Written by Dave Young, President of Paragon Wealth Management
Taken from Paragon's 4Qtr 2011 print newsletter
2011 was a very difficult year for investors. Even though it was one of the most volatile I have ever experienced, the year ended about where it began. The overall trend changed so many times that it was impossible to extract any gains from it. A thousand point move up followed by a thousand point move down became routine. Since August, intraday daily swings averaged 261 Dow points.
The initial 2300 point sell off in July was triggered by our Treasury Bonds being downgraded for the first time in history. Next, the market became manic-depressive and entered an entirely new realm of volatility. The up and down gyrations were unbelievable and continued for almost six months. Over that time period there were over 20 significant market swings - with the market moving 400 to 1200 points at a time. It was impossible to lock onto a trend because there wasn’t one.
It was a war between the bears and the bulls. The bulls could not believe how cheap stocks were. Prices are close to where they were 12 years ago even though earnings have almost tripled since then. It doesn’t make sense for stocks to be trading at such low prices, based on their continuously increasing earnings.
On the other hand, the bears were scared to death with what was going on in world financial markets. Our treasury bond downgrade had all kinds of potential negative ramifications. No one knew for sure how it would affect the thousands of other bonds issued by U.S. corporations and municipalities. No one knew how it would affect stocks. The outcome of the downgrade held a lot of unknowns, which in turn created a lot of fear and selling.
An even bigger problem was the situation in Europe. The countries of Italy, Spain and Greece were on the verge of a financial meltdown. If a solution was not found to deal with their debt, then it was likely that those countries would default. If they defaulted, they would likely destroy Europe’s biggest banks. If the European banking system went down, it could potentially take some big U.S. banks down with it. That could trigger a major financial meltdown and have the potential to create a repeat of the 2008 meltdown all over again.
This was a high-risk situation with a lot of moving parts. Because it was outside the United States it was very difficult for U.S. investors to understand or assess what was going on. The lack of transparency made investors very nervous and ready to sell at a moment’s notice, which they did repeatedly during the second half of the year.
Usually when markets sell off we start buying aggressively because the downturns are temporary. This time the situation with Europe was different. Our research showed that unlike most downturns, if the worst case played out we could potentially see a rerun of 2008 or worse. That forced us to hold more cash than normal and to invest in defensive sectors for protection – just in case.
Our clients pay us to generate the best returns we can. They also hire us to do what we can to help protect their investments. Historically much of our excess returns have come from minimizing losses in rough markets. This year our efforts to protect client accounts from a potential European meltdown reduced our overall returns.
To summarize what made 2011 so difficult:
- The volatility was unprecedented and created endless whipsaws.
- There was no trend to capitalize on.
- High correlation between market sectors limits our ability to generate excess return. Usually there is a large range of varying returns among the 250 sectors we track, and we are able to identify those sectors that are growing the fastest. For the last 18 months the range of returns between the sectors has been much smaller than normal limiting our ability to benefit by identifying top performing sectors.
- The extreme level of risk created by Europe forced us to be very defensive.
- It was reported in October that 75 percent of all active managers had underperformed the S&P 500. In part that was because large cap stocks (the S&P 500) were the best performers in 2011. Many hedge fund managers got knocked around in the volatility as well. No one was immune with big names like John Paulson (down 35 percent) and Bill Gross (2010 manager of the year) underperforming 90 percent of his peers.
To be continued next week...
Disclaimer
Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.
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