Michael Santoli

In 2012, the Market Has Been Shockingly…Normal

Michael Santoli

If you want to sound truly perverse at this month's office holiday party, make a remark about what a "normal" year 2012 has been.

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Sure, we've endured a knife-flashing presidential campaign that cast the country's economic future as imperiled. The ax of debt default still hovers over important European countries while the Continent undergoes a scarring recession. And as 2013 approaches, the vicious political standoff over tax cuts and slashing spending is threatening a fiscal seizure Jan. 1.

Yet the crazy thing is, in many important respects, the market has indeed turned in a rather normal year.

The Typical Rate of Return

Stocks, as measured by the Standard & Poor's 500 index, are up around 12% year to date, roughly in line with what used to be taken as the equity market's "typical" annual rate of return but more recently stands out as a happy bonus. Strikingly, this performance is matched almost exactly by other developed markets. Both the Nikkei in Japan and the Euro Stoxx 600 are up around 13% for 2012.

In the U.S., the market has essentially tracked the increase in corporate profits -- pretty much what they're normally expected to do. Stocks have also just about perfectly matched the average low-teens percentage returns of previous presidential election years when an incumbent was running.

The market also continued to follow the cadence and trajectory of the prior bull market -- which began in earnest in March 2003 and hit a new high in 2007 -- the way this one blasted off from the climactic bear-market low in March 2009. For calendar-year 2003, the S&P 500 logged a total return of 28.7%, close to the 26.5% of 2009. Then it went 10.9% in 2004, versus 15.1% in 2010, followed by a single-digit, mostly sideways year in the bull market's third year.

Need it be said that the actual level of the S&P 500 is almost exactly the same now as six years ago?

Similarity With a Stark Difference

Clearly, the particulars of the current environment differ starkly from those of the mid-2000s, notwithstanding the close (and maybe flukey) resemblance of the market action. Sure, both featured plodding U.S. economic expansions, but the earlier phase was animated by a housing bubble, and then the emerging markets and commodity super-surge. In its latter stages, the Federal Reserve was lifting interest rates.

And yet this fact supports more than refutes the case for an outbreak of normalcy this year.

Normal doesn't mean "as expected" or "comfortable" but rather describes a situation where the specific mix of corporate fundamentals, financial liquidity and investor psychology are being metabolized by the markets in familiar ways.

Students of the markets understand that it tends to do the thing that confounds the greatest number of people. For the past year, this has meant snubbing the crowd of fretful investors who have persistently bet on abiding economic abnormalities and frequent market breaks.

Memories of the Meltdown

The psychological muscle memory of the meltdown remains strong. Bernie Schaeffer of Schaeffer's Investment Research has noted for some time that retail and professional investors have tirelessly bought "protection" against a big surge in market stress through instruments tied to a rising S&P 500 Volatility Index which has nonetheless been in a clear if jagged downtrend. The VIX is down 40% this year alone, and other measures of underlying market vulnerability in the options market are likewise quiescent.

Clearly, the backdrop of a generational banking and solvency crisis in 2008 -- and the stunning, unprecedented levels of central-bank response -- are extraordinary and carry the potential for new and nasty financial mishaps some unknowable distance in the future.

But even though it's likely that the era of uncertainty has peaked, the trauma of '08 seems to have insured that investors will reliably over-anticipate the frequency and severity of accidents.

Impressively Sturdy Credit Conditions

For the moment, the $8 trillion in Western central banks' money creation has fostered a medicated condition of normalcy, of forcibly repressed financial volatility. This effort has operated most directly where the early strains of eventual contagion began, the credit markets. Credit conditions in the U.S. and Europe remain impressively sturdy.  Italian government bond yields for the benchmark 10-year, for example, have collapsed to 4.55% from over 7% since early summer (although they did hit a two-week high Thursday).

Stocks have mostly just tagged along behind the strengthening corporate credit markets in sticking near post-crisis highs.

The hope is that, eventually, a long enough stretch in which normalcy prevails will spur companies and individuals to take more risk and spend and invest for the long term with a diminished fear of calamity. It is by no means clear that this will happen, and another market coronary would set this hoped-for process back.

But, perversely, the more people obsess over "abnormal" risks, the more likely the next downturn will be routine rather than crippling.

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