3rd Qtr Portfolio & Market Observations 2012

As we state in the Commentary below, this last quarter was a true textbook stock market rally. The real risk would have been had you remained in cash on the sidelines and not been in the market. There have been signs of economic slowdowns, both here and abroad, due to the uncertainty of the upcoming election in the U.S. and the fiscal cliff. However, despite these negative trends the stock market not only rebounded, but extended its year-to-date gains.

Today, the engine driving the economy is the stock market. The continuing effort of the Fed and many worldwide central banks to keep rates low in order to spur growth is forcing more investors to look toward equities for higher investment returns. Bernanke has said he expects the Fed to continue using programs that will keep rates low now through 2016, and to reinforce this position he went on to say that even if employment and the economy does pick up, these programs would remain in place until we are well on our way to recovery.

So, what does that mean to our clients? It means that we need to be invested in the stock market if we hope to get returns that will provide any level of financial comfort. The traditional view of fixed income providing cash flow does not apply today. With real rates at or near zero, buying U.S. Treasuries or investment grade corporate bonds will not provide the necessary income for families. As we talked about in our last letter, we have been using a portion of our fixed income allocation to buy higher yielding securities. While this does provide for more immediate income it does also carry more risk. That is why we do not allocate 100% of the fixed income to these types of securities and keep a set percentage of cash on hand to offset any price risk.

In the summer of 2011 we began allocating money to higher paying dividend income ETFs. The securities within the ETFs have a history of strong dividends and dividend support. A year later we are seeing the rewards of that investment, not only in dividend growth but the stock price, as well.

We have been talking about the “funnel effect” which basically forces an investor to make an investment in stocks that they wouldn’t have in other periods. Again, interest rates being so low and, for now, showing no signs of rocketing higher, means investors must be in the stock market for any possibility of a meaningful return. We believe this is our current situation and that it plays a strong part in why the stock market, despite so much negative news, continues to outperform versus others type of securities.

At Dumont & Blake we design and construct your portfolios based upon the fundamental question of how much risk do you need to take in order to achieve your long-term goals. While many know the possible outcomes to taking excessive risk, it should be strongly pointed out that taking insufficient risk (such as being underinvested in common stocks) can and will bring a long-run failure in realizing your objectives.

Markets will move up and down and reversals from current levels are a very strong possibility, but taking a long-term view, the strongest case to be made right now is still for holding some reasonable percentage of stocks over bonds. Following this strategy with a well diversified portfolio, mindful of cash flows and future growth opportunities, is the best chance we have of achieving your long-term goals and objectives.

Market Commentary

The stock market rally that started in late June of 2012 helped the broad-based U.S. equity indexes erase all losses from the dismal second quarter and extend their year-to-date gains. During the third quarter, the S&P 500 Index added 6.35% and the NASDAQ Composite Index rose by 6.54%, reaching 16.45% and 20.73% returns for the year respectively.

The latest two months of 2012 provided investors with a true textbook stock market rally. In the beginning of August, the stock market transitioned from the broad-based early stages of the advances from June 2012 lows to a typical market move ahead of the economic recovery, with small companies besting the large ones, growth outpacing value and aggressive sectors topping those more defensive. Since August 1, 2012 the small company focused Russell 2000 Index gained 6.73% vs. 4.89% for the S&P 500 and 3.82% for the Dow Industrial Average, showing the decisive leadership of small and midsize companies. During the same time, more aggressive sectors like Information Technology (6.38%) and Consumer Discretionary (7.79%) led the market and extended their strong year-to-date performance, while defensive Consumer Staples (0.99%) and Utilities (-3.00%) stalled or lost ground.

With the exception of the Shanghai Composite and the Nikkei 225 losing -6.3% and -1.5% respectively, all major global markets posted healthy returns. The MSCE EAFE gained 7.00% for the third quarter.

The bond market continued to present a challenge for fixed income investors since so much hinges on the European debt crisis. The ongoing “flight to quality” keeps the yield on the 10-Year U.S .Treasury bond far away from the historical average of 6.5%. The current rate of 1.63% represents only marginal improvement from the all time low of 1.4% posted in July of this year.

