
  • 10-Year Bond Yield: Currently trading at 1.946%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: +19.50
    • Dow Jones Industrial Average: +185
    • NASDAQ Composite: +37.03

Positions in stocks mentioned: None

For more of Mr. Moenning’s thoughts and research, visit StateoftheMarkets.com

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