2012 was a fun year for investors because it was hard to lose money. Every major asset class except cash provided a solid real return. The S&P 500 finished up 16%. US stocks and bonds took a breather in the fourth quarter, but the party continued for globally minded investors. The MSCI All Country ex-US Index jumped 7% in the final three months, finishing the year up 19% and besting US stocks.
During the fourth quarter the media focused on the presidential election and fiscal cliff. Both proved anticlimactic. Obama handily won another term, while congress remained divided. This ensures not much will change in the next four years. Gridlock may not solve our long term problems, but stocks tend to like it, thriving in periods of legislative calm.
A solution for much of the fiscal cliff was reached, though technically not until hours after the close of the quarter. Based on the agreement, income tax rates will remain permanently unchanged for all but the highest earners ($400,000 single filers and $450,000 joint filers). However, the 2% payroll tax reduction was allowed to expire and results in a significant reduction in take home pay for all Americans. Capital gains and dividend tax rates were increased for incomes above the same levels.
The agreement had many shortfalls. It made the tax code more complicated, failed to seriously address spending cuts or the debt ceiling, and contained a lot of pork. Still, the core tax rate solution was reasonable and better than continued uncertainty. Making tax rates permanent and putting a permanent AMT patch in place were both positives. The stock market will be happier knowing we won’t have to go through this again in a year or two. Indeed, markets rallied on the news because many investors did not expect an agreement so soon. In reality, the two sides were not very far apart and an eventual deal was inevitable. We were glad to see an agreement, but are neither more bullish nor more bearish as a result of the New Year’s Day solution.
The Fed continued to push the envelope. The central bank announced it will begin buying $45 billion of Treasuries per month in addition to the $40 billion of mortgage backed securities it already buys. The new purchases will be “unsterilized”, meaning the Fed is essentially printing money to fund the program. Bernanke also attempted to add clarity by stating the Fed would look to raise short term rates when either the mid-term inflation outlook exceeds 2.5% or unemployment drops below 6.5%.
“Fiscal Cliff” Tax Bill Summary
- Income tax cuts maintained for most. Increases for individuals making $400,000+ per year, families making $450,000+ per year. Tax rates rise from 35% to 39.6%.
- Capital gains and dividends taxes for this group will rise from 15% to 20%.
- Wealthy Americans will also face a health care reform surtax of 3.8% on capital gains, making the total capital gains tax rate for this group 23.8%. Reduced itemized deductions could potentially push this to 24.8%.
- Those in the 25%, 28%, 33% and 35% income tax bracket will continue to pay 15% on capital gains and dividends.
- 2011-2012 payroll tax cut eliminated. This refers to the 2% decrease in Social Security tax paid by workers on income up to $113,700, restoring the rate to 6.2%.
- Estate and Gift Tax lifetime exemption unchanged. It will remain at $5 million or more per individual.
- For 2013, top estate tax rate to increase to 40% from 35%.
- Alternative Minimum Tax (AMT) permanently adjusted for inflation.
- American Opportunity Credit for education extended five years. This credit is worth up to $2,500.
- Child tax credit extended five years. This is worth up to $1,000.
Capital Markets Outlook
The fourth quarter of 2012 may prove to be the period when the United States finally lost immunity from the global sovereign debt crisis.
Europe still has major problems, but ECB President Mario Draghi’s third quarter “bazooka” successfully relieved much of the short term pressure. Draghi announced a program authorized to buy unlimited sovereign debt and said the ECB would do “whatever it takes” to keep the euro together.
Focus quickly shifted to America. The media honed in on the potential growth reduction of fiscal cliff tax increases and spending cuts, but the real story is the fact that the US spends too much relative to what it takes in—about $1.1 trillion more in 2012. This is down from $1.5 trillion in 2009 and $1.3 trillion in 2010 and 2011, but it is still too much—nearly $10,000 per household and over 7% of GDP. Our estimated 2012 net debt to GDP stands at 84%. This is bad, but the rate of new debt is the bigger problem.
Enter Ben Bernanke’s monthly purchases of $45 billion of Treasuries and $40 billion of mortgage backed securities. At this pace, the Fed will be purchasing half of next year’s debt with new money. The Fed rebates interest to the Treasury, so our government will be lending
money extremely cheaply again this year. This is good and bad. It makes servicing debt easier but also feeds a habit that is very, very hard to break.
