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4th Qtr and 2012 Overview

2012 was a year that was full of uncertainty from elections, policy, geo-political conflicts, major fiscal problems in Europe, fiscal cliffs in the U.S. and for some people even the thought that the end of the world was coming.  But despite all the uncertainty the markets posted a solid year.  Though the S&P 500 was down for the 4th quarter all the other major indices were up and for the full year all but the Aggregate bond index posted strong returns.  Our aggressive portfolios slightly underperformed as we maintained a defensive posture in the wake of 2012’s many uncertainties while our conservative and fixed income portfolios outperformed their respective benchmarks.

4th Qtr 2012

Full Year 2012

S&P 500 Index -0.40% 16.00%
S&P US Small Cap 600 2.20% 16.30%
MSCI EAFE International Index 6.60% 17.30%
MSCI Emerging Market Index 5.60% 18.20%
Aggregate Bond Index 0.20% 4.20%

 

Although we have overcome much of the uncertainty from the issues that surrounded 2012 there are still some big unknowns in our future that we will need to monitor.  The Fiscal Cliff was partially solved and signed into law on January 2nd of this year, but it postponed the major budget cuts for two months and the effects of the raised taxes and cuts in spending will need to be monitored.  A low debt service (low percentage of debt payments compared to disposable income) and a strong real estate market in the U.S. have created strength but it hinges on the Fed continuing its easy money policy. We will provide an update on the international and emerging markets.  Finally, the last issue we will take a look at is the stock market’s obstacles from a technical perspective.

Fiscal Cliff – Part 1

The partial passage of the Fiscal Cliff deal, we’ll call this Fiscal Cliff Part 1, was enough to avert falling off the cliff. Part 1 of the Fiscal Cliff focused on the tax law changes but “kicked the can down the road” for the cuts to spending (aka sequester cuts) which will be accompanied by another raising of the U.S. debt ceiling, most likely around the end of February or March.  The passage of Part 1 provided some temporary relief and helped remove some of the uncertainty of excessively higher taxes which in turn caused a sharp rise in the stock market to open the year. Although the administration pitched this deal as only affecting the top 2% of income earners, they did raise the payroll tax 2% which affects all of the working population regardless of income. Click on the links below or go to our website under market commentary to see more about the tax law changes:

http://www.allgenfinancial.com/financialnews/market-commentary/tax-law-changes-for-2013-fiscal-cliff-part-1/

http://www.schwab.com/public/schwab/resource_center/expert_insight/personal_finance/tax/taxes_whats_new_now.html

Fiscal Cliff – Part 2 (Sequestration) Pending Debt Ceiling and Budget Cuts Debate

As of January 2013, Congress was unable to reach agreement on spending cuts, and the sequestration was delayed until March 2013 as part of the American Taxpayer Relief Act of 2012. At the same time the U.S Government has hit its debt ceiling and can’t borrow any more to fund its deficit spending until the debt ceiling is raised. As it stands now, the deficit reduction sequester (budget cuts) is designed to enforce savings of $1.2 trillion through 2021. For 2013 and each year after that, it roughly means a $55 billion cut in defense and a $55 billion cut in non-defense spending.  Democrats are fighting to limit cuts to non-defense spending, while Republicans would prefer to limit the cuts to defense spending while reducing the entitlements of Social Security, Medicare and Medicaid.  Republicans will likely use the debt ceiling as leverage to negotiate a deal to cut spending on entitlements while democrats will most like try to avoid spending cuts (except for defense cuts) and pressure Republicans to avoid default.  If no agreement is reached in March, the sequestration cuts outlined in the fiscal cliff deal are scheduled to go into effect. In the near term, the biggest risk for the economic and market outlook would be a protracted battle on the debt ceiling and/or spending cuts that mirrors what happened in late-summer 2011, particularly if accompanied by a another debt-rating downgrade.

(Source: Charles Schwab “Taking Care of Business, DC-Style, to Avert the Fiscal Cliff”)

(Source: http://www.cnbc.com/id/100378424 “Sequestration – CNBC Explains”)

Underlying Strength of the U.S. (Low Debt Service and Housing)

The U.S. economy has potential for further growth mostly driven by two primary factors: the public’s low debt service and increased household creation which has strengthened the housing market.  One of the successes of the Federal Reserve’s easy money policy is that it has brought down interest rates thereby lowering payments on debt (home loans, car loans, credit cards, etc.).  At the same time the public has been deleveraging since 2009 – leaving the public with less debt and lower payments, and in turn more disposable income available to spend or invest.  The other primary factor for increased economic strength is a strong housing market.   After nearly five years of declines in home prices and a slowdown on home construction, the housing market turned around in 2012 and looks poised for continued improvement.  When the markets crashed in 2008 many Americans lost their home and moved in with family or friends; this decreased the demand (potential buyers) and increased the supply of homes.  These same people who were hurting financially are starting to find jobs and look for houses again at much lower prices. This significant rebound in demand is creating the need for new homes.  Each home that is built in the U.S. on average creates three new jobs.  Currently housing inventory is near record lows (see chart below).  This suggests homebuilding needs to accelerate to meet demand which will help create new jobs, thereby continuing the cycle of economic improvement.

