The final three months of 2012 saw mixed results from the financial markets (although full-year returns were strong across nearly all asset categories). In the fourth quarter, domestic large-company stocks declined marginally, while smaller-company stocks and most overseas markets posted low- to mid-single-digit percentage gains. Real estate securities rose strongly, while commodity investments (including gold) fell modestly. Benchmark bond yields moved slightly higher (10-year U.S. Treasurys finished at 1.76%, compared to 1.64% at the end of September), but most categories of fixed-income investments still posted positive returns.
Within the U.S. market, the best three-month results came from companies in the Basic Materials, Capital Goods and Financial Services sectors; underperforming groups included Consumer Cyclicals, Energy and Technology. Small-company stocks outperformed their large-cap counterparts, reversing the pattern of the prior six months, while value-oriented names bested those in the growth category.
Benchmark Performance – Equities
|Fourth Quarter 2012||Last Twelve Months|
|S&P 500 Index||-0.4%||+16.0%|
|Large-Cap. Core Mutual Fund Avg. (Lipper)||+0.2%||+15.0%|
|Small-Cap Stocks (Russell 2000)||+1.9%||+16.4%|
|Non-U.S. Stocks (MSCI ACWI ex-U.S.)||+5.9%||+16.8%|
Benchmark Performance – Fixed Income
|Fourth Quarter 2012||Last Twelve Months|
|Barclays Intermediate Gov’t/Credit Index (taxable)||+0.3%||+3.9%|
|Intermediate Municipal Mutual Fund Avg. (Lipper)||+0.4%||+4.7%|
Despite gloomy headlines dominated by political dysfunction, 2012 was in fact a year of steady progress on a number of fronts important to investors. These improving trends were reflected in the performance of financial markets, nearly all segments of which provided better-than-average (and, we suspect, better than widely appreciated) twelve-month returns.
Perhaps no issue showed more improvement than the European debt saga and investor perceptions regarding the future of the region’s single currency. Following an anxious spring that saw markets swoon anew over problems in the Spanish banking system, an important corner was turned at June’s European Union summit, followed by European Central Bank president Mario Draghi’s dramatic July announcement that he and his fellow central bankers were prepared to do ‘whatever it takes’ to save the single currency. Peripheral-nation (most importantly, Spanish and Italian) bond yields, the exchange value of the Euro, and prices on major European stock markets all began to improve within a day or two of Draghi’s comments and essentially never looked back, finishing December at levels not seen since early 2011.
On this side of the Atlantic, the U.S. economy continued its gradual improvement – growing by better than 2% – in the fourth year of recovery following the 2008 financial crisis and ensuing recession. Important positive trends included a steady decline in unemployment, nine straight monthly gains in house prices and a nascent improvement in credit growth. With fiscal policy hamstrung by Washington gridlock, the Federal Reserve continued to play an unusually active economic role, holding to its policy of near-zero short-term interest rates, while suppressing longer-term yields via ongoing purchases of bonds (‘quantitative easing’). And despite worries that sluggish global growth would lead to disappointment, corporate profits notched another gain, with S&P 500 earnings increasing by around 3% for the year.
Meanwhile, the November elections passed with only moderate drama. Although many members of the ‘investor class’ were doubtless disappointed with the outcome, the world did not end (a feat repeated – to widespread relief – on December 21st, when the ancient Mayan calendar re-set without incident). Regardless of one’s political views, the election had the important effect of removing some of the uncertainty that dogged investors and business leaders for much of the year. December’s far-from-ideal ‘fiscal-cliff’ agreement, which further reduced uncertainty about future taxes, was another step in this market-friendly direction.
Market-moving developments elsewhere overseas were less dramatic than in Europe, but still largely favorable. In China, the first half of the year witnessed a worrisome economic slowdown, accompanied by political scandal and intrigue in the run-up to November’s once-a-decade leadership transition. However, key economic indicators seemed to stabilize in late summer and had begun to show improvement before yearend. Though the Xi Jinping era is in its infancy, many observers have commented approvingly regarding the new regime’s economic pronouncements as well as its early focus on combatting corruption within the Communist Party. Across the East China Sea, Japan’s December election yielded a strong majority for the pro-growth/pro-business Liberal Democratic Party, unleashing a yearend stock-market rally that capped the Nikkei’s best performance since 2005. Finally, flying somewhat below the radar, Mexico (also home to a late-year political transition) saw its economic and stock-market performance eclipse emerging-market heavyweights Brazil and India, both of which under-achieved in 2012.
