3Q 2012 Market Review and Outlook
Third Quarter Market Recap
Money, money and more money.
Central banks around the world unleashed a tsunami of cash during the third quarter. This backdrop formed the primary plot line for capital markets.
In the US, the Federal Reserve carried out the second stage of “Operation Twist”, exchanging over $100 billion of shorter dated securities for longer dated debt. In September, it upped the ante, announcing an open ended program to buy $40 billion of mortgage backed securities every month.
In Europe, ECB President Mario Draghi politically outmaneuvered the hawkish Deutsche Bundesbank, successfully announcing a program authorized to buy unlimited sovereign debt from troubled nations like Spain, Italy and (maybe) Greece. The Bank of England continued to work through an existing $610 billion stimulus program.
Not to be outdone, the Bank of Japan boosted its asset purchase plan to 80 trillion Yen, or roughly a trillion dollars. For perspective, this program represents a greater share of Japan’s GDP than the entire balance sheet of the Fed relative to US GDP.
Stimulus is designed to promote economic activity, create jobs, and boost asset prices. It is difficult to quantify if or how asset purchases drive production, but there is little doubt they are having a direct impact on capital markets.
Stocks rose sharply during the quarter. Record low mortgage rates drove year over year home price gains in the US for the first time since the financial crisis surfaced in 2007. Heightened inflation fears led to a modest decline in Treasury prices, while gold and most other commodities rallied.
The full impact and ramifications of Bernanke’s aggressive actions won’t be known for years, but the ECB’s new ability and willingness to wield the printing press had immediate consequence. With the announcement of the ECB’s bond buying authority, yields on Spanish debt dropped from the critical 7% range back to the neighborhood of 6%. The mere perception that the ECB will support bond prices should buy Spain and Italy significant time to get their financial houses in order. Unfortunately, Spain will most likely still require a bailout, and Greece surely will – if it is not forced out of the Euro first.
Capital Markets Outlook
We are in midst of a strong bull market. As of the end of the third quarter, the S&P 500 is 42 months removed from the 2009 low. Since then, the index has returned well over 100%, including nearly 20% this year.
We believe there is more room to run. There are three main reasons.
- Unprecedented and massive central bank stimulus. Central banks want asset prices to go up and are flooding the system with money like never before. How this plays out down the road in terms of inflation or other problems is unknown, but for the immediate future we believe it is wise to heed the classic advice, “Don’t fight the Fed”. The Fed wants stocks and home prices to go up, and they likely will.
- The housing market. Record low mortgage rates are making housing very affordable. This creates all sorts of positives. New construction creates jobs, rising home prices make people feel wealthier and spend more, and increased sales volumes support all sorts of jobs from mortgage bankers to furniture makers. Meanwhile, refinancings are giving millions of families an instant raise. The idea that everyone has already refinanced is flat wrong. The last week of the third quarter saw the largest increase in refinancing applications in three years.
- Sentiment & Valuation. We are just now starting to see signs of greed creep back into the market, but most remain skeptical or fearful. There is a huge pile of cash sitting on the sidelines earning a negative real yield. People won’t sit idle forever. The flow from cash into stocks and real estate has moved from a trickle to a small stream. It may not take much to become a gushing river. By standard valuation measures, the market is fairly or attractively priced. Bull markets usually end with high valuations, not low or middling ones.
We’re optimistic, but not overconfident. There are legitimate risks, including the Fiscal Cliff, Iran, a hard landing in China, and Greece and Spain. There is no good solution for Greece, and we expect the most likely outcome is it will be forced from the Euro. This would create significant uncertainty and cause a spike in volatility.
The current bull market is a big one, but the S&P 500 remains below its 2007 peak. This is backward looking, and doesn’t matter much. Focus on the present and the future, not the past.
Those heavily weighted in bonds should proceed with caution. Just after quarter end, unemployment dipped below 8% for the first time since January, 2009. It could be a blip, but if it trends below 7% the Fed will be forced to backtrack quickly. Rates would rise. A mere one percent rise in yields on a 30 year Treasury would currently cost its owner 20% in value.
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.
- Real progress was made in Europe this quarter. The ECB’s ability to purchase unlimited bonds from troubled countries, mostly Spain, is very significant and should prevent a catastrophic breakup of the common currency (other than perhaps Greece).
- 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 near 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.
- Very few people expect large gains in stocks.
- Corporate balance sheets are strong.
- Stocks usually rally following a Presidential election, regardless of who wins.
- The US housing market is growing again.
- Record low mortgage rates are allowing millions of families to refinance, freeing up extra money to spend or invest.
The Bearish Case
- The European debt crisis remains volatile. There is still no viable solution to fix Greece.
- Q3 earnings and sales for S&P 500 companies are projected to decline for the first time in three years, according to an analyst survey by Bloomberg.
- Europe is in recession and faces increased austerity measures.
- 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.
- The “fiscal cliff” could push the US into recession.
- Leading indicators of the US economy are mixed.
