Other Updates

Summary

The U.S. economy proved to be resilient in 2011, strengthening quarter by quarter throughout the year despite a challenging global environment. Stocks rebounded sharply in the fourth quarter, but full-year results were still negative for world markets. Bond returns were modest in the fourth quarter but surprisingly strong for the year, as interest rates declined significantly. Stocks have rarely been as attractive relative to bonds as they are today by most metrics.

The Economic Environment

Despite all of the turmoil in world markets in 2011, the U.S. economy continued to strengthen quarter by quarter. Real growth in Gross Domestic Product (GDP) improved over the first three quarters of the year.

2011 GDP Growth

First Quarter:  0.4 percent
Second Quarter:  1.3 percent
Third Quarter:  1.8 percent

Most estimates of fourth-quarter GDP growth are in the range of 2.5–3 percent, primarily due to strong holiday retail sales and strength in manufacturing. The ISM manufacturing index has now expanded for 29 consecutive months.

Slow job growth has plagued the economy for the past three years, but this was one of the most important areas of improvement in the final three months of the year. Several positive employment trends developed in the fourth quarter:

• The U.S. unemployment rate declined to 8.5 percent in December, down from 9 percent at the beginning of the quarter.
• The U.S. economy added more than 100,000 new jobs in each of the last five months, including 200,000 in December.
• Initial unemployment claims held below 400,000 for the fourth consecutive week in December.

Although full employment is still years away, private sector job gains were significant in 2011.

After several years of contraction, the housing market has recently shown signs of bottoming. Although housing is unlikely to return as a driver of economic growth anytime soon, it could provide a modest contribution in 2012, which is a positive development. The combination of lower home prices and extremely low mortgage rates has resulted in the best home affordability ratios in 40 years, according to JP Morgan Asset Management.

The U.S. economy was resilient in 2011, delivering accelerating—albeit modest—growth while developed markets in Europe struggled. But global economic risks remain, as do U.S. debt concerns. By some estimates, the European debt crisis could subtract 1 percent from U.S. growth in 2012.  Improvement on these fronts will be important to maintain current economic momentum in 2012.

The Stock Market

Stocks posted a significant rebound during the last quarter of the year. The rally was sparked by optimism that European policymakers were making progress in addressing the debt crisis in Greece and other Eurozone countries. Strong third-quarter corporate earnings also added to the lift. The net result was a strong finish for U.S. stocks, which served primarily to offset the significant declines of the prior quarter. Here are the major stock index returns for the quarter and for the full year of 2011:

Index	4Q2011	2011
S&P 500	11.82%	2.11%
S&P MidCap 400	12.98%	-1.73%
Russell 2000	15.47%	-4.18%
MSCI EAFE	3.33%	-12.14%
MSCI Emerging Markets	4.84%	-18.42%
Sources: Standard & Poor's, Morningstar, Inc.

The S&P 500 index return for 2011 would suggest flat performance. However, the pattern of returns was anything but smooth during the year:

• The S&P 500 index began 2011 at 1257.64 and ended the year at 1257.60—a nearly identical price level!
• However, the index traveled almost 5,000 points within the year before returning to its starting value (cumulative absolute intraday price movement, according to Thechartstore.com).
• There were two significant reversals within the year after an initial gain of 9 percent through April 29—from April 29 to October 3, the market declined by 19 percent; then from October 3 to December 31, the index gained 14 percent.

Returns through the end of April were largely driven by improving corporate fundamentals. However, market forces changed over the summer, and the second half of the year was dominated by “macro” factors—primarily worries over debt problems in the U.S. and Europe. Lack of confidence in the ability of politicians both here and abroad to deal with these issues made matters even worse.

International stock returns suffered in 2011, primarily due to European economic challenges, but also because of China’s efforts to moderate their own economic growth to combat inflation. The latter factor had a significant impact on the performance of emerging markets, which have fed into the robust economic growth of the Chinese economy in recent years. The “flight to safety” that developed during the second half of the year also caused the U.S. dollar to strengthen. The resulting currency effect accounted for nearly one-third of total emerging market stock losses experienced by U.S. investors in 2011.

