The July-September period saw strong performance by nearly all categories of financial investments, adding to already-solid year-to-date returns.  Domestic large-company stocks rose more than 5%, on average, while those of smaller U.S. firms gained almost twice as much.  Robust showings in key European and developing-world markets also resulted in double-digit returns for non-U.S. stock benchmarks.  Meanwhile, gold bounced more than 7%, and other commodities notched smaller though still meaningful gains.  While many real-estate securities saw small declines, those with a timber/forestry focus rose substantially.  And following a volatile spring, bond markets were relatively calm (the 10-year Treasury yield finished the quarter at 2.61%, up from 2.48% at the end of June), allowing most categories of fixed-income investments to record modestly positive results.

Reversing the pattern of the April-June quarter, the best three-month results among U.S. stocks came from companies in the Basic Materials and Capital Goods sectors; relatively poor returns came from Financial Services, Consumer Staples and (for a second-consecutive quarter) Utilities companies.  Likewise, growth-oriented names, which lagged during April-June, handily outperformed those in the value category.

Benchmark Performance – Equities

  Third Quarter 2013 Last Twelve Months
     S&P 500 Index +5.2% +19.3%
     Large-Cap. Blend Fund Avg. (Morningstar) +5.7% +20.4%
     Small-Cap Stocks (Russell 2000) +10.2% +30.1%
     Non-U.S. Stocks (Developed – MSCI EAFE) +11.6% +23.8%

 

     Non-U.S. Stocks (Emerging – MSCI EM) +5.8%   +1.0%

 

 

Benchmark Performance – Fixed Income

  Third Quarter 2013 Last Twelve Months
    Barclays Intermediate Gov’t/Credit Index (taxable) +0.6% -0.5%
    Intermediate Municipal Fund Avg. (Morningstar) +0.2% -2.0%

 

Review

The third calendar quarter was marked by proverbial dogs that didn’t bark: the U.S. didn’t strike Syria; the Federal Reserve didn’t ‘taper’ the scale of its bond-buying program; Larry Summers wasn’t named the next chairman of the Federal Reserve; and Washington lawmakers didn’t find a way to avoid a government shut-down as the quarter drew to a close.  Meanwhile, economic data were generally supportive, and bond yields better behaved, allowing nearly all financial markets to move higher during the period.

Domestic economic data published during the quarter continued to paint a picture of a steady, if lack-luster recovery.  Most encouraging were sharply lower first-time claims for unemployment insurance, robust new-car sales, and a distinct up-tick in closely-followed purchasing-managers surveys.  And while a worrisome shrinkage of the workforce was partly responsible, the unemployment rate continued to decline as the economy created an average of 162,000 (net) jobs each month.

At its mid-September policy meeting, the Federal Reserve surprised investors by opting to maintain rather than begin to curtail (‘taper’) the monetary stimulus it has been providing to the economy via purchases of Treasury and mortgage securities (‘quantitative easing’).  In reaching this decision, Fed officials likely focused on the unhelpful rise in bond yields (and mortgage rates) since they began telegraphing their intent to taper in May, persistent low inflation, as well as the headwind associated with a government shut-down (to say nothing of a failure to raise the nation’s borrowing limit).

Overseas economic developments during the quarter were almost uniformly positive (although coming from a depressed base: global growth for the twelve months ended June 30th was the slowest since the bottom of the 2009 recession).  Numerous reports indicated the U.K. and major Eurozone economies had emerged from recession, while in Japan evidence continued to accumulate that ‘Abenomics’ had a fighting chance of pulling the world’s third-largest national economy out of its 20-plus-year slump.  In emerging markets, the currency rout ushered in by the perceived shift in Fed policy and concomitant rise in U.S. bond yields eased noticeably after the Fed’s September no-taper decision.  While many emerging market bourses rallied sharply in response, the majority of real-economy statistics continued to indicate sluggish conditions across most of the developing world.  Importantly, however, the Chinese economy, largely shielded from currency turmoil by strict capital controls, showed encouraging signs of stabilizing in the 6%-8% growth range that Beijing now seems to be targeting.

 

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 +5.2% S&P 500 total return?

Third Quarter (July-September) 2013
Dividend Income +0.5% +5.2%
+ Change in Forecast Earnings +3.3%
+ Change in Valuation +1.4%
= Total Return +5.2%


Our read
: A slowly improving economic and profit picture, combined with prospects for continued low inflation and interest rates, have been a boon to U.S. equities. While valuation continues to rise, it remains far below levels reached during the stock-market bubbles of 1999-2000 and 2006-2007.

Despite the low-growth economic back-drop, the profits of U.S. companies continued to expand to new record highs.  For the April-June quarter (reported during July/August), the companies that make up the S&P 500 Index recorded aggregate earnings that were about 4% higher than in the year-earlier period.

Outlook

Developments in Washington seem likely to dominate the investment landscape for some time.  The spectacle of the government shut-down will be followed immediately by a much higher-stakes drama surrounding the approach of the nation’s borrowing limit (the so-called debt ceiling).  Once those obstacles have been negotiated, the question of evolving Federal Reserve policy (and who will be the next Fed Chairman) will move front and center.  So it may be a while before investors begin to focus again on the pace of global economic growth (improving), the likely path of interest rates (remaining very low), and the prospect for corporate profits (reasonably good).

