What a difference a year makes – or does it? In writing this letter and preparing our notes on the economy, we had a sense of déjà vu. In fact, other than the dates and a few minor changes we could have just reprinted the letter from the fourth quarter of 2011. Here is what we reported then:
The month of January 2012 was up 4.48%, the rally starting in October 2011 had the S&P advancing 11.82% for the fourth quarter, U.S. Treasury bonds were yielding less than 1% for five year maturities and 1.9% for ten year maturities, and a diversified stock portfolio yielding 2 to 3% at current valuations.
In that letter we reported our investment strategy was to:
• Increase our asset allocation moderately toward stocks
• Own higher yielding fixed income investments
• Reduce exposure to high quality bonds
• As bonds matured/called, deploy proceeds into higher dividend paying stocks, higher yielding ETFs and closed-end funds
Our outlook going into 2012 was that it would be a good year for equity markets. We saw an improving economy, low interest rates and low expectations with the market having more upside potential than downside risk. So, how right were we?
• The S&P returned +16% for 2012.
• From October 2011 through today the S&P has advanced 27.55%.
• We purchased higher yielding fixed income investments which, as you read in the commentary, posted a 15.81% gain.
• We reduced exposure to high quality bonds which returned only 4.16% for 2012.
We were correct in stressing that last year was the time to decrease our allocation of high quality bonds and that the stock market would be attractive for both income and growth. The incremental risk we added to the portfolios did indeed add meaningful returns. A year later we still see five-year U.S. Treasuries yielding less than 1% and the ten-year Treasury yielding 1.9%, while a diversified stock portfolio carries yields of 2 to 3% even at today’s valuations. The underlying market fundamentals combined with the low interest rate environment imply another optimistic year for the U.S. stock market. Our outlook for 2013 continues to remain positive.
Your portfolio is well positioned for an environment where the economy is improving modestly and the interest rates remain relatively low. Economic reports are showing that the U.S. economy is beginning to show signs of traction and housing seems to have bottomed out. We are still in a low interest rate environment and, if we are to believe the Fed, they should stay low for the near-term. Because rates on quality bonds are so low we are investing a portion of the bond proceeds into higher yielding securities, with greater volatility, and keeping a higher than normal cash position.
The final quarter of 2012 capped an eventful year for financial markets. The defining events, for both the economy and the financial markets, were the Presidential elections in November and the uncertainty of the “fiscal cliff” issue, which, as we predicted in the Third Quarter’s Commentary, was accompanied by a “a great deal of game playing, public pandering and back-room deals”. The latter contributed to high levels of daily volatility throughout the fourth quarter, as markets rallied, slid and finally recouped some losses. The S&P 500 ended the quarter with a small loss, less than one percent, while the Dow Jones Industrial Average and NASDAQ Composite lost 1.74% and 2.74% respectively. Despite a roller-coaster ride on the political and economic fronts, all the major market indices recorded double-digit gains for the year. The S&P 500 ended the year with a 16% advance, the NASDAQ Composite Index gained 17.75% and the Dow Jones Industrial Index increased by 10.24%.
The strong performance of equity markets across the board reflected generally positive progress. We are seeing an economic recovery in the United States, real political improvement in Europe where the debt crisis appears to have been largely contained, and a successful leadership transition and apparent economic “soft landing” in China.
The housing market slowly improved throughout the year. The number of existing home sales surged 5.9% in November, beating even the high-end estimates, and home values reportedly increased 4.3% compared to the prior year for the first time since 2006. Home builders reported the best conditions in more than five years.
Fixed income markets also performed well in 2012. The U.S. 7-10 Year Treasury Index advanced by 4.16% for the year, while U.S. Corporate High Yield Index posted a stellar 15.81% gain. The yield on 10 year U.S. Treasuries traded in a relatively narrow range throughout the year, from a high of 2.07% in January to an all time low of 1.43% in July, ending the year at a meager 1.71%.
Employment also picked up. Despite weakness in the second quarter, employment growth recovered in the third and fourth quarters. The November jobs report was surprisingly positive, with the payroll jobs rising a moderately strong 146,000, following an increase of 138,000 in October and a gain of 132,000 in September. The unemployment rate declined from 8.5% at the start of the year to 7.7% near the end, a much larger improvement than had been expected.
Consumer spending followed the recovery in the housing market and employment, rising 3.5% year-over-year in November. Though the savings rates fell slightly, the U.S. households’ debt-to-disposable income ratio has declined from a peak of 134% to 112.7% in the fourth quarter of 2012, indicating U.S. consumers are making good progress repairing their personal balance sheets.
An economic recovery has taken root in the U.S., and domestic economic trends look encouraging. The fall off the “fiscal cliff” has been averted, at least for now. The U.S. Congress found a detour around the year-end “fiscal cliff” of scheduled tax hikes and spending cuts with an agreement to extend current tax rates for the overwhelming majority of taxpayers. Only individuals earning more than $400,000 a year, and couples earning more than $450,000, will see their rates rise in 2013 – however taxpayers, at all income levels, will be subject to a two-percentage-point increase in the employee portion of the Social Security tax. It will rise to 6.2% from 4.2%, where it had been set for several years as part of a fiscal stimulus package.
These measures reduced the uncertainty associated with the direction of tax policy going forward. However, we must acknowledge that no material changes in spending were addressed in this decision, which only temporarily suspended the scheduled cuts of $110 billion in federal outlays; thus the debate on spending was postponed for another two months. This upcoming debate will coincide with the need to raise the debt limit at the end of February, so, even beyond the “fiscal cliff”, Washington, fiscal policy and governmental dysfunction will likely remain in focus next year and will present a certain risk for the U.S. markets. In 2011, a similar debate on the debt ceiling almost led to a default on U.S. government debt, resulting in the unprecedented downgrade of the U.S. credit rating.
Nevertheless, even in the face of these risks, developments in the U.S. and around the world bode reasonably well for the markets at the start of 2013 as the risks are containable and the damage done by the “fiscal cliff” is relatively limited. The U.S. economy is forecast to grow at the rate of at least 2.0% in 2013, and since top line companies’ revenue flow directly from nominal GDP growth rates, this forecast implies that 2013 should be a positive year for the equity markets. Even after a strong 2012, the U.S. stock market does not appear to be overvalued as the trailing 12-months price-to-earnings ratio, which now stands at 14.50, is not above historical averages. Moreover, since interest rates are widely expected to remain low for years, stocks look much more attractive when comparing the 2.14% dividend yield of the S&P 500 Index to that of the yield on 10-year Treasuries, which now stands at 1.9%. Treasuries today produce negative real returns (nominal yield less inflation), and that is before taxes. Even the 30-year Treasury bond, which effectively offers a 3% coupon, provides no real yield with long-term inflation at around 2.0% to 2.5% a year, and the Fed’s continued purchase of long-end debt in the mortgage markets keeping the long-term interest rate artificially low. Meanwhile high quality and above average yield stocks are currently providing positive real returns, and have produced real growth in the past and presumably in the future.
Entering 2013, we believe that cautious optimism is the appropriate stance and advise our clients to neither shun the markets nor become overconfident, but instead stay focused on their long-term strategic allocations and goals.
Dumont & Blake Investment Advisors, LLC
December 31, 2012