William Riegel, Senior Managing Director, Global Equity Investments
Equity markets spent much of 2011 reacting more to daily headlines about global developments than to company-specific fundamentals. Europe’s sovereign debt crisis, the status of the U.S. economic recovery and prospects for changes in the growth trajectory of emerging economies such as China and Brazil helped fuel frequent market reversals during the year.
In the fourth quarter, equity markets rebounded from the steep declines of the third quarter, when downward revisions to GDP growth fanned fears of a double-dip recession in the U.S. and the urgency of the debt crisis in the eurozone began to take center stage. Although overarching macroeconomic concerns persisted in the fourth quarter, the U.S. equity market climbed the “wall of worry,” grinding higher despite the uncertain environment. Investors found cause for optimism in the stream of favorable data released as the quarter wore on: resilient corporate earnings, better-than-expected employment growth, solid gains in manufacturing activity and rising consumer confidence.
As a result of their strong fourth-quarter performance, U.S. equities ended 2011 essentially where they began, with the S&P 500 Index up a slight 2.1% in terms of total return for the year, but marginally down in price terms. This flat performance belied the daily market gyrations and continual shifts in risk appetites that prevailed over the course of the 12 months. Ultimately, for the year as a whole, investors sought to shed risk and seek relatively safer investments in sectors that provided a degree of protection from perceived global risks.
Along these lines, domestic equities outperformed foreign developed and emerging markets in 2011, and investors favored larger-cap, growth-oriented companies over small or mid-sized value plays. For similar reasons, investors shunned cyclical and economically sensitive sectors, while buying more stable, dividend-paying stocks found in the utilities and consumer staples sectors, both of which scored double-digit gains for the year.
The challenge for active managers
Against this backdrop, it was very difficult for active fund managers to deliver outperformance in 2011. For example, only 18% of actively managed funds (298 out of 1,649) in Morningstar’s U.S. Large Blend category beat the S&P 500 Index for the year. Moreover, the average fund in the Large Blend category returned -1.27%, lagging the S&P 500’s 2.2% return by more than 340 basis points (3.4%).
Why the limited success rate?
First, it’s fair to say that fund managers may have underestimated the severity of the sovereign debt issues facing Europe, leading some managers to be more aggressively positioned than was warranted. Second, manager performance was influenced by the atypical ways in which markets traded during the year. As many investors exited equities in favor of other asset classes, trading was increasingly driven by fewer market participants, resulting in lower volumes and reduced liquidity. This reduction in liquidity, along with heightened risk sensitivity on the part of many investors, led to trading patterns that tended to penalize bottom-up, company-specific research strategies.
For example, valuations at the individual security level factored less importantly into investment decisions, with volatile price movements fueled by investors’ attempts to quickly gain or reduce exposure to specific sectors or investment styles that were broadly affected by changing macroeconomic conditions. In addition, with higher-than-normal correlations prevailing in the markets during 2011, stocks in general tended to move more in lockstep, regardless of fundamentals. One result of these developments is that wide disparities in valuation have emerged between companies that have similar prospects, or, conversely, companies with very dissimilar prospects are being valued similarly in the market. This could represent an increasing opportunity for active managers to exploit these mispriced securities in the coming year.
That said, given ongoing uncertainty about Europe’s ability to resolve its financial challenges and the significant hurdles that continue to stand in the way of global growth, we do not expect market volatility to diminish, nor do we expect a return to “normal” market conditions in the near future. Over time, though, as stronger, well-positioned companies differentiate themselves from their weaker counterparts, their respective earnings prospects should become apparent, creating a more level playing field that rewards active stock pickers.
“Certain uncertainty” to prevail in 2012
As for the market’s overall direction from here, there are some encouraging signs. We anticipate continued benefits from higher employment, further inventory restocking, and perhaps a positive surprise from the housing sector, which finally appears to be bottoming. It is notable, for example, that homebuilding stocks are up roughly 60% from their October lows, which could help support the U.S. equity market in the first half of 2012.
Tempering this guardedly optimistic outlook, however, are consensus forecasts of a slowdown in U.S. GDP growth, lower corporate earnings guidance for the fourth quarter of 2011 and for 2012, post-holiday caution on the part of consumers, and continued fiscal policy gridlock in Washington. These potential headwinds—along with Europe’s ongoing problems and other global challenges, both predictable and unforeseen—suggest that the one certainty investors can count on is continued uncertainty.
Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA).