Through The Economic Lens: 2012 Looks More Like 2010

The recent sell-off in the market, with nervous investors made all the more so because of the media's obsession with financial issues in Europe, is renewing talk about bear markets and recessions as people head for cover. In the midst of their misguided fears of a contagion effect, there is also concern about the "fiscal cliff," spending cuts and higher tax rates that, at this point, will take effect on January 1 (funny how that sounds like it would be a good idea for our debt problem).

Looking at recent events through an economic lens makes things much clearer to see and understand. The recent deviation between economic data and market performance -- whereby the economy slowed and even contracted, but the market appreciated -- was highly unusual. The explanation (read: excuse) is most likely the mildness of the contraction compared to the severity of the 2008 economic disaster combined with highly unusual central bank actions. This rare outlier, however, does not make a trend. As the current economic data and sentiment continue to show improvement, we need to see market fluctuations and overreactions to events that do not materially impact our economy as just that: fluctuations and overreactions.

The short-term economy reminds me of Q2 2010, when concern over Europe and a flash crash had investors heading for the sidelines with the events of 2008 fresh in their minds. Unlike 2008, however, the economy in 2010 was growing, not slowing. The market, which ultimately took its cue from the underlying economic trend, also improved over the next few quarters. In fact, by the time we got to Q2 2011, the market was up 18% from Q2 2010.

The opposite occurred in 2011, as the market responded to the Japanese tsunami, debt problems here and abroad and a faltering economic expansion. The economy, based on our analysis, was slowing and even contracting in 2011. With all that turmoil over the last 12 months, there is about a 30% differential between the high and the low. But if you compare where we are at Q2 2012 (for example, as of May 14, 2012), versus Q2 2011, the market is only slightly lower. That kind of volatility made the timing of portfolio shifts over the past 12 months more statistically significant than before. However, that is unlikely to continue.

In other words, the impact of timing will be less relevant to longer term performance. Of far greater importance, especially to our economics-based investing approach, is that the data suggest improvements in the economy are sustainable. Equity prices will most likely be higher this time next year -- not because of arbitrary price levels today, but because the economy's sustainability will likely produce steadily higher values.

Our portfolios have experienced lower volatility from our high to our low, but unfortunately we are not basis points from levels one year ago. However, we are confident that our portfolios are positioned to perform over the next few quarters to be well above current levels and with less volatility.

The euro turmoil and the financial cliff will likely cause the market to be volatile, but when looking at economic factors, we believe that 2012 looks more like 2010 (when the economy was growing) than 2011 (when it was slowing/contracting). As a result, we would also anticipate this year will produce returns in line with 2010, as well.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.