1/4/13

2012 produced a continued “slow turn upward” in the U.S. economy.  This along with reduced fears of a hard landing in China and a glimmer of hope in Europe provided the building blocks of a very good year for equities in 2012.  Investors may end up remembering 2012 for what didn’t happen: Greece survived the year and did not exit the euro, China did not see a sharp decline in economic growth and the U.S. did not fall off the fiscal cliff.  The S&P 500 Index rose 13.41% in 2012, the Dow Jones Industrial Average gained 7.26% and the Nasdaq Index rose 15.91%.  The Barclays U.S. Aggregate Bond Index rose 4.22%. The Russell 2000 (small cap stocks) gained 16.35% and the MSCI Emerging Markets Index rose 15.15%.

The media “noise” impacts all of us and we continually have discussed focusing on fundamentals (earnings, economic data, etc.) rather than the often overblown “fear” from all the experts on T.V.  A report out recently from Bloomberg showed that approximately 80% of the Wall Street experts that made bold predictions in 2012 were wrong.  Fear sells ads so we know they will push things such as the end of the world if we go over the “fiscal cliff” or if the U.S. is downgraded due to the deficit issues.  We will be bombarded with more of the non-stop expert fear mongering in 2013, as investors we need to buffer the noise and focus on the hard data on the economy and earnings.

U.S. Economic Indicators Improved in 2012:

In the U.S. many key economic indicators improved in 2012. The year saw major rebounds in the housing market.  Low interest rates, improving employment and home prices that remain almost 30 percent below their July 2006 peak have drawn buyers back into the market. A limited inventory of houses for sale has helped push up prices.  Sales of existing homes increased in November to an annual pace of 4.9 million, up 2.3 percent from October and 11 percent from a year earlier. Permits to build new homes, a proxy for future construction, rose to a four-year high in November.  As home values rise, and more homeowners are freed from negative equity, we expect a continued slow transition to a more normal housing environment.

The Conference Board’s consumer confidence poll fell in December to 65.1 as fears over the fiscal cliff caused consumer expectations of economic conditions to become more reserved.  Consumer spending has been a major contributor for the U.S. economic recovery over the past three years.  The “new normal” argument whereby consumers were supposed to change behavior and dramatically increase their savings rate simply is not occurring in the U.S.  The consumer has improved their balance sheets by reducing debt but they still love to shop.  Low interest rates and stable gas prices could continue to support strong consumer spending in 2013.

The unemployment rate for December was 7.8% down 0.5% from January 2012 and 2.3% from three years before.  The December report showed that 155,000 jobs were created after adding 161,000 jobs in November.  In order to reduce the high unemployment rate we will need to see over 200,000 jobs created per month on average in 2013.

U.S. economic growth was weak in 2012 but may surprise to the upside in 2013.  GDP was 1.9% annualized in the first quarter of 2012, 1.3% in the second and according to the federal government’s third estimate, 3.1% in the third quarter.  Super Storm Sandy may actually provide a boost to 2013 GDP as clean-up and subsequent rebuilding efforts will bring increased economic activity.

The latest Consumer Price Index showed a 1.8% yearly gain.  Inflation is still within the Fed’s target range which should allow the Federal Reserve to continue to focus almost exclusively in 2013 on supporting low interest rates in an effort to improve unemployment.

Auto sales were a major contributor to the U.S. economic recovery in 2012.  Auto companies are expected to have sold 14.5 million new vehicles in 2012, according to Kelley Blue Book. That’s a 13 percent rise over last year and the highest number of sales since the financial crisis hit.

The “Fiscal Cliff” was averted (for now): 

Congress finally passed a patch work bill to avoid the fiscal cliff.  The terms of this bill includes:

— Tax rates will permanently rise to Clinton-era levels for families with taxable income above $450,000 and individuals above $400,000. All income below the threshold will permanently be taxed at Bush-era rates (there are no sunset provisions that will cause them to lapse).

— The tax on capital gains and dividends will be permanently set at 20 percent for those with income above the $450,000/$400,000 threshold.  The 15 percent rate will remain for those below these income levels as well as the 0 percent rate for those in the lowest income brackets.

— The estate tax will now be set at 40 percent, with a $5.12 million exemption. That threshold will be indexed to inflation.

— 401(k) participants can convert any money in their tax-deferred accounts to a so-called Roth 401(k) account, if their employer offers one, which can be withdrawn tax-free in retirement.

— The 2009 expansion of tax breaks for low-income Americans: the Earned Income Tax Credit, the Child Tax Credit, and the American Opportunity Tax Credit will be extended for five years.

— The Alternative Minimum Tax will be permanently patched to avoid raising taxes on the middle-class.

— The payroll tax holiday will be allowed to expire. Employees will once again pay 6.2 percent on the first $113,700 of earned income in 2013 (was 4.2 percent past two years).

— Two limits on tax exemptions and deductions for higher-income Americans will be re-imposed: Personal Exemption Phase-out (PEP) will be set at $250,000 and the itemized deduction limitation (Pease) kicks in at $300,000.

—The full package of temporary business tax breaks — benefiting everything from R&D and wind energy to race-car track owners — will be extended for another year.

