“In the business world, the rear view is always clearer than the wind shield.” – Warren Buffett
In our Market Outlook – 2012 we saw the new year as an opportunity for investors. From an investment perspective, we shunned more speculative equity investments and believed 2012 would give long-term investors the chance to purchase high quality equities at fair prices. For income, we suggested the need for greater diversification, including global holdings. For everyone, we recommended an investment plan. What follows is a look back at 2012 and our thoughts on 2013.
A Look Back – 2012 in Review
In 2012 the S&P500 was outstanding with a 13.41% gain for the year and global markets were mostly positive. Bonds had a decent year as well, with a 4.22% gain for the Barclays Aggregate Bond Index. Commodity prices were generally up but mixed, and the US Dollar was slightly weaker against a basket of foreign currencies. These results came during a period of political and economic stress in Europe, economic slowdown in China, and a contentious Presidential election in the United States.
The year started with a quickly advancing stock market. By the end of the first quarter the S&P 500 had advanced more than 12%, the Dow Jones Industrial Average (DJIA) was up 8.14%, and the NASDAQ had increased an impressive 18.67%.
After that run up over first quarter, the market became more volatile and only slightly positive over the final three quarters. During that time there were two major breakdowns in the market that gave every indication of a selloff becoming a bear market. The first was the market bottom in June and the second was in November. In both cases the market indices fell below the 200 Day Moving Average, a key marker in technical analysis. Both of these market breakdowns coincided with global economic issues.
From an investors perspective, it was not an easy year. After three years of a bull market we entered 2012 in a rather unsure investment environment that included risks from both the global economic environment as well as at the individual company level. These overriding issues resulted in a market that reversed trend a number of times over the course of the year.
In a year where the stock market is trending – up or down – it is fairly easy to make decisions on what to do. In a steady bull market you typically go long, keep your short position at a minimum, and lighten up your bond exposure. Think 2003 or 2009. In a bear market you typically stay heavy in cash, hold more bonds, maybe keep a good-sized short position, and hold only high conviction, long-term positions. Think 2008 into 2009 or 2000-2002. This year, however, was a completely different beast. Looking back a decade from now, we believe 2012 will look good on paper (because when is a +13% gain in the S&P 500 not a good thing?), even as it was a hard year to be an investor.
Figure 2 Courtesy of www.stockcharts.com Indexes are unmanaged and you cannot invest directly in an index.
Maybe not so ironically, it is the macro-economic factors that truly made it impossible to be fully invested in the stock market. Europe spent the year battling recessionary levels of growth while trying to work through debt and spending issues in the southern part of the continent; China was dealing with rising inflation and slower growth levels; Middle Eastern countries continue to have political issues; in the United States we came close to a debt ceiling debacle and had a contentious Presidential election. When you begin to look at individual companies, we generally have seen slower revenue and earnings growth across the board. In retrospect, the robust market averages appear to have increased with a gloomy economic background and slowing earnings growth.
The Year Ahead – 2013
Every year many big Wall Street firms come out and generally predict that the stock market will be up with some justification as to why this will occur. At the same time, the perma-bears once again come out with their doom-and-gloom scenario with justifications for the imminent collapse of equity prices. On the opposite side of the argument are the perma-bulls, who once again expect “huge upside gains.” The one thing they all have in common is that they will give you a target number for stock market indices and usually an interest rate target as well. As we have stated in the past, trying to predict where the market averages will be at the end of the year is a fool’s game to play, and one that plays out much the same every year. At Magellan Financial, we prefer to take a look at the underlying factors that will affect equity prices, credit and interest rates.
From a purely historical market perspective, the first year of the 4-year presidential cycle is typically the weakest. If you think about it, this is a rational situation and tied to the economy. In the two years leading up to an election, the economy is generally much better than it is in the first two years, as the occupant of the White House will work very hard to stimulate the economy before the election. Even a lame duck President has this motivation as he wants his successor to be from his political party. This doesn’t always work, but it is a factor worthy of consideration.
