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Oh, 2012, how Wall Street misunderstood you

| Saturday, Jan. 5, 2013

From John Paulson's call for a collapse in Europe to Morgan Stanley's warning that stocks would decline, Wall Street got little right in its prognosis for the year just ended.

Paulson, who manages $19 billion in hedge funds, said the euro would fall apart and bet against the region's debt. Morgan Stanley predicted the Standard & Poor's 500 Index would lose 7 percent and Credit Suisse Group AG foresaw wider swings in equity prices. All of them proved wrong last year and investors would have done better listening to Goldman Sachs Group Inc. Chief Executive Officer Lloyd C. Blankfein, who said the real risk was being too pessimistic.

The ill-timed advice shows that even the largest banks and most-successful investors failed to anticipate how government actions would influence markets. Unprecedented central bank stimulus in the United States and Europe sparked a 16 percent gain in the S&P 500 including dividends, led to a 23 percent drop in the Chicago Board Options Exchange Volatility Index, paid investors in Greek debt 78 percent and gave Treasuries a 2.2 percent return even after Warren Buffett called bonds “dangerous.”

“They paid too much attention to the fear du jour,” said Jeffrey Saut, who helps oversee about $350 billion as the chief investment strategist at Raymond James & Associates in St. Petersburg, Fla. “They were worrying about a dysfunctional government in the U.S. They were worried about the euro quake and the implosion of Greece and Portugal. Instead of looking at what's going on around them, they were letting these macro events cause fear to creep into the equation.”

The market value of global equities increased by about $6.5 trillion last year as the MSCI All-Country World Index returned 17 percent including dividends. The Bank of America Merrill Lynch Global Broad Market Sovereign Plus Index of government debt returned 4.5 percent.

While Bank of America Merrill Lynch indexes show Treasuries of all maturities returned an average of 2.2 percent last year, including reinvested interest, an investor who bought what was then the benchmark 10-year note would have gained 4.01 percent after taxes, according to data compiled by Bloomberg.

Money managers who aim to beat markets lagged instead.

The Bloomberg Global Aggregate Hedge Fund Index, which tracks average performance in the $2.19 trillion industry, increased 1.6 percent last year through November. More than 65 percent of mutual funds benchmarked to the S&P 500 trailed the gauge in 2012, according to data compiled by Bloomberg. The 50 stocks in the S&P 500 with the lowest analyst ratings at the end of 2011 posted an average return of 23 percent, outperforming the index by 7 percentage points, the data show.

Blankfein was more prescient. “I tend to be a little more positive than what I'm hearing from other people,” the 58-year- old CEO told Bloomberg Television in an April 25 interview. “One of the big risks that people have to contemplate is that things go right.”

Ten-year Treasury yields have climbed 0.52 percentage point from a July low to 1.91 percent, while the so-called VIX index of volatility is up 8.3 percent from last year's nadir. Greece's economy will contract 4 percent this year, the International Monetary Fund predicted in October, as euro membership prevents the country from boosting exports with a weaker currency.

Paulson, the founder of New York-based Paulson & Co., told clients in April he was wagering against European sovereign bonds and buying credit-default swaps on the region's debt. The contracts insure against default and increase in value when investor perceptions of the borrower's creditworthiness decline.

Citigroup Inc. economists led by Willem Buiter in London said in February the possibility Greece would leave the euro within 18 months had increased to 50 percent from between 25 to 30 percent. They raised the risk to 75 percent in May and by July to 90.

Greek bonds surged the most worldwide and the country stayed in the euro as the European Central Bank pledged a bigger rescue effort, German Chancellor Angela Merkel softened her stance on aid and Prime Minister Antonis Samaras delivered on austerity commitments in Athens.

Money managers who bet against the conviction of European leaders to hold together the 17-nation currency union missed out on some of the best investment opportunities as the euro strengthened about 9.4 percent from a July 24 low against the dollar, Germany's DAX Index of shares returned 29 percent for the year and credit-default swaps on Portugal dropped 644 basis points to 449.

“There really is only one ‘worst trade' and that is the ‘euro crisis' trade,” Michael Shaoul, chairman and chief executive officer of Marketfield Asset Management LLC in New York, wrote in a Dec. 31 e- mail.

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