Global Economy in Brief
Economic data released in Q3 was mixed. Corporate profits increased, but lower personal consumption expenditures led to slowing GDP growth in the second quarter. This, coupled with stubbornly high unemployment, led the Federal Reserve to initiate an aggressive stimulus program to jumpstart the economy. On a positive note, the US housing market continued to show signs of improvement with rising prices, strong sales and low inventories.
- US GDP growth slowed in the second quarter. Revised estimates showed an annual pace of 1.7%, which was subsequently lowered to 1.3% in the latest estimate released in September.
- Corporate profits were up 1.1% in the second quarter, compared to a 2.7% decrease in the first quarter.
- Unemployment ticked down to 7.8% in September.
- US Federal Reserve announced open-ended commitments to buy $40 billion of mortgage-backed securities per month and signaled intention to keep interest rates low for years.
- Case-Shiller home price index showed a 1.2% year over year increase in July; new and existing home sales were up sharply in July and August over previous year levels.
Fear once again gripped Europe, leading to slowing economic conditions and record high unemployment. Greece took a back seat as bond yields in Spain and Italy spiked. However, the ECB’s proposal to purchase unlimited quantities of shorter duration bonds from struggling nations helped alleviate concerns.
- Euro area GDP contracted 0.2% in the second quarter, down from a revised 0.0% in the first quarter. The contraction was driven by lower fixed investment and consumer spending.
- Spanish 10 year bond yields spike to record levels in July on Euro fears, but subsequently pulled back and ended the quarter under 6%. ECB President Mario Draghi’s pledge to purchase government debt helped drive down yields.
- European unemployment registered at 11.4% in August, in line with June and July figures.
Growth is slowing in much of Asia. The largely export driven economies are feeling the impact of weaker economic conditions in Europe and the US. China’s growth is now at levels last seen in the 2009 downturn, while the country’s real estate prices continue to decline.
- Second quarter GDP growth slowed to 7.6% year over year, down from an 8.1% annual pace in the first quarter.
- Year over year growth in home prices remains negative, coming in at -1.2% in August.
- Retail sales growth continued to slow, coming in at 13.2% in August, which is down from 13.7% growth in June.
- Export growth slowed dramatically coming in at 1.0% and 2.7% in July and August, respectively. This is down from 11.3% in June.
- Economic growth slowed to 1.4% in the second quarter, compared to 5.5% in first. Softer consumer spending and sluggish exports were the primary detractors.
- Exports fell 5.8% year over year in August, the third such decline on weak demand from Europe and China.
US Housing and Mortgage Rates
Record low interest rates (3.4% for a 30-Year Fixed at the end of the third quarter) have pushed the US housing market into recovery mode. According to the National Association of Realtors, the median sales price in August was $187,400 – up 9.5% from a year earlier. This marks the largest increase since 2006. New home starts rose 2.3% for the month and sales of existing homes rose 7.8%, both ahead of expectations. We expect this trend will continue.
Anecdotally, we can’t remember a time when so many individual investors say they are planning to buy a property in the next 12 months. There’s a reason for that – lower home prices and cheaper financing are making homes more affordable and making buying significantly more attractive than renting in most areas.
The financial crisis which began in 2007 was the aftermath of a housing bubble fueled largely by government incentives. Interestingly, the new Fed-driven solution to high unemployment is to promote home purchases more aggressively than ever by artificially driving down mortgage rates. Quite frankly, in a pure economic sense, the average American does not deserve to be able to borrow large sums of money at 3.5%. But they can.
What all this cheap money will mean for the economy and the US dollar in five or ten years is unclear. In the meantime, home prices will probably rise further and the economy should benefit from a meaningful tailwind.
The Fiscal Cliff
We are about to fall off the “Fiscal Cliff”. That sounds pretty scary—such was the intention of Ben Bernanke when he coined the term in February. It refers to an automatic $660 billion of assorted spending cuts and tax increases which will trigger at the end of the year.
The financial media has implied these changes will cause immediate disruption and chaos. But the reality is the cliff is more like a rolling hill.
In some ways, the fiscal cliff is a blessing because the country has a serious debt problem and it forces action. Inherent advantages like being the default reserve currency and having a strong central bank have so far shielded the US from a debt crisis similar to what is currently occurring in places like Spain and Italy. But this won’t last forever if our government continues to spend trillions more than it takes in. Some combination of lower spending and higher taxes is necessary, and soon.
Unfortunately, the vast majority of the fiscal cliff comes in the form of tax increases, not spending cuts. Tax revenues are projected to rise roughly 20%, mostly due to the expiration of the “Bush tax cuts” first implemented in 2002. Spending is projected to be cut by a meager 1%, so the economic impact should be minimal. In all likelihood the government will end up spending more, not less. They’re good at that.
We acknowledge the economy is too fragile and unemployment remains too high to justify major tax increases. But there is very little chance the majority of scheduled tax increases will be in place very long. Republicans and Democrats both want to keep lower tax rates for all but the highest earners, typically defined as families with incomes over $250,000 or individuals with income over $200,000. Republicans want to maintain the current marginal rate of 35% for the highest earners while Democrats want it to revert to the pre-2002 rate of 39.6%.
It is extremely unlikely much progress will be made before the election on November 6th. This leaves precious little time to get anything done before the end of the year. As such, the fiscal cliff will likely become a reality.
But let’s consider this scenario. Tax rates will rise. From there, new legislation will technically be a tax cut, regardless of the specifics. Every legislator loves to vote for a tax cut. Therefore, compromise will be much easier in 2013. For the vast majority of Americans, we expect 2013 income taxes will be reduced back to the current levels well before 2012 returns are due in April of next year. This includes some type of extension of the AMT “patch”.
Some taxes increases will remain. Most important is the expiration of the 2% Social Security payroll tax cut. This will hit most Americans as a 2% pay cut, which is significant. But it is not enough to send the country back into recession. High earners will also start to pay for the Patient Protection and Affordable Care Act (Obamacare) in 2013. They will pay an additional 0.9% income tax on earnings above $250,000 ($200,000 for individuals) and an additional 3.8% on unearned income such as capital gains. We would argue recent momentum in the housing market will more than offset the macro impact of these tax increases.
The fiscal cliff matters and it will be a headwind for the economy. But as far as stocks are concerned, at this point it may actually be a reason for optimism. Excessive fear of the cliff may already be priced into the markets, opening the door for a relief rally when the eventual reality is less severe.
The race to the White House intensified as both candidates looked to boost popularity ahead of national debates. The biggest waves were made when Romney announced Paul Ryan as his vice presidential nominee and running mate. Picking the 42 year old congressman from Wisconsin seemed to invigorate and energize the Republican campaign, for a time. But beginning in early September Obama’s lead widened and he maintains a narrow lead in national polls.
At this point an Obama victory seems probable. A rebounding housing market and strong stock market returns will increase voter complacency with the current administration—despite stubbornly high unemployment. More of the same is often an easier choice. We don’t see either candidate having a particularly positive or negative short-term impact on the economy.
That said, the race got a little more interesting after the Colorado debate on October 3rd. To the surprise of many, Romney emerged as a formidable opponent. He focused heavily on policy details and appeared more effective than the usually smooth talking Obama. In fact, national polls taken immediately after the debate showed Romney as the clear victor. But this is more likely an isolated incident than a turning point in the election.
Perhaps the more important story concerns congressional elections, as these will determine whether the President has any power to pass legislation. The outcome is uncertain, but at this point the Republicans appear likely to maintain the House while Democrats will hold the Senate. In other words, gridlock. So whether it’s Obama or Romney in the White House, legislation will have to be watered down for any hope of approval. That is generally a positive scenario for stocks.
The Ever-changing Investment Landscape
401k Fee Disclosures
The investment world is constantly evolving. Our hope is these changes tilt the balance of power in favor of the investor—this quarter we witnessed just that. As of July 1st, 401k plan providers and employers were required by law to disclose all fees to plan participants. This may not seem like a big deal, but the US Government Accountability Office found small plans cost on average 1.33% annually for recordkeeping and administrative services alone. Add investment management fees and the total annual cost could be as high as 2% to 3%, sometimes more.
To make matters worse, most investors are completely unaware. An AARP survey found 70% of 401k participants had no idea there were embedded fees reducing their performance. And about 50% of plan sponsors didn’t know if they or their participants paid investment management fees, according to the General Accountability Office survey. These are alarming statistics, particularly when you consider how it impacts retirement. A difference of 2% in fees over 25 years results in almost 40% less money. That’s enormous!
Luckily, the tide has now turned. This new law brings excessive 401k fees into the spotlight. Of course, many firms will attempt to bury them in lengthy, complex disclosure packets. But they’re in there. And over time an increasing number of participants will blow the whistle and drive down these unnecessary charges. It should also bring greater attention to 401k investment options, which are often costly and inefficient active mutual funds.
This is a big deal. Over 60 million Americans have a 401k plan. Score one for the investor.
The Race to 0% Index Fund Fees
The trend to lower fees has been underway for some time. It started decades ago in the mutual fund industry with the creation of passive index funds. Given these investment vehicles track existing stock and bond indices, much of the overhead costs embedded in active funds were eliminated. This translated into significantly lower fees for investors, and often better performance. As a result, passive fund assets increased from $371 million in 2001 to almost $1.1 trillion at the end of 2011, according to the Investment Company Institute.
Investors scored again with the creation of exchange traded funds (ETFs). Similar to passive mutual funds, these investments mimic the return and composition of a specific index but trade on the secondary market and tend to be more tax efficient.
There were two big developments this quarter. First, Vanguard reduced the fees on many of its ETFs, and is positioning for additional reductions down the road. The company recently announced it is ditching MSCI for many of its benchmarks in favor of alternatives with cheaper licensing fees. It’s a good move. There are similar options with much lower costs. Second, Schwab aggressively discounted several of its index ETF fees, undercutting the traditional price leader, Vanguard, in many cases.
The means lower costs for investors—always a good thing.