Very closely tied to the aforementioned is probably the biggest wildcard in 2013: will our political leaders in Washington D.C. get their act together and start addressing the issues that need to be resolved? We are past the presidential elections with essentially the same cast of characters. We have a situation where both parties will have a say in how we move forward. It is time for leaders on both sides to lead. If they decide to compromise on the issues that need to be addressed we believe politics can play a significant role in moving the economy forward. If, however, they choose to continue on as they have for the past few years, we will likely face crisis after crisis throughout 2013. Not good for “certainty;” not good for the economy; not good for the stock market.
One issue that does appear certain is the continued very low short-term interest rate stance of The Fed. In December Chairman Ben Bernanke was very clear in stating Fed policy of continued historically low short-term interest rates until the unemployment rate dips below 6.5% or inflation moves above their comfort zone. Purchasing U.S. Treasury Bonds and mortgage-related debt will continue on as well. While we do not expect change, if there is, the effects will be felt in both the equity and debt markets.
Beyond our borders, the issues of 2012 will continue on into 2013. Europe, still not economically sound, has been making progress on cleaning up their economic mess. China, under new leadership, is starting to verbalize the need for their economy to become more consumer-based. If policy backs up rhetoric the positive economic consequences would be felt all over the globe. The economies of Latin America have not received the attention of other regions, but continued progress will be positive for global growth. Political and military tensions continue on in the Middle East. From a market perspective, we could see gains in some or all of these regions as they move from bad to not-so-bad.
Of course, there will also be other unknown issues that will help determine the direction of the markets. With such a background we have no illusion to accurately predicting where the stock market indices or interest rates will end the year. What we can say for sure is that 2013 will be another interesting year for the market observer.
Heading into 2012, we observed the mixed bag of positive and negative factors and that the stock market is not rational but emotional by nature. It is now obvious that the positive factors won the day in spite of investor sentiment being less than positive. Even as mutual fund investors were investing heavily in bond funds and pulling money from stock funds, stock markets produced sizeable gains, as measured by the S&P 500; not the rational market one would expect. In our opinion, this situation can continue on for some time, but it cannot continue forever.
In 2013, we continue to see companies with solid balance sheets, benign inflation, and a low interest rate environment. Profits are at historically high levels as are corporate profit margins. Even with stock valuations being generally slightly greater than they were a year ago, markets, on the surface, do not appear to be overvalued.
According to Wells Fargo Advisors’ Economic and Market Forecast, S&P 500 earnings are expected to grow $5, from $103 in 2012 to $108 in 2013. This is good, not great, for a number of reasons. First, the growth rate has been decelerating and is the slowest it has been since 2009. Second, early forecast levels are continuously revised, more often than not lower. Finally, the previously mentioned wide corporate profit margins make it hard for individual companies to continue to grow profits. As more expansion is unlikely, companies must rely on increasing revenues while maintaining current margins. From a fundamental perspective, then, the markets are set up for modest gains in 2013, in line with the first year of a Presidential Market Cycle.
Fortunately or unfortunately – depending on how the year plays out – it is not quite that easy. Unlike most years, we are of the opinion that U.S. markets will be overly influenced by what is happening in Washington D.C. In more normal times, markets have embraced split government at the federal level. When neither party has full control over government policies, little of significance gets done; keeping government out of the way of the real economy. In challenging times, however, gridlock can quickly become a negative. Right now we are in challenging times where we need our leaders to make hard decisions of real economic consequence. If, when, and how these issues are resolved will have a direct effect on how the U.S. stock market performs in 2013.
In the best case scenario, we have a long-term solution to the issues surrounding tax rates, tax policies, spending levels, entitlement programs and the debt ceiling. From an economic perspective, as long as there is agreement on a long-term resolution, we believe individuals and companies will adjust and begin to move forward in short order. Will growth be cut short relative to where we would be if tax rates stayed exactly the same with exact same spending continuing? Yes. Any combination of pulling money out of the system with slightly higher taxes and slightly less spending will do that. Even so, we believe there will still be modest growth, likely a bit better than currently perceived, as corporate America will have reason to begin to think growing forward as opposed to playing defense.
What we do not want to see is a complete evasion of the true issues from our political leadership. For years we have heard the cry for certainty. More recently, corporate leaders have been out front in calling for a balanced resolution. A complete breakdown, a short-term solution, or another decision to keep the status quo for a period of time (we refuse to use the kick-the-can-down-the-road cliché) will likely cause an economic slowdown as the uncertainty continues. Corporate leaders are ultimately beholden to their corporate board of trustees and will make decisions based on what they determine best for their specific company. With no political resolution we expect these leaders to make the rational choice to continue to hold back on spending and hiring, hurting the economy as well as corporate profits.
