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Volatility Will Prevail in the Early Days of 2012

By Roger Conrad on December 30, 2011

The US economy will grow faster in 2012–if it isn’t knocked off track by upheavals in Europe. That’s the less-than-illuminating forecast from a recent Associated Press survey of “leading” economists.

Other survey highlights include a consensus prediction of 8.4 percent unemployment, near zero interest rates at least through mid-2013 and 2 to 3 percent overall growth in gross domestic product (GDP). Overall that would be a slight improvement on 2011–continuing the trend of the past several months–but with the caveat that some outside event could turn everything on its ear.

For most economists, the cardinal sin is to be made to look foolish by being completely caught out on a forecast. The exceptions, of course, are the perma-bears, who glory in making ordinary investors’ hair stand on end.

But it’s no coincidence that consensus predictions always reflect what’s happening right now rather than anything prescient. Nor is it any secret that only rarely do they prove accurate, or that they’re usually completely useless as the basis for an investment strategy.

Investment markets have proven time and again that they’re the best discounters of future events ever invented. In fact, by the time any economist issues a forecast stock prices will have long since reflected the current reality that shaped those predictions.

At the same time, however, the market itself is hardly a perfect forecaster. True, stock market rallies have traditionally preceded economic growth. But while stock prices in the long term reflect the value of companies’ underlying businesses, in the short term they reflect investor perception, which may or may not have any basis whatsoever in reality.

In 1999, for example, the technology-laden Nasdaq doubled. Two years later it was back where it traded in 1996. Even now it’s less than half its all-time high.

Many companies behind Nasdaq’s run up have indeed vanished from the planet, including the competitive local exchange carriers that were supposed to run big telephone companies out of business. Many companies, however, have continued to grow rapidly and still dominate the technology markets that have literally transformed the global economy. Ironically, their stocks have never come close to revisiting the heights of the late 1990s.

That example hardly supports any idea of a rational market. It is, however, logical–so long as one considers markets are at their core run by human beings, and therefore emotional, with the mood constantly moving between fear and greed.

When and where greed dominates, stock prices run higher. When fear is the dominant emotion, investors pull back to what they consider to be safe. The more extreme the emotion becomes, the more violent the mood and the more volatile the market action.

What made 2011 so remarkable wasn’t downside. Many of the emerging markets that had done well in 2009 and 2010 did lose ground, as concern about Europe’s debt crisis combined with “black swan” events in the spring (Japan’s earthquake/tsunami and the Arab uprising) to boost fear levels and trigger a flight to safety.

But other stocks did very well, as investors considered them safe havens. Pipeline companies and most big electric utilities generally had super years, tacking on big gains to similarly strong returns realized in 2009 and 2010. Although dividend-paying stocks in other industries were beaten up in the fall selloff, many have been able to fight their way back to the black by the end of the year.

In short, 2011 actually proved to be a decent year overall for owners of dividend-paying stocks who practiced the discipline of diversification and balance–and who didn’t average down in falling stocks. In fact, the biggest challenge for many will be to rebalance their holdings–paring back the biggest winners and adding new high-quality positions–in a tax-efficient way by the end of the year.

That’s a very different situation than at the end of 2008, when virtually everything was down and the challenge was deciding what could still get up. Rather, what made 2011 a remarkable year are really two things.

First, the volatility worked both ways, sometimes in the same week, as investors went from buying to selling in response to events that put in perspective proved trivial. Second, despite the fact that the US economy grew and many investors finished the year on higher ground, the prevailing mood is 2011 was a complete disaster for investors, and that 2012 is setting up to be even worse.

More Volatility Ahead

If anything can be concluded from the AP survey of economists I cited above, it’s that we can expect more of the same conviction-less stock market volatility at least into early 2012. There are ways to take advantage, such as entering buy limit orders at “dream” prices for stocks you want to own.

One example would be to enter a “buy limit” order for Enterprise Products Partners LP (NYSE: EPD) at $38, which is slightly below its second half 2011 low. Buy limit orders are only executed when the specified price is hit. That may never again happen at $38 for Enterprise. But the stock did hit an intra-day low in the low 20s in the last 18 months, thanks to what appeared to be a large number of trailing stop-losses that were executed at the same time.

Stop-losses don’t guarantee investors will be taken out at any set price. But they do generate sells when that price is reached. And if enough are executed at the same time, the result will be an avalanche of sells that will drive a stock’s price down until they’re offset by buy orders. In Enterprise’s case, the buys came in swiftly and drove the master limited partnership’s unit price back up to close virtually where it had opened the day.

Investors who didn’t set stops likely didn’t even realize what had happened but still had their positions in this very strong MLP. Those who set buy limit orders, meanwhile, were executed at “dream” prices and immediately earned hefty profits. Those who set stop-losses, meanwhile, were unfortunately dumped out at abysmal prices, in some cases for huge losses. Those who did get back in had to pay much higher prices.

