2012 4th Quarter Commentary

We have remarked to many of our clients recently that this has been a year of conflicting realities. While politically and internationally “turbulent” seems to be an appropriate adjective, the capital markets have painted a different scene. Despite a close Presidential election, a “Fiscal Cliff,” countless European Summits and Sovereign Debt debates, both the stock and bond markets posted respectable returns. The economy continues its slow march towards recovery and on a variety of fronts we have increased clarity on what the future holds. Below are the highlights from 2012 and our thoughts on the markets and economy as we head into 2013.

Considering all the uncertainty we discussed in the letter last quarter, it was reassuring to see recent economic data that came in better than expected. This is exactly what our country needs given the continued political brinksmanship on display in Washington. In November we saw a 0.4% growth in consumer spending and a 0.6% growth in personal income. These are historically strong figures and what Morningstar’s leading economist has called some of the best numbers we’ve seen in this recovery.[1] Additionally, new home sales continue to strengthen as the real estate market gains momentum. The manufacturing sector also appears to be in recovery with orders for durable goods showing solid demand, indicating businesses are investing for the future.

We think these forces will lead to an increase in GDP estimates for this quarter. The third quarter’s GDP growth rate was revised up to 3.1% (which was a positive surprise). While we do not think the fourth quarter will match that figure, GDP should be more robust than what was expected even a month ago.

Given the political theatre in Washington, there is clear rationale why consumer confidence is depressed. However, at the end of the day the consumer continues to spend and that is driving our economy forward. To the consumer’s benefit, we have seen gasoline and food prices coming down. Since part of the political deal to resolve the “Fiscal Cliff” (more on this in the attached summary) was an increase in the payroll tax, falling prices will be critical to help offset higher taxes. Our belief is that while we may have slower growth due to higher taxes and Government budget cuts, we will avert recession in 2013 – although the level of growth seems to be predicated on the final outcome of the political negotiations in Washington.

There are a number of economic catalysts in 2013 that could materially help the economy:

  • Sustained housing market recovery
  • Oil and gas exploration continues to grow
  • Low inflation
  • Continued improvement in job market

As well as a number of unknowns that could depress the economy:

  • Outcome of the U.S. Debt Ceiling debate
  • European sovereign debt issues
  • Chinese economic recovery
  • Geopolitical risk (Iran/North Korea)

As we suggested in our last letter, our return expectation for the stock market had already been achieved by the beginning of October. The final weeks of the quarter met heavy selling in the fear that a “Fiscal Cliff” deal would not be achieved. In what has become an increasingly familiar approach, our elected leaders pieced together a patchwork deal that averted looming budget cuts, slightly raised revenues and quite frankly kicked the can down the road, again. The market had priced in some level of failure in the negotiations. When news broke that a deal was reached the market rallied to a five year high.

Despite all of this uncertainty, the stock market saw above average returns for 2012, as equity investors largely looked past the prevailing headwinds and moved stock valuations higher. The Dow Jones Industrial Average returned approximately 10% while the broader S&P 500 posted a 16% return.

The Financial and Consumer Discretionary sectors led the way for the stock market returning 26% and 22%, respectively, for the year. The aversion to the Financial sector dissipated as banks continued to rebuild their balance sheets and work down foreclosure inventory. Many large financial institutions were trading and continue to trade below their book value (assets minus liabilities). Investors are beginning to acknowledge that the worst of the financial/housing crisis is behind us. The Consumer Discretionary sector continues to improve as home prices recover and unemployment drops (now under 8% nationally).

Pulling up the rear were the Utility and Energy sectors. The Utility sector was down nearly 3% for the year, a wide dispersion from the overall Index average. Interestingly, in 2011 the Utility sector was up nearly 20% while the Index was basically flat. This dynamic reversed in 2012 as investors’ increased appetite for risk ignored this more stable sector. The concern over dividend tax rate increases may have also played a role as many feared dividend income would revert to the ordinary income tax bracket.

Concerning the Energy sector, it appears there is a glut of new oil and gas reserves in our country. The natural gas market was oversupplied for all of 2012, and prices dropped to multi-decade lows during the year. Gas exploration and production companies were forced to idle rigs and curtail production. Oil production improved markedly although the U.S. infrastructure to move oil from the heartland down to the refineries near the Gulf of Mexico is lacking. This is being remedied and consumers could see benefits at the pump in 2013. All this is to say the energy glut and new dynamic of production hurt margins and profitability for the Energy sector and thus led to a gain of only 2.3% for the year.

