On the heels of a surprisingly strong 2013, most categories of financial investments produced subdued but still positive returns in the first three months of the New Year.  Blue-chip U.S. stocks gained around a percentage point, although many overseas markets saw modest declines.  Reversing the late-2013 pattern, real-estate- and commodity-related securities posted somewhat stronger gains; gold climbed 6%.  Bond yields drifted lower (the 10-year U.S. Treasury note finished at 2.72%, compared to 3.02% at yearend), allowing most fixed-income investments to post solidly positive returns.

Within the U.S. market, the best three-month results came from companies in the Financial Services, Health Care, Technology and Utilities sectors; underperforming groups included Capital Goods, Consumer Cyclicals and Energy.  Returns from small-company stocks were roughly in-line with those of large-caps; value-oriented names, as a group, performed marginally better than those in the growth category.

Benchmark Performance – Equities

  First Quarter 2014 Last Twelve Months
     S&P 500 Index +1.8% +21.9%
     Large-Cap. Core Mutual Fund Avg. (Morningstar) +1.7% +21.2%
     Small-Cap Stocks (Russell 2000) +0.8% +23.3%
     Non-U.S. Stocks (Developed – MSCI EAFE) +0.7% +17.6%
     Non-U.S. Stocks (Emerging – MSCI EM) -0.8% -3.9%


Benchmark Performance – Fixed Income

  First Quarter 2014 Last Twelve Months
    Barclays Intermediate Gov’t/Credit Index (taxable) +0.4% +1.5%
    Intermediate Municipal Mutual Fund Avg. (Lipper) +2.3% -0.3%



Compared with last year’s financial-market fireworks, the first three months of 2014 were decidedly low-key.  Stocks of both large and small U.S. companies were roughly flat on the quarter.  Overseas, developed-economy markets, as a group, were also largely unchanged, while many emerging markets continued to lag.  Volatility was subdued, with only brief and shallow dips following some minor communications miscues from Federal Reserve officials and the unexpected developments in Ukraine.   Meanwhile, declining benchmark yields combined with narrowing credit spreads – the premium above ‘reference’ rates (like the yield on 10-year U.S. Treasury notes) that investors demand to compensate for higher risk of default – resulted in a solid quarter for nearly all fixed-income investments.

Data on the U.S. economy released during the quarter appeared to show a deceleration from the relatively brisk growth logged in the second half of 2013, though harsh weather seems likely to have been partly responsible.  Garnering the most attention were disappointments on the employment front, with both December and January job-creation figures falling well short of estimates.  Though the February report was better, the three-month average was roughly half the rate that prevailed through the first 11 months of 2013.  Surveys of purchasing managers also seemed to indicate a soft patch.  Finally, the housing market continued to show signs of cooling in response to a roughly one-percentage-point rise in mortgage rates during 2013: while prices generally continued to rise – up around 13% nationwide over the past year – the pace of existing home sales declined for eight-straight months through February.

Abroad, the gradual recovery of the Eurozone economy continued to gather momentum.  Fourth-quarter 2013 growth (reported in February/March) accelerated , exceeding forecasts in most of the region’s major economies (Italy being an exception).  Meanwhile, Japan seemed headed in the opposite direction, with 4Q13 growth decelerating to a disappointing +1.0% annual rate, largely as a result of weak exports to emerging markets.  China was again in the spotlight, and recent data revealed yet another downshift in growth: retail sales, industrial production and investment all came in below expectations.  Brazil surprised prognosticators by avoiding recession, posting 4Q13 GDP comfortably above expectations, although, at +2.3% for the year, growth was hardly robust.

Earnings of U.S. publicly traded companies reported during the period (covering the final months of 2013) generally came in above expectations: for the companies in the S&P 500 Index, fourth-quarter earnings were 22% above the year-earlier period, bringing the calendar-year 2013 gain to a healthy +11.5%.

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 +1.8% S&P 500 total return?

First Quarter (January-March) 2014
Dividend Income   0.5% +1.8%
+ Change in Earnings +3.3%
+ Change in Valuation -2.0%
= Total Return +1.8%

Our read
:  A healthy pause in price increases, allowing earnings to ‘catch up’ and resulting in improved (cheaper) valuation.


Receding economic and political uncertainty is, in our view, a major factor underpinning the roughly 65% rise in U.S. stock prices since the third quarter of 2011.  Key elements of the improved outlook include avoiding a meltdown of the European monetary union; edging away from federal-budget/debt-ceiling brinksmanship and the threat of default on U.S. financial obligations; and ongoing, albeit disappointingly gradual, improvement in the U.S. economic recovery.  Looking ahead, we are somewhat uneasy that so much improvement is in the rearview mirror – no longer available as a catalyst to move markets higher.  Meanwhile, new sources of potentially market-unsettling uncertainty have arisen: Russia’s newfound bellicosity; worries about China and other emerging-market economies; and the tricky road ahead for the Federal Reserve as it slowly unwinds five years of extraordinarily stimulative monetary policy.

