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Investment Letter

2nd Quarter 2013

The first half of 2013 provided a thrilling ride for stock investors as modest economic improvement fueled the financial market’s performance. May was a particularly strong month for domestic equities. The S&P 500 Index and the Dow Jones Industrial Average (DJIA) both set new all-time highs. The S&P 500 broke the all-time high record on May 21 to close at 1,669.16 points. The DJIA followed with its record breaking performance on May 28 when it closed at 15,409.39 points. Unfortunately, the equity markets were unable to sustain the upward momentum but did close the quarter on a positive note. 

The DJIA finished the quarter at 14,909.60 points with a total return of 2.92%, and the S&P 500 Index finished at 1,606.28 points with a total return of 2.91%. The chart below recaps the 2ndQuarter performance of other major indices:  

Asset Class

Index

2ndQtr. 2013

Total Return

2013 YTD

Total Return

Cash

ML Three-Month U.S. Treasury

0.02%

0.04%

U.S. Bonds

Barclays Intrmd-Term Treasury

-1.42%

-1.28%

U.S. Large Co. Stocks

S&P 500 Total Return

2.91%

13.82%

U.S. Small Co. Stocks

Russell 2000 Total Return

3.09%

15.86%

International Stocks

MSCI EAFE (net div.)

-0.98%

4.11%

Real Estate

DJ Select Real Estate Securities Total Return

-1.29%

5.66%



Source: Morningstar
 

According to the most recent data, the Federal Open Market Committee (FOMC) reported that the U.S. economy continued to expand at a moderate pace during the quarter. The FOMC also indicated that while unemployment remained elevated, labor market conditions improved. Moreover, they stated that the housing sector strengthened, business fixed investment advanced, and inflation remained below the Committee’s long-run objective.[1]

Gross Domestic Product (GDP) was revised downward to a final 1.8% from 2.4% for the 1stquarter. The final number was disappointing, but the cyclical sectors of the economy showed signs of strength with light vehicle sales and manufacturing leading the way. We are hopeful this will lead to stronger growth numbers for the 2ndquarter and second half of 2013. Additional economic data showed that inflation remains flat and is still below 2.0%, the unemployment rate remained at 7.6% in June, initial jobless claims declined, and the average hourly earnings of all private employees had its strongest year-over-year gain in almost 2 years. Lastly, it appears corporate earnings estimates for many S&P 500 companies will be favorable and profits will increase, but the 3rdquarter earnings season just started and estimates can change as the season advances.  

Once again, the Federal Reserve stated they would continue to follow 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 ($85 billion monthly pace) of Mortgage Backed Securities and Treasury securities. Despite the previous statements from the Fed that hinted at a policy change if economic conditions evolved, a timetable for action was never discussed until now. Chairman Bernanke dropped this bombshell at a press conference on June 19, 2013 when he hinted the Fed would probably begin to phase out Quantitative Easing (QE) later this year and end the phase out by the middle of 2014 ifeconomic conditions continued to improve. Investors knew that eventually QE would come to an end, but the shock of hearing the “Fed Taper” could start this year sent a wave of panic through the financial markets. The sharp selloff erased most of the quarter gains in equities and added further pressure to the fixed income market. As a result, high yield bonds took a significant hit and yields on 10-year Treasury notes rose past 2.5% for the first time in 22 months. Despite the overreaction by investors, there is some validity to their concerns. Eliminating the economic lifeblood for the economy is dangerous during a period of weak growth. The Fed has consistently assured investors that they are prepared to take the necessary steps to reduceor increasethe pace of further purchases to maintain the appropriate policy accommodations given current market conditions. Chairman Bernanke reiterated the same sentiment in his press conference by stating the following, “I would like to emphasize once more the point that our policy is in no way predetermined and will depend on the incoming data and the evolution of the outlook as well as on the cumulative progress toward our objectives. If conditions improve faster than expected, the pace of asset purchases could be reduced somewhat more quickly. If the outlook becomes less favorable, on the other hand, or if financial conditions are judged to be inconsistent with further progress in the labor markets, reductions in the pace of purchases could be delayed. Indeed, should it be needed, the Committee would be prepared to employ all of its tools, including an increase in the pace of purchases for a time, to promote a return to maximum employment in a context of price stability.”[2] 

Based on current economic data and the Fed’s commitment to maintaining its accommodative strategy, we believe the domestic economy is still headed in the right direction and have no reason to change our belief that slow growth will be the norm for the foreseeable future. If the Fed Taper starts later this year, the markets could be in for some increased short-term volatility. Long-term, we believe the Fed will be able to balance the dual task of keeping the domestic economy on track and decrease its balance sheet through a gradual reduction in the asset purchase program. The challenge for the Fed will be finding the point at which the economic spigot needs to be left on to keep the economy growing while not being wasteful and overfilling the bucket.  

