Plain English Guide to the Economy

1. 2012 was an unusually good year form investors.

All investment classes did well last year, with strong rises in just about all asset classes.  That is unusually, as if investors were attracted to both high-and low-risk assets at the same time.

2. Sentiment has driven the markers.

Usually its business fundamentals but for the past few years sit was sentiment (watch the Confidence Indicators, both business an private).

Public companies have increased earnings and margins, and reduced debt and debt-to-equity ratios.  This means balance sheets are stronger now, but it hasn't changed share prices; even the last rally was driven by good feelings about world problems being over.

3. Economic policies worked

Many of the government policies in Europe, China and the US were feared, but did exactly what they were supposed to.  China has not had a hard landing, although its growth dropped from 10% to 7.9% (if you accept the figures are calculated rather than picked out of a hat).

4. The Australian dollar is overvalued.

The A$ has been above parity with the US$ since 2008, good for overseas holidays and importers, not good for exporters.  It is about 30% overvalued, but that doesn't mean it will ease any time soon.  (One way to measure a currency is 'perfect price parity', one is known as the Big Mac Index).  Australian interest rates are higher so global investors find it attractive to park money here, for which they need to buy A$, which forces up demand for the currency.

5. What does this mean for investors?

One lesson is clear; there are too many unknowns so it is difficult to guess the market.  If you look at charts for all investment classes since 2007 seeking a pattern, sadly there is not.  The key is to diversify and balance the portfolio.  (Remember:  Goals, Risk, Timeframe).