One area that continues to look fairly benign, however, is the domestic economy.  The apparent winter slowdown notwithstanding, most observers expect aggregate growth to reaccelerate back into the fairly healthy 3% range recorded in the second half of 2013.  Support should come from the lingering impact of 2013’s $8-trillion increase in real-estate and stock-market values, reduced ‘fiscal drag’ at both state/local and federal levels, and an overdue pick-up in business spending in response to a depleted capital base, high profit margins and low borrowing costs.  Private-sector ‘deleveraging’ (paying down debt) also appears to be abating: at $240-billion, the fourth-quarter increase in consumer credit was the largest since 2007.  We are closely monitoring the slowdown in housing markets in response to higher mortgage rates.  At this point, we view the moderation as mostly healthy, as it reduces the likelihood of a renewed bubble.  However, a further substantial rise in mortgage rates (which we believe is unlikely over the next year or so) would be more worrisome.

Elsewhere, the economic outlook is considerably less sanguine.  As discussed more thoroughly below, the Ukraine crisis has modest potential to impede the fledgling Eurozone recovery, but will likely deal a greater blow to Russia (the world’s eighth-largest market).  Meanwhile, the Japanese economy faces a substantial increase in the consumption tax; the last time this occurred (in 1997), it dealt a severe setback to growth.  But the biggest question mark is the outlook for China and other emerging markets.  At the same time that China is embarking upon a multiyear economic restructuring aimed at more sustainable, though slower, growth, it is also encountering cyclical headwinds from bubbly real-estate markets and a build-up of dubious loans in its financial system.  Consequently, there is currently an unusual degree of uncertainty about the near-term outlook for the world’s second-largest economy.

Recent currency- and asset-market turbulence has led to rising fear of a more widespread emerging-markets crisis, echoing that which engulfed a host of developing nations in 1997-’98.  The fact that emerging economies, as a group, now constitute a more important engine of global growth than in the late-1990s only exacerbates the worry.  We believe these concerns are overdone, however, as much has changed for the better since the earlier episode: most major emerging-market economies now have market-determined (as opposed to pegged) currency regimes; they have replaced much of their foreign-currency debt with home-currency issues; and they have amassed substantial foreign-exchange reserves – all in response to the painful lessons of the late-1990s.  Moreover, trade and finance linkages between North America, Europe and Japan and today’s most troubled emerging economies (the so-called ‘fragile five:’ Brazil, India, Indonesia, South Africa and Turkey) are small in comparison to those between the developed world and a much longer list of crisis-struck economies in the 1990s.  So, even if emerging economies, on average, face a period of slower growth (the result of structural impediments, high debt and in some cases unhelpfully elevated interest rates) we do not foresee a spreading ‘contagion’ that could prevent a modest uptick in global growth compared to a sluggish 2013.

We’re not sure quite how to read the investment implications of the rapidly unfolding Ukraine/Russia crisis (though judging from the remarkably subdued market reaction, most investors are unconcerned).  On one hand, events to date are likely to have a relatively minor immediate economic impact: while Russia has suffered a run on its currency and asset markets, and has been forced to raise interest rates to protect the ruble, the contemplated sanctions regime will have little impact on the broader European economy.  More worrisome, in our view, is that Russia’s actions mark a meaningful turning point in the post-Cold War international order, the ultimate implications of which are difficult to quantify.  On one level, it seems likely to mean abandonment of the two-decade project of re-integrating Russia into the global economy on terms largely framed by and favorable to the West.  On another, depending on how things play out in the weeks ahead, it may herald an unanticipated increase in geo-political risk that needs to be factored into investor attitudes, which can only be negative for asset valuations.  We will be watching intently as the situation unfolds.

Another area that continues to be of keen interest to investors is the evolution of Federal Reserve monetary policy, as the long-anticipated unwinding of extraordinary stimulus proceeds.  Periods of transition in Federal Reserve policy often coincide with increasing stock-market volatility and price ‘corrections.’   Moreover, another jump in bond yields similar to that which accompanied the first hints of change (last May, when ex-Chairman Bernanke first mooted ‘tapering’ the bank’s long-term bond-buying program) is the last thing the still-fragile economic recovery needs.  Accordingly, the Yellen Fed will surely proceed deliberately and with extreme caution as it attempts to return monetary policy to something approaching normal.  With no sign of inflation (in fact, inflation is running substantially below the Fed’s preferred level) and employment-growth still lagging well behind a ‘typical’ recovery pace, we expect the Fed will continue to maintain extraordinarily low short-term rates well into 2015.  Managing the expectations of twitchy investors, however, seems likely to remain a delicate task.

Following the strong 2013 performance of U.S. stocks, which propelled major benchmarks past the record highs of 2000 and 2007, we have heard concerns from clients about the possibility that the market is approaching an important ‘top.’  This probably-healthy skepticism is also reflected in recent surveys of both professional and individual investors, which have not shown the degree of complacency (or greed) that usually accompanies market peaks.  Nevertheless, it is unarguably true that over the past year U.S. stocks became more expensive (as the S&P 500 index gained some 30% and earnings rose by just 11%), while many non-U.S. stocks and nearly all bonds got cheaper.  In recent weeks we have seen signs that investors may be ‘rotating’ their commitments away from potentially over-valued, high-flying asset categories (e.g., bio-tech and internet stocks) and toward last year’s laggards (e.g., commodities, utilities, emerging-market stocks and even long-term bonds).  If this trend persists, a balanced portfolio featuring a solid core of blue-chip U.S. stocks, but complemented by exposure to other kinds of investments, should be well positioned to provide steady performance.

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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759 North Milwaukee St.  Suite 605
Milwaukee, WI 53202
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634 Water St. Suite A
Prairie du Sac, WI 53578
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13160 West Burleigh Rd.
Brookfield, WI 53005

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