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January 2013 Market Commentary

Off to a great start

January got the year off to a great start. The S&P 500 Index was up 5.18 percent, and the Dow Jones Industrial Average climbed 5.91 percent. The perceived successful resolution of the fiscal cliff sparked the best January market performance since 1997. The beaten-down energy sector led markets upward, while the technology sector lagged. The S&P 500 ended the month only about 2 percent below its 2007 peak, having posted double-digit returns in three of the past four years.

The strong market action continued on good corporate earnings data and in spite of mildly disappointing revenue results. As of the most recent data, 71 percent of S&P 500 companies beat earnings expectations in the fourth quarter of 2012, but only 43 percent beat on revenues. Since late 2009, when nearly 80 percent of companies beat earnings estimates, the trend has been downward. According to Bloomberg, only 64 percent of companies beat in the third quarter. So the possible rebound to 71 percent may be another reason why investors have been optimistic.
Technically, equity markets show signs of continued strength. The S&P 500 remains above both its 50- and 200-day moving averages and briefly crossed a key price level of 1,500. Other technical market factors are also positive. The strong performance of the Dow Jones Transportation Average and the breadth of stock price appreciation suggest that bullish investors are enjoying significant momentum.
Developed international markets beat U.S. markets, but emerging markets lagged. The MSCI EAFE Index rose 5.27 percent, and the MSCI Emerging Markets Index returned 1.31 percent on a price basis for the month. Given the diversity of markets and economies included in these indices, it is difficult to draw general conclusions. It does appear, however, that continued economic recovery and the reduction in political uncertainty have made the U.S. and developed markets relatively more attractive.
Value stocks outperformed growth stocks across the globe, and European peripheral countries such as Italy and Portugal were top performers. Analysts expect European gross domestic product (GDP) to contract 0.1 percent in 2013, but investor spirits continue to be buoyed by the European Central Bank’s pledge to buy sovereign debt if necessary.
Technically, the MSCI EAFE and Emerging Markets indices remain above their 50- and 200-day moving averages, though the emerging markets benchmark is getting close to its 50-day, suggesting an erosion of investor confidence.

The Grinch has Already Stolen Christmas

Just as shoppers are putting away Christmas decorations and paying the credit card bills from last year’s holiday gifts, they have less money in the bank to pay their bills.  According to a recent Gallup poll, most consumers planned to spend $770 during the holiday season, slightly more than they spent in 2011.

In 2009, President Obama advocated for a two percent reduction in employee payroll taxes to ease the economic burden on working families.  Workers have enjoyed the extra take-home pay since Congress passed that tax cut into law.  But as folks opened their pay stubs in the first weeks of this year, they noticed their checks were smaller.  Although Congress voted and the President signed the bill to keep many tax cuts in place for middle-class Americans, they actually raised taxes on the majority of workers by allowing the payroll tax cut to expire.

By raising the payroll tax withholding from 4.2 to 6.2 percent, a worker making $50,000 a year will pay an additional $1,000 in taxes.  That’s $83 a month that will go to the government instead of putting that money into their gas tank or saving it for next Christmas. The Grinch has shown up well before Christmas Eve 2013, and will most likely have a significant impact on consumer’s ability to spend money.   Take a moment to assess what your family spent on holiday gifts, meals and travel last year.  Will your plans this December be different after you’ve looked at your January paycheck?

This month-long tax hike began in January and affects all wage earning workers regardless of their incomes. The financial pain isn’t as immediate, but having 2 percent less in each paycheck may force consumers to make choices and forgo purchases.   It has the potential to significantly constrict economic growth.  With the debt ceiling debate in Washington in a matter of weeks, tepid corporate earnings and fragile economic data, these tax increases could lead the economy back into recession.


The product of a nation overburdened by welfare entitlements

This is from the Congressional Budget Office

What Caused Total Spending on Means-Tested Programs and Tax Credits to Rise Over the Past 40 Years?

