Issue #37

Since 2007, Barnes Capital has made annual predictions about what will happen in the New Year.
Thinking about the future and what could happen is crucial in our role as a steward of people’s money.

2011 Predictions Recap:
We got a lot of things really right in our 2011 predictions and a few things wrong.

1) We said municipal bonds are cheap again, and we were delighted to buy them with 4% to 7% tax-free yields.  We said that Meredith Whitney’s December 2010 prediction that in 2011 there would be hundreds of billions of defaults on municipal bonds was completely wrong.  Actual 2011 municipal bond defaults were $2.1 billion.  We put our own, and our clients’ money where our mouths were.  We bought as many bonds as we could for our clients.  Medium and longer municipal bonds rallied 5-10% in the first half of the year and another 10% in the second half.  The Merrill Lynch Muni Index which includes shorter maturities gained 10.5%, bested only by 2002′s +10.73% gain.

2) We said Gold would climb to $1600 this year.  Reality is that Gold climbed past $1900 in the summer only to lose luster and pull back 20% in the last quarter to end the year at $1565.

3) We said that oil would break out to more than $100 a barrel.  Oil started around $90, ran to $110 and finished the year at $99.  With that, we hit the bull’s eye.

4) We said that real estate prices would continue going down.  That’s happening.  While some lower-priced, smaller homes in good areas are not getting cheaper; big homes, expensive homes, homes that are hard to heat and cool, and homes in less-desirable locations are still tanking.  Real estate data, however, is incredibly unreliable due to all the unresolved mortgages, foreclosures and short-sales.

5) We said stocks would perform decently.  To a point, they did.  It was a tale of two markets. Dividend stocks with global franchises did very well: McDonalds, Abbott Labs, Intel, Apple, IBM, and Chevron.  We saw great changes every week, but on the year, the SP 500 index declined from 1257.64 to 1257.60, a percentage change of 0.003% before dividends.

Other predictions which we said are less likely, but it wouldn’t surprise us if:
6) We said stocks might party like its 1999.  They didn’t. Moving into the summer 2011, stocks were up 10%, but then the fears of Europe’s implosion sent equities reeling in June, and they fell apart in August.  Stocks stayed lower for most of the fall before strengthening modestly after Thanksgiving.  The ending result: A flat year, with dividend stocks strongly outperforming the others.

7) We said states would seek cover in the courts to solve their budget problems.  This didn’t happen.  State budgets stopped the bleeding and were able to refinance their debt at ever more attractive bond rates throughout 2011.
We stated that the foreclosure problem hasn’t been solved.  One year later, that’s still the case.  We said that the 4 out of 5 economics professors who forecast 2%-7% increases in Orange County in had their plus and minus signs mixed up.  We were right; Orange County homes dropped another 4.91% through October according to the Case-Shiller Index.  Other prices around country, except for Washington D.C., were down 2%-6%.

9) We said the National Commission on Fiscal Responsibility and Reform (also known as the Simpson-Bowles Plan), would stay on life support.  It has.  It remains the most serious plan to restructure the nation’s budget and long-term liabilities.  Neither Democrats nor the Republicans are willing to compromise yet.  It will take future disasters to motivate politicians to do the right thing. We believe that stock market is be being held back by the lack of political will to restructure the deficit and the budget.  In 2011 Bond markets rallied on the perception that government will continue to kick the can down the road, which will lead to lower long-term growth as far as the eye can see (hint, that’s not very far).

10) We said Gold might enter into the third and most speculative phase of its bull market which is always the phase when the most money is made (think tech stocks in the late 1990s).  It didn’t.  Gold stocks crumpled at the end of 2011. Major mining stocks declined 16% for the year while junior mining stocks declined 38%.

Overall our 2011 predictions were on target.  We have less confidence in our 2012 outlook.

