The first quarter of 2013 is off to a great start, with the S&P returning 10.61%. Despite having a positive outlook on the U.S. stock market, we realize things will not continue on the same trajectory. With the market ready for a pause or pullback, this is a good time to review what we have implemented in your portfolios and explain how we are positioning for the near future.
We have discussed in past commentaries that one impact of low interest rates is that funds are funneled into riskier assets in an effort to increase return. Many of our clients have balanced portfolios with a mix of both fixed income and equities, however the interest rate we receive for holding bonds is not currently generating enough cash to meaningfully contribute to paying one’s living expenses. When we are in an interest rate environment such as we are today, we must find other options for increasing return. So, what have we been doing?
Back in June 2011 we started allocating a percentage of our portfolios to dividend paying stocks. As we can see from the results, we not only were able to get cash payments in the 4% range, but we got an opportunity for growth of the share price. Why did we do this? First, we need to understand the differences between bond interest payments and stock dividend payments. When we buy a bond we get a set interest rate, and as long as we hold that bond to maturity, that is the rate we get. With stock dividend payments we have the opportunity to see dividends increase. For example, in June 2011 IBM paid a quarterly stock dividend of .75 per quarter or $3.00 per share a year in payments. In June of 2012 that quarterly dividend payment was increased to .85 a share or $3.40 per share a year in payments. That is a 13% yearly increase in payout. Had we bought a 2% bond over the same period, we would have had 0% increase as the rate it pays is a fixed amount for the life of the bond. In addition, the price of IBM stock from June 2011 through June 2012 appreciated +13.5%.
We are not suggesting that stocks and bonds carry the same risk. While equities are riskier and more volatile, bonds today offer little return for the risk taken. That is why we don’t take 100% of the portfolio and buy only stocks. By using some of the bond allocation money to buy dividend income stocks we are modestly increasing the portfolio allocation to equities.
Around the same time in 2011, we started adding higher yielding fixed income securities to the portfolio. Approximately 10% to 15% of the fixed income money was allocated to high yield investments. These securities are paying about 6%-8% in income as opposed to less than 2% on a high quality U.S. government bond, so we are getting a more meaningful return for the risk we are taking. Also, we are exposing less money to the market yet getting the same amount of cash generated with a larger bond position. Let me explain:
If we bought $25,000 of a high quality bond that had a coupon of 2% we would get $500 annually in income. That is $25,000 at 2% = $500 per year. Using the higher yielding fixed income instruments we invest $10,000 and get approx 7% in income – $10,000 at 7% = $700 per year. So, we received $700 in interest which is more than the $500 AND we only invested (or exposed) $10,000 to the market.
Do these same securities carry more risk than a high quality bond? Of course they do; that is why we don’t allocate the entire fixed income portion to them, just 10% to 15%. Also, a key component of this strategy is that for every $10,000 we invest we leave $10,000-$15,000 in cash to offset the risk of prices coming down. Remember, before we were buying $25,000 to get $500 in income and now we are buying $10,000 to get $700 in income.
As enticing as these alternate options may be, we know that it is important to take measured risk and not succumb to the temptation of reaching for higher yield. This means we are still maintaining elevated levels of cash in the account, and until market dynamics change we will continue to do so. Remember, the extra cash we are holding is there to offset the price risk of our higher yielding securities. It is not at the expense of being under-allocated in other asset classes.
Companies have more cash than ever before and, for now, inflation is nowhere on the horizon. At the time of this writing, the 10 year U.S. Treasury bond yield is back down to 1.7%. We strongly believe earnings will continue to muddle along despite the government’s inability to put programs in place to sufficiently stimulate our economy. At the end of the day, the potential for strong job growth will come from small and mid-size companies. The large cap companies of the S&P have spent the last decade utilizing technology and fewer personnel to increase productivity – and it has worked; earnings are the strongest ever. It might not feel like it or seem like it, but the U.S. economy is poised to explode in the not too distant future. Both domestic and foreign companies are finding the cost to produce goods in the U.S. is competitive with manufacturing overseas. Companies are bringing back production to the U.S. primarily because of our newly discovered energy reserves. The pieces are falling into place and eventually legislative action will be taken. That action will be the spark that ignites this economy. We believe the market has not yet reached the point where we would consider it expensive and feel it still has much more upside potential.
The first quarter of 2013 caught many investors by surprise with a decisive continuation of a strong rally that started in November 2012. Despite the uncertainty surrounding the debt ceiling and sequestration here in the U.S. and the disarray which continued to drag new countries into the fold in Europe, politicians managed to avoid any terrible missteps during the quarter. Even the raiding of people’s savings accounts in Cyprus failed to set off any panic alarms with investors around the world. Though there was no single issue that appeared to be driving markets higher, it seemed fairly clear that investors have largely decided there was enough good news in the private sector to compensate for the ongoing struggles in Washington and Europe. As a result, we enjoyed a market that seemed to know no upside bounds.
While slightly shy of the last year’s 12% first quarter gain, the S&P 500 Index advanced a solid 10.61%, finally closing at a new record high on the last trading day of the first quarter. The previous high was set in October 2007 shortly before the 2008-2009 recession and financial crisis. It has taken almost five and a half years for the market to return to the old high, nevertheless, investors certainly feel more optimistic as the economy slowly recovers from the recession. A steady rise of the stock market through the first quarter of 2013 produced 11.93% and 8.51% gains for the Dow Jones Industrial Average and the NASDAQ Composite Index respectively. Mid-cap companies outperformed large cap, making the S&P 400 Mid Cap Index the top performer for the quarter with a 13.45% increase. Foreign markets lagged U.S. equities with the EAFE Index barely reaching one half of U.S. major market indexes advances, supporting the concept of the strong dominance of our domestic economy and stock market.
