How Stocks Beat Bonds and Commodities in 2012

When it's midnight and there's no one around to kiss, you take what you can get. Your editor has always employed this strategy on New Year's Eve. Looking back on 2012, it looks like investors adopted pretty much the same strategy: take whatever you can get to beat currency debasement and stupid central banking.

It's customary to look forward when the New Year has begun. But we can't help looking back at 2012 one last time. What actually happened? And did anything happen that gives you a leg up on 2013? Let's begin with lead.

That's lead, as in the stuff bullets are made of. It was the single best performing commodity in the Goldman Sachs Commodity Index for 2012. It beat wheat, corn, coffee, gold, silver, oil, gas...you name it, lead beat it. For the record, element number 82 on the periodic table was up 14% for the year.

The chart isn't terribly impressive. In fact, commodities as an asset class only returned 0.1% for the entire year, according to the Standard & Poor's GSCI total return index. If you'd timed your entry to the June lows, however, and then sold at the top, lead would have returned about 31.25%.

Still, stocks turned out to be a lot safer than lead, commodities, and bonds in 2012. The Dow finished up 7.3% and was up for the fourth year in a row. The S&P 500 finished up 13% and the Nasdaq was up 16%. Financial stocks were the best performing sector on the S&P, up 26%. Here in Australia, the S&P ASX/200 finished up 14.6%.

But global GDP was up just 2.2% in 2013. China's rate of expansion was the slowest in 13 years. The US had/has persistent fiscal issues. And until June, when the European Central Bank bailed out Spain, everyone thought the European Union was on a slow road to disintegration. You wouldn't describe any of those conditions as 'bullish '.

Stocks aren't dirt cheap either. The MSCI index of global stocks trades at a price earnings ratio of 15.4. That's below the historical average of 20.7. But it's not the kind of PE ratio that makes you want to pound the table and shout 'buy' with all the conviction in your heart.

No...it wasn't a great buying opportunity that led to the second half rally in stocks. It was fear of fighting the Fed. Most major indexes bottomed in June of 2012. That's when the EU delivered a mighty kick to its perpetual debt can. And by September, investors were banking on more bond buying from the Fed.

No one can force a man to take a risk he doesn't want to take. But at some point, if the beaters are behind you, and just behind them are the men with guns, you're going to take flight out of necessity. The risk for investors is that if they don't buy stocks, they'll get burned by doing nothing, or get torched by the declining value of cash (inflation).

Nowhere is this point easier to understand than in Venezuela. Venezuela's main stock index went up 342% last year in local currency terms. That's a great year. But official inflation is running at 18%, and probably much higher than that. Stocks are the best performing asset class out of necessity.

The Venezuela case study could be pretty useful to keep in mind in 2013. You have a world where more economic activity is being run by the government. In Venezuela, the socialist buffoon Hugo Chavez has nationalised dozens of industries. The more entrenched the government becomes in the allocation of productive resources, the more scarcity, inefficiency, and corruption you get.

Of course some people will see the Chavez experiment as a model to emulate. Get ready for more of that. The more the State commandeers productive resources - including your income through higher taxes to make the pain of deficits more 'fair' - the fewer good investment choices you have. Your main aim becomes preserving what you already have.

We're leaving out an important part of the story, though. Venezuelan price inflation is the exception and not the rule right now. Chavez's sorry excuse for a command economy creates consumer price inflation by creating scarcity. Producers go on strike, or hoard production. Goods disappear from shelves. Prices rise.

In the rest of the world, the inflation in the pipeline has been quarantined on the balance sheets of central banks. The ECB, the Fed, the Bank of England, and the Bank of Japan have added trillions of dollars in assets to their balance sheets. But that new money has not leaked into consumer prices in a big way. And the central bankers assure us it never will; thus their policies aren't really inflationary.

We'll see about that. It's shaping up as one of the big questions for 2013. Will there be a next stage to the global money crisis? Or will this be the year things start to get back to what you'd call normal? Can all these extraordinary experiments in money be wound back without doing real damage to the economy, to purchasing power, and to real people's lives?

Let's hold that thought for a while. There's no need to answer those questions today anyhow. We don't know the answers, for starters. What we do know is that this whole affair is an attempt to stave off the deflation John Exter warned of years ago. More on Exter tomorrow .

Regards,

Dan Denning
for The Daily Reckoning Australia