Finally, both the U.S. markets and global markets will see an influence from economic developments in Europe and China. Coming into 2013 we see both as potential catalysts for equity markets. Europe, currently struggling with recession appears to be dealing with the underlying problems that have belittled their economy. China, under new political leadership, has been working aggressively to enable forward economic growth. We are positive on global equities in 2013.
Factoring all this in, Magellan Financial is looking for a modestly positive year for the U.S. stock market, with volatility picking up later in the year. We are positive on the Financial and Technology Sectors, as well as companies tied to infrastructure, both at home and abroad. Consumer companies with a foothold in the emerging economies are also an area of interest. We are less constructive on Utilities, Telecom, and Consumer Staples.
Stocks offer long term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
Investments that are concentrated in a specific sector or industry may be subject to a higher degree of market risk than investments that are more diversified. Technology and internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market.
Bonds and Income Investing
Assuming you are old enough to remember what a record is, we apologize for sounding like a broken record when discussing income investing. After three decades of declining interest rates, we can once again say we believe rates will eventually go up, but that time is not necessarily today. The Federal Reserve (The Fed) is targeting a very low interest rate environment through their statements and their actions. In 2012 The Fed expanded the asset purchase program to include a much more aggressive program of purchasing long-dated securities in an explicit attempt to push down the long end of the interest rate curve. Not surprisingly, it was a success. Our expectation is The Fed will continue on with its asset purchases for the indefinite future.
If you take a look at the chart of the 30-Year U.S. Treasury bond you can see the downtrend as well as the acceleration down in yields over the past few years. Amazingly, rates dipped below 2.5% on the 30-Year Treasury and below 1.4% this past summer. This is a great situation if you were in the market to refinance or get a car loan, but not so good for the investor who prefers bank issued CDs or U.S. Treasury bonds.
Figure 3 Courtesy of www.stockcharts.com
As a result, the income investor has been faced with choices that have not been ideal. With short-term interest rates pegged around 0%, finding a relatively lower risk investment that pays an attractive yield is a near impossibility. In order to get a greater interest rate, many investors have made the choice to invest in areas of the income market they would never consider in the past, high-yield (“junk”) corporate bonds being a good example. Other investors have reacted by investing in short-term bonds or bank-issued CDs, accepting very low returns while they wait for higher interest rates. In either situation, the investor is taking on risks they are likely not accustomed to or possibly do not understand.
With interest rates at such low levels, interest rate risk is the major risk faced by today’s income investor. Higher rates, on the surface, may sound like a nice situation for a bond investor. Unfortunately, the side effect of rising interest rates is lower bond values for existing bonds. In a rising interest rate environment it is possible for the value of your bonds to decrease at a rate that would be greater than the income received from the bonds held. With rates as low as the currently are it doesn’t take much price movement to turn positive income into potential negative returns.
We see three factors that could negatively affect bonds in 2013:
- Issues related to the U.S. Government Debt Ceiling – Congress and the President have to come to a resolution to the debt ceiling before the first quarter ends. If a stalemate occurs, forcing the U.S. Government to even partially default on payments, chaos could occur. In such a situation, it seems reasonable to assume investors will sell their U.S. Treasury Bonds, causing higher interest rates (and falling bond values).
- A steady increase in rates could cause small investors to sell their bond funds, causing interest rates to continue to rise in the face of Fed purchases. In recent years there have been heavy inflows into bond funds, contributing to the depressed yields available in the market. A reversal of this trend would likely have the opposite effect.
- The Fed decides to slow or stop its asset purchase program.
At Magellan Financial, we see modest gains for bonds as the best case scenario. We believe the income investor needs to have a portfolio that is more credit sensitive and less susceptible to interest rate movements, primarily due to the current low interest rate environment. Global diversification is more important than ever.
Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility.
While stocks generally have a greater potential return than government bonds and treasury bills, they involve a higher degree of risk. Government bonds and treasury bills, unlike stocks, are guaranteed as to payment of principal and interest by the U.S. Government if held to maturity.