Looking forward to 2013, we continue to see catalysts for earnings growth. First, Corporate America has never been stronger from a balance sheet perspective. Second, there is the likelihood that some of the numerous lawsuits from GSEs and government regulators will be settled, allowing our banking system to move past dealing with the crisis. Third, there is the possibility that we get some sort of corporate tax overhaul this year. The U.S. has some of the highest corporate tax rates in the industrialized world yet years of lobbying and side deals have resulted in many of the largest corporations not paying much in taxes. A simplified, equitable code, with more competitive rates and an equal playing field could really spur manufacturing again.

Finally, we are in a new era where the possibility of energy independence is staring us in the face. Not subsidized wind farms or solar fields, but economically viable opportunities from the private sector. With a “real unemployment” rate somewhere in the mid-teens, the prospect for lower domestic energy costs and possible corporate tax reform means we could be in a position to grow our way out without artificial government intervention. The return of American manufacturing, spurred on by low energy costs and a simplified tax code, is an encouraging hope.

We will avoid making any material predictions this year as it seems even the ‘experts’ are unable to forecast market movements.[2] As market participants are keenly aware, the market always does what it is supposed to do, just not when it is supposed to do it! We continue to focus on a “bottom up” valuation approach, purchasing durable businesses at the right price, which has served us well over the years.

The bond market took a back seat to the strong equity markets in 2012. The taxable bond market, as measured by the Barclays Aggregate Index, returned 4.2% for the year, a rather average year for bond investors. The U.S. Treasury market underperformed with average returns closer to 2% driven mainly by investors finding better yields in other sectors. Financial related corporate bonds led the way, with intermediate bonds in this sector up 13% and long dated bonds returning an eye popping 23.5%. This dramatic outperformance occurred due to the general pessimism and risk aversion in this sector. The bottom line is that the financial industry is the best capitalized it has been in decades, and the bonds were mispriced at the beginning of the year. The extra yield investors required to own these bonds has dropped precipitously and this sector seems fairly valued at today’s levels.

The ten-year U.S. Treasury closed the year with a 1.75% yield, the 30-year with 2.95%. The direction of these bellwether yields is unclear at present. The Federal Reserve is still purchasing bonds in the open market in an effort to hold down interest rates. On the other side of this equation, there is a general strengthening in the economy, specifically the job market. If the Federal Reserve ceases its quantitative easing and the economy picks up steam, we will see yields rising from here (meaning bond prices will fall). The rebuttal to this bearish stance is the range of possible outcomes for the upcoming debate on the debt ceiling and any government spending cuts that may be required to raise it. Further revenue increases coupled with large spending cuts could slow our economy to the point where the Fed continues its unconventional stimulus. Our stance is to brace for higher interest rates with fits and starts along the way. Government Agency step-up notes continue to be our asset class of choice in this environment as we can earn an above average up front coupon and have the benefit of higher coupons should rates rise.

The municipal sector fared better than the taxable market, with the returns up nearly 7%; much of this return came from “riskier” states as bankruptcy fears subsided. Investors bid up the prices of municipals because the fear of higher income tax rates seemed very real after the Presidential election. Municipal bond mutual funds saw inflows of over $50 billion for the year, the most since 2009. Banks and insurance companies also increased their holdings in this asset class as the fiscal situation for most states improved in 2012. Much of the new issuance of bonds in 2012 was intended to refinance existing debt, as opposed to fund new projects; therefore a mismatch occurred with demand outstripping supply. We still like the relative value of municipal bonds for investors in moderate to high tax brackets, however if rates rise overall then munis will not be spared entirely. We expect tax revenues to continue to improve for municipalities, so the safety factor will play a role. We like the above market coupon structure with short to intermediate call dates where yields to call are over 2% with the yield to maturity in the range of 3.35 to 3.5%.

The “Fiscal Cliff” negotiations are over for now, though more decisions are yet to be made on the debt ceiling and future spending cuts. Obviously we think it is a good thing to get our deficits under control and it would be very positive to actually get a dually passed budget out of Washington. Ultimately, this self-inflicted crisis will fade to the background and the real economy will determine how the stock and bond markets perform in the long term.