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Investment Letter

1st Quarter 2013

The emergence of warmer temperatures means it is time to awaken from our winter hibernation. Mother Nature’s magic is starting the process of rebirth, and Old Man Winter’s icy grip on the weather is finally fading. Welcome back Spring!  

The U.S. equity market skipped the winter hibernation during the first quarter of 2013 and delivered impressive returns for investors. It was commonly believed the ongoing concern over the fiscal cliff situation and the federal budget sequestration would contribute to a slow down or reversal of gains in the U.S. equity markets. In response to these worries, Congress passed a bill that lessened the impact of some of the budget cuts and averted the possibility of a government shutdown. Fortunately for investors, it appears the influences of short-term fiscal policy changes on the equity markets were slightly overstated.     

The Dow Jones Industrial Average (DJIA) continued its record breaking trajectory upward and increased by 1,475 points during the 1stQuarter to end at 14,578.54 points. The positive 11.94% return by the DJIA was its best first quarter performance since 1998, and the seventh overall largest quarter return since the 1stQuarter of 2000 (total of 53 quarters). 

The chart below recaps the 1stQuarter performance of other major indices: 

Asset Class

Index

% Change

1stQtr 2013

Cash

ML Three-Month U.S. Treasury

0.02%

U.S. Bonds

Barclays Intrmd-Term Treasury

0.14%

U.S. Large Co. Stocks

S&P 500 Total Return

10.61%

U.S. Small Co. Stocks

Russell 2000 Total Return

12.39%

International Stocks

MSCI EAFE (net div.)

5.13%

Real Estate

DJ Select Real Estate Securities Total Return

7.04%



Source: Morningstar
 
The S&P 500 Index also broke a record by closing up 143 points for the quarter to finish at an all-time high of 1,569.19 points. The index eclipsed the previous high from October 2007 after flirting with the milestone before the quarter ended. The 10.61% 1stQuarter total return for the S&P 500 marks the 16thtime in the last 25 years the index has enjoyed a double digit return during a calendar year quarter.   The chart on the following page illustrates the dramatic ride the index has been on since the October 2007 record high and the new record high set on March 28, 2013. The first 17 months of this period illustrates just how brutal it was for those who were invested in the S&P 500 as the index lost over 888 points or a percentage decline of 56.78%. It took over 48 months from the March 2009 low to break the record high again.  

The table below provides historical downturn and recovery data for the S&P 500 Index dating back to 1926.  

Downturn

Months

% Loss

Recovery

Months

Sept 1929 - Jun 1932

34

-83.4%

Jul 1932 - Jan 1945

151

Jun 1946 - Nov1946

6

-21.8%

Dec 1946 - Oct 1949

35

Aug 1956 - Feb 1957

7

-10.2%

Mar 1957 - Jul 1957

5

Aug 1957 - Dec 1957

5

-15.0%

Jan 1958 - Jul 1958

7

Jan 1962 - Jun 1962

6

-22.3%

Jul 1962 - Apr 1963

10

Feb 1966 - Sep 1966

8

-15.6%

Oct 1966 - Mar 1967

6

Dec 1968 - Jun 1970

19

-29.3%

Jul 1970 - Mar 1971

9

Jan 1973 - Sep 1974

21

-42.6%

Oct 1974 - Jun 1976

21

Jan 1977 - Feb 1978

14

-14.3%

Mar 1978 - Jul 1978

5

Dec 1980 - Jul 1982

20

-16.5%

Aug 1982 - Oct 1982

3

Sept 1987 - Nov 1987

3

-29.6%

Dec 1987 - May 1989

18

Jun 1990 - Oct 1990

5

-14.7%

Nov 1990 - Feb 1991

4

Jul 1998 - Aug 1998

2

-15.4%

Sep 1998 - Nov 1998

3

Sep 2000 - Sep 2002

25

-44.7%

Oct 2002 - Oct 2006

49

Nov 2007 - Feb 2009

16

-50.9%

Mar 2009 - Mar 2012

37

Source: Ibbotson

The recovery from the most recent downturn is over, but the upward movement in the S&P 500 index continues as the current bull market (born on March 9, 2009) celebrated its 4thbirthday. The stock market’s resilience over the past four years has been impressive considering the mountain of obstacles it overcame. From the near collapse of the financial system, to record oil prices, government and central bank bail-outs, a severe debt crisis in Europe, a U.S. credit rating downgrade, fiscal and political gridlock, double dip recession fears, and numerous natural disasters…it is truly amazing that the bull lasted as long as it has. This bull market’s spirit to survive has led many on Wall Street to develop the opinion that this is the start of a secular or long-term bull market despite the fact that history shows us the average lifespan of a bull market is 56 months. Regardless of the current bull’s age or the gray around his horns, it is highly possible that the positive movement in the market is far from being over as long as the Federal Reserve has anything to say about it. 

