Most categories of financial investments produced solid gains during the January-March period.  Domestic large-company stock benchmarks posted three-month returns of around +10%; overseas results were much more subdued (with the exception of Japanese stocks, which continued a strong rally that began in late 2012).  Real-estate securities notched high-single-digit gains, while the prices of most commodity-related investments fell modestly.  Benchmark bond yields moved slightly higher (the 10-year U.S. Treasury finished at 1.85%, compared to 1.76% at the end of 2012); most categories of fixed-income investments produced positive three-month results.

Among U.S. stocks, the best three-month results came from companies in the Consumer Staples, Health Care and Utilities sectors; the weakest sectors were Basic Materials and Technology.  Small-company stocks, on average, outperformed their large-cap counterparts, while value-oriented names bested those in the growth category.

 Benchmark Performance – Equities

  First Quarter 2013 Last Twelve Months
     S&P 500 Index +10.6% +14.0%
     Large-Cap. Blend Fund Avg. (Morningstar) +10.4% +13.0%
     Small-Cap Stocks (Russell 2000) +12.4% +16.3%
     Non-U.S. Stocks (MSCI World ex-U.S.) +4.8% +11.0%


Benchmark Performance – Fixed Income

  First Quarter 2013 Last Twelve Months
    Barclays Intermediate Gov’t/Credit Index (taxable) +0.3% +3.5%
    Intermediate Municipal Fund Avg. (Morningstar) +0.3% +4.5%



The post-financial-crisis bull market reached its fourth anniversary in early March, and both the S&P 500 and Dow Jones Industrial Average closed the period at new all-time highs for the first time since late 2007.  From its early-2009 nadir, the S&P 500 Index has advanced more than 130%, a compound annual rate of more than 23%.  Meanwhile, despite a mid-quarter spike that briefly pushed the 10-year Treasury above 2.0%, bond yields remained near ‘new normal’ multi-decade lows.

When we wrote to you in early January, the near-term outlook was dominated by the ongoing fiscal-policy stalemate in Washington.  While no long-term ‘grand bargain’ was reached during the quarter, policymakers surprised investors by successfully avoiding disaster in dealing with three distinct fiscal obstacles: the federal debt limit, across-the-board budget sequestration, and a looming government shut-down.  The markets’ calm reaction to this uninspiring series of ‘kick-the-can’ measures suggests investors are growing more comfortable with the near-term fiscal outlook, which has been improved not only by recently agreed tax increases and spending cuts, but also by the slow but steady economic recovery.

Following a sluggish final quarter of 2012, U.S. economic statistics released during the January-March period showed improvement on a number of fronts; particularly encouraging were readings on the real-estate and jobs markets, while measures of consumer confidence and spending as well as industrial production also firmed.   Data emerging from the Euro zone were bleak, however, with a number of downside surprises coming from ‘core’ economies like France and the Netherlands.  In Japan, though the Nikkei continued to rally, whether the new government’s policies will have much traction in the real economy remained to be seen.  Meanwhile, the once-a-decade political transition in China proceeded apace, and – following a mid-2012 soft-patch –  the world’s second largest economy seemed to have returned to the 7%-8% annual growth pace deemed necessary to maintain social cohesion.

Global monetary authorities continued to play prominent roles during the first quarter.  Though the European Central Bank didn’t have to purchase a single sovereign bond, the mere existence of its ‘Outright Monetary Transactions’ program to backstop the region’s debt and its explicit commitment to do ‘whatever it takes’ to preserve the Euro have clearly stabilized the situation there.  The Japanese market rally, which has seen the Nikkei surge by 40% since early November, has likewise been driven largely by the prospect of a new central bank team that has promised bold new stimulus measures designed to end the country’s 20-year battle with deflation.  And U.S. markets briefly swooned in February on the mere hint that Federal Reserve policymakers might be wavering in their commitment to easy money.

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 +10.6% S&P 500 total return?

First Quarter (January-March) 2013
Dividend Income +0.5% +10.6%
+ Change in Forecast Earnings +3.0%
+ Change in Valuation +7.1%
= Total Return +10.6%

Our read
:  The market’s advance is increasingly being driven by valuation expansion as investor uncertainty has ebbed.  While this phenomenon could have further to go, we would feel more comfortable if earnings growth were to accelerate during 2013.

Against a backdrop of meager global growth, American corporations were increasingly hard-pressed to increase profits.  The earnings of S&P 500 companies reported during the first quarter (covering the final three months of 2012) were essentially flat versus the year-earlier period; total profits for all of 2012 were likewise about the same as for 2011.[1]


Despite sluggish economies and lackluster earnings growth, global financial markets have benefitted greatly over the past year from a gradual, but cumulatively marked, reduction in uncertainty on a number of key fronts: the performance of the U.S. economy has become more robust and self-sustaining; the once-a-decade political transition in China has not untracked this important engine of global growth; European political and financial leaders have mustered the resolve to keep the monetary union intact; and even Washington policymakers have come to seem less liable to inflict fiscal disaster on the economy and markets.  Looking ahead, investment performance is likely to hinge partly on the future course of these salutary trends.  Even (or perhaps especially) if events proceed relatively smoothly elsewhere, investors will increasingly turn their gaze to the evolution of monetary policy as the global economy continues its slow climb back toward normal following the epochal 2007-2008 downturn.  Finally, earnings growth (or a continuing lack thereof) and evolving investor sentiment in response to new market highs may also garner more attention.

