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Investment Letter

3rd Quarter 2013

Another quarter is in the books and despite several headwinds facing the economy, the financial markets produced positive results in most areas. It seems this bull market is always climbing a wall of worry or overcoming potential stumbling blocks to advance or maintain positive momentum. This quarter was no different as events in Syria nearly forced a military response by the U.S. and the fiscal debate in Washington started to heat up. This resilient bull market is now in month number 55 since bottoming out on March 9, 2009. Even though the average lifespan of a bull market is approximately 45 months, the current bull still appears to have some fight left. 

The performance for equities during the 3rd Quarter added to the already impressive returns year-to-date (YTD) for stocks. The Dow Jones Industrial Average (DJIA) finished the quarter with a total YTD return of 17.64% and a 3rd Quarter total return of 2.12%. In fact, the DJIA index reached a record high on September 18, 2013 to close at 15,676.94. The S&P 500 Index also had a good quarter of performance with a total return of 5.24% and a total YTD return of 19.79% as of September 30, 2013. Domestic U.S. Small Cap stocks continued to be the performance leader for 2013 as the Russell 2000 had a total return of 10.21% for the 3rd Quarter and 27.69% YTD. 

The chart below recaps the 3rd Quarter performance of other major indices: 

Asset Class


3rd Qtr. 2013
Total Return

2013 YTD
Total Return


ML Three-Month U.S. Treasury



U.S. Bonds

Barclays Intermediate-Term Treasury



U.S. Large Co. Stocks

S&P 500 Total Return



U.S. Small Co. Stocks

Russell 2000 Total Return



International Stocks

MSCI EAFE (net div.)



Real Estate

DJ Select Real Estate Securities Total Return



Source: Morningstar

Data released during the quarter showed the domestic economy advanced. The Federal Reserve confirmed this in their latest version of the Beige Book, and stated “economic activity continued to expand at a modest to moderate pace during the 3rd Quarter”. Like previous quarters in 2013, overall growth remained at a low level, but the Fed reported the economy saw positive economic improvement in many areas. Consumers spending rose; travel and tourism activity increased; manufacturing activity expanded modestly; inflation remained low; residential real estate activity increased slightly; and demand was strong for agriculture products despite extreme weather causing weak production and growing conditions. Not all the economic data painted an encouraging picture for the economy during the quarter. Even though the unemployment rate declined to 7.3%, it is still at a high level. Mortgage rates increased during the quarter to hinder the real estate market, and overall lending conditions remained tight due to unchanged standards. Interest rates on U.S. Treasury securities experienced a spike during the quarter, but retreated back to previous levels as investor’s concerns were shifted by monetary policy expectations. The table below provides the movement in yields during the quarter.[1] 

3rd Quarter Treasury Yield Summary





2 Year




5 Year




10 Year




30 Year




The Federal Open Market Committee’s (FOMC) statement during the 2ndQuarter let investors believe the Fed was ready to adjust monetary policy by starting the phase out (Taper) portion of the Quantitative Easing program in the fall or late 2013. The negative reaction to that announcement caused some instability in the markets as investors came to grips with the idea of a reduction in accommodative policy. However, it appears that anxiety was overstated because the FOMC decided to delay the Taper at their meeting in September. The Fed reminded investors that their decision to Taper or not to Taper was conditional…not set in stone for a 2013 start. The committee stated that based on the current economic conditions and taking into account the extent of the federal fiscal retrenchment, they needed additional evidence the economy could sustain the positive momentum before adjusting the pace of asset purchases. Instead of the Taper, the FOMC decided to continue their current accommodative monetary policy strategy to support economic growth. The strategy consists of keeping the Fed Funds rate low and continuing their purchase program (at an $85 billion monthly pace) of Mortgage Backed Securities and Treasury Securities. Investors welcomed the news that the Fed lifeline will continue for the near future, but we all know that the Fed cannot kick the can down the road permanently. Once the taper starts, it is highly likely investors will shift their confidence in the market’s ability to sustain momentum without the Fed’s assistance. 

Economic activity in the rest of the world was a little better during the quarter. Japan, China, and most areas in the Eurozone showed additional economic improvements. For the most part, the sovereign debt issue in Europe is on the back burner as European leaders have shifted their focus to sustaining growth. Economic activity in Asia accelerated as China’s growth stabilized and Japan’s latest economic data showed firm growth. There are still issues that all three are dealing with, but it is a good sign that these developed areas are showing signs of economic advancement. Conversely, emerging market economies continued to struggle versus developed global economies. Expect any improvement in emerging markets over the short-term to be a mixed bag that will vary country by country. 

Unfortunately, the events in Washington dominated much of the news late in the quarter. The political standoff over the fiscal budget and debt ceiling caused a partial government shutdown on October 1. Approximately 800,000 “non-essential” workers were furloughed and the million or so “essential” government workers are scheduled to work without pay until a budget is agreed upon (these workers will receive back pay once the budget issue has been resolved). The debt ceiling is another crucial issue that will need to be addressed by politicians. While the overall debt has been coming down, the problem is the aggregate size of U.S. government obligations. The debt limit allows the government to borrow the money it needs to finance these obligations including Social Security, Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments. If the debt ceiling is not raised, there will not be enough money to cover these obligations. After going through one recent downgrade in the debt quality of the U.S., investors do not want to see the government default on a debt payment. Despite the remote possibility of a default, the chance is still there and thus it is a strong political point for those in the negotiating rooms. See the list below for the important dates over the next month if an agreement is not reached. 

  • Oct. 1– Official date of U.S. Government shutdown
  • Oct. 17– The government will exhaust the emergency measures it has used to borrow money. The U.S. Treasury predicts the government will have approximately $30 billion on hand to pay obligations.
  • Oct. 22-31– Sometime between these dates the Congressional Budget Office (CBO) estimates the government will run out of cash. Payment of the Treasury debt would be the top priority to avoid a default, so that means cuts will have to be ade. Look for programs like Social Security, Medicare, and Veteran’s benefits to take a funding hit.
  • Oct. 23- $12 billion Social Security payment is due.
  • Oct. 24- $57 billion in maturing debt is scheduled to be rolled over.
  • Oct. 31- $6 billion dollar interest payment is due and $115 billion in maturing debt is scheduled to be rolled over.
  • Nov. 1- $55 billion in Medicare, Social Security, and military payments are scheduled to be made. 

The inability of our elected officials to negotiate a solution is beyond frustrating. However, the political grandstanding is becoming more of the norm, so don’t think this is the last time we will hear about a political rumble over the current or future fiscal situation in Washington. So what is going to happen with our budget/fiscal battle? We anticipate that an agreement will be reached…hopefully sooner than later. It could possibly include an extension that will give politicians more time to discuss and negotiate, or a short-term deal that will reopen the government and pay our debt obligations on time. The global economies all agree that it is in the mutual interest of ALL parties to solve these financial issues before events intensify. 

In spite of the current fiscal predicament, our economic outlook continues to be optimistic. We are hopeful that the fiscal debate in Washington will be successful and an agreement reached. Over the short-term, the success and length of the fiscal debate will dictate much of the volatility in the financial markets. The economic impact is not quite as certain. The longer the impasse lasts, the greater impact on economic growth.   Over the long-term, our outlook for the economy continues to be similar to previous quarters, and we believe overall economic growth will continue to advance but at a slow pace. We believe that job growth will continue to improve, but it will be a gradual and sometimes an arduous process. The improvement in the housing market is not as dramatic as we hoped, but activity remains favorable. Going forward, we believe that positive activity in the housing market will continue to drive economic growth. Despite the market reaching a record high during the quarter (again), the Price-to-Earnings forward (P/E) ratio is still lower than previous market highs. This is significant because in a low inflation and low interest rate environment, we believe this signals that individual stocks are not over bought at these levels. We do think the fallout from the fiscal debate will linger somewhat, but we do not anticipate a lasting impact on the economy. We expect the Federal Reserve to continue the current level of the asset purchase program through the end of 2013 and possibly consider a reduction in the pace of purchases in the first half of 2014. The Taper will happen…it is only a matter of time, but investors are aware it is coming and the initial impact should be minimal. Once there is more stability in the fiscal situation, we believe the economy will start to show signs of increased improvements in economic growth. 

 We have already identified one significant risk (U.S. fiscal debate) to the global economy. A default on the U.S. debt seems unlikely, but it is a possibility that would rattle world economies if it happens. Another homegrown risk is the timing and pace of the Fed’s actions later this year and in 2014. As leadership of the Federal Reserve prepares to change hands to Janet Yellen, an unexpected shift in the Fed’s decisions and policies could significantly change the rules of the game. There are also other risks in play that could pose a threat to the success of the global economy. The Syria issue is not totally resolved and could flare up again resulting in a U.S. military response. Continued strife in the Middle East could cause a global disruption in the oil supply and spike to oil prices. While the U.S. has been reducing its reliance on imported oil, a dramatic spike in prices would negatively affect the global economy. A reemergence of the debt crisis in Europe and slower growth in emerging markets could put considerable downside pressures on the global economy. Of course, the geopolitical or terrorist wild card is always in-play as an unforeseen event that could derail economic prosperity. 

As the end of the 2013 tax year approaches, it is time to get your tax planning strategy organized. Before you finalize your plan, you should be aware of the following changes that could affect your 2013 tax situation. See the summary below: 

  • Top income tax rate increased to 39.6% for taxable income over $400,000 (single) and $450,000 (married filing jointly).
  • The 2% reduction in Social Security payroll tax rates expired.
  •  Long-term capital gain and dividend tax rates are 20% (39.6% tax bracket), 15% (25% - 35% tax bracket), and 0% (10% - 15% tax bracket).
  • A new 3.8% Medicare Surtax will apply to net investment income for taxpayers with modified adjusted gross income above $200,000 (single) or $250,000 (joint filers).
  • The alternative minimum tax (AMT) income levels increased to $51,900 (single) and $80,800 (married filing jointly) for 2013.
  • Medical expense deduction (to be deductible) must first exceed 10% of adjusted gross income (AGI) floor (compared to a 7.5% threshold in 2012). A temporary exemption exists for those who are 65 or older back to the 7.5% threshold until 2016 (in the case of a married couple, only one spouse must qualify). Beginning in 2017, all taxpayers must use the 10% threshold.
  • The itemized deduction limitation was reintroduced for high income earners. It reduces otherwise allowable itemized deductions by 3% of the amount by which AGI exceeds the threshold amounts with some exceptions.
  • Mortgage insurance premiums may qualify as qualified residence interest (continued through 2013).
  • The option remains to deduct state and local general sales taxes (continued through 2013).
  • Estate and gift tax rates increase from 35% to 40%.
  • The annual exclusion gift amount increases to $14,000 from $13,000.
  • The estate tax applicable exclusion, gift tax lifetime exclusion, and generation-skipping tax (“GST”) exemption all remain increases to $5,250,000 for 2013. 

In summary, our investment philosophy remains based on the fundamentals. We believe that it is time---not timing---that matters most. That is why we believe the successful long-term investor is patient, weathers market swings, and adheres to a disciplined investment process that includes a diversified asset allocation strategy based upon a tolerance for risk and need for return. 

Your financial health is important to us, so please contact our office to schedule an appointment to discuss any changes to your financial position.  

In closing, I want to thank you for the opportunity of working with you and for your continued confidence and trust. Please contact me if you have any questions.  



[1]Source: U.S. Department of the Treasury. Daily Treasury Yield Curve Rates. http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield  
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