Generally, CDs may not be withdrawn prior to maturity. CDs are FDIC insured up to $250,000 per depositor per insured depository institution for each account ownership category. CDs may be issued by out of state institutions.
Currencies and Commodities
In 2013 there are two factors that will drive the price of commodities – economic growth in China and the strength of the U.S. Dollar. According to many analysts, China has been turning the economic corner over the past few months and appears to be shifting to a new model of growth. The new political leadership has been making changes to the economic growth model that puts more emphasis on consumer driven growth in combination with economic reforms designed to stem corruption, expand the ability of banks to set interest rates, and expand economic transparency. Combined with the current industrial model, these changes should accelerate the Chinese economy, and thus, the volume of commodities needed to support the growth of infrastructure and production.
The other important factor in commodity pricing is the value of the U.S. Dollar against other global currencies. When the dollar is weakened, commodity prices in dollar terms increase. A stronger dollar would have the opposite effect. In 2012 the value of the dollar, as measured against a basket of global currencies remained flat. The U.S. Dollar Index started and ended the year around 80, with little fluctuation during the year, making the currency a non-factor in commodity pricing.
Buying commodities allows for a source of diversification for those sophisticated persons who wish to add commodities to their portfolios and who are prepared to assume the risks inherent in the commodities market. Any purchase represents a transaction in a non‐income producing commodity and is highly speculative. Therefore, commodities should not represent a significant portion of an individual’s portfolio.
Currency and foreign exchange trading is not suitable for all clients.
After a year with better than average equity returns and run of the mill bond returns, we enter 2013 with fewer immediate opportunities and potential pitfalls. Income portfolios that are not properly designed could suffer if we finally get rising interest rates. For equities, we are looking for positive returns, but do not expect the returns to come easy. Facing a domestic economy that is still growing below 3.0% it is hard to imagine robust corporate earnings as a driver of a runaway market. As a result, we still favor large, high quality companies that have solid business models and the ability to organically increase revenues. We favor the Financial and Technology sectors, as well as companies tied to infrastructure.
Diversification beyond the United States is important for both bond and equity investors. While global growth will be driven by the emerging economies, the developed countries of Europe and Japan appear favorable and offer investment opportunities. As always, we suggest global investments through diversified products like Exchange Traded Funds (ETFs), mutual funds, or individual fund managers.
After solid gains in 2012, the early months of 2013 are an opportunity to evaluate your investment plan and adjust your portfolio accordingly. Specific asset allocation should be built off your Envision® Plan[i] and future income needs. With equities currently outperforming bonds by a wide margin, at the very least, adjusting your asset allocation for balance and diversification is appropriate. In many cases, however, the gains of 2013 will help the prudent investor to seek to reduce portfolio risks while maintaining their retirement goals.
Past performance does not guarantee future results.
Exchange Traded Funds seek investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched. Exchange Traded Funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost.
Technical analysis is only one form of analysis. Investors should also consider the merits of Fundamental and Quantitative analysis when making investment decisions.
Asset allocation and diversification do not ensure a profit or protect against a loss in a down market.
Margin borrowing may not be suitable for all investors. When you use margin, you are subject to a high degree of risk. Market conditions can magnify any potential for loss. The value of the securities you hold in your account, which will fluctuate, must be maintained above a minimum value in order for the loan to remain in good standing. If it is not, you will be required to deposit additional securities and/or cash in the account or securities in the account may be sold.
Indices are unmanaged and you cannot invest directly in an index. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value. The Dow Jones Industrial Average is an unweighted index of 30 “blue-chip” industrial U.S. stocks. The NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market. The Barclays Capital U.S. Aggregate Bond Index is composed of the Barclays Capital U.S. Government/Credit Index and the Barclays Capital U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities.
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
Jonathan D. Soden Robert I. Cahill
Partner Managing Partner
Ann L. Drescher Jeffrey T. Bogert
 Source: Investment Company Institute (https://www.ici.org/)
[i] Envision® is a registered service mark of Wells Fargo & Company and used under license. Wells Fargo Advisors Financial Network, LLC is a registered broker-dealer and a separate non-bank affiliate of Wells Fargo & Company. ©2011 Wells Fargo Advisors Financial Network, LLC. All rights reserved.