Momentum from 2012's surprisingly strong performance continued into the first quarter of 2013 with stocks rising sharply. Our portfolios did well but lagged behind our benchmarks in the quarter. Taking a little longer view, over the trailing 12 and 36 months we mostly matched the double-digit gains of our benchmarks, which we are very pleased with since we usually underperform during strong market advances. So far this year small- & mid-capitalization, value, and domestic stocks were the market leaders, while international, growth, commodity stocks and Apple were laggards. We made a few minor changes during the quarter and are very happy with the make-up of our portfolios. We see considerable value in our international holdings, especially emerging markets. Based on MSCI's global indices, emerging markets' forward price-earnings of 11 times is at a historical discount to developed markets' multiple of 14 times.
There are plenty of valid reasons for investors to be bearish. In fact, three separate events during the quarter knocked stocks down briefly - (1) Federal Reserve minutes highlighting that several members would prefer a winding down of quantitative easing; (2) the Italian elections widely seen as a blow to austerity; and (3) the Cyprus bank bailout that calls into question the value of depositor guarantees throughout Europe. In addition, Europe's economy is shaky including the perennial stalwart Germany which saw output shrink 0.6% in the fourth quarter of 2012 compared with the previous three months. Our biggest concern is the trend in corporate profits which has been the rock upon which the bull market has been built. In the fourth quarter of last year, earnings per share of companies in the S&P 500 grew at an annual rate of 6%. The growth rate is expected to be just 1.2% in the first quarter of this year, and 0.1% if financial companies are excluded. Not surprisingly, analysts are expecting profit growth to accelerate in the second half of the year. But if this outlook proves optimistic, stocks could falter.
Despite these concerns investors have chosen to emphasize the positive. The narrative widely touted is that "tail risk" has been avoided and that equities look better than the alternatives. That is, the probability of a serious negative event is much lower, primarily due to the actions of the world's central banks. We've written quite a bit about our Federal Reserve and the European Central Bank supporting stock prices through their various programs collectively referred to as quantitative easing. More recently, the Bank of Japan (BOJ) has joined the party. Japan's new Prime Minister Shinzo Abe is agitating the BOJ to get more aggressive to revive their moribund economy by targeting a higher inflation rate of 2% and committing to an open-ended asset-purchase program. Furthermore, Abe unveiled a $116 billion economic stimulus package that the government says will lift gross domestic product by 2% and create 600,000 new jobs. It is not unreasonable to believe the bull market will continue as long as the central banks of America, Britain, Europe and Japan keep buying assets.
There are other positive factors supporting stock prices. On balance we see the fiscal cliff resolution as a positive. Although the very wealthy will pay higher taxes, it shouldn't be enough to hurt their spending habits and the overall economy. For most individuals, the tax rates on long-term capital gains and dividends, as well as federal income tax rates for 2013 will be the same as last year and are now permanent, along with a permanent patch for the alternative minimum tax. Slowly but surely economic fundamentals are improving: US jobless claims dropped to 5-year low, housing starts surged 12.1% in December to a near 5-year high, and household debt, which peaked at almost $13 trillion in 2008, has fallen to $11.4 trillion as mortgage debt has declined. U.S. households are feeling better as their net worth rose to $66.07 trillion, the highest level since the fourth quarter of 2007, according to a Federal Reserve report.
On one hand we've come a long way from the depths of the financial crisis, but on the other hand, the stock market is still trading at a level it first reached 13 years ago. Will the third time be the charm? Conditions are much more favorable this time around (see Chart). The big difference is that valuations are attractive, especially for high-quality, dividend-paying stocks. While there is less value than a year ago and we expect volatility to increase, the stock market remains an attractive place to invest.
The chart (below) views the market from a valuation perspective. While the markets have returned to levels reached pre-financial crisis, earnings for the same companies in the market are much higher than they were at that time.
Be sure to call us if you have any questions.
Jim Tillar, CFA
This electronic message transmission contains information from Tillar-Wenstrup Advisors, LLC., which may be confidential or privileged. The information provided in this report should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities listed herein will remain in an account's portfolio at the time you receive this report. It should not be assumed that any of the securities holdings listed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. In addition we do necessarily agree with or endorse any outside commentary within this newsletter. If you have received this electronic transmission in error, please notify us by telephone (937) 428-9700 or by electronic mail [email protected]. Chart source: Stansberry Research. Tillar-Wenstrup does not warrant or endorse any outside commentary or guarantee its correctness.
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