Continuing an advance dating from last November, U.S. stocks added another modest gain during the April-June quarter, capping their best first-half calendar year since 1999.  However, most other categories of financial investments encountered significant volatility during the period and registered modest to substantial losses.  Worst hit were emerging-market equities, commodities (including gold) and real-estate investments (REITs).  Perhaps the least anticipated losses came in the bond market, as benchmark yields surged (the 10-year Treasury closed June with a yield of 2.48%, up from just 1.85% at the end of March) and credit spreads widened.  As a result, most multi-asset (‘balanced’) investment portfolios recorded modest three-month losses.

Among U.S. stocks, the best three-month results came from companies in the Financial Services, Consumer Cyclical, Technology and Health Care sectors; relatively poor returns came from Basic Materials, Capital Goods, Utilities and Consumer Staples companies.  For a second consecutive quarter, small-company stocks slightly outperformed their large-cap counterparts, while value-oriented names bested those in the growth category.

Benchmark Performance – Equities

  Second Quarter 2013 Last Twelve Months
     S&P 500 Index +2.9% +20.6%
     Large-Cap. Blend Fund Avg. (Morningstar) +2.6% +23.8%
     Small-Cap Stocks (Russell 2000) +3.1% +24.2%
     Non-U.S. Stocks (MSCI World ex-U.S.) -1.4% +17.6%


Benchmark Performance – Fixed Income

  Second Quarter 2013 Last Twelve Months
    Barclays Intermediate Gov’t/Credit Index (taxable) -1.7% -1.5%
    Intermediate Municipal Fund Avg. (Morningstar) -3.0% -0.2%



The first six weeks of the April-June quarter saw a continuation of the low-volatility stock-market advance of the prior five months.  The corporate earnings season was largely uneventful, while fresh domestic economic data seemed to indicate a sustainable albeit tepid recovery.  By May 21st, the S&P 500 Index had gained another 6% above the all-time high reached on March 31st.  Meanwhile, bond yields meandered first modestly lower then somewhat higher, but the 10-year Treasury remained comfortably below 2%.

Then, on May 22nd, the Federal Reserve published minutes from its April meeting, a seemingly innocuous development that ushered in a major change in the markets.  The minutes included hints – later confirmed by Chairman Bernanke following the June meeting – that the Fed was beginning to contemplate a schedule for reducing – or ‘tapering’ – the monetary stimulus it has been providing to support the economy, which has also been an important prop to the financial markets.   Whether this development actually represented a change in Fed policy/outlook is still being debated (numerous Fed officials have clearly stated in recent days that there has been no change in policy).  Nevertheless, financial market participants were clearly surprised and inclined to interpret the news as a signal of an impending shift in policy direction – the first in over five years.

The results in the markets were fairly dramatic:  U.S. stock market indices dropped around 6% from their May highs; emerging-market equities shed more than 10%; measures of market volatility (a gauge of investor uncertainty and perceived risk) surged; and the dollar rallied strongly against most foreign currencies.  In the bond market, losses were the worst since 1994, with the damage spread far and wide: the Barclays Aggregate Government/Credit Index fell 2.3%; bond guru Bill Gross’s PIMCO Total Return Fund dropped 3.7%.  Meanwhile, an unprecedented $80 billion flowed out of bond mutual funds during June, reversing nearly three-quarters of the inflows from January through May.

Of note, the May-June swoon was the U.S. stock market’s first 5% dip of 2013.  The recently smooth advance stands in contrast to the earlier part of the post-2008 bull market: the S&P 500 experienced fifteen declines of 5% or more during 2009-2011, but only three since the beginning of 2012.

Domestic economic news during the quarter was generally solid, but far from robust.  Continuing the pattern of recent quarters, the consumer side of the economy was fairly buoyant, while industrial/business sectors were sluggish.  Perhaps the best news came from the real estate sector, where a steady advance over the past 15 months resulted in a year-over-year average price gain of more than 12% – the best reading since 2006.  Not coincidentally, consumer confidence reached a five year high, though income gains were scant and the unemployment rate remained stubbornly high.  Although first-quarter GDP growth came in at a relatively meager +1.8%, most observers were favorably impressed with the economy’s resilience in the face of government spending cuts and tax increases.   Corporate profits reported in April/May (covering the first three months of the year) were roughly in-line with subdued expectations, showing a growth rate of about +6% versus the same quarter last year.

Outside the U.S., economic developments were mixed.  In Europe, gauges of consumer sentiment and manufacturing activity appeared to be bottoming, suggesting the region’s recession – which is approaching its second anniversary – may be nearing an end.  Meanwhile, the Chinese economy continued to slow, with first-quarter GDP growth falling below 8% and recent purchasing-managers surveys showing a modest contraction in industrial activity.   More unsettling, the Chinese financial sector was convulsed in late June by a brief but acute credit crunch, orchestrated by the Chinese central bank in an effort to wring speculative lending out of the system’s largely unregulated ‘shadow banking’ sector.  Finally, the ‘Abenomics’ experiment in Japan remained a work in progress.  First-quarter GDP growth of +4.1% raised more than a few eyebrows, and recent readings suggest deflation may be ebbing.  The Nikkei stock average surged some 25% through mid-May (at which point it had risen more than 80% since late-October) before stumbling into quarter-end some 12% off its recent high.

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 +2.9% S&P 500 total return?

