2013 1st Quarter Commentary

The first quarter of 2013 witnessed the best equity returns over a three month period for quite some time with both the Dow Jones and the S&P 500 reaching all-time highs.  The strong performance overshadowed the discussions in December of budget impasses, sequestration and overreaching tax plans.  The market was driven by relatively strong 4Q earnings reports, stronger than expected economic readings and less noise from Washington that had elicited fear from investors.  It is almost comical how quickly sentiment can change.  Below is our review of what occurred during the quarter and where we think we may be heading.

Economists have been scrambling to raise their quarterly estimates of GDP growth following the low expectations that came after the 0.1% growth in the fourth quarter of 2012.  We have seen continued strength in economic metrics that signal healthier growth in GDP.  Allaying fears of a consumer spending slowdown due to the payroll tax, month over month retail sales data increased 1.1% from January to February.  We’ve also witnessed a consistent drop in unemployment claims with corresponding strength in jobs numbers.  The jobs number for February was a positive surprise as total nonfarm payroll employment increased by 236,000, with job gains in professional/business services, construction, and health care. In the prior 3 months, employment had risen by an average of 195,000 per month so this number was materially higher than the average.  The initial March release was lower than expectations and bucked this developing trend.  However, it is only one month and it included upward revisions to the last two months.  On top of the improving jobs numbers, the Purchasing Managers’ Index (PMI) rose to 54.9 in March.  Any number above 50 indicates expansive business conditions.  Drilling deeper into this report suggests that the growth rate of manufacturing activity in the U.S. is accelerating.  Durable manufacturing output is now above pre-recession levels for the first time since the recession started in 2007.[1]

One of the contributing factors to this economic strength is the housing sector. According to CoreLogic, home price appreciation is continuing to accelerate which is why (along with a rising stock market) consumers continue to spend despite strong headwinds.  The housing market in the U.S. represents roughly $20 trillion in value; an 8% year over year growth in housing prices means Americans have added $1.6 trillion in equity over the last 12 months alone.  An $85 billion cut in Government spending due to sequestration pales in comparison.  As homeowners continue to refinance at low rates, the savings has helped offset the payroll tax and freed up cash for investing or spending.

In addition to increasing homeowner wealth, the housing market also plays a major role in other parts of the economy.  According to Deutsche Bank, housing related spending has averaged 20% of GDP in “normal” years.  Emerging from the recession, that ratio is currently closer to 17%.  As this number normalizes, we should see continued positive effects on GDP.  The other virtuous effects of housing can be seen in the February jobs report where 48,000, or 20% of the 236,000 new jobs provided were from building construction.[2]  New construction jobs added since September 2012 now total 151,000.

The breadth of the upturn in various economic indicators is an encouraging sign.  Retail spending, job growth, industrial production, factory utilization, housing starts and building permits are all showing signs of improvement.  The fact that we are seeing positive readings across multiple economic measures is a good sign of economic stability and should bode well for the economy this year and next.[3]

While we are encouraged with the U.S. economic progress, ongoing economic and political difficulties in Europe along with our own political challenges continue to give us pause.  Any spillover effect from Cyprus to the other Mediterranean economies could cause a disruption to the progress we are experiencing domestically.  An additional “immeasurable” risk is the potential for one of the numerous regional issues boiling over into a larger war, either in the Koreas or in the Middle East.  We continue to follow these issues closely and manage portfolios accordingly.

Stocks wrapped up a stellar first quarter with the S&P 500 finishing at a new high of 1569.19, slightly higher than its previous record of 1565.15 from October 2007.  The S&P 500 soared 10% and the Nasdaq was up 8%.  The Dow Jones, which has been trading at record highs since early March, rallied more than 11% and booked its best first quarter since 1998. The majority of this strong performance occurred during January.

During the quarter, all 10 economic sectors of the S&P 500 posted positive returns.  The top three performing sectors were Healthcare, followed by Consumer Staples and Utilities.  These three sectors are ranked highly in the index when measured by dividend yield.  These higher income-paying equities may have seen stronger interest for several months as investors shy away from historically low yields in cash deposits, CD’s and fixed income.

