Globally, governments demanded way too much of the media’s time in 2012. Nary a month went by without news of some government, somewhere, teetering on the edge of insolvency or fighting over tax increases and spending cuts. It wasn’t all just rubbernecking by the financial infotainment industrial complex, though.  Tax rates are  important to investing, although probably not quite as important as the media made them out to be. For that matter, governments are not as important. After all, if they were so all-powerful that their shorter run screw-ups could trigger the next Depression, wouldn’t they also have the power to usher in boom times by getting things right?

Although the European economy appears to be on the mend, with  some of the biggest financial misfit euro-area countries now able to borrow again, U.S. hijinks should continue for much of 2013, since many of the decisions that need to be made about the debt ceiling and spending cuts were largely kicked down the road for later theatre. Are you not entertained?

But despite all of the sound and fury of 2012, the market did well. If it looked like an asset and quacked like an asset, it was probably up in 2012. The S&P 500 was up just over 15%. Foreign markets – coming off a fairly crummy five-year run – rebounded and had a nice year with major indexes up slightly more than the S&P 500 for 2013.

Through it all, our model portfolios did well for their risk levels. The Conservative portfolio was up 8.48% in 2012, the Aggressive was up 13.85%, the latter now almost tripling since its inception in early 2002. 

Risk and Return

Here's a somewhat simplistic way to ballpark the amount of risk you're taking compared to a benchmark:  How did your portfolio do during the worst month of the year compared to the benchmark's worst month? 

In 2012, the worst month was May. The S&P 500 (VFINX) was down 6.02%, including dividends. During the same month, the Conservative portfolio was down 1.1%. The Aggressive portfolio was down 3.73%. 

One of our fears going forward is that what's helped us smooth out the downside (largely longer-term, higher-grade bonds) will stop working. This isn't some bond bubble fear that rates are going to skyrocket any day now, just a concern that with the low rates, upside in bond prices is limited, no matter how hard stocks slide. 

Also, if rates climb, and this is still an if, it may not be because of some spike in supposedly long-overdue inflation, but as a result of stocks sliding and pushing dividend yields up to levels that make bond investing even less attractive than it is today. 

Broadly speaking, our biggest mistakes in 2012 were not increasing our risk level further during the down months by increasing our stock allocations and getting out of safer areas like utilities and into harder-hit, more upside areas like financials and even Italy (we did own financial and European funds in 2012, but didn’t make any timely changes).

Psychic Time – 2013 and Beyond

There will be another day of reckoning for investors, but it won’t be in the form of some big hit to the stock market (maybe a medium hit…,) and it may be a few years away. Investors have a way of overdoing things, and given the alternatives out there, a stock market that yields over 2% isn’t such a bad deal, even though the upside may be limited to a 5% average total return over the next 5 years. 

Bigger concerns lie ahead for investors still piling into emerging market debt markets where yields are laughably low relative to safe U.S. company debt (no jokes by those who were peddled supposedly safe U.S. investment-grade mortgage debt a few years ago). 

Seriously, peoples . Apple stock, recently under $500 a share,  yields nearly as much (2.1%) as emerging market bond funds (the cheap ones.) Popular iShares Emerging Markets USD Bond ETF (EMB) yields a mere 3.29% - and that’s with big higher-risk yields from questionable credits like Venezuela. Actively managed PIMCO Emerging Markets Corporate Bond Fund A (PECZX) yields just 2.8%. Let’s not forget stock dividends are still taxed more favorably than bond payments (thanks, Congress!) 

Sure, Apple is risky, even after the recent 25%+ slide, but which investment offers a better inflation-adjusted return over the next 10 years? We’re not comparing Apple to…oranges (safe, low-yield U.S. Treasuries) here. I’d argue that if Apple were to fall 50% more and had to cut their dividend (certainly possible – it fell 60% in the last crash) in such an economy, some emerging markets would already be on the road to default, and a "safe" emerging market bond fund would go down 25% or more, too. At least, the Apple stock has upside – in dividends and stock price.

Our assessment? Investors are acting as irrationally as ever. They hate low yields, so they buy…no-yield gold and commodities? They're scared of a global government debt crisis, so they own… higher -risk corporate debt? Good luck getting paid back when the great debt collapse kicks in. 

They fear a European meltdown, so they lend money to…Venezuela and Argentina? They fear U.S. stocks and move to the safety of…emerging market stocks? They fear inflation, so they buy TIPS, effectively lending the government money at negative 1.5% returns,  hoping for at least 2% inflation to make their investment beat the lowest-yield investment around — regular, no- inflation adjusted Treasury bonds? 

The whole notion of solving your inflation fears by lending (buying bonds) is preposterous. If you're really afraid of inflation, buy inflatable assets (stocks, real estate, heck, even classic cars) with borrowed fixed-rate money. The lender loses with inflation. Fortunately, we're not worried about  inflation quite yet, so we can ignore semi-dire warnings of pending doom in the form of inflation somehow magically solved by the right mix of bond funds.

The whole bond management business is about a 200 b/p (2%) shift down in the yield curve from having the same trouble money market funds have had since the economy clogged up in 2008: How do you charge a fee to manage an asset with a near-zero yield? 

The most likely future may be one no one sees coming: higher inflation AND lower bond yields. Imagine a 3% inflation rate and 1% yield on 10-year Treasuries and 2% on corporates — taxable at the new higher top income bracket for some investors. That’s PIMCO’s real nightmare. That’s when all the hundreds of billions that went to PIMCO and other bond fund managers in recent years goes back to Janus.

As for stocks, the path of least resistance is for dividend yields to slide lower by stock prices going higher. Ultimately, this will lead to low future returns, as we face a still-sluggish economy with high stock valuations, but we can worry about that day when it comes.

So in closing, 2012 was a great year for assets. The Federal Reserve has lifted all yachts. Rolls Royce sales are at all-time highs. Most yield products yield less than they did before the debt crisis that hit yield-oriented investments hard. Things were less spectacular for the actual economy and those who actually work or want to work. Hopefully the economy will catch up to the Red Bull investment markets before the sugar, caffeine, and whatever else is in that drink runs out. We’re still betting on America. In spite of the Gov’ment.

Past performance is not a guarantee or a good indicator of future results.  Investing in stocks and bonds through funds or ETFs is subject to risks including but not limited to economic, market, interest-rate, default, and inflation risk. Investing in foreign denominated and/or domiciled securities even through U.S. funds can involve heightened risk due to currency fluctuations, global economic and political risks – notably with funds that own emerging market stocks.

This material contains the opinions of the author and can change without notice. The author, MAXadvisor clients, and family members may own long or short positions in ETFs and funds mentioned in our articles. This material is for informational purposes only and should not be considered investment advice. Figures and information contained herein are from sources believed to be reliable, but not guaranteed.