Second Quarter (April-June) 2013
Dividend Income +0.5% +2.9%
+ Change in Forecast Earnings +2.7%
+ Change in Valuation -0.3%
= Total Return +2.9%

Our read
:  A rare period where the market gain was almost entirely explained by earnings growth and dividends.  Given the rise in bond yields, the relatively small decline in valuation may leave the market vulnerable to continued volatility, unless we see renewed vigor on the earnings front.


As we have noted in past letters, the unfolding saga of the Fed’s ‘exit strategy’ following five years of extraordinary monetary policy measures seems sure to be an important factor in the near-term course taken by the markets.  Other important influences will likely include developments in the Chinese economy and financial sector; clues regarding the staying power of Abenomics in Japan; and how the U.S. housing market copes with higher mortgage rates.  Still on the radar (but off the front burner?): Euro Zone banks/bond markets; Washington dysfunction; and popular unrest (or worse) seemingly everywhere (e.g., Turkey, Brazil, Egypt, China’s western Xinjiang province – not to mention Syria).  Should be sufficient to keep us busy.

It’s a mystery to us what the Fed was trying to accomplish by initiating a detailed discussion of its planned ‘exit strategy;’ but surely they did not wish to see long-term bond yields – which drive mortgage rates – move dramatically higher.   Chairman Bernanke’s June 19th comments clearly indicated the Fed intends to begin ‘tapering’ its stimulus only if the economy grows at (or above) the pace predicted by the Fed’s internal forecasts (which have throughout the current recovery been far too optimistic).  In fact, Chairman Bernanke seemed to go out of his way to warn investors that if they interpreted his remarks as a fixed timetable for removing accommodation, they would be mistaken.   Moreover, he took pains to reiterate his desire to see stimulus removed very deliberately and in stages over a period of years.  The April meeting minutes also indicated a growing majority on the Open Market Committee expects short-term interest rates to remain near zero into 2015.

In hindsight, it seems clear that despite explicit caveats, warnings and reassurances, investors nonetheless concluded the Fed would not have chosen to begin discussing an exit if it had not meaningfully upgraded its assessment of the economy.  And with yields at historic lows, many investors – particularly hedge funds and investment banks using substantial leverage (borrowed money) to enhance otherwise miniscule returns – were not about to wait around and get caught on the wrong side of a surprise increase in yields like that which occurred in 1994.  The ensuing rush for the exits probably resulted in at least a modest over-shoot in terms of yields; many observers expect rates to drift somewhat lower in coming weeks.

As we look ahead, we are encouraged in that any putative change in Fed outlook (as well as a reasonable interpretation of how markets reacted) indicate an improving U.S. economy and continued low (or even falling) inflation.  Inflation-protected Treasury notes (‘TIPS’) suffered some of the worst price declines within the bond market in the April-June quarter – the opposite of what would occur if investors were apprehensive about looming inflation.  The recent drubbing taken by gold (down 23% on the quarter) also jibes with a low-inflation outlook.  If recent developments indicate 1) a strengthening U.S. economy; 2) subdued inflation; and 3) a Fed intent on being very deliberate when it eventually returns monetary policy to normal, we could be looking at an extremely favorable near-term investment environment.   Many commentators believe the Fed’s growth forecast (rising to around 2.5%-3%) remains too optimistic; if data come in softer, investors may come around to the view that the actual ‘tapering’ schedule will be even more drawn out than the Fed has suggested.  In any case, recent turbulence has likely reduced speculative excesses and restored at least a degree of value to the bond market: we are now being offered high-quality municipal bonds maturing in five to seven years with yields around 3% (which equates to more than 4% on a taxable-equivalent basis); in early May we were hard-pressed to get much above 2%.

An area where we expect to focus additional analytical effort in coming weeks is emerging-market investments.  Emerging-market stocks have dramatically underperformed their developed-market counterparts since the end of 2011: over that 18-month period the S&P 500 gained almost +32% and the EAFE developed-markets index rose +22%, while the BRICs (Brazil, Russia, India, China) collectively declined by -2%.  This divergence erased the performance advantage accrued by emerging markets in the wake of the 2008 financial crisis (although they still hold a comfortable lead going back to 2002-2007).  Poor recent performance has been driven by slowing growth in China and its impact on other markets dependent either on trade with China (e.g., South Korea) or on the prices of commodity materials that have fallen due largely to waning Chinese demand (e.g., Brazil).  The performance gap has lately been exacerbated by the surprising strength of the dollar (which results in currency-translation losses) and a rerouting of ‘hot money’ investment flows in favor of asset categories with improving fundamentals (such as Japanese and U.S. stocks).

Does the recent performance divergence make emerging markets a ‘buy,’ or is it a harbinger of another ‘emerging-markets crisis’ along the lines of 1997?  Recent tremors in the Chinese banking sector surely bear close scrutiny, as does potentially worrisome currency weakness in countries with dollar-denominated corporate or sovereign debt.  Nevertheless, much has changed for the better since 1997, and we feel emerging-market stocks possess several characteristics that make them compelling long-term growth investments: high rates of underlying economic growth; low levels of fiscal deficits/debt; generally improving financial accounting, corporate governance and respect for the rule of law (though these remain areas of concern); and a still-low level of ownership by developed-world investors relative to emerging markets’ growing economic clout.  While we expect these markets will continue to be more volatile than their developed-economy counterparts, we think that after their recent ‘rerating’ they offer an attractive reward/risk trade-off, and are inclined to use continued weakness as an opportunity to establish and/or add to portfolio holdings.

We hope you are enjoying the summer; please let us know if you have questions or comments about our management of your investments.

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


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