Economics 101 teaches that printing large amounts of money to fund government debt eventually leads to inflation. This infers a bad outcome for owners of cash and debt, a less bad outcome for owners of stocks, and a reasonable outcome for owners of real assets like property and commodities. But economic theory isn’t always right and is rarely helpful in predicting timing. It is impossible to understand the unprecedented dance between the Treasury, the Fed, and other bond buyers. Anyone who claims to know the outcome is ignorant. Still, we are concerned for people with excessively large bond allocations—especially ones including long duration Treasuries or leveraged mutual funds.
If Treasuries do surrender some of their gains from the last few years, it would create fear and paint a difficult backdrop for stocks to rally. But stocks often do best when climbing a wall of worry. The fundamental environment for equities is positive. There is an unprecedented amount of cash sitting on the sidelines doing little more than losing value to inflation. If 2013 gets off to a strong start, investors will grow impatient, particularly after 2012’s strong returns. A trickle of cash pouring into the stock market could easily become a powerful river.
Valuations are moderate. The forward PE of the S&P 500 is 13.7, according to the Wall Street Journal. This multiple could easily expand by 20% or more. If the housing market sustains momentum and drives economic growth above consensus, earnings could significantly exceed expectations. Very few expect a big up year for stocks, but the environment is right.
As always, there are areas of concern. For 2013, we view the biggest risks as:
- Re-emergence of the European debt crisis
- The beginnings of a US debt scare (a full-blown crisis is unlikely in 2013 because unlike Europe, the US can always print its way out of default)
- An attack on Iran spreading into broader war in the Middle East
- Hard landing in China (recent positive economic data makes this seems less likely than a year ago, in our opinion).
Putting it all together, we believe 2013 will most likely be a good year and will very likely exhibit bigger absolute moves than 2012. Volatility always causes discomfort, but when prices are rising, increased volatility can be a good thing.
Entering the fifth year of a bull market, we believe there is more upside potential for stocks than usual. Bonds should continue to play a meaningful role in most portfolios but must be managed with caution.
We know of no good way to forecast gold prices. As has been the case for a while, the price of gold is wildly higher than its intrinsic value, but there is no particular reason to think people will stop paying it. If bonds start to struggle, risk-averse investors may seek safety in gold, but there is no clear long term historical relationship between gold and interest rates. As usual, a low-to-mid single digit allocation for the coming year is appropriate for most.
The Bullish Case for Stocks
- Central banks globally are massively accommodative and continue to buy billions in bonds every week, flooding economies with money. Long term, this could prove inflationary, which is bad for stocks but worse for bonds. In the short term, stimulus should provide a boost to asset prices.
- Stocks are cheap globally. The S&P 500 is trading at about 14 times expected 12 month forward earnings, close to the historical average. The European market continues to hover just above book value.
- Interest rates are extremely low. Historically, valuations of stocks are inversely correlated with rates, implying stocks should move higher. The earnings yield on equities is around 8% (with a dividend yield of 2.2%), compared to just 1.6% in ten year Treasuries. This is massively bullish if you believe earnings will continue growing.
- Sentiment remains mostly negative. Very few people expect large gains in stocks.
- Corporate balance sheets are strong. US companies are holding over $1 trillion in cash.
- The US housing market continues to demonstrate momentum. Housing prices are beginning to rise, creating a wealth effect and stimulating the economy.
- Record low mortgage rates are allowing millions of families to refinance, freeing up extra money to spend or invest.
The Bearish Case for Stocks
- Significant legislative uncertainty surrounding spending reduction and the debt ceiling remains.
- Higher tax rates, primarily the elimination of the payroll tax holiday, could hamper economic growth.
- The European debt crisis is dormant but not solved. There is still no long-term solution likely to keep Greece in the Euro.
- Europe remains in recession with little promise of short term growth.
- China’s property slowdown could accelerate, unleashing a wave of bad debt issues which could slow global growth.
- Risk of geopolitical tension stemming from Iran remains elevated.
- Leading indicators of the US economy are mixed.
- The first year of a President’s term is historically the worst performing.
Global Economy in Brief
Most economic data released in the fourth quarter was positive on balance. Somewhat lost in the fiscal cliff noise was US GDP, which grew at a better than expected 3.1% annual pace in the third quarter. Corporate profits accelerated, and the latest S&P/Case-Shiller report showed further recovery in home prices. Unemployment remained elevated, but was flat with September and down from a year ago. Other housing data also showed signs of strength.
