2013 4th Quarter Outlook

Review of 3rd Quarter

The third quarter was another good one for domestic stocks; U.S. large company stocks increased in value by 5.2%, and small company stocks did even better, increasing by 10.2%. International stocks also rose in value, with developed market stocks increasing by 11.6%, and emerging market stocks going up by 5.9%. Even the bond market had a slight recovery – investment grade bonds rose by 0.6%. The table below shows historical returns (all of the returns except for the past three months and nine months are annualized:

Political Theater

At the time we are writing this, there is still no final resolution on the raising of the debt ceiling and the reopening of the government. In theory, the lack of a deal before October 17 would mean the government will default on its bonds, which could have major adverse impacts on our economy, both short and long term. Having been through event s like this – in which, according to the press, our leaders hurtle without agreement towards a deadline with staggering consequences – every few months over the past three years, we are, once again, impassive. With so many debt ceilings, sequesters, shutdowns, and fiscal cliffs being threatened, it is like watching a play with the same dramatic moment offered several times throughout the evening. Yawn. Yes, the consequences of defaulting on our debt are more severe – however, because of that, the likelihood that in the end our leaders will allow that to happen are more remote. Our belief is either there will be a last minute accord, or the circumstances of the debt ceiling will be mitigated, so that we will not default on our major obligations. And then the press and politicians can start setting the fuse for the next fiscal crisis.

Broadly the markets seem to be in agreement. On September 18, the S&P 500 hit its all-time high. Since then, it has bounced around a bit, and some of the declines have been blamed on the debt ceiling impasse. Yet, at present, it is within less than 1% of that record level, so the average investor in the market place believes that we are not headed for a true crisis.

Current State of the Economy

So let’s get back to the real economic analysis, which offers good news. The unemployment rate continues to decline – the most recent reported level for August is 7.3%. Inflation remains under 2%, and the average forecast is for it to continue to stay low for the next several years. Real GDP growth for the 2nd quarter was 2.5%, which is close to the 20-year average. The headline analysis suggests the economy is growing at a slow and steady rate.

The other signs that we have alluded to in past commentaries that support these headline numbers remain positive:

• Housing starts continue to rise and home inventories remain low (in part because, on average, it is currently cheaper to buy a house than it is to rent one)

• New car sales remain strong

• Capital goods orders are far above their historical average

• Net energy imports have been in steady decline since 2005, in part because of increasing U.S. natural gas production

• Household net worth is at an all-time high, and household leverage is at an all-time low (fueled by a combination of low debt and low interest rates)

• Corporate leverage is at an all-time low

• Defaults on mortgages, consumer loans, and commercial loans have been in steady decline since 2010.

Stock and Bond Markets

While all of the economic indicators are positive, stock valuations are near all-time highs – they have increased by 150% since the bottom of the market in 2009. The average price-earnings ratio, while still slightly below its long-term average, has also increased since 2009. Our point is that current stock market prices reflect much, if not all, of that good economic news. Hence, while we think it is still a good time to be an equity investor, one should expect modest returns going forward (the long-term average annual return for the S&P 500 is around 10%).

We spent a lot of time discussing bonds in our last quarterly outlook, and our view is relatively unchanged since then. To summarize:

• The outlook for Treasury bonds is not good – interest rates will definitely rise over the next few years, so the maturity of the Treasury bonds in your portfolio should not be greater than your investment horizon.

• Not all sectors of the bond market will follow Treasuries (in fact, high yield bonds have earned positive returns this year), so it is important to diversify across different sectors of the bond market and different bond managers to reduce risk

Question of the Times

Lately, from clients and commentators alike, I have been hearing the following question: Because the economic data are strong, and the bond market is shaky, isn’t this the time to have all assets in equities. For example, a recent article in Time Magazine suggested that the Dow 30 might replace bonds as the safe place to put money. Our response is – nothing has changed, and suggesting that stocks are safer than bonds is irresponsible, even for a journalist. The motive to invest in bonds has never been high return – its preservation of capital. And that benefit persists today.

Step back from the hype, and ask yourself, which is safer – an investment in the AA rated bonds of Apple, which reflect a promise to pay interest and principal over 10 years that must be honored in order for the company to remain solvent, or an investment in the stock, which will widely fluctuate dependent on the success and failure of the company’s product releases and business strategy. Our belief is if one of your goals is safety, you should have a portion of your money in bonds.

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