What We Can Learn From 2011′s Reversal of Market Fortune

If it�s entertainment you�re after, 2011 delivered all an investor could ask for. The markets led us through more twists and turns than a spy novel.

The last time I sat down to peer ahead into the new year, the global economy still was expanding briskly, healing from the wounds of the 2008 financial crisis. Despite isolated problems (Greece already was a sore spot), stock markets around the world were posting solid gains.

The heady momentum augured well for 2011 — and indeed, the first four months of the year brought a rousing performance for stocks. However, the party screeched to a halt in early May. Greece�s woes worsened. Then, during the summer and into the fall, concern grew about the soundness of not only Portugal�s government debt but also that of Italy, Spain and even France.

Here in the United States, our congressional charade over the debt ceiling (August), followed by the failure of the budget supercommittee (November), helped provoke two steep declines from which equities have still only partly recovered. I�m just grateful that my balanced portfolio strategy enabled me to keep my head above water.

In short, 2011 started out as a rewarding year for investors, then slipped on a banana. What can we learn from this reversal of fortune?

Not Your Typical Cycle

The most obvious conclusion is that we aren�t in a typical business cycle. Normally, two years after the official end of a recession, the U.S. economy would have restored a much higher percentage of the jobs that were lost — only about 40% of the lost jobs have come back. Normally, by now, industrial production would be challenging or exceeding its previous high — we�re still about 6% below the 2007 peak.

The stock market, too, is behaving atypically. Since 1900, the S&P 500 index has tacked on an average price gain of 11.3% in the third year of a president�s term, and 13.4% if you consider the president�s first term alone. At the end of the year, the market hadn’t moved a single percent since January. While I�m sure President Barack Obama is doing everything he can think of to spruce up the economy for his re-election campaign, the bloodless verdict of the market says he isn�t making the normal amount of headway.

Even if we knew nothing about Europe�s sovereign debt crisis, the abnormally soft economy and abnormally weak stock market in the president�s third year should put us on guard this year. Feeble trends are the most liable to break down.

What�s more, we do know a lot (unfortunately) about the European situation. Data from Europe�s purchasing managers indicate that the continent is already in recession, with effects that will ripple out to our shores, probably as soon as Q1.

Click to Enlarge Finally, let�s not forget the demographic time bomb (see chart). In 2012, the Prime Savers Ratio takes a big drop as the number of people entering the over-65 age group races ahead of those entering the 40-to-60 bracket (�prime savers�). Unless other factors intervene to lift the market, a shortage of prime savers will tend to drain money out of stocks this year.

Given these risks, I think it�s wise to plan for at least a 50/50 probability that the headline U.S. stock indices could undercut their October 2011 lows sometime in the months ahead. I don�t expect a bear market on the scale of 2008 or 2002 because values provide more support this time and P/E ratios are lower. However, I wouldn�t be surprised if the S&P were to trade as low as 1,000 sometime during Q2 or Q3 before rebounding strongly into election season.

Two Steps to Safety

To ride out the turbulence I foresee, I recommend building strong, defensive capabilities into your portfolio. That�s exactly what I been doing in recent months, but here are two additional steps I suggest you take in the first few weeks of the new year:

• Shift another increment of your stock holdings into fixed income (The amount will differ, depending on your personal circumstances).
• Swap out of volatile stocks and mutual funds into steadier names.

At the moment, I view health care as one of the market�s safer havens. Many other traditionally defensive sectors — such as foods, beverages and utilities — already have rallied a long way off last summer�s lows, making these issues less appealing for new money.

For example, earlier in December I sold media conglomerate Time Warner (NYSE:TWX) and bought Covidien (NYSE:COV), a leading maker of medical devices and supplies.

It�s not that I dislike TWX management or the company�s long-term prospects. History shows, though, that the stock gets hammered in economic downturns. If business activity slows in 2012, TWX, with its heavy dependence on advertising revenue, will feel the pain.

Covidien, on the other hand, sells things sick people can�t do without, from surgical instruments and imaging systems to syringes and specialty drugs. Spun out of Tyco Healthcare in 2007, COV has since doubled its annual R&D spending, resulting in a surge of new products. On Dec. 15, COV also announced plans to spin off its own pharmaceutical business — a move designed to unlock additional value.

At less than 11 times estimated year-ahead earnings, COV is quite cheap relative to both the market and the historical trading range for medical-device companies. Before the bottom fell out in 2008, it was common for device makers to trade at 20 times forward estimates, and more.