Two broad factors were responsible for the growth of spending on means-tested programs and tax credits between 1972 and 2011: increases in the number of people participating in those programs and increases in spending per participant. (This discussion focuses on the 40-year period ending in 2011 because that is the most recent year for which data on the number of participants are available for those programs.) Both of those increases were themselves the result of multiple factors. For example, the rise in participation stemmed from three important causes:

  • Population growth (the U.S. population increased by almost 50 percent during that period),
  • Changes in economic conditions (particularly the recession that occurred from 2007 to 2009 and the weak recovery that followed it), and
  • Actions by lawmakers to create new means-tested programs and tax credits and to expand eligibility for some existing ones.

Increases in spending per participant resulted mainly from two factors:

  • Growth in the cost of providing assistance (such as rising costs for medical care), and
  • Actions by lawmakers to provide more generous benefits (such as increases in SNAP benefits).


In their recent research piece, 3D Hurricane, Research Affiliates calculates Structural GDP which factors in unsustainable growth derived from debt.



And compares our debt to other countries:



Facing the Fiscal Cliff

We all have a higher authority to answer to. While voters spoke in November by reaffirming divided leadership, the government must ultimately answer to whoever finances our debt and deficits.

In August 2010, Joint Chiefs of Staff Chairman Admiral Mike Mullen declared that our debt is our largest national threat. Standard and Poor’s brought the issue back into focus when they downgraded the country’s credit rating in August of 2011. But with the cost to borrow money for 10 years at 1.65 percent, the market doesn’t appear worried about our national debt.

Eventually, the market may force the government to a workable solution by increasing interest rates on our debt.

We owe 1.6 trillion dollars to China, 1.1 trillion to Japan, 242 billion to Brazil, 191 billion to Taiwan, and 165 billion to Switzerland. For now, these countries are eager to own a large amount of our debt paying nearly zero interest. While lawmakers have legal and moral obligations to citizens, they have a financial obligation to debt holders.

These countries are the bull elephants that could easily start a Greek-like stampede out of Treasury debt. Stampedes are irrational, binary events. They happen fast and are unpredictable. Lawmakers must act rationally now to prevent an irrational market force.

Aging demographics in Japan and China will eventually force them to dip into their respective reserves (3 trillion dollars in China). As their citizenry ages, Japan and China will likely need to offer some sort of social safety net to their citizens. In 10 years, Japan will move from a net saver to a net spender, forcing them to sell their U.S. Government debt to finance these expenditures.

We need a plan to pay off our debt ahead of these massive demographic shifts.

What will work? Our one-trillion dollar annual deficit cannot be closed by higher taxes alone. We have to cut discretionary spending, which accounts for around 35 percent of the Federal budget. The rest is defense and entitlements. The right solution is one that shares the burden on both the spending and tax side.  

Healthcare advances are extending our longevity, and the work we typically do is more service-based than the back-breaking manual labor jobs of the industrial revolution. Our long-term debt solution will likely mean we work until 70 or longer before receiving government benefits.

As the largest economy on the planet, we have more time to find a solution than Greece or Spain, but we need to do so quickly. Without compromise by both parties, we will not fix the debt problem.



There Goes the Neighborhood

After the recession, homeownership has declined to near 50-year lows. Multi-family (i.e. apartments) housing starts jumped dramatically in October while single family starts declined. This can create a variety of difficult-to-solve problems for the dwindling group of owners. These problems stem from the same basic element—rental occupants aren’t making a long-term commitment which allows them to save money in the short run.

What motivation would a short-term renter have in repainting their rented space or keeping their yard in tip-top shape? If you found out that a used car you are considering was part of a rental fleet you would mark it off your buyers list because of the likelihood of abuse.

Owners have committed more time and financial resources to their purchases and therefore have more at stake. They have an incentive to exercise greater care for their purchase than a renter.  