Today’s extreme volatility makes stop-losses and particularly trailing stops a very dangerous strategy. A better idea is simply to keep tabs on the financial health of your holdings, staying in there so long as they’re growing earnings and dividends. That won’t save you from volatility. But you’ll still be in good positions no matter how the market mood shifts.

With the market this fearful, however, we’ll almost certainly see more people misuse stops and therefore drive market volatility. That means setting buy limit orders at dream prices will continue to pay off for patient investors. Note that you’ll need to keep cash on hand to cover the orders if they’re executed. But that, too, should improve most investors’ well being, as cash is the ultimate security in a weak market.

Taking advantage of volatility is really the best you can hope for in an environment like this, where every new development seems to push things in another direction. History shows, however, that either bulls or bears will win eventually. And the key to 2012 will ultimately be betting on the correct side.

Implausible as it may seem to some, my bet is on the bulls for three reasons. First, there’s investors’ lack of conviction that stocks can actually go higher, and especially that underperforming stocks can possibly recover once they sell off.

These beliefs were born in the wake of the implosion of several once-popular stocks this year as much as macroeconomic worries. But, for whatever reason, there are a lot of stocks selling as though doom was inevitable, including more than a few that have increased dividends at least once in the last 12 months.

There are also still seem to be a number of investors who are basing their investment strategy on their political views. This was an especially disastrous strategy adopted by those fearful of President Obama in early 2009, and many will never recover from missing out on the historic 2009-10 rally.

Political investing backfired just as badly this autumn on those who believed forecasts that an S&P downgrade of US Treasury bonds would bring doom. And it will no doubt prove equally deadly in 2012, as an election year stirs passions all over the spectrum.

The bottom line is keeping your politics out of your investment strategy is just as critical now as it’s ever been. Yet many investors will no doubt follow the siren calls from the popular media into the trap, buying or selling at the wrong time and needlessly wiping out wealth.

That’s something that only happens when sentiment is gloomy, which, ironically, is the exact point where big rallies always begin. And despite the volatility we’re likely to see, the pieces are actually in place for pretty solid macro conditions in 2012.

In the current issue of Personal Finance, my colleague Elliott Gue presents his “2012 Cheat Sheet” of what to expect for 12 major markets and indexes in the year ahead. Two of them highlight particularly critical trends for income investors that I’ve pointed out in my advisories Utility Forecaster and Canadian Edge.

First, we’re in the most accommodative market for issuing corporate debt in memory, with no end in sight. Second, the US economy–despite what seems to be a “can’t do” attitude of many Americans–is still chugging along.

The first ensures the capital intensive/dividend-paying industries I focus on will continue to build and buy cash-generating assets, which, in turn, will fuel more dividend growth. And it ensures these companies will not be vulnerable even a collapse in Europe temporarily tightens credit conditions. In fact, if the action this fall is any guide, a worsening in Europe could actually wind up driving down corporate America’s borrowing costs even more, by attracting safe-haven seeking money from around the globe.

Second, worries about a slowdown in the global economy have kept companies’ operating and financial management exceptionally conservative. That means growth is insulated against turmoil around the world. And so long as the US economy continues to grow, earnings will be in place to meet and beat expectations.

Of the 210 plus companies I track in Utility Forecaster’s How They Rate table, more than 90 percent were on track after the third quarter to meet or beat management’s full-year profit guidance. The others were primarily European companies that were forced to bend a bit due to the Continent’s financial storms, but weren’t breaking.

We won’t have numbers for 2011 until late January and early February. But indications are we’ll see more of the same good news. And given that, it’s going to take a lot from overseas to hold back further gains.

As long time readers know, I’m fundamentally a bottom-up advisor and analyst. I prefer to look at what’s going on at the individual companies I’m extremely familiar with and use that as a guide for the big picture rather than come up with a big picture theory to graft on everything below.

That’s probably somewhat due to studying anthropology years ago, a science that emphasizes the value of human differences. But for me, that’s where the action is. And if Southern Company (NYSE: SO) is telling me industrial demand for electricity is virtually back to pre-2008 crash levels, that means more to me than an economist preaching the end of American manufacturing. So do reports of potential major new investments in North American businesses using natural gas liquids as feedstock.

It’s our companies that pay our dividends. And it’s the health of those companies that determines how much they can pay. That may or may not be affected by the kind of macro views trumpeted ad nauseam in the investo-tainment world. But it’s the companies we own and may own in the future that deserve our attention as income investors. Everything else is background noise, however entertaining and/or thought provoking.

Here’s to a great 2012.

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  1. avatar
    Marion Massey Reply January 2, 2012 at 10:37 PM EDT

    Thanks for a very special overview/forecast so masterfully written.

  2. avatar
    Steve Maher Reply December 31, 2011 at 5:32 PM EDT

    I am on it for long term dividends