Global equity markets took investors for a wild ride in 2011.

To recap the year, we compiled the biggest headlines from a jam-packed year, offset against the S&P 500, which vacillated dramatically in a continued “risk on / risk off” manner.

Major investment market price-reversals occurred with a record frequency, especially during the second half of the year (as measured by 90% reversal days – a technical metric that triggers when 90% of stocks in an index move in a unison, opposite in direction to the recent trend).

It all made for manic investing, where many banks, investment managers, and individual investors either blew up (e.g. MF global), severely underperformed (e.g. famous hedge fund manager John Paulson reportedly lost over 52% in his Advantage Fund), or just headed for the sidelines (e.g. incredibly low market volume was recorded in 2H/11).

Chart I: 2011 – An Eventful and Volatile Year

Despite posting a flat -0.003% return, US equity markets were the best performing asset class in 2011.

This resilience to global turbulence was the direct result of a slowly and steadily improving US economy.

Foreign market equities underperformed significantly, with 15-30% declines due to direct crisis impacts, as well as indirect policy tightening in emerging markets to fight surging inflation.

Many Wall Street firms and analysts are prognosticating more fear and volatility heading into 2012.

However, while there will undoubtedly be some unexpected twists and turns in 2012, we believe there will be much lower volatility due to some EU resolutions, more reasonable growth globally due to a recovering global economy, and a reflation of assets that were taken to panic lows during 2011 (especially within Emerging Markets).

Early Recovery, But Still Shaky

Portfolio Review (Q4/2011)

Heading into Q4, our indicators suggested that US equity markets were fairly valued to slightly undervalued, while Emerging Markets were significantly undervalued following a major Q3 correction.

With inflation on the decline, we were on the lookout for a policy easing catalyst from Emerging Market countries.

In fixed income, we remained overweight high-yield bonds and held on to our short US treasuries positions, on the expectation of a relief rally and some modestly rising interest rates.

With our Volatility Timing Model, we held our largest possible short position, on expectations that Q4 would calm in comparison to an incredibly volatile Q3.

Q: What worked?

The following investments contributed positively:

  • Allocations to US equities and short volatility contributed positively to absolute and relative returns as US markets rebounded and volatility began to subside.
  • Selected stock picks in the US also outperformed equity indexes.
  • Rotation out of natural gas and into oil was timely, as natural gas declined 20-30% while oil outperformed.

Q: What didn’t work?

While all portfolios had gains for the quarter, there were areas of relative underperformance.  Specifically, the following positions underperformed:

  • Major positions in Emerging Market equities underperformed for two of the three months in Q3.  While showing some outperformance in November, they disappointed heading into year-end.  There are hints of easing to come in early 2012, which would help EMs to once again regain leadership.
  • Short US Treasuries positions continued to defy conventional wisdom, with interest rates reaching record low levels as global investors poured into the “safety” of US debt (seems like an oxymoron to us, and one that will come to an end at some point in the near to mid-term future).
  • Real estate and diversifiers delivered positive returns, but they lagged US equity benchmarks.

Net Results

Client portfolios all had positive absolute returns for Q4.

However, returns were less robust than expected as two of our three major recovery themes remained depressed (Emerging Markets and Short US Treasuries).

We were encouraged that our short volatility position began generating healthy returns, and expect our other themes will get going shortly as well.

The full year of 2011 proved to be challenging.

As discussed earlier in this newsletter, many investment legends closed their shops this year due to massive underperformance and sometimes full-on collapse.

Given our global exposure to investing, we too shared in the pain as the crisis unfolded.

However, these temporary losses were managed within individual client risk profiles, and we expect to gain back ground in 2012 as a recovery plays out and global growth once again resumes.

Continuing to Climb the Wall of Worry

Looking Ahead to Year 2012

From a long-term perspective, markets are still recovering from a potential generational low in March of 2009.

Portfolios are far higher today than during early 2009, despite record-level market volatility and EU debt crisis aftershocks.

We expect 2012 to continue with the longer term recovery theme.

The EU debt crisis will continue, but much of its potential affects are already priced in to expectations, and EU leaders are dead-set on improving stability.

In the US, we would become increasingly bullish if our government began seriously addressing long-term fiscal imbalances.

Overseas, our positions will be most influenced to the upside if inflation subsides further, allowing for emerging market policy loosening.

On the downside, we will closely monitor events with Iran, as escalating tensions could spike oil prices and cause economic contraction.

Finally, we have made a number of improvements to our investment models heading into 2012.

The past year did not disappoint in offering us some humbling new lessons about how markets can behave, which we formally evaluate in our quarterly review process.

The two new major improvements are:

Improvement #1

Policy actions are causing greater market movements than have historically been the case.

As such, we believe there are certain inflation trigger levels where policy actions tend to be initiated in specific emerging markets.

We are now tracking these specific inflation levels on a weekly basis.

Improvement #2

Our Volatility Timing Model is affected by what is called a “futures roll.”

Each day a fraction of the current month contract is rolled to the next month, and price differences in these contracts can be in your favor or not.

Adding this roll impact to our model helps us to better manage the size of our positions, and to improve the odds of success when we put the trades on.