2012 Predictions
1) Bonds are now definitely expensive.  But uncertainty about slashing budgets, the situation in Europe, and interest rates remains high.  Since stocks have fallen 50% twice in the last decade, the stability of bonds is still very attractive.  Bonds are likely to deliver flat to mid-single digit total returns in 2012.

2) Gold. For the moment, Gold is out of favor as we enter 2012.  Gold will struggle in the first half of the year, but reach new highs in the second half of the year to finish at $2000/oz.  Gold’s weakness is a function of the asset being viewed as a risk asset.  The move towards new highs will be powered by the short-term memory of buyers and the uncertainty of the election and European debt problems.  Here’s a look at gold’s value over the last 13 years.
1999 –  $288
2000 — $271    -6%
2001 — $278     2%
2002 — $348   25%
2003 — $415    20%
2004 — $437     5%
2005 — $516    18%
2006 — $634    23%
2007 — $833    31%
2008 — $881    6%
2009 — $1096  24%
2010 — $1421   30%
2011 –  $1566   10%

3) Oil:  Oil prices are strong, indicating that global growth isn’t as weak as feared and that the new normal for Oil is greater than $80 a barrel. We expect Oil to remain range bound from $90 – $115.

4) European Debt: The big question mark is the issue everyone knows about, the European debt.  The Euro reaches few conclusions, weakens a bit, and all major issues including Greek default are pushed off until 2013.

5) The Euro:  The Euro will weaken to 1.20 but not break below 1.15 in 2012 versus the dollar.  For some perspective, the Euro was launched in 1999 at $1.17 per Euro.

6) Unemployment: Currently the unemployment rate has declined below 9%, but that’s only because many job seekers have STOPPED LOOKING. Unemployment will remain the Achilles Heel of the current administration and remain stubbornly around 9%.   Until our society is transformed by higher energy costs, unemployment of 8% is the new normal.  Retail (particularly among travel agents and sales clerks), low-skill manufacturing and real-estate-related jobs aren’t returning this decade, if ever.

7) GDP growth:  The Gross Domestic Product will putter along with growth that’s greater than 2% but less than 3%, solving no problems but creating few as well.
The election:  The presidential race will be a nail biter. Nobody will know the outcome until Election Night, November 6th.

9) Housing:  After 5 years of waiting for prices to return to 2007 levels, homeowners will get real.  Homeowners who want to move will start to do so. Until the mortgage, foreclosure and short sale issues are resolved, however, the real estate market data is suspect.   We expect this process to take at least another 3 to 5 years.

10) Forecasting: Barnes Capital will retire from the forecasting business, citing “impossible expectations,” “poor compensation” and “declining confidence” in our own omniscience.

In Conclusion
The Year 2012 will provide continued strong corporate earnings and government-subsidized low interest rates.  The economic resolution of Europe will make minimal progress as it continues to wait for political consensus.  Don’t hold your breath.  Stocks are priced slightly more attractively than they were one year ago.  Bonds are much less attractively priced. Therefore, we will not increase our risk exposure substantially this year, in order to achieve a Pyrrhic one-year victory.

Our clients’ primary needs are wealth preservation. We believe that real wealth preservation in inflation-adjusted terms is going to be difficult to achieve this decade.  Our investment strategy is focused on safe returns, not optimal returns. We remain believers in the solid returns of strong dividend-paying stocks, covered call writing, and municipal bonds, including California General Obligation bonds and Gold.

A cataclysmic meltdown in 2012 is unlikely.  There is simply too much money being printed by Bernanke’s Federal Reserve for things to fall apart.  Austerity, it isn’t. But, to employ an overused cliché, we’re just kicking the can down the road. Let the next Administration start the process of structural change; this one’s just muddling through.

Daniel A. Barnes, CFA
December 31, 2011

Barnes Capital LLC is a Registered Investment Advisor. We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds and high-quality companies which raise their dividend every year. We add Gold to portfolios for diversification. Call Daniel at (925) 284-3503 and visit www.barnescapital.com