As we write, the federal government shut-down is in its fourth day.  Past experience suggests this event will have only a small (negative) effect on the economy (each week of closure would trim 0.1% to 0.2% from fourth-quarter GDP); the impact on financial markets should be even less (although the dollar has taken a fairly large hit in the early going).  The same cannot be said of a failure to raise the debt ceiling, which by late-October could force the U.S. government to begin reneging on financial obligations ranging from Social Security benefits to interest and principal payments on Treasury bills, notes and bonds.  The impact this would have on the global economy is difficult to overstate.  Borrowing costs would rise for the government and countless businesses and consumers.  Perhaps worse, because the presumed inviolability of U.S. Treasury securities underlies an almost incalculable volume of financial transactions, anything that called into question the absolute soundness of those securities would have hard to predict but likely catastrophic effects on the global financial infrastructure.  A ‘near miss’ with a debt-ceiling-induced default in mid-2011 caused the U.S. stock market to dip nearly 20% before a last-minute deal was reached.  Investors appear considerably more sanguine this time around, possibly because the two sides in the struggle seem less evenly matched than in 2011: with the federal deficit in steep decline over the past two years, it is now more difficult to raise populist alarm about the nation’s fiscal predicament.  We tend to agree with the recent assessment of former senator Judd Gregg (R – New Hampshire), who likened the debt-ceiling stand-off to taking a hostage (the credit-worthiness of the United States government) that you dare not harm.  Accordingly, we feel confident that cooler heads will (eventually) prevail.

As we have noted in past letters, the Federal Reserve’s ‘exit strategy’ from the extraordinary stimulus programs undertaken in the wake of the 2008-2009 financial crisis is of great interest to investors, as these programs have provided meaningful support to the financial markets over the past five years.  Some observers have suggested that, after months preparing investors for an imminent ‘tapering’ of stimulus, the September decision to stand pat dealt a serious blow to the Fed’s credibility and increased investor and business uncertainty about the Fed’s plans.  Others have argued the significance of quantitative easing (QE) – particularly the precise timing of its withdrawal – is overstated; the important issue, they say, is the future path of short-term interest rates, which is independent of QE.  Recent Fed research and the known predilections of presumptive Chairman-nominee Janet Yellen support the notion that the central bank’s decision makers will begin to place more emphasis on near-zero short-term rates and providing clear ‘forward guidance’ to help investors and businesspeople divine the most likely timeline for raising them.  We believe the weak-growth/low-inflation environment that the Fed believes calls for extraordinarily low rates is likely to persist through 2015 and perhaps beyond, and accordingly do not expect much further rise in bond yields over the next several quarters.

If developments in Washington ever permit investors to turn their attention back to more fundamental matters, the near-term view of the U.S. economy may seem relatively benign.  Notwithstanding the near-term obstacles posed by the government shut-down and debt-ceiling fight, the drag imposed by last year’s budget deal, with its payroll-tax increases and ‘sequestration’ of federal spending, will diminish.  Consumers will be further buoyed by a gradually improving job market, as well as by wealth gains from real estate and the financial markets (though, as noted, the recent back-up in bond yields/mortgage rates is a concern).  Finally, if political and economic uncertainty continue to ebb (albeit incrementally), businesses may finally ramp up investments in capital equipment after five years of retrenchment, which could also sow the seeds of a further uptick in hiring.  All told, we think 2014 holds the potential, not to say the promise, of being the year the economic recovery finally shifts into a higher gear.

Overseas, the economic outlook is murkier, but on balance looks likely to be an improvement over the recent past.  The Eurozone/U.K. economies, as a group, will likely plod ahead in a subpar recovery, but the worst of fiscal austerity and bond-market volatility appears to be securely confined to the rearview mirror.  Though always a low-confidence call, China appears to have settled at least temporarily onto a moderate-growth trajectory, but we expect structural changes in the world’s second-largest economy to play out over the next decade or more, with numerous bumps along the way.  Other emerging markets are a decidedly mixed bag: some, like India and Brazil, are freighted with structural problems that seem likely to impede growth for years; many smaller Asian and Latin American markets should benefit from more predictable even if slower growth in China; and Eastern and Central Europe could fare relatively well if growth is sustained in the neighboring Eurozone nations.  Continuing the pattern of the last year or two, some of the world’s fastest growth will be found in Africa and other ‘frontier’ markets, and we expect to spend more time analyzing these economies in the months ahead.  Finally, Japan may be the biggest wild card, as its nascent recovery is at a stage where it could become self-sustaining – or not.  Come January 2015, we expect to report that the performance of the Japanese economy in 2014 was a key determinant of global growth, whether positive or negative.

As we noted when we wrote to you in July, the combination of gradually improving economic conditions across much of the globe and the likelihood of a prolonged period of exceptionally low interest rates should be supportive of stocks and other growth-oriented investment categories.  The gains recorded over the first nine months of 2013 reflect a fair amount of good news and may leave relatively modest upside in the immediate future.  While the strong showing by non-U.S. stocks in the third quarter reduced what had become a substantial valuation discrepancy, we continue to believe that select overseas markets may offer a more compelling reward/risk trade-off in the period ahead.  Similarly, the May-June back-up in yields removed some of the risk from high-quality fixed-income markets, and we are seeing many more attractive bonds on offer than we did earlier in the year.

As always, we encourage you to let us know if you have questions or comments about our management of your investments.

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

 

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