Unfortunately, the same dynamics have surged into investment markets since 2008. The current crop of brokerage advertisements displays a similar theme. Everyone has tools to help you be a better trader. One ad even shows a guy trading on his phone while waiting to pick his kid up from the school bus stop. 

Trading isn’t ownership, it is renting. Traders place short-term bets on the table and are ready to close them out in days, if not minutes. In their quest for short-term profits, traders can bet on price increases or price decreases (short selling). Traders who use leverage in its various forms are trying to gain the benefits of ownership without the financial commitment of a long-term investor.

If you are the latter, consider how this impacts your investing “neighborhood.”  As you patiently build your investment account or 401K around reliable long-term holdings, these short-term renters are undermining your efforts by creating price uncertainty. They thrive on market volatility because it gives them more opportunities to profitably trade in and out of a position.

Long-term investors need to acknowledge the effects of short-term trading on their long-term holdings and adapt their investment philosophy to accommodate higher volatility. At LeConte Wealth Management, we use broad market exposure, sector valuation analysis and economic trend analysis to reduce risk and rebalance our client portfolios.

The notion of “buy and hold” turns a blind eye to the risks inherent in today’s trader-driven markets.



December 2012 Market Review

An eventful year, but one that investors can celebrate

December capped an eventful year for financial markets. Despite a roller-coaster ride on the political and economic fronts, the S&P 500 Index notched a 16-percent gain for the year, while international markets also performed well, as the MSCI EAFE Index returned 17.32 percent and the MSCI Emerging Markets Index posted a price return of 15.15 percent. The strong performance of equity markets across the board reflected general progress—an economic recovery in the U.S., led by the housing market; real political improvements in Europe, where the debt crisis appears to have largely been contained; and a successful leadership transition and apparent economic “soft landing” in China. Outside the U.S., the risks appeared to be much more manageable at the end of 2012 than at its start.

In December, markets fluctuated with news from Washington, DC. The defining event of the month, for both the real economy and the financial markets, was the fiscal cliff issue. On the final trading day of the year, a small compromise appeared to be in the making, with an agreement to raise income taxes for households making $450,000 or more per year, raise capital gains tax rates to 20 percent, and limit itemized deductions for individuals making more than $250,000.

The S&P 500 ultimately rose over the course of the month, by 0.91 percent, but the small change did not reflect the daily volatility. Markets rallied, slid, and finally recouped some gains. Politics dominated the economic and financial discussion and will likely continue to do so, as the next round of debt ceiling discussions comes around.

During the past year, midsized companies outperformed large- and small-capitalization companies, and value beat growth. On a sector basis, financial and consumer discretionary stocks did best, while the utilities and energy sectors lagged. Stocks have stealthily pushed higher over the past four years, with the S&P 500 now just 9 percent below its 2007 peak.

The strong performance of international markets continued in December. Through month-end, the MSCI EAFE and MSCI Emerging Markets indices rose 3.2 percent and 4.78 percent, respectively. These returns generally reflected an improving economic climate in emerging markets and a stabilization of European markets. These regions were also less affected by the fiscal cliff in the U.S. (see chart).

Fixed income markets also performed well in 2012, with the Barclays Capital Aggregate Bond Index showing a return of 4.22 percent for the year and the Barclays Capital U.S. Corporate High Yield Index returning 15.81 percent. High-quality bonds lost some ground in December, with the Aggregate Bond Index declining 0.14 percent. Yields on Treasuries traded in a relatively narrow range throughout the year, reflecting the generally high degree of risk aversion in the markets.

Valuations vary across asset classes

As we enter 2013, U.S. stocks appear to be fairly valued based on short-term indicators, such as the trailing 12-month price-to-earnings ratio, which at 14.5 is neither significantly above nor below historical averages. Stocks, however, appear less attractive according to other metrics, such as the Shiller P/E ratio. Currently, the most value to be found is in developed Europe and Japan, where stocks look particularly compelling from a price-to-book value perspective. Emerging market stocks also look reasonably attractive, particularly in more cyclical sectors.