The Fixed Income markets, on the other hand, had a mediocre quarter. Most of the major Fixed Income indexes ended the first three months of the year virtually flat, while the price on the 20+ years U.S. Treasury prices fell by 2.82%. It is worth noting that while short-term yields did not change in the first quarter, remaining pinned down by the Federal Reserve at just under 0.1%, the yield on the longer term 10-Year Treasury note rose from an average of 1.69% in the fourth quarter of last year to 1.92% in March 2013. This effectively increased the difference between the two and thus steepened the slope of the yield curve, which traditionally is indicative of a stronger outlook for economic growth.
Another clear sign of increasing investor confidence was the better performance of U.S. equities as compared to gold prices. During most of the past decade, when the U.S. economy looked worse than many others, the dollar weakened and the gold prices outperformed domestic equities. Now that many of those concerns have shifted to foreign economies, the value of the dollar has strengthened and gold has underperformed U.S. stock prices.
Driven in part by an extremely accommodative Fed policy, the U.S. economy kept gaining traction. After a negative print in the third quarter of last year, corporate America returned to year-over-year earnings growth in the fourth quarter. With nearly all of the S&P 500 companies having reported fourth quarter results, corporate earnings growth came in at 4% on average, marking the previous quarter merely a pause in the long term positive trend.
February’s readings of the Purchasing Managers Index (PMI) reached its highest level since June 2011. The orders for long-lasting U.S. made durable goods surged 5.7%, reversing the January’s drop which was associated with the fiscal cliff uncertainty, and resoundingly beat economists’ expectations.
Job data continued to improve, albeit slowly. More importantly, job growth is now being driven by sustainable private payroll expansion. Total employment increased a respectable 236,000 in February despite a loss of 10,000 of government jobs. The strength of the private sector should be able to easily push employment higher throughout the year.
Consistently strong home price data over the past several months provided convincing proof that the housing sector has finally turned the corner. All 20 metropolitan areas tracked by the S&P/Case Schiller Index showed year-over-year price increases for the first time since March of 2006. The housing recovery should help stabilize overall economic progress as increased construction and sales add jobs and fuel growth across a wide range of industries beyond housing.
The American consumer took the end of the payroll tax holiday in stride and continued to push the economy higher. Despite GDP growth of only 0.4% in the fourth quarter, it sure felt like a strong economy at the consumer level, with retail sales reaching all-time high of $421 billion in February.
U.S. economic growth appears to be on track while Europe is clearly in contraction and remains exposed to periodic negative surprises. China has been slowing down, and South and Central America have pockets of strength and weakness. It proves once again that our economy is, by far, the strongest and makes the United States one of, if not the best place in the world to invest in.
Despite a double digit advance of the S&P 500 Index in recent months, its average P/E ratio stands at 15X, which is close to the historic median. While it does not present a bargain level, the market is far from being dangerously overvalued, given the consistently growing corporate earnings and the balance sheet strength of American corporations.
After a strong first quarter performance of the U.S. stock markets, which showed impressive resilience to continued headwinds, a certain pullback is inarguably possible. The discussion remains around the extent of this pullback. Some of the Wall Street pundits equate the expiration of the tax holiday to the introduction of Social Security by FDR, and post-financial crisis bank regulation to the doubling of bank reserve requirements in 1937. Since this combination of fiscal and monetary policy changes led to the contraction of private sector debt, doubled the unemployment rate from 10% to 20% and caused a 50% stock market plunge, they predict a severe deterioration of the stock market conditions. We acknowledge the remaining cloud of debt ceiling negotiations, which were only pushed back in January. We concede the fact that politicians tend to make mistakes on the fiscal policy front. However, we firmly believe that economic and market situation in 2013 is not the same as in 1937. Ben Bernanke, a renowned scholar of the Great Depression, will be doing his best to make sure that any fiscal policy mistake will not be compounded with monetary policy mistakes of the same magnitude. Therefore, we are siding with those who believe that an anticipated market correction should not present a major concern to long term investors, given reasonable valuations and many signals to ongoing gains. This recent rally differs from the first quarter of last year’s advance. The former was dubbed a “stealth rally”, because during Q1 2012 many investors were on the sidelines as they have been since the onset of the financial crisis five years prior, and the overriding sentiment was very bearish. The environment surrounding the U.S. stock market seems to have changed dramatically over the course of the rally from November of last year. Since the lows of 2009 the stock market recovery was often marked by nice runs interrupted by relatively sharp pullbacks. Wary investors sold domestic equities on largely macroeconomic concerns such as the European debt crisis or U.S. fiscal troubles. It appears now that investors are increasingly running toward U.S. stocks and the U.S. dollar during times of increased worries. This limits the extent of U.S. stock market pullbacks. Investors, who have missed out on the recent rally or the massive gains seen since the lows, appear to be looking at these times as opportunities to buy showing a marked difference from the first few years of the recovery. This is a crucial change that should fuel further gains in stocks as the year progresses.
Dumont & Blake Investment Advisors, LLC
March 31, 2013