The Materials sector was the worst performing sector (though still positive) followed by Technology and Telecom.  Telecom is typically lumped in with the previously discussed “high dividend” sectors, but this quarter it diverged due to a number of company specific factors.  The underperformance of the Technology sector was impacted by the second consecutive quarter of weakness in Apple.  Apple is a large component in the sector and has had a difficult time lately.  We believe there is a “changing of the guard” occurring as this company transitions into a “Value” stock where it has historically been viewed as a “Growth” stock.  Apple now pays a dividend and “game changing” product releases have slowed down.  This transition may take time but we believe with the enormous amount of cash and free cash flow, there is real value in this company.

The major market indices have achieved multi-year highs and are most likely overextended at the moment.  It is important to remember that although markets may be “overextended” it does not mean they have to fall.  There are many examples in history where markets “consolidate,” or allow valuations to catch up with prices.  The upcoming earnings reports from the first quarter will give us better clarity on market valuation.

Even if we are currently overextended, there are reasons to be positive when investing in equities. Corporations (at least the ones we invest in) are in the best fiscal shape they have been in for many years.  Management teams continue to stay conservative and are using excess cash flow to increase share buy-backs and dividends rather than expand production into uncertain markets.  It seems many lessons were learned from the credit crisis of 2008.  The fact remains that relative to the types of returns investors can earn in Treasuries and other bonds, stocks are an attractive alternative.

While equities charged ahead during the first quarter, both taxable and tax exempt debt prices treaded water.  The U.S. Treasury 10-year note closed the quarter with a yield of 1.85%, up 0.10% from the year end close.  The 30-year bond yield increased to 3.10% from 2.95%.  This slight increase in yield is a little surprising given the strengthening economic figures we have seen.  The message coming from the bond market seems to be in contrast to what we perceive coming from the stock market.  Bond prices are signaling a sluggish economic environment with growth near or below 2% this year and a similar or weaker environment for 2014.  Stocks are signaling a more robust economy.  Uncertainties remain on the path of interest rates; however the path of least resistance in the short run is flat to higher.  The Federal Reserve continues to purchase $85 billion of government-backed mortgages and U.S. Treasuries each month, therefore a disorderly increase in rates is unlikely.  We find value in corporate issues on the short end of the yield curve coupled with longer dated step-up coupon agency callable notes to capture above market income streams.

Municipal bond prices also barely budged in the quarter.  Yields on municipal bonds are still over 100% of the Treasury equivalent.  Therefore for individuals that are in a high tax bracket, municipals still make sense.  Tax receipts nationwide have recovered to their pre-recession levels and the credit profiles of the issuers we favor continue to improve.  Some states, like California and Illinois, are still struggling and we do expect more municipalities to fall into fiscal emergencies.  However, we are steering clear of the trouble spots and investing only in the highest quality issuers.

Government policy risk is still present as lawmakers on the Federal level wrestle with the deficit reduction ideas in Washington.  Some investors fear there will be a limit on the amount of tax-free income one can claim, therefore potentially making some of the income from these bonds taxable.  We do not believe, given the fiscal strain seen in some States coupled with the fact that municipalities finance most of the infrastructure in the country, that lawmakers will do anything to disrupt the financial wellbeing of this sector.  We favor above market coupons with longer dated final maturities and short/intermediate call structures to obtain attractive yields well in excess of comparable Treasury securities.

Fear and euphoria have always been part of market psychology.  To quote the late Sir John Templeton “Bull markets are born on pessimism, grown on skepticism, matured on optimism and die on euphoria.”  The fear in the fourth quarter that Washington DC would ruin the economy was followed by record setting levels in the Dow Jones and S&P 500.  The most likely case going forward is for some level of consolidation before we head higher.


[3] The most recent slate of economic reports in April (including the jobs report) have been less robust than we have seen in the first quarter. However we have noted the volatility of these readings during this recovery and continue to see trendline improvement that keeps our slow growth thesis intact.