Why 2012’s Market Will be Good

Larry is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The market is doing well thus far this year. Will it swoon? Historical patterns say it will not.

Hollywood has a typical formula for movies. They start well so the audience knows what is at stake if things go wrong. Invariably they do, but whatever is lost is eventually recovered by the time the movie ends.

By that standard, the 2011 stock market followed a simple Hollywood script. The first few months brought cheers, only for everything to go wrong by mid-summer. Slowly things improved toward the end, and the stock market recovered from severe losses to end the year just where it started. 

That movie won’t win any awards. No clear reason was given for why things finally got better. As a result, the audience was left with little hope that they wouldn’t worsen again. The end was less a cliffhanger than a letdown, and the 2012 sequel looks less like a sequel than a rerun, as it starts just like 2011.

But if the past is any guide, cyclical patterns suggest 2012 should be a good year, better than go-nowhere 2011. Let’s explain why.

The first few data points of the year continue to show a moderate improvement in economic conditions that started a few months ago. Unemployment is a notable indicator, as jobless claims are now at the lowest level since early 2008. Furthermore, private employment has taken off, and government employment, apart from a census-related peak in 2010, has been declining for the last two years. While the U.S. still has a long way to go, it seems that it is heading in the right direction. All this suggests that, along with record corporate profits, good times may lie ahead for the stock market.

How to take advantage of this? By buying some good exchange-traded funds that follow market indexes. The Standard & Poor’s 500, as tracked by the SPDR S&P 500 (NYSE: SPY), is a broad proxy for U.S. stocks. The only thing missing in it are small-capitalization stocks.

The S&P 500 ETF is not richly priced: It’s trading at around a 14.9 price/earnings ratio, lower than the average 16 in the postwar era. This particular ETF has rock-bottom expenses, according to Morningstar – 0.09% of assets yearly. That is almost half the 0.17% charged by the storied Vanguard 500 index mutual fund. As a result, the SPDR vehicle has a slightly better year-to-date return than the underlying index, 11.61% versus 11.02%. Even a small amount like that, when compounded over time, makes a big difference. 

The way to take care of the S&P 500’s lack of small stocks is by investing in ETFs that specialize in small-cap Russell 2000 indexes. Although the Russell 2000 represents just 8% of the U.S. equity universe, it has the virtue of outpacing large caps: up 7.5% annually over the past 10 years, compared to 3.1% for large stocks. The Russell ETFs have a higher beta than the broad market (percent-wise they go up or down more than the S&P). Therefore, they could register very nice returns if the broad market, as I expect, ends the year in a solid note.

You can capture the entire small-cap benchmark with iShares Russell 2000 (NYSE: IWM), or its value roster with iShares Russell 2000 Value (NYSE: IWN) or its growth offering, iShares Russell 2000 Growth (NYSE: IWO).

In addition to encouraging economic signs, market cycles also offer reasons for optimism.

Since 1901, the Dow Jones Industrial Average history had 14 years when the last quarter climbed more than 11.5%, including 2011’s final period, when it gained almost 12%. Out of the 13 previous times, 10 were followed by a positive first quarter. Also, 10 were followed by a full year’s return averaging more than 15% (or with a median of almost 21%).

The only times a full year was down after a positive fourth quarter were 1906 (prior to the Panic of 1907), 1929 (the onset of the Great Depression) and 2002 (the aftermath of the dot-com implosion and the beginning of the Iraq War).

This is where this year seems better than 2011. If the pattern holds, the only thing that would prevent 2012 from being a positive year is a large shock that would obliterate otherwise benign market and economic conditions. 

As far as we currently know, the danger comes from Europe. The Continent’s debt crisis continues – Italy’s long-term borrowing costs are at 7%, an unsustainable level -- and Europe seems poised to tumble into a recession. We also know that spoilers can come from anywhere. Growth is slowing globally. But Europe may well avoid a disaster, and the U.S. may manage to stay on track.

If so, the way 2012 just started suggests that it could end leaving stock market investors far more satisfied than after the year that just finished.

At the beginning of the year the danger seemed to come from Europe, but since then borrowing costs for Italy and Spain have gone down to almost “normal” levels and Greece has seemingly averted a messy default with a gigantic debt restructuring deal. While Europe still seems poised to tumble into a recession and markets are unsure of Portugal, the crisis feeling has abated on the back of growing confidence and aggressive European Central Bank intervention. 

We know that spoilers can come from anywhere, like China or the Middle East. But the breadth of indicators suggesting that the U.S. recovery is real may well be the story behind the markets this year. If so, the way 2012 started suggests that it could end leaving stock market investors far more satisfied than in 2011.

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