Nearly all categories of financial investments produced solid returns in the July-September quarter.  Domestic large-company benchmarks gained more than 5%; overseas markets were mixed, with strong gains in Europe, and smaller gains and even a few losses on emerging-market bourses.  Commodity-related investments, including gold, generally out-performed common stocks, while real-estate securities provided mixed results.  Though benchmark bond yields were essentially unchanged (the 10-year Treasury ended the period at 1.64%, compared with 1.66% in June), improving credit-quality spreads resulted in another quarter of solidly positive fixed-income returns.

Among U.S. stocks, the best results came from companies in the Communication Services, Consumer Cyclical, Energy and Financial Services sectors.  Basic Materials, Capital Goods and Utilities names were weaker, on average.  Small-company stocks slightly underperformed their large-cap counterparts for a second-consecutive quarter.  There was little difference, on average, between growth- and value-oriented names.

Benchmark Performance – Equities

  Third Quarter 2012 Last Twelve Months
     S&P 500 Index +6.4% +30.2%
     Large-Cap. Core Mutual Fund Avg. (Lipper) +6.2% +27.5%
     Small-Cap Stocks (Russell 2000) +5.3% +31.9%
     Non-U.S. Stocks (MSCI ACWI ex-U.S.) +7.4% +14.5%


 Benchmark Performance – Fixed Income

  Third Quarter 2012 Last Twelve Months
    Barclays Intermediate Gov’t/Credit Index (taxable) +1.4% +4.4%
    Intermediate Municipal Mutual Fund Avg. (Lipper) +1.9% +6.5%



Following a modest spring setback, the post-2008 financial-market rally resumed in earnest during the third calendar quarter.  Despite a decelerating rate of global economic growth and increasing odds of four more years of divided government in Washington, investors welcomed positive developments in Europe and aggressive policy moves by global central banks.  The 6% rise in the S&P 500 Index brought the benchmark’s gain over the last 12 months to 30%.  Blue-chips finished the period less than eight percentage points below the all-time high (October 2007) and up over 100% from the March-2009 low.  Meanwhile, bond yields remained near the multi-decade lows established in the spring.

The European debt crisis took a decided turn for the better.  The German constitutional court affirmed the legality of the pan-European rescue fund; the European Commission took important steps toward a European banking union; and, most important, the European Central Bank announced its willingness to buy unlimited amounts of troubled-nation sovereign debt, with strings attached to appease German (and Dutch and Finnish) tut-tut-ers.  Spanish and Italian government bond yields fell dramatically, reducing the likelihood these nations would require Greece/Portugal/Ireland-like bail-outs.  While conceding that contentious political wrangling still lay ahead, many observers, including the editors of The Economist magazine, opined that recent developments would likely be seen in retrospect as an important turning point in the crisis.

On this side of the Atlantic, the Federal Reserve, too, provided investors with a pleasant September surprise.  With unemployment seemingly tethered to 8% and few signs of inflationary pressures in the economy, the Fed announced aggressive new policy measures, including a new round of asset purchases (‘QE3’; focused on mortgage securities), and another extension of its commitment to maintaining unusually low interest rates (through mid-2015).  While these measures may have a fairly muted impact on the ‘real’ economy (and are unwelcome news to many savers and retirees), they are likely to have the salutary effect of supporting higher valuations for most investment assets, including stocks, bonds and real estate.

What’s Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1)         Dividend Income (for three months this is the annual yield divided by four)

2)         +/- Change in Earnings per Share* (average for S&P 500 companies)

3)         +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

            * based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to give us the +6.4% S&P 500 total return?

Third Quarter (July-September) 2012
Dividend Income +0.5% +6.4%
+ Change in Earnings +0.3%
+ Change in Valuation +5.6%
= Total Return +6.4%

Our read
:  The increase in valuation reflects relief that the worst has been avoided in Europe as well as the effects of amplified easy-money policies by global central banks; the meager increase in earnings (and broadening slow-down in the ‘real’ global economy) augur caution going forward.

Supportive policy developments were accompanied by mounting evidence of a slowing global economy.  The ongoing Euro crisis has devastated both consumer and business confidence, consigning that region to what seems likely to be a protracted recession.  Meanwhile, Japan’s economy has down-shifted (again), following a post-earthquake growth spurt.  And as we noted when we wrote in July, the Chinese economy, too, appears to have entered a slower-growth mode, with recent figures pointing to expansion in the 7%-8% range, down from 10%+ prior to 2012.  Finally, here in the U.S., economic growth has slowed from a late-2011 rate of around 4% to just 1.3% in the April-June 2012 quarter.  Data printed during the third-quarter were characterized by a continuation of the welcome firming in the residential real-estate market, but a weakening in the manufacturing sector.  These developments combined to yield the lowest rate of global economic growth (estimated at 2.8% in the April-June quarter) since the final three months of 2009.

Sluggish end-markets and already-high profit margins appear to have begun hampering the earnings growth of U.S. public companies.  For the April-June quarter, the aggregate earnings of the companies that comprise the S&P 500 increased by only 2% compared to a year earlier.  The growth rate for all of 2012 is now pegged by Wall Street analysts at just 5%, down from an expected 8% in July.  And while the analysts are calling for a re-acceleration in 2013, weak underlying fundamentals may interfere.


Though a late-September rash of anti-austerity protests gives us pause, we suspect that recent developments in Europe have removed enough uncertainty from the situation there to allow investors to focus elsewhere in the weeks ahead.  And while the home stretch of the U.S. election campaign may yield a surprise or two, it seems likely that the two key issues going forward will be changes in the perceived trajectory of the global economy and post-election wrangling to avoid the so-called ‘fiscal cliff’ that promises draconian spending cuts and tax increases come January.

As we assess the prospects of the global economy, the most important variables will be the U.S. and China, as Europe and Japan seem fated to suffer lengthy periods of anemic growth (or worse).  Despite the weak (backward-looking) second-quarter G.D.P. report, the U.S. economy actually looks relatively sound to us over the near term.  Rising stock prices and an improving housing market are boosting consumer sentiment, while the job market, though far from robust, seems to have stabilized following a few anxious months earlier in the year.  The manufacturing sector has been buffeted by slowdowns in major export markets, but the latest purchasing-managers’ index showed a surprising improvement there as well.  Finally, we expect the election and resolution of the ‘fiscal cliff’ predicament (see below) to reduce the regulatory/tax uncertainty that seems to be holding back business investment and hiring.  While a return to 4% growth does not appear to be in the cards, the underpinnings look solid for steady if unspectacular progress going into 2013 – the fourth full year of the current economic expansion.

Assessing the vast and unusually opaque Chinese economy is always difficult, but currently the task is further complicated by the imminent once-a-decade political transition, and the fact that today’s challenges appear long-term/structural, rather than cyclical, in nature.  In the near term, some observers believe the authorities will be intensely focused on maintaining growth to facilitate a smooth political transition; others assert that the transition is distracting policymakers from implementing the kinds of decisive policy actions that have in the past propped up flagging growth.  Longer-term, China needs to make a structural transition to a more balanced economy, with increased consumer-sector demand supplanting historical (over-) reliance on exports and real-estate investment.  However, the transition will be gradual (measured in years if not decades), is likely to result in more uneven growth than experienced over the past 15 years, and seems certain to result in a meaningfully lower, but ultimately more sustainable rate of expansion in the world’s second-largest economy.

As we suggested in July, we expect the looming ‘fiscal cliff’ situation to cause substantially less financial-market turmoil than the debt-ceiling debacle of July/August 2011.  Though the details will be influenced by the election, we suspect that, at minimum, a short-term solution will avert most of the near-term tax increases and spending cuts, which, if allowed to transpire, would deal a sharp blow to a fragile economy.  We worry, however, that in dodging the near-term crisis, the nation’s longer-term fiscal predicament will remain unaddressed.  As bond-fund manager Bill Gross recently pointed out, a proper accounting for future entitlements shows the U.S. facing a ‘fiscal gap’ of more than 10% of GDP – meaning the nation needs to move toward a fiscal posture that improves the balance between revenue and spending by more than $1.5 trillion per year.  Early discussions regarding the ‘fiscal cliff’ reportedly envision a deal that would amount to around $400 billion per year; that is, roughly one-quarter of a long-term solution.  A lasting solution to the fiscal dilemma is mathematically feasible only if it includes both reforms that slow the growth of entitlements and tax changes that increase revenue; many mainstream economists suggest one dollar of increased revenue for every three dollars of reduced spending.  Unfortunately, this formula lies far outside the realm of current political reality, and we are not optimistic that will change meaningfully after November 6th.  Happily, bond investors are not yet expressing impatience – they remain willing to lend to the U.S. government for long periods at absurdly low rates.  Bill Gross thinks we have five to ten years to solve this difficult problem; we would like to see meaningful progress in the next four.  The longer this work is postponed, the greater the chance that the markets will someday impose a most unpleasant solution.

As we detail in the ‘What’s Changed?’ box above, the continuing market rally in the face of decelerating earnings growth is beginning to raise valuation (i.e., how much investors are willing to pay for future earnings).  Although the market’s price/earnings ratio calculated using current-year profits remains a reasonable 14-times (not much different from the historical average), other measures (such as the ‘cyclically-adjusted’ P/E and the ratio of market to replacement values) are becoming stretched, though they remain far below the extremes of 1999-2000 or 2007.  Valuation alone is unlikely to derail the current market advance, particularly as this rally has not been accompanied by a worrisome increase in investor euphoria or use of leverage. (To the contrary, this remains one of the least-trusted bull markets ever, with flow-of-funds data showing billions of dollars exiting stocks in favor of savings accounts and high-quality bonds month after month.)  However, the combination of rising valuation and slowing earnings growth is reason for caution, and we believe it is prudent to maintain a balanced portfolio posture that is not overly dependent on continued strong returns from stocks.

We welcome your comments and questions regarding our management of your investments

Alan Purintun, CFA                                                             Robert W. Phelps, CFA
Principal & Portfolio Manager                                          Principal & Portfolio Manager

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