From an absolute yield perspective, bonds on the whole look expensive. High-yield and municipal bonds rallied significantly in 2012. Though there may still be some opportunity with respect to their spread over Treasuries, they are less attractive now than they were at the beginning of the year.

A slow global economy spurred government intervention

The one overarching factor in all markets in 2012 was the influence of governments and central banks. The first quarter of the year saw markets rally as a result of the European Central Bank’s (ECB) Long-Term Refinancing Operation, designed to inject capital into troubled European banks. A continuation of the U.S. Federal Reserve’s (Fed) Operation Twist also aided the rally in risk assets. After a market pullback in the second quarter, the ECB took further action by announcing its willingness to buy sovereign debt of distressed peripheral nations. Not to be outdone, the Fed promised to engage in a third round of quantitative easing, this time with an open-ended time horizon and targeting an unemployment rate of 6.5 percent. European and U.S. central banks were also joined by their peers in the developing markets, as both China and Brazil cut lending rates during the year.
The backdrop for this extraordinary intervention on the part of central banks was a soft global economy. The eurozone fell into mild recession, the Japanese economy struggled, and global manufacturing stagnated. In the U.S., the economy continued to grow at a slow pace, largely as a result of an improving housing market and reasonable levels of consumer spending.

The willingness of the Fed and the ECB to serve as backstops caused investors to assign a smaller likelihood to the possibility of “really bad” scenarios, such as a disorderly dissolution of the eurozone, coming to fruition. This reduction in investor worries moved markets higher, even as the global economy struggled.

U.S. housing and consumer spending recover, business lags

In the U.S., 2012 was the year that the economic recovery started to get real. Housing slowly improved throughout the year, with home values reportedly increasing year-over-year for the first time since 2006. Inventories remained below historical levels, suggesting that prices would continue to rise. In many markets, buying became cheaper than renting, which further supported the housing recovery. In addition, there were signs that household formation was starting to recover and that the housing market would further benefit as pent-up demand moved into the market.

Employment also improved, with 2012 job gains seeming to be on a pace similar to that of 2011 and close to that of 2004 and 2006. Despite weakness in the second quarter, employment growth recovered in the third and fourth quarters, and the unemployment rate (U3) dropped from 8.5 percent at the start of the year to 7.7 percent near the end—a much larger improvement than had been expected.

Consumer spending followed the recovery in housing values and employment, tracking previous recovery levels and moving back above the peak of the previous cycle. Consumer savings rates fell but remained at reasonable levels, and consumer debt and debt service levels declined to multiyear lows, suggesting that demand would be sustainable.

Business spending was much weaker, driven by policy uncertainty with respect to taxes and federal spending. This remained the weakest part of the economy, and whether this will improve in the coming year is still unclear.

On to 2013

An economic recovery has taken root in the U.S., and domestic economic trends look encouraging. The political and economic risks in Europe remain but are significantly reduced relative to the start of last year. China and other emerging markets are showing signs of stronger growth after a slowdown. 

A major risk for the U.S. is governmental dysfunction. A pending debt ceiling debate awaits early in the new year. In 2011, a similar debate almost led to default on U.S. government debt, resulting in a credit rating downgrade. Another risk is the reduced scope of the possible policy responses available to central banks. Now that monetary authorities have fully committed themselves to bolstering the recovery, investors will have to rely on individual consumers and businesses to drive the economy forward.

Nevertheless, even in the face of these risks, developments in the U.S. and around the world bode reasonably well for markets at the start of 2013. In the U.S., the risks are containable and the damage done by the fiscal cliff may well be limited. Cautious optimism is the appropriate stance. Investors should neither shun markets nor become overconfident but instead stay focused on their long-term strategic allocations and goals.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research associate, at Commonwealth Financial Network.

© 2013 Commonwealth Financial Network®

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