As for the financial markets, 2012 should go into the record books as a year of few disappointments. Stock benchmarks representing both large and small U.S. companies gained more than 15%, while volatility (a measure of perceived risk) plummeted from levels that prevailed during much of 2011. Overseas returns varied, but indexes aggregating both developed- and emerging-market stocks gained nearly 20%, following two years in which they lagged their domestic counterparts. Non-equity, ‘hybrid’ investment categories also pulled their weight: high-yield corporate and emerging-market government bonds gained 15% to 20%, while real-estate securities rose between 15% and more than 30%, depending on geographic and sector exposure. Commodity investments, including gold, were a rare damp squib, though even these produced low- to mid- single-digit gains. Finally, investment-grade bonds posted yet another solid year, with 12-month returns running from the low- to-mid-single-digits for those of the highest credit quality to the 6%-8% range for lower-quality issues. All in all, 2012 turned out to be a very satisfactory year for investors willing to embrace a growth-oriented strategy in the face of the many worries that permeated the markets as the year began.
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 -0.4% S&P 500 total return?
|Fourth Quarter (October-December) 2012|
|+ Change in Earnings||+1.2%|
|+ Change in Valuation||-2.2%|
|= Total Return||-0.4%|
Our read: Paltry earnings gains seem at odds with the market’s strong (twelve-month) advance; if profit growth does not reaccelerate in 2013, stocks may labor to maintain last year’s gains.
After fiscal-cliff-avoidance euphoria subsides, the early weeks of 2013 seem likely to be taken up by wrangling over the important ‘details’ left unaddressed by the eleventh-hour denouement: raising the debt ceiling, tempering the indiscriminate spending cuts of ‘sequestration,’ and passing legislation to continue funding essential government operations. Of these, the debt-ceiling negotiation has by far the most potential to roil markets, as it impacts the government’s ability to make good on its financial obligations, not least making timely payments to Treasury bondholders. Investors will recall with distaste the near-20% stock-market swoon that accompanied the last confrontation over this issue (in the summer of 2011), which prompted Standard & Poor’s to down-grade its credit rating on U.S. Treasury debt.
If Congress and the White House can avoid generating too much early-year consternation – we concede this is a big ‘if’ – a calmer political landscape would allow investors to refocus on more fundamental matters that, on balance, appear likely to be supportive. Most important, the U.S. economy could be poised for a relatively good run. Consumer confidence, buoyed by rising real-estate and stock-market values (not to mention falling energy bills), has already been on the upswing for several months. If business sentiment, too, were to turn up following resolution of near-term fiscal challenges, we could see a burst of investment in new plants and equipment and a surge in hiring. The resulting improvement in the capital goods and jobs markets could generate a virtuous circle leading to accelerating growth as the year progresses. (Perhaps this is what Wall Street analysts see in their collective crystal ball: they currently project 2013 growth of around 13% for earnings of the companies that comprise the S&P 500.) At the same time, we believe the New Year will see increasing attention focused on two related, long-term domestic growth stories: energy independence thanks to cheap and abundant natural gas, on one hand, and a manufacturing/industrial renaissance with the potential to reverse the flow of outsourcing/ offshoring of the past 15-20 years, on the other.
Overseas, the view is a bit murkier. Growth expectations are fairly subdued for many important markets (e.g., Europe, Japan, Brazil, India), but this cloud comes with a silver lining: a low likelihood of major disappointment and room for an upside surprise or two. We are nevertheless mindful that unforeseen obstacles could reverse the recent easing of the European financial crisis, potentially unnerving investors who may have become complacent with regard to this issue. We will be eyeing European bank stock prices and sovereign credit spreads for warning signs of trouble ahead.
We will wager this is not the last time we mention the prospects for economic growth and social/political change in China as pivotal elements of the investment outlook. China is now the world’s second largest and, more importantly, most dynamic – i.e., changing – economy. At the same time, the country is home to a political system that is in many ways at odds with global developments of the past two-plus decades, and thus under continual pressure to change. Recent data and anecdotal reporting have been encouraging on both fronts – trends that, if sustained, would go a long way toward solidifying the investment picture for the year ahead. Conversely, any hint of a renewed slowdown or meaningful social upheaval could bode ill. As noted previously, the unusual opacity and sheer foreignness of the Chinese political and economic systems make handicapping these prospects a particular challenge, one to which we expect to devote increasing resources over the months (and years) ahead.
As we look ahead into 2013, we are impressed by nothing so much as the ‘new normal’ conditions prevailing in global financial markets: money-market funds yielding 0.10%, five-year CDs at 1.0%; 10-year Treasury Notes (as well as German Bunds and, until recent days, British Gilts) under 2.0%. We continue to believe that, compared to such instruments (which wags have dubbed ‘return-free risks’), the stocks of world-class companies like Emerson Electric, Procter & Gamble, Novartis and Intel – all with dividend yields above 3% – look like compelling long-term investments (even though they come with more short-term volatility). This conviction seems all the more valid now that preferential tax rates on dividends and capital gains have been locked in for most investors. Accordingly, we feel strongly that for investors able to tolerate shorter-term price fluctuations, a portfolio strategy that includes a substantial commitment to high-quality stocks continues to make eminent sense.
We welcome your comments and questions regarding our management of your investments, and wish you a happy and prosperous New Year.
Alan Purintun, CFA Robert W. Phelps, CFA
Principal & Portfolio Manager Principal & Portfolio Manager