At the end of September, U.S. economic growth for the second quarter 2012 as measured by GDP was unexpectedly revised downward to 1.3% annualized compared to the expected upward revision of 1.7%. This number was sharply lower than the 2.0% growth seen in the first quarter and the 4.1% boost posted for the fourth quarter of last year. However, the bulk of other economic indicators prove that the U.S. economy remains steady. The PMI (Purchasing Managers’ Manufacturing Index) continued to show modest monthly growth in business activity. Industrial production, with the exception of the August drop to a still expansionary 51.5, continued to advance. The details of the latest ISM (The Institute for Supply Management) survey backed the optimism with new orders at 53.2, showing solid growth. The U.S. manufacturing sector remains in good shape with healthy balance sheets and the lowest debt-servicing costs in decades, due to solid profits and historically low financial rates.

Employment data reported through the last quarter pointed to a moderate but steady improvement in the U.S. labor market. Initial jobless claims fell by a very sharp 26,000 in the last week of September and continuing claims for the same week showed the best level since May. Sentiment indicators continued to hold up as the National Federation of Independent Business (NFIB) survey exhibited the percentage of small businesses with job openings at a four year high. Though the private payroll numbers softened somewhat with the increase of only 103,000 in August, the unemployment rate dropped to 8.1% from 8.3% in July and the overall trend for employment shows incremental progress.

The National Association of Homebuilders reported significant improvement in activity with the Housing Market Index rising to 40 in September. It was the fifth consecutive monthly gain that lifted this index to a five year high. Despite the slight decline of 0.3% for new home sales and 2% for pending existing home sales in August, the longer term trend of improvement in housing is still upward with 10% year-over-year gains. Fundamentals remain positive as demonstrated by low supply and rising prices. Overriding all economic data in the last days of the quarter was news from Germany and the U.S. Federal Reserve. In Germany, constitutional courts agreed to ratify the European Stability Mechanism, bringing this treaty into force on September 27, 2012. Approval of the ESM, whose purpose is to support European countries that have gotten into financial trouble and can’t borrow normally, removed some uncertainty from the market, which was clearly a bullish sign for stocks.

In the U.S., in addition to extending Operation Twist until the end of the year as planned, the Federal Reserve took a somewhat unexpected step and moved into another round of quantitative easing with the so-called QE3. The Fed will purchase additional agency mortgage-backed securities at a pace of $40 billion per month for as long as it takes for the outlook of the labor market to improve substantially. The Committee also stated that it expects to maintain the highly accommodative stance of monetary policy for a considerable time after the economic recovery strengthens.

Our Outlook

The world economy still faces many challenges in the coming months. The European debt crisis, fiscal adjustments aimed at deleveraging and soft global trade are factors that could weigh on activity in the coming quarter. However, the U.S. faces a less daunting outlook. In comparison with the Eurozone, the U.S. economy is much further along the path to real healing from the depths of our own debt crisis of 2008-2009. Our economy is not as vulnerable to the swings in global demand as Germany’s, with its net exports being the virtual sole contributor to growth since the introduction of the euro. Despite aggressive government intervention in the form of buy-outs and regulations, the U.S. is not over-reliant on government investments like China, where private consumption makes up only 34% of GDP, and it is the resilience of the American consumer that keeps the U.S. economy going.

That’s not to say investing won’t be challenging in the meantime, as markets wait to see what action the lame duck Congress takes after the November 6th elections to prevent the “fiscal cliff”, or the automatic trigger of $600 billion of tax hikes and spending cuts in January. If the entire menu of tax hikes and spending cuts were to take effect at once, it would amount to the most severe fiscal tightening since the 1969 tax increase passed to pay for the Vietnam War and will significantly slow the recovery or even turn an expanding economic scenario into a recessionary one.

Unfortunately, 2012 is a major election year, so uncertainty, which could keep market volatility elevated, is likely to rule between now and November. Depending on whether the control of the Executive and Legislative branches remains between Democrats and Republicans or is handed to a single party, potential responses to the fiscal cliff, as well as their timing, could take a variety of forms. Given current political dysfunction in Washington and biased reporting in the press, it is impossible to make intelligent, high-probability forecasts until the outcome of the November elections are known. However, we believe that U.S. constituents, as a whole, are probably not in favor of near-term fiscal austerity, and, as a result, after a great deal of game playing, public pandering and back-room deals, the fiscal cliff will be dealt with in time for the U.S. economy to avoid slipping into another recession and continue to hopefully improve its growth. While it does not make us expect a run-away bull market, we believe that the resolution of the fiscal cliff combined with continuing problems in the rest of the world will ensure a continued flight to safety into dollar assets and that U.S. stocks will continue to outperform global benchmarks.

Dumont & Blake Investment Advisors, LLC
September 30, 2012




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