Are We There Yet?

October, 2012
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

Ever since Henry Ford invented the Model T, parent drivers have been subjected to persistent questioning from those in the back seat. As one who has recently taken a family road trip from Indiana to Florida, I was not exempt from this ritual. However, my children have forsaken the ever popular “Are we there yet?” with my 11 year old commenting, “That’s really kind of a dumb question, because if you are still driving, you are obviously not there.” I attribute this remarkable insight to the intellectual genes she received from her parents and I’ll leave it at that. This time around, every couple of hours, someone would emerge from their electronic screen induced stupor, pull off their headphones, look around and ask “Where are we now?” This would then inevitably be followed by some sort of a comment on the immediate surroundings such as:

  • “Wow, those mountains are really beautiful.”
  • “Ah man, another traffic jam.”
  • “Is that where the Tennessee Titans play?”
  • “Why is everything in Atlanta named after peaches?”
  • “Those must be Christian cows because there’s a cross in their field.”

As investors, this same question is an important one to ask from time to time. So, where are we now?

The answer to this is of course much easier to describe in the context of where we’ve come from than where we are going, but we will discuss some of each.

After reaching the end of a bear market cycle in March, 2009, we have experienced a market recovery that has seen the S&P 500 rise 113%. The economy has survived the severe global financial crisis of 2008 and is still in the process of recovering, albeit not as robustly as most would like. The most recent GDP (Gross Domestic Product - the most common measure of economic growth) showed a growth of just 1.3% - compared to the 20 year average of 2.5%.

We are glad that this number is positive, but it is not big enough to indicate that enough jobs are being created to really improve the employment situation. The GDP number would need to be above 3% in order to create the 250,000 new jobs every month needed in order to drop the unemployment rate 1% over the course of a year. It takes about 125,000 new jobs per month just to keep up with population growth. The latest jobs report showed 2 different stories. One stated that only 114,000 jobs were created, while the other showed a dramatic drop in the unemployment rate to 7.8%

One reason for the slow economic growth is that people have been saving more and spending less. When economists calculate GDP, about 70% of the total value comes from consumption (you, me, and everyone else in the country buying stuff). As you can see by the chart below, households have been saving more and reducing debt, breaking a long trend of exactly the opposite.

Source: BEA, FRB, J.P. Morgan Asset Management. Personal savings rate is calculated as a personal savings (after-tax income - personal outlays) divided by after tax income. Employer and employee contributions to retirement funds are included in after-tax income but not in personal outlays, and thus are implicitly included in personal savings. Savings rate data as of August 2012. *3Q12 Household Debt Service Ratio is a J.P. Morgan Asset Management estimate. All other data are as of 2Q12 which is most recently available as of 9/30/12.

During this past quarter, the Federal Reserve (the Fed) announced that they will buy $40 billion a month of agency mortgage bonds. This has become known as QE3 because it is the third round of Quantitative Easing that the Fed has produced in an effort to stimulate the economy, however some are calling it QE∞ because unlike the previous rounds, no end date for this program was given. This is a mixed bag as far as investors are concerned. On one hand, this type of stimulus has shown itself to be favorable to the market; but on the other hand, the reason such a thing is needed is because of the weakening fundamentals of the economy. We remain skeptical of the overall benefit, though 2 specific areas should receive a boost: housing and exports.,

Housing has started to become a bright spot instead of a drain. Inventories are dropping and prices are rising. The Fed’s actions are helping to keep mortgage rates low which make homes even more affordable.

When interest rates are low, that typically puts downward pressure on the dollar. Foreigners wishing to buy American made goods can then do so at a price that is cheaper for them which increases demand and benefits those that produce exported goods and services.

Inflation remains mild with the latest reading showing 1.2%, significantly less than the 50 year average of 4.2%. Though the overall number is pretty tame, consumers are feeling the pinch of a drought induced increase in food prices combined with higher gas prices.

Here’s a look at how the markets did in the 3rd quarter:

Index 3rd Qtr 2012 1 Year Return 3 Year
Annualized Return
5 Year
Annualized Return
S&P 500 6.4% 30.2% 13.2% 1.1%
Dow Jones Industrial Average 5.0% 26.5% 14.4% 2.2%
Nasdaq Composite 6.2% 29% 13.7% 2.9%
Russell 2000 5.3% 31.9% 13.0% 2.2%
MSCI EAFE 7.0% 14.3% 2.6% -4.8%
Barclays US Aggregate Bond 1.6% 5.2% 6.2% 6.5%

So with the economy moving along sluggishly, why has the stock market done so well? One reason is that corporate earnings are high with profit margins near all time highs.

Source: Standard & Poor’s, Compustat, BEA, J.P. Morgan Asset Management. EPS levels are based on operating earnings per share. Most recently available date is 2Q12. Past performance is not indicative of future returns. Data are as of 9/30/12.

So that’s a picture of where we are; the next question is where are we going? One of the things markets don’t like is a high degree of uncertainty. Obviously no one knows for sure how the future will unfold, but the 3 issues that are most likely to impact investors are 1) corporate profits, 2) the November elections, and 3) the “Fiscal Cliff.”

We are facing the possibility, if not the likelihood that corporations will be less profitable. Throughout this past quarter, the number of companies indicating that they will be making less than expected has outnumbered those saying they will exceed expectations by a ratio of about 4 to 1. The implications for the market in this scenario are clear.

The November elections will impact many elements related to the direction of the country. The best outcome for investors is one that instills in Congress a willingness to work together to get things done; this for a group that would seem to have difficulty agreeing on what day of the week it is. Political and Policy Analyst, Michael Boland states it this way:

“The greatest risk is that the 2012 elections will cause the center of gravity in the Senate to move toward the left, not toward the center. This is not partisan; it would simply not set up the two bodies in Congress for fruitful negotiations, the kind that may greatly reduce investor uncertainty.”

It is likely that you will hear more and more discussion in the coming months related to what is called the “Fiscal Cliff.” This refers to several policy elements that are scheduled to be enacted all around the first of the year, that have the potential to limit or even squash the economic growth that we have been experiencing.

The first is the debt ceiling. You likely recall the heated debates last summer which eventually led to an extension of the debt ceiling. This extension only lasts through December and must be resolved soon.

The second is something called sequestration. This came as a result of the Deficit Committee failing to agree on a solution last November which now mandates cuts of $53 billion from both defense and discretionary spending to take place in the beginning of 2013 and continue each year until 2021.

The third and probably most important element of the Fiscal Cliff is the December 31 expiration of the tax cuts implemented during the Bush administration. If nothing is changed, we would see an increase in income taxes, capital gains taxes, and dividend taxes on top of the taxes required by the new Healthcare law.

It is clear that Congress will have some work to do to avoid damaging an already fragile economy. Most analysts seem to think that the most likely outcome is that the can gets kicked down the road, with both cuts and taxes put on hold for another quarter to allow time for the new Congress to work something out.

In conclusion, we continue to be optimistic over the long term and cautious over the short term. We think maintaining a broadly diversified portfolio gives investors the best opportunity to meet their financial goals. Keeping a somewhat reduced level of equities during this time of heightened uncertainty seems to be prudent to us. If the market presents a correction, we would view that as a buying opportunity.

Thanks again for letting us partner with you. If you have any questions regarding your portfolio or your financial journey, feel free to give us a call.

Sincerely,
The Castle Investment Advisors®, LLC Investment Team 

                    
 
Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. 
Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.