The remarkable volatility experienced during 2011 is a symptom of the high degree of uncertainty in today’s markets. The silver lining, though, is that profits rose significantly during the year. Given that stock prices were flat to down, price-to-earnings multiples have fallen to attractive levels across most global stock markets. Historically, such low valuation levels have translated into strong returns going forward, irrespective of the challenges of the day.

The Bond Market

Interest rates were largely unchanged in the fourth quarter. The benchmark 10-year Treasury note yield began the period at 1.92 percent and finished at 1.87 percent. The stable interest-rate environment translated into a modest gain for the BarCap Aggregate taxable bond index, up 1.12 percent for the quarter. However, for the year, the index gained 7.84 percent as 10-year Treasury rates fell from 3.3 percent to below 2 percent. This decline in rates resulted in bond price gains, particularly in the U.S. Treasury segment, which enhanced total returns.

A year ago, certain market strategists predicted significant municipal bond defaults in 2011. These predictions proved to be inaccurate, as municipal bonds were one of the best performing asset classes last year. The BarCap Municipal Index posted a total return of more than 10 percent. With credit quality stable across most segments of the market, average duration proved to be a significant differentiator of returns in bond portfolios for the year. When interest rates decline, longer-term bonds gain more in price than short- or intermediate-term bonds. However, going forward, an extended maturity structure could have negative consequences as longer-term bonds decline the most when interest rates rise.

The satellite bond segments—namely high-yield and emerging markets bonds—both underperformed in the “risk-off” environment of the last six months. But with current yields of 8 percent and 7 percent respectively, and generally improving credit characteristics, these bond segments appear attractive when compared to the sub-2 percent yields of U.S. Treasury debt.

The Investment Outlook

After a strong start to 2011, a series of challenges arose that took the wind out of the market’s sails:

• Devastating natural disasters—the earthquake and tsunami in Japan, destructive tornadoes in Joplin, Missouri, and Tuscaloosa, Alabama, and massive floods in Thailand
• Unrest and riots throughout the Arab world
• Intensification of the European debt crisis, particularly in Greece and Italy
• A first-ever downgrade of U.S. Treasury securities by Standard and Poor’s

Investors had much to worry about in 2011. Yet two important pre-conditions for favorable investment results remained in place throughout the year:  a growing economy and rising corporate profits. The resiliency of the U.S. economy in weathering yet another round of challenges is impressive and should encourage investors.

Looking forward, the fact that S&P 500 earnings grew 15 percent in 2011 while stock prices remained flat creates a compelling valuation scenario. At December 31, stocks traded at less than 13 times trailing earnings and less than 12 times expected 2012 profits. Many international markets are even less expensive. Stocks are as cheap as they have been since the crisis lows of 2009, according to Thomson Reuters, even though the economic backdrop has significantly improved since then. Although 2011 provides a reminder that reasonable valuations and a growing economy don’t always guarantee great investment results in the short run, current stock market characteristics should reward patient investors nicely in coming years.

Some of the greatest risks in the current environment are extraneous to the markets themselves but are real and have the potential to alter the positive path our economy has been on for the past 30 months. Any exercise of political will by world leaders, including in the U.S., to address mounting debt problems during 2012 would be well-received by investors and improve sentiment.

Given the current backdrop, here is a summary of our views regarding portfolio positioning as we enter the new year:

• Stocks are positioned to outperform bonds and cash in 2012, given very reasonable valuation levels and extremely low bond yields.
• Our commitment to global diversification remains strong, despite the poor second-half results for international stocks and bonds. We continue to believe that emerging markets will be the growth engine of the world economy in coming years, and as a result, these markets should produce superior returns over time.
• Many satellite asset classes, including high-yield bonds, emerging markets bonds and commodities, appear attractive.
• From an income standpoint, a global balanced portfolio currently produces nearly double the yield of the 10-year U.S. Treasury note. The balanced approach not only enhances the ability to meet current income needs, but also improves the likelihood of reaching accumulation goals over time.

Thank you for the confidence you have placed in BKD Wealth Advisors, and we look forward to the progress we’ll make together in 2012!

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The views presented in this Market Commentary are those of the Investment Committee of BKD Wealth Advisors, LLC and do not represent any specific investment returns or promises of performance in the future. The comments in this Market Commentary are not to be construed as investment advice or the recommendation to buy or sell any specific investments. Before making changes to your current portfolio, please contact your advisor for a personal consultation.