2012 Review and 2013 Outlook

Review of Last Year

Before turning to 2013, it is useful to look at what was being written about 2012 a year ago. The consensus among analysts was that 2012 would be a troubled and volatile year. There were several reasons given for this concern – the European debt crisis, belief that the European Union might crumble, recent high instability in worldwide markets, the sluggish state of the U.S. economy, and the upcoming presidential election. And while all of those facets were valid, nearly all press reports were ignoring two key lessons from history. First, “crises” are seldom as influential as they seem to be at first glance, because economic leaders take strong actions to mitigate the damage – that is what happened in Europe last year. Second, U.S. presidential elections seldom have much effect on stock markets.

Despite all of the pessimism last January, stock markets had a very productive year, and it was one of the calmest markets over the past 20 years. The table below shows estimates of historical annualized returns:

2012 was a great year in terms of stock market performance, not just in U.S., but overseas as well. In the U.S., the extreme pessimism we had in January eroded throughout the year as the economy showed signs of improvement and corporate profits returned to their pre-recession levels. Overseas, where the negativity was even greater, the returns were also greater when much of that pessimism proved to be unfounded. Bonds also had a solid year, as interest rates continued to fall and investors became more confident in corporate borrowing.

Current State of the Economy

Much of the current economic data is very promising. The unemployment rate has been continuing its steady decline from the double digit levels of 2010. The consensus of the Survey of Professional Forecasters (published by the Philadelphia Federal Reserve Bank) is predicting 2%-3% real GDP growth over the next few years (close to its average over the past 20 years). Inflation has been very low, and according the Survey of Professional Forecasters, is expected to stay below 2½% for the foreseeable future. Beyond the broad numbers, there are three specific areas that lead to optimism:

1) Real Estate Recovery – While new home construction is nowhere close to its pre-recession level, and may never approach that level again, housing starts have consistently been on the rise since 2009, and the inventory of houses available is at its lowest level in over a decade.

2) Reduced Use of Leverage – The corporate debt ratio is at its lowest point in 20 years, individual debt service as a proportion of household income is at its lowest level in over 30 years (albeit, that later statistic is more influenced by the low level of current interest rates than by borrowing levels). A low level of debt service means higher credit worthiness and less financial stress if there was a slowdown in the economy.

3) Domestic Energy Production – A huge economic risk in the past was the U.S. reliance on foreign energy sources. However, U.S. oil inventory is at its highest level in 20 years. Net imports of energy as a proportion of total consumption have been steadily declining since 2005, and according the U.S. Energy Information Administration, are expected to continue to decline in the future. Part of the reason is the development of shale gas in the U.S.; because of that resource, the cost of natural gas in the U.S. is less than half of the cost in other countries.

Stock and Bond Markets

The specific stock market data are also promising. U.S. corporate earnings have grown to their pre-recession levels, and yet, the average price-earnings ratio for U.S. stocks is far below both its 2007 level and the average over the past 20 years. A low price-earnings ratio, in general, means there is lower downside risk in investing in stocks. The price-earnings ratio is even lower for most other countries, perhaps reflecting the lower expected growth rates in Europe and Japan. Even though the prospect of the collapse of the Euro seems to have been averted, there are still debt problems and slow economic growth potential in European economies. However, economic growth has been and is expected to be higher in most of the emerging markets, which suggests the relatively low price-earnings ratios for emerging market stocks might be unwarranted.

The bond market, while having had an unprecedented 25-year run of solid returns, is troubling looking forward. With government bond yields having fallen to below 1% for bonds maturing in five years or less, investors in bonds will have difficulty achieving any significant return unless they invest in longer-term bonds (which increases interest rate risk and inflation risk), or seek other types of bonds such as high yield or emerging market debt (which increases credit risk).

While much of the economic analysis suggests it’s a good time to invest, there are still several concerns:

• Unemployment – While the joblessness rate in the U.S. has been in decline, it is still above its long-term historical average of 6%. That high unemployment rate suggests some degree of sluggishness in the economy. • Politics Again – We survived the dreaded fiscal cliff, but we are in no way immune from politically-created economic crises. In March, we are expected to hit another debt ceiling standoff; the last impasse, in June of 2011, led to extreme market volatility, and the creation of the mechanism for the fiscal cliff in the first place. The inability of our leadership to resolve disputes in an orderly manner is a huge hindrance to our economy. • End of European Vacation – For several months the financial press has set aside its concerns about Europe to focus all of their attention on the election and fiscal cliff. Now that they have nothing else to do, they will see that many of the problems in Europe are still unresolved, and the growth prospects in most European countries are dismal. • Stuff Happens – Most of the huge declines in the stock market over the past 40 years have come because of factors that were unforeseen at the beginning of the year (the banking crisis of 2008, the internet bubble of 2000, Russian credit problems of 1998, etc.). So what will the next crisis be? By definition, it is unforeseen. But the potential is always out there.

Summary

To summarize, we have come through a good year of economic recovery and investing in stocks. We currently have a stable U.S. stock market, with modest prices relative to earnings, and reasonable growth prospects. The situation is less settled in Europe, but the potential for growth in emerging markets is still considerable. Bonds, while providing desired stability and diversification attributes, will likely be providing modest returns in the future. While there will always be risks of being in the stock market, we feel very comfortable recommending balanced portfolios including an appropriate portion of equities.

#MarketUpdates