- US economic growth accelerated in the third quarter. GDP increased at an annual pace of 3.1%, up from 1.3% growth in the second quarter. This was the third revised estimate.
- Corporate profits were up 2.4% in the third quarter, faster than the 1.1% growth in the second quarter and 2.7% decline in the first.
- Unemployment remained flat at 7.8% in December. This is down from 8.5% in December of 2011.
- US Federal Reserve in December announced it will begin monthly purchases of Treasuries in addition to its existing purchases of mortgage backed securities. It stated it will not raise short-term rates until unemployment falls to 6.5% or the mid-term inflation outlook exceeds 2.5%.
- Case-Shiller home price index showed a 4.3% year over year increase in October. The latest figures for US building permits and existing home sales also came in ahead of expectations.
The euro-zone continued to struggle and officially entered recession with the third quarter’s contraction in GDP. Greece posted the highest level of unemployment, helping raise the aggregate euro-zone rate to 11.8%. Stronger nations like Germany recorded only modest growth, which has slowed in each of the last two quarters. Most expect further contraction in the fourth quarter.
- Euro area GDP contracted 0.1% in the third quarter, a slight improvement from the 0.2% decline in the second quarter. GDP fell 0.6% from the same period last year.
- European unemployment registered at 11.8% in November, up from 11.7% in October and 11.6% in September.
Economic growth in China slowed in the third quarter, but conditions appear to be stabilizing. Following eight straight months of year over year declines, home prices slightly increased in December. Retail sales have also steadily increased. Conversely, conditions in Japan worsened with the nation officially entering recession in the third quarter. Falling exports to Europe and China were the largest detractors.
- Third quarter GDP growth slowed to 7.4% year over year, down from 7.6% in the second quarter and 8.1% in the first.
- Housing prices were up 0.03% in December.
- Retail sales were up 14.9% in November, up from 13.2% growth recorded in August.
- Exports were up 2.9% in November, but down from 11.6% growth in October.
- GDP fell at an annualized rate of 3.5% in the third quarter. This is down from the 0.1% contraction in the second quarter.
- Exports were down 4.1% year over year in November.
US Housing Market
US housing has turned the corner to become an economic bright spot. We pointed out a few green shoots when 2012 was just getting underway, but it was still too early to declare the “r” word. Global economic conditions remained fragile and troubles in Europe risked derailing any positive momentum. Luckily, the overseas fallout was muted and a genuine housing recovery took hold. This was true for most of the year as positive data points continued to surface—the fourth quarter was no exception.
Compliments of the US Federal Reserve, financing a home is now cheaper than ever. According to Freddie Mac, thirty year fixed mortgage rates now sit at 3.35%, a historical low. The Fed’s $40 billion monthly purchases of mortgage backed securities, coupled with attractive home prices, is helping drive the recovery. As seen in the second figure below, prices have begun to rebound, albeit slowly.
As always, monthly data will ebb and flow. What matters are longer-term trends. As seen in the following charts, almost all are positive. Single family existing home sales have trended upward over the course of 2012 while inventories have fallen—both bode well for future price increases. US building permits and housing starts also now sit at multi-year highs.
All of this should add a much needed tailwind to US economic growth. Housing’s contribution to GDP has historically been around 17% to 18%, according to the National Association of Home Builders. This includes both residential fixed investment and consumption spending on housing services. Currently, these combined categories make up approximately 15% of GDP. This leaves plenty of room for growth, if only to return to historical levels. There is also a wealth effect whereby home-owners feel richer, and spend more, as the value of their homes increase.
The question then becomes: will the recovery continue? As long as the US doesn’t fall back into recession, which we view unlikely, housing will likely maintain its positive momentum. Home prices are simply too attractive and mortgage rates too low for potential buyers to ignore. Renting is also becoming increasingly expensive. According to Deutsche Bank, the ratio of rent to after-tax mortgage payments was 107.8% in the third quarter, implying rent is more expensive than a monthly home payment (for median homeowners). This is well above the 85% average since 1991.
Main Story: Iran
It’s been some time since Iran captured front page headlines. This is partially the result of domestic issues stealing the spotlight (i.e. Presidential elections and fiscal cliff). But Iran’s nuclear program and standoff with the international community remain an important issue to watch. Discussions with members of the UN Security Council broke down mid-year, and only recently has the country announced its willingness to resume talks. Saeed Jalili, the current secretary of Iran’s Supreme National Security Council, said he expects these discussions to take place in January. Whether this is a serious gesture or mere stalling remains to be seen. It is difficult to tell how long Iran can withstand international sanctions given its suffering economy.
According to the International Monetary Fund, Iranian GDP contracted by -0.9% in 2012, down from 2.0% growth in 2011 and 5.9% growth in 2010. The country has been plagued by government economic mismanagement, high inflation, a depreciating currency, and Western sanctions. The latter has had a particularly strong impact on oil sales which make approximately 80% of exports. In fact, Iran’s oil minister recently admitted that international sanctions led to a 40% drop in oil revenue. This is a marked change from the country’s previous policy of denial regarding the success of international pressure.
The end result has been deteriorating conditions across the country. There are numerous reports of rampant price increases leaving common household goods out of reach for poor and middle class families. And a lack of jobs is forcing many of the nation’s educated youth to seek employment in other countries.
These are major issues the country faces, but many doubt they will place enough short-term pressure to halt its nuclear program. Most believe Iran will have the capability to produce a nuclear weapon at some point in 2013. Some estimates place it within a few months. Regardless, the clock is ticking and Iran has yet to flinch.
So what next? There are a few possible outcomes. Additional sanctions could be placed, but the full impact would take time to materialize—time the international community doesn’t have. An Israeli led preventative strike is also possible, as is Iran obtaining a nuclear bomb. We view both scenarios as roughly equally likely. Both would cause increased volatility in stocks, but neither should be particularly negative for global markets unless a conflict spread and engulfed the broader Middle East in war.
Anti-American sentiment amongst Russians is nothing new. But the country’s recent bill banning U.S. citizens from adopting Russian children demonstrates President Putin’s willingness to use extreme measures to make a point. This act of defiance was in response to recent U.S. legislation that banned Russians accused of human-rights violations from obtaining visas. It will be interesting to monitor how relations between the US and Russia develop following Putin’s return to the presidency in 2012. His contempt for the West is widely known.
Another Rough Year for Mutual Funds and Hedge Funds
One of our core investment principles is avoiding actively managed mutual funds. There are several reasons. They are tax inefficient, tend to have high fees, and it is difficult to maintain a cohesive strategy with a blend of active funds. Most importantly, the vast majority of active mutual funds underperform their benchmarks.
2012 was no different. According to a Goldman Sachs study, two thirds of them lagged last year, roughly in line with the long term average. These are difficult odds to fight. Investors owning a diversified portfolio of funds almost guaranteed themselves poor performance.
Things were even worse in the hedge-fund world. A whopping 88% of hedge funds failed to keep pace with the S&P 500, and 635 of them shut down, according to Bloomberg. Meanwhile, high profile scandals such as insider trading allegations at SAC Capital Advisors further tarnished the industry.
None of this is a surprise, and it reinforces our belief in our Smart Indexing investment approach.
What’s New at Personal Capital Advisors
It was an exciting year for Personal Capital Advisors. 2012 marked our first full calendar year managing money for clients. We are very pleased with the results and are more confident than ever that our approach to wealth management and service is something special. More individuals and families are discovering the value every day, and we expect to pass $100 million in assets managed sometime in the first quarter. We recently moved into a larger office in San Francisco to facilitate growth, and continue to add talented new Advisors who are excited to help our clients improve their financial lives.
Thank you for your continued interest.
Bill Harris, Craig Birk, and Kyle Ryan
The Personal Capital Advisors Investment Committee
This article is distributed for informational purposes only. The author’s statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. Diversification strategies do not ensure a profit and cannot protect against losses in a broadly declining market. All investments involve risk including the loss of the principal amount invested. Data and statistics contained in this report are obtained from what Personal Capital considers to be reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.
The statements contained in this article relating to future performance, including, without limitation, future revenues, earnings, strategies, events and all other statements that are not purely historical, are forward-looking statements. Although we believe that our expectations are based on reasonable assumptions, we can give no assurance they will be achieved. Inherent risks and uncertainties could cause actual results to differ materially from the forward-looking statements made herein. Forward looking statements made in this article only apply as of the date of the article.
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