— Federal unemployment insurance will be extended for another year, benefiting those unemployed for longer than 26 weeks. This $30 billion provision won’t be offset.

— A nine-month farm bill fix was included, averting the newly dubbed “milk cliff.”

Now the fight starts all over in Washington regarding the debt ceiling negotiations. This will likely consume the first part of the year, even if President Obama attempts to shift Congress’s attention to immigration reform and gun control.   If they can overcome their differences and enact a deficit reduction plan, it would be a very big catalyst for the market in 2013.

Europe is Standing Still…but Still Standing:

In the first half of 2012, economists were wondering if the European Union might be headed for a breakup. While German chancellor Angela Merkel and French president Nicolas Sarkozy affirmed their support for the EU, detractors felt that the strongest Eurozone economies were shouldering more than their fair burden in the prolonged, agonizing bailout effort. Prospects to keep the EU stable brightened when European Central Bank president Mario Draghi pledged to do “whatever it takes” to sustain the euro, with the ECB subsequently introducing an unlimited easing program paralleling our own QE3.  In the end, 2012 was a significant step forward to recovery for the Sovereign debt crisis in Europe.

China “engineering” a soft landing: 

The world’s second largest economy seems to have averted the “hard landing” that economists had predicted and is actually showing signs of accelerating after monetary stimulus largely in the form of infrastructure spending was authorized in 2012.  China’s new leadership will be transitioning the economy to address income inequalities and improving the livelihood of the emerging middle class.  Internal consumption should continue to become a larger part of the Chinese economy as wages rise.  These large scale changes will lead to uncertainty but we are optimistic that China will be able to grow their economy at the targeted 7.5% each year for the foreseeable future.  Stock valuations remain at an attractive 12.5 times earnings.  Lower raw material and energy prices should help corporate earnings in emerging markets heading into 2013.

Outlook for 2013:

While risks remain elevated due to the political infighting in the U.S., a fragile financial restructuring in Europe and geo-political issues in the Mid-East, there are several factors in place that could provide the backdrop for another good year for equities.

First, the “safe” money that still remains in low yielding money markets, CD’s and Treasury Bonds is estimated at approximately three trillion dollars.  The ten year Treasury bond currently is yielding 1.8% which is below inflation so in effect those investors are losing purchasing power every day they remain in these bonds.  Any sign of confidence should result in a rotation of the safe money into higher yielding investments in 2013.  The guidance from the Federal Reserve has been clear: the aggressive policies that began in 2008 will last into 2015. While Fed policy is complicated and has many implications, for investors it will likely have the intended effect of squeezing them out of “safe haven” assets and forcing them further up the risk curve into higher yielding investments such as dividend paying stocks.

Second, valuations of U.S. blue chip stocks remain attractive and dividend yields for many quality companies are higher than bonds.  Since 1935 the average price to earnings (P/E) ratio for the S&P 500 has been 16.9.  As we closed 2012 the S&P 500 traded at a (P/E) of 14.  The 12 month forward (P/E) is at 13.  Historically, when the ten-year Treasury bond yield is less than the 50 year average of 6.7% (it is 1.8% currently) the market’s average (P/E) ratio has been 23.6.

The average estimate for 2013 S&P 500 earnings is $105 which translates into a fair value of 1,774 – a 24% premium to the December 31, 2012 closing value of the S&P 500 index.  With all the political and macro-economic risks around the world it is impossible to predict market direction, but it is important to consider the fact that if confidence recovers and safe money starts to flow into stocks the market has room to move higher without running into resistance due to valuations.

Third, energy prices are likely to remain stable in 2013 due to exploration in the U.S. and concerns over global economic growth which may restrain energy demand.   U.S. oil supplies were 371 million barrels for the week ending Dec. 21 which was 15.6 percent higher than the five-year average.  For the same week, data showed U.S. oil production at nearly 7 million barrels per day, the highest since December 1993.  Thanks to the shale revolution in the U.S. we are on the verge of becoming a major energy supplier.

Fourth, political dysfunction in the U.S and Europe has tempered expectations that lawmakers can successfully come to an agreement on deficit reduction programs and economic growth initiatives.  If policy makers surprise investors with credible action on these issues in 2013 the markets would quickly move higher.  On the other hand, investors are getting somewhat conditioned to expect the drama and bickering of the politicians in Washington and Europe. Therefore inaction may not lead to a severe correction for the markets unless a catastrophe occurs.  In the U.S. business leaders want to see corporate tax reform and less red tape from regulations so they can have the confidence they need to make financial commitments for the long term.  We think the political risks are too high for both parties so they may actually get some things done in 2013, but not without turning it into a last minute crisis as they continue their partisan political gamesmanship.

Conclusion:

2013 will likely be very similar emotionally for investors as it was in 2012.  Volatility and political drama will almost certainly be present.  Our plan is to maintain our diversified portfolios and continue to focus on dividend paying companies as part of the core holdings.  We will benefit as the rotation of low yielding investments that are losing purchasing power over time moves into U.S. companies with solid balance sheets and good dividends.  There are several macro investment themes that are attractive at this time including banks, companies involved in natural gas development, agribusiness, mobile technology, and infrastructure.  We will be constantly looking for undervalued investments in these areas that fit in our overall asset allocation.