In our view, the prospects for the U.S. economy are as good as they have been in several years, although that is an admittedly low hurdle.  Data released in recent weeks suggest the economy grew by as much as 3.0% to 3.5% during the January-March quarter, a welcome improvement from the anemic 0.4% rate recorded in the final three months of 2012.  While expansion will be held back by the drag of federal budget sequestration during the next couple of quarters, ongoing recoveries in the real-estate and jobs markets (not to mention rising stock prices) bode well for continued gains in consumer spending, which accounts for some two-thirds of U.S. economic activity.  And although recent data emanating from American businesses have been more ambiguous, this sector is benefitting from reduced tax/regulatory uncertainty as well as a healthier U.S. consumer, though it is hamstrung by weak overseas markets.

Across the Pacific, both China and Japan are in the spotlight.  The new leadership in China is acutely attuned to keeping growth on track to avoid social unrest so early in its term.  Among developments we are monitoring are renewed efforts to avert a potentially dangerous bubble in the exuberant Beijing and Shanghai real-estate markets.  Meanwhile, the new government – and even newer central bankers – in Tokyo have elicited a remarkable response from Japanese investors with their promises of more effective policies.  After two decades of stagnation, it is easy to forget that Japan remains the world’s third largest national economy; a successful turn-around there would have a meaningful positive impact on the rest of Asia and indeed the global economy.

Highlighted by the recent Italian election fiasco and ham-fisted bailout of Cyprus, Europe’s debt/bank/currency crisis remains unresolved.  However, the financial markets’ rather indifferent reaction to these latest hiccups, in contrast to earlier episodes, suggests that investors now have a high degree of confidence in the inviolability of the currency union and the solvency of the region’s sovereigns and major banks.  While we wouldn’t rule out more turmoil, we suspect the worst of the Euro crisis has past, and investors will gradually turn their attention to the prospects for economic recovery.  On this score, 2013 is likely to be a write-off, but with much of the needed fiscal adjustments complete, 2014 could be considerably brighter.

With other worries seemingly on the wane, the focus of U.S. investor anxiety will likely shift to Federal Reserve monetary policy, which, through four-plus years of extraordinary accommodation, has provided important support to the bull market.  In mid- February, hints (later disavowed) that Fed officials might be contemplating an earlier-than-expected curtailment of stimulus produced a sharp drop in stock prices that could be a harbinger of increased volatility to come.  Chairman Bernanke is acutely aware of the importance of unambiguous communication (‘transparency’) as the Fed formulates and executes its ‘exit strategy;’ his worst nightmare: a reprise of 1994, when the Greenspan Fed failed to prepare investors for a rapid change in policy, resulting in the worst bond-market rout of the past 30 years.  To date, the Fed has put investors on notice that it will continue (and may even augment) its extraordinary policies until either a) the unemployment rate falls below 6.5% or b) expected inflation rises above 2.5%.  So far, so good; but given the extreme degree of accommodation since 2008, the Fed is sailing in largely uncharted waters.  And no matter how skillfully the Fed manages the exit process, investors surely will react quite differently if the Fed is forced to act due to an (unwanted) spike in inflation rather than a (welcome) acceleration of growth and surge in employment.  While at this point the unwanted-inflation scenario seems more remote, we will be carefully monitoring incoming data for signs that is changing.

As noted, earnings growth has all but ground to a halt in recent quarters.  Undaunted, Wall Street analysts are as optimistic as ever, calling for an improbable aggregate profit gain of more than 20% this year.  With underlying economic growth running at 5%-6% (including inflation) and profit margins at multi-decade highs (making further gains hard to come by), the actual figure is sure to be much less.  Market-cycle analysis by Wells Capital Management strategist James Paulsen has shown that incremental gains in mature bull markets are often driven by valuation expansion (i.e., an increase in what investors are willing to pay for earnings) rather than by robust earnings growth (which tends to occur earlier in the bull cycle).  The current cycle seems to be no exception: the 25% price gain over the past five quarters has been accompanied by essentially flat reported earnings.  The resulting rise in valuation has left the market modestly expensive by historical standards.  We have also begun (only begun) to see signs of investor complacency returning to the markets; after four years in the grip of doubt and fear, a growing share of investors are again heeding the siren-song of greed.  Neither valuation nor sentiment has yet approached worrisome levels – 2013 feels to us nothing like 1999 or 2007; but of late both gauges have been moving in the wrong direction.  A resumption of earnings growth is our hoped-for cure; barring that, a market ‘correction,’ perhaps spurred by wind of a change in Fed policy, could be a healthy development that sustains the bull market in its fifth year.

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

[1] ‘Flat’ earnings here refers to already-reported figures; 3% growth noted in the ‘What’s Changed?’ box below measures the change, during the past three months, in Wall Street analysts’ projections of earnings to be reported over the next four quarters.

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