The Fed Taper most likely will bring additional yield increases for the 10-year Treasury. As rates increase, investors can expect some short-term volatility, but we do not believe this will have a negative impact on the success of the economy over the long-term. In fact, we believe this is a signal of the Fed’s confidence in the economy. Reducing and eliminating the infusion of cheap money means that the economy can support its own growth without extraordinary help from the Fed. We are not alone in our belief that this is positive news for the domestic equities market. According to research by Birinyi Associates, Inc., the last nine periods since 1962, when the 10-year Treasury yield has moved at least 2 percentage points higher, the S&P 500 has posted an average annual gain of 10.8%.[3] 
 
 

Begin Date

Begin Rate

End Rate

10-Year Treasury Yield Change

S&P 500 Change

December 1962

3.80%

8.20%

4.40% pct points

10.60%

November 1971

5.70%

8.60%

2.90% pct points

-12.70%

December 1976

6.80%

13.70%

6.80% pct points

6.10%

June 1980

9.50%

15.80%

6.40% pct points

0.10%

May 1983

10.10%

14.00%

3.90% pct points

-9.50%

August 1986

7.00%

10.20%

3.20% pct points

19.30%

October 1993

5.20%

7.70%

2.50% pct points

-3.20%

October 1998

4.40%

6.80%

2.40% pct points

36.40%

June 2003

3.20%

5.20%

2.00% pct points

50.00%

Average

 

 

3.80% pct points

10.80%

Source: USA Today, Birinyi Associates 

Despite the immediate sell off that occurred after the Fed Taper timetable was announced, domestic equities have recovered. The +13.8% (total return) for the S&P 500 during the first half of 2013 (i.e., January-June) marked the 16thtime since 1990 that the index has produced a positive total return during the six month period. In the previous 15 times that the index was positive during the January-June period, the stock index followed up with a positive total return 12 times or 80% of the time. [4] We are very optimistic that the trend of positive stock performance will continue. 

Overall, 2013 has been a difficult year for the international economy. Fiscal crisis headwinds continue to slow Europe’s growth, and emerging markets are struggling due to falling commodity prices, currency instability, and China’s slower growth. As a result, our outlook for the international economy is not as strong as previous quarters. Going forward, we believe European and emerging markets will continue to struggle with slower growth, and thus performance in these asset classes will suffer. However, with more than half of the global equity market capitalization consisting of international stocks, it is still prudent to keep international stocks as part of a diversified portfolio despite the recent poor performance.  

There are a number of risks in play that could disrupt global economic prosperity. Continued strife in the Middle East could cause further spikes to oil prices. Financial turmoil from the ongoing debt crisis in Europe and slower growth in emerging markets could drag the global economy down further. Another domestic fiscal cliff situation caused by U.S. Government officials’ inability to compromise could undermine our domestic economic growth. The pace of the Fed’s actions or lack of actions could cause a domestic economic slowdown. Of course, the standard disclaimer regarding an act of terrorism or geopolitical uncertainty is always applicable. The Boston Marathon bombing back in April of this year was a stark reminder of this wild card.   

As I have often stated, 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 returnA portfolio that is weighted too heavily to one specific asset class or an individual security can be a very risky proposition if it falls out of favor. The chart attached to this letter illustrates the benefits of using a diversified asset allocation strategy. Individual asset classes can move from the best to the worst performer in the blink of an eye, but an asset allocation strategy with exposure to multiple asset classes may help to smooth out the highs and lows experienced in the financial market. As illustrated in the chart, the asset allocation strategy returned a cumulative total return of 117.7% over the 10 year period (2003-2012). Additional data shows that an investment in the S&P 500 Index produced a 98.6% cumulative total return, an investment in the Barclay Aggregate Bond Index produced a 65.7% cumulative total return, and an investment in Cash squeaked out a cumulative total return of only 18.2% over the same 10 year period.   Simply put, the chart helps to reinforce our belief that a diversified asset allocation strategy is a great method to manage portfolio risk while endeavoring to maximize portfolio returns.  

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. 
 


1Source: Federal Reserve System. 2013 Monetary Policy Press Release. 19 June 2013.  http://www.federalreserve.gov/newsevents/press/monetary/20130619b.htm
2 Source: Federal Reserve System. Media Center - FOMC Press Conference. 19 June 2013. http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20130619.pdf
3 Adam Shell, “Stocks Maintain Resilience Despite Fed’s Planned Pullback,” USA Today, July 10, 2013, 1B-2B.
4 Source: By the Numbers Research, 07/08/2013, “Six Down, Six To Go”, “And Then?”
 

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