Recent data released by the Federal Reserve in the Monetary Policy Report and the minutes from their March 2013 meeting confirmed that the U.S. economy continued to expand at a moderate rate after the slowdown during 2012. They also suggested that labor market conditions have improved, but the overall unemployment rate remained elevated.  

Additional positive news for the economy during the 1stQuarter included the following: 

  • Manufacturing production increased
  • Household spending and business fixed investment advanced
  • Housing sector activity strengthened
  • Long-run inflation remained stable
  • Trade deficit narrowed

The Federal Open Market Committee (FOMC) reiterated its commitment to their current accommodative monetary policy, keeping the Fed Funds rate low, and continuing their purchase program ($85 billion monthly pace) of Mortgage Backed Securities and Treasury securities. As with the last few statements from the FOMC, the Fed provided specific circumstances that would signal a possible change in their accommodative monetary policy. The two important markers are the unemployment target of 6.5% and an inflation target of 2.5%. However, Chairman Bernanke recently indicated that the Fed may begin to vary the pace (decrease purchase volume) of the asset purchases in the coming months to respond to changing economic conditions, but would reserve the right to increase purchases again in the event the economy starts to weaken. 

The improvements in job growth and the housing sector played a major role in the market’s success during the first quarter. While economic growth projections remain (mildly) positive, the concern is that the economic numbers are becoming more mixed and may not be able to sustain an advance in economic activity. Profits are not as strong as previous quarters, the unemployment rate is still high despite some improvement, and the effects of tax increases and tighter fiscal policy will get stronger the deeper we go into 2013. 

Given the current economic data, our outlook for the economy is not as sanguine as previous quarters. We are optimistic for many sunny days in the 2013 economic weather forecast, but we realize there is always a threat for clouds and a stray thunderstorm. Specifically, we believe the domestic economy needs further improvements in the housing sector and job growth to finally break out of this period of low growth. Until this happens, investors can expect low domestic economic growth for the foreseeable future. Slower growth would seem to adversely affect the stock market, but this market keeps hurdling every obstacle it faces. We are uncertain as to the direction of the market because no one can accurately predict the final outcome. However, we are optimistic that the stock market can continue to advance. On a relative basis, stocks are still cheap. The two previous market highs for the S&P 500 (March 24, 2000 at 1,527 points and October 9, 2007 at 1,565 points) had higher forward Price-to-Earnings (P/E) ratios than the current market high on March 28, 2013 at 1,569 points. This is significant because in a low inflation and low interest rate environment, we believe this signals that individual stocks are not over bought despite the index level being at an all-time high. We also believe there is still additional slack in the economy that can support further growth. Household net worth has improved as consumers are paying down their debts, and vehicle sales, housing starts, private inventories, and capital goods orders are either below or hovering at their long-term averages.  

Overall, the global economy is looking better. Growth seems to have turned positive for many developed countries during the first quarter of 2013. Economic activity remains weak in the Eurozone due to the ongoing Sovereign Debt saga, and reports indicate that economic activity in developing and emerging markets are getting stronger.  

There are still many global and domestic risks that could derail the economic prosperity train. The financial turmoil in Europe is an ongoing issue that doesn’t seem to have a quick fix. Higher oil prices have climbed back onto the radar screen after the recent spike in price to over $95 per gallon during the first quarter. Credit conditions remain challenging, and the fiscal drag from the Sequester and tax increases could have a negative impact on economic activity in the coming months. The geopolitical or terrorist wild card is always in play and more appropriate lately as North Korea has been flexing its muscles in a way that many hope is just simple posturing instead of a reckless prelude to war. 

Given all the risks and current market conditions, 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. 

As I have often stated, our investment philosophy remains based on the fundamentals. We believe that it is time---not timing---that matters most. History shows us that turbulent times are unavoidable, but the prudent investor is rewarded by staying the course. See the following examples:  

MISSING THE BEST AND THE WORST - The total return for the S&P 500 was a gain of +16.0% (total return) in 2012. If you missed the 3 best percentage gain days last year, the +16.0% gain falls to a +8.4% gain. If you avoided the 3 worst percentage days last year, the +16.0% gain rises to +24.5% gain.[1] Furthermore, a hypothetical $1 investment in stocks invested at the beginning of 1993 grew to $4.85 by year-end 2012. However, that same $1 investment would have only grown to $1.79 had it missed the 12 best months of stock returns. One dollar invested in Treasury bills over the same 20-year period resulted in an ending wealth value of $1.81. Summarizing, an unsuccessful market timer, missing the 12 best months of stock returns during this period, would have received a return lower than that of Treasury bills[2 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.  

WILLIAM HOWARD & CO. FINANCIAL ADVISORS, INC.
 
 


 

1BTN Research 1/1/2013
2Principia® Presentation and Education, Principles of Investing Module, Dangers of Market Timing 1993–2012

 

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