new-existing-home-sales

 

International and Emerging Markets

After large negative returns in 2011 and the first half of 2012 the international and emerging markets are starting to turn around for the better.  Over the last few years Europe has gone through some extreme austerity measures and they have fought to get their fiscal house in order.  During that time there have been recessions, scares of sovereign defaults, rioting and some 11th hour deals to avoid disaster.  Although Europe has a long way to go in terms of taking care of their fiscal health, we feel that the bulk of the negative news has already been factored into the price and there is potential for their markets to rebound.

Emerging markets have faced a different set of problems.  Most of these countries have maintained strong fiscal fundamentals.  However, their economies have been cooling off as have their housing markets, plus they have had more inflationary pressures than the developed world.  Their stock markets started to decline in late 2010 and most of them stayed in bear markets until mid 2012.  Most of the BRIC countries (Brazil, Russia, India and China) declined over 30% during that time from their high to low.  After declining and consolidating for over 2 years it appears these markets have a better foundation for growth going forward.

Bonds

2012 was an average year for bonds as a whole.  Some areas like Muni, Corporate, High Yield, International and Emerging Market bonds did well while US Government bonds lagged. The fundamentals for bonds remain strong.  Supply is low and demand is strong.  The problem for bonds going forward is that they have already gone up so much that the upside is limited.  Interest rates look to remain low through this year and possibly next with inflation being tame and the Fed continuing to buy US Government bonds, for now.  Going forward the risk is that inflation and rates will start to rise which could cause bond prices to decline, but we don’t see that occurring in the near term.  Opportunities still abound in the bond market but you have to search harder and be more open minded to alternative types of debt instruments like international, emerging market and other less common issues.  In an effort to navigate the risk of potentially higher rates in the future we may need to shorten the duration of our current holdings and possibly add some floating rate bonds that tend to go up with rising interest rates.

Technical Update

The S&P 500 is getting close to testing a major resistance of 1550 (the red and yellow horizontal line in the chart below) which are the previous highs of 2000 and 2007.  A break-out above the 1550 ceiling could leave the door open for a new secular bull trend.  This would bring an end to the 13 year secular bear market that we have been in since 2000.  On the other hand a failed break above that line could lead to the end of the current cyclical bull market that we have been in since 2009.  We will continue to keep a very close eye on this level and give you updates as they occur.  

S&P500

Where Do We Go From Here?

Major changes are on the horizon and these are exciting times as a money manager and student of the market.  As a country we are finally starting to address our major fiscal problems and although the process is painstakingly slow and frustrating, it is encouraging that we are at least making some small steps in the right direction.  Furthermore, public opinion is starting to favor a fiscally responsible government.  Don’t get me wrong, I’m not excited about the fact that we have trillion dollar deficits, over $16 trillion in debt and a Fed that continues to print trillions of dollars.  It will be interesting to see over the next two months how the Fiscal Cliff Part 2 will be resolved and how serious our government really is at trying to tackle our fiscal problems.  Fortunately, markets look at factors other than just policy decisions and it appears the market believes there are reasons to be bullish in the near term.  A strong housing market rebound accompanied by a reduction in people’s debt expenditure has increased economic momentum and consumer confidence.  At the same time international markets and emerging markets are starting to turn around off of multiple quarters of consolidation which could provide a better foundation to build from and produce greater returns going forward. Though we do not currently detect signs of inflationary pressures or rising interest rates we will continue to monitor these aspects in order to successfully navigate through the bond market.  Technically the market faces a major hurdle trying to get above its long-term resistance.  Our plan over the next two months will be to maintain our defensive posture as we go into the Fiscal Cliff Part 2 negotiations. If these negotiations are similar to 2011’s debt ceiling and budget debate it could increase volatility and potentially cause the market to correct which could allow us to buy into the markets at lower levels and transition out of our defensive posture.  We will continue to stick to our Investment Philosophy of managing risk first in order to avoid major losses and striving to outperform our competition over an entire market cycle net of fees.

Written by:
Jason Martin, CFP®, CMT
Chief Investment Officer
Allgen Financial Services, Inc.
martin@allgenfinancial.com

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