Global financial markets struggled throughout 2011, with many asset classes locked in a seesaw pattern driven by persistent uncertainty. Year- to- date, the S&P 500 Index is down -1.3 percent ... despite yesterday’s 3 percent pre-Santa Claus rally.¹

Stocks have experienced sharp swings all year driven by the crisis in Europe and political gridlock in Washington. For the second year in a row, investors feared the Eurozone debt crisis might derail the US economy and cause a double-dip recession.

While recession never materialized, just as in 2010, it didn’t prevent the S&P 500 Index from falling nearly 20 percent at its low point in October.²

Yet despite this day-to-day volatility, stocks have been mostly range bound over the past two years as investors wrestled with this backdrop of economic uncertainty.

As a result, financial markets haven’t been able to sustain any momentum ... either up or down.

Choppy Markets a Familiar Pattern

Unfortunately for investors, this pattern of behavior is becoming all too familiar. But this action is not unexpected. As we pointed out in a previous article (Issue 31 • August 24, 2011), “In the aftermath of great financial turmoil, history tells us that the economy and financial markets rarely return to business as usual right away. Instead, the healing process takes time.”³

We acknowledge that it is a frustrating environment for investors. But successful investing takes time and this period in particular highlights the importance of taking a longer-term view regarding your investments and maintaining proper asset allocation within your portfolio.

At times like these, many risk-averse investors tend to latch onto the dire predictions of doom and choose the sidelines rather than dealing with the uncertainty. That’s understandable — to a point. However, it’s important to recognize that negative headlines may be overshadowing what appears to be genuine fundamental improvement in our economy.

At Banyan Partners, we are maintaining a cautiously optimistic view for the US economy and financial markets for 2012. Since there hasn’t been much meaningful progress in resolving the major global uncertainties, these issues will likely keep markets volatile into 2012. However, we are confident that the US remains a bastion of relative stability in an increasingly uncertain world and that investors are beginning to recognize this fundamentally.

In fact, as we pointed out just a few weeks ago in the Banyan Letter, (Issue 46 • December 7, 2011), multiple leading indicators for US growth are improving. This includes a substantial rebound in consumer confidence entering the holiday season, renewed strength in manufacturing and industrial production, and a surprisingly strong jobs report last month.

Granted, there’s still plenty of progress to be made considering the uneven growth we’ve witnessed, but that’s not uncommon following such a severe recession. US gross domestic product (GDP) growth was essentially at a standstill in the first quarter of 2011, for instance, but has steadily picked up each quarter since.⁴

In fact, economists have been raising forecasts, and it now looks like fourth quarter GDP may continue accelerating at a 3 percent annual growth rate. The economy may have started out slow but continues to grow. Indeed, the leading economic index, as shown in the graph above, points to a continued expansion for the US economy in the quarters ahead.⁵

Meanwhile, profits of US companies posted a new all-time high last quarter. Relative to the overall size of our economy, corporate earnings reached a record level at 10.3 percent of GDP. According to the official tally, after-tax corporate profits expanded by $160 billion, or 11.4 percent, during the third quarter from the same period last year, while corporate dividend payouts grew 8 percent, a $60 billion increase.⁶

Be Disciplined and Opportunistic in the New Year

Of course, this positive data point is also one of the main arguments the pundits of pessimism are using to predict doom.

They’re concerned that corporate profit margins are unsustainably high at today’s levels and are bound to reverse course at some point. When profit margins do inevitably peak and begin to decline, the stock market is bound to take a big hit, or so the bearish argument goes.

Based on actual research, however, this argument doesn’t hold up.

The US economy has experienced periods of declining corporate profit margins before. It has happened at least 10 times over the last 60-plus years — and historically the S&P 500 Index has been higher one year after profit margins peak about 90 percent of the time!⁷

It seems that fears of falling corporate profits leading to a stock market decline in 2012 may be misplaced.

Therefore, we remain optimistic for continued profit growth in 2012; however, the robustness of that growth may be tempered if we encounter new headwinds not currently on our radar screen. In this climate, we favor high-quality stocks with a definite preference for dividend-paying companies where the income yield offers an additional margin of safety in volatile markets.

At present, we’re holding higher levels of cash than usual, as a means to take advantage of new opportunities as market conditions warrant. Perhaps the best approach for the year ahead will be to adopt a more flexible, opportunistic strategy within your portfolio and we expect dividend-paying US stocks to be a key investment theme in 2012 ... a topic we’ll explore in more detail in the New Year.

In the meantime, unexpected events may continue to influence markets, regardless of the improving fundamentals. As investors, we must maintain a disciplined investment approach no matter what’s in the headlines.

Happy Holidays,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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¹ Wall Street Journal market data as of 12/20/11
² Ibid.
³ Banyan Market Letter, 8/24/11
⁴ Bureau of Economic Analysis, 11/22/11
⁵ The Conference Board Leading Economic Index, 11/18/11
⁶ Bureau of Economic Analysis, 11/22/11
⁷ BCA Research: Global Investment Strategy, 5/13/11