3Q 2013 – Commentary

3Q 2013 Commentary

by Richard Siegel, CFP®

The third quarter was a strong period for the capital markets. Globally, equity markets delivered strong returns and bond yields/prices stabilized from their period of enormous volatility in the months from May to August. The latest reading on domestic growth as shown by U.S. GDP has increased to an annual rate of 2.5%. Overseas, Europe is emerging from a recession, China appears to have averted an economic slowdown, and Japan is showing signs of life after many years of economic struggle. Although the Federal Reserve indicated a few months ago that they would begin reducing their large scale asset purchases this fall, they have delayed the tapering until there are clearer signs that the U.S. economy is strong enough to sustain less stimulus. Much of the growth in the U.S. has been driven by the housing market and auto sales. These sectors should continue to exhibit strength based on pent up demand of the U.S. consumer. Interestingly, the average age of passenger vehicles on the road today is a record 11.4 years.

Recent headwinds to growth and confidence have centered on unrest in the Middle East and the political posturing and gridlock in Washington. This feels all too familiar. There was a threat of a U.S. default on its obligations just two years ago. Investor sentiment and confidence was shaken, our credit rating was cut from AAA to AA+, and the markets normalized in short order. It appears that we are once again facing a debate in Washington over the “debt ceiling” and it is our contention that although market volatility will likely pick up, a deal will ultimately be struck. Structural damage to the economy and markets would only be realized if no deal is struck and/or the rating on U.S. Treasury bonds is once again downgraded.

AGG = U.S. Bond Market, ACWI = World Stock Index (50% U.S. / 50% foreign markets), GLD = Gold

The charts below illustrate a recent pick-up in the housing market and overall economic growth. Although the economy as measured by GDP is by no means strong, we are far from an economic contraction. The Fed continues its easy money policy, the Treasury yield curve is quite steep, and corporate profitability remains strong, all pointing to a relatively healthy economic backdrop.

Equity Overview

The recent gains in equity markets can be attributed to investor demand for stocks in the face of rising interest rates, reasonable valuations, and corporate earnings. As expected, the performance of foreign equities, specifically European markets, has begun to outpace U.S. equities based on more attractive valuations and an emergence from a shallow recession.

ACWI = Global Stock Market, S&P 500 = U.S. Stocks), IEV = European Stock Market

Based on the three year chart below, both the broad global market and the European market have a long way to go to equal the returns of the U.S. Stock market even after their recent outperformance. Historically, the returns for the regions have all been similar. It is therefore our contention that either foreign markets will produce stronger returns to the upside or will offer more downside protection in the event of a market correction over the next one to three years.

Strategically, our client portfolios are slightly over-weighted in foreign equities relative to our targets. Additionally, we have taken profits from U.S. equities for our longer term clients whose portfolios have realized large gains in domestic stocks this year.

Going forward, U.S. stocks continue to look attractive relative to bond investments and cash. However, valuations are beginning to normalize and inch closer to historical averages. In order for U.S. stocks to deliver strong returns, corporate earnings will need to grow at or above trend. Ultimately, it is corporate earnings that drive stock prices. Over the last several years, the corporate sector has been able to achieve solid growth with innovation, job creation, and healthy balance sheets.