It Was the End of the World as We Know It, and I Feel Fine

- 2012 4th Quarter

2012 is in the history books and what a year it was. From the Elections to the Olympics to the devastating natural disasters and to the Mayan “end of the world”. It was a tumultuous, exciting, and sometimes tearful year. But we made it through and are now looking ahead to 2013. It was a good year for the U.S. equity markets. The S&P 500 returned an approximate 16% gain (fourth up year in a row), which is well above historical averages of around 8% while international markets also performed well, as the MSCI EAFE Index returned 17.32% and the MSCI Emerging Markets Index a 15.15 % return. The strong performance of equity markets across the board show a belief in the economic recovery in the U.S. led by the housing market; political improvements in Europe, where the debt crisis appears to have largely been contained; and a successful leadership transition in China. Outside the U.S., the risks appear to be much more manageable at the end of 2012 than at its start. (BTN Research).

In December, markets fluctuated with news from Washington, DC.1 The defining event of the month, for both the economy and financial markets, was the “fiscal cliff” issue. Lawmakers did buy a little time with a New Year's agreement but left themselves only two months to settle the issue of how much the U.S. should borrow/ spend and where those budget cuts will come from. What was decided:

  1. Payroll taxes are going back up, for most workers, you have already seen your paycheck shrink by 2 percent ( the Social Security payroll tax applies only to the first $113,700 of earnings – so higher salaries are not affected at the same percent).
  2. Income over $400,000 for individuals or $450,000 for couples will be taxed at a top rate of 39.6 percent, up from 35 percent. Everyone else keeps their current income tax rates.
  3. Capital gains and dividends are rising from 15 to 20 percent. And the tax on estates worth more than $5 million will go up to 40 percent, from 35 percent.
  4. The alternative minimum tax — designed to keep the wealthy from using loopholes to avoid taxes – will be permanently indexed for inflation.
  5. Tax breaks for families with children, college tuition, and low-income workers will continue for five years.
  6. Emergency federal unemployment benefits to help 2 million people out of work for at least six months will be extended a year.
  7. A scheduled 27% cut in Medicare payments to doctors will be held off for a year in what's become a congressional ritual.2

In 2012, midsized companies outperformed large and small-cap companies, and value beat growth. On a sectorbasis, financial and consumer discretionary stocks did best, while the utilities and energy sectors lagged. Stocks have stealthily pushed higher over the past four years, with the S&P 500 now just 9 percent below its 2007 peak.

The international markets continued to rise in December. Through month-end, the MSCI EAFE and MSCI Emerging Markets indices rose 3.2 percent and 4.78 percent, respectively. We believe these returns evidence an improving economic climate in emerging markets and a stabilization of European markets.

In Europe and U.S. an influx of capital into the marketplace by banks and the Federal Reserve boosted the Market both at home and abroad. In Europe a successful second round of long-term bank refinancing operations (LTRO 2) combined with ECB Governor Draghi’s securing the agreement of member states to bring forward the implementation of the European Stability Mechanism (ESM), the single currency’s bailout fund successfully stopped market volatility and concerns that had arisen at the end of the first quarter.3

In the U.S. Federal Reserve’s (Fed) Operation Twist also aided the rally in risk assets. The Fed engaged in a third round of quantitative easing (QE3) with an open-ended time horizon targeting an unemployment rate of 6.5%. European and U.S. central banks were also joined by their peers in the developing markets, as both China and Brazil cut lending rates during the year.4

While the ECB and Fed engaged in specific areas of relief, the Eurozone fell into mild recession, the Japanese economy struggled, and global manufacturing stagnated. In the U.S., the economy continued to grow at a slow pace, largely as a result of an improving housing market and reasonable levels of consumer spending. The engagement by the Fed and ECB triggered confidence in investors that a disorderly dissolution of the Eurozone was unlikely which spurred Market growth, even as the global economy struggled.

On the upside, 2012 was the year that the economic housing recovery in the U.S. got off the ground. Economists have been encouraged by three straight months of increases in the S&P/Case-Shiller home price index, a pick-up in sales of existing homes and home construction, and a big jump in the price of new home sales. Mortgage rates are also likely to remain near record lows thanks to the Federal Reserve's purchase of $40 billion in mortgages a month for the foreseeable future.5

Another good sign of economic recovery is that unemployment dipped to its lowest level in four years to 7.7% at year end 6. The nation’s employers added 146,000 jobs in November in line with the average of 151,000 a month in 20127. The growth is a substantial improvement from the end of 2011/ beginning of 2012 and went far to foster investor’s confidence.

Consumer spending followed the recovery in housing values and employment, tracking previous recovery levels and moving back above the peak of the previous cycle. Consumer savings rates fell but remained at reasonable levels, and consumer debt and debt service levels declined to multiyear lows, suggesting that demand would be sustainable.

On the down side, business spending was lackluster as companies held off on purchase of computers, industrial equipment, and manufacture goods. This remained the weakest part of the economy, and whether this will improve in the coming year is still unclear.

So that’s where we were – where are we headed?

An economic recovery has definitely taken root in the U.S., and domestic economic trends look encouraging. The political and economic risks in Europe remain but significantly reduced since the beginning of last year. China and other emerging markets are showing signs of stronger growth after a slowdown.

A major risk for the U.S. is if whether the government can act in a responsible, bi-partisan manner regarding the pending debt ceiling debate. In 2011, a similar debate almost led to default on U.S. government debt, resulting in a credit rating downgrade. Another risk is the reduced scope of the possible policy responses available to central banks. Now that monetary authorities have fully committed themselves to bolstering the recovery, investors will have to rely on individual consumers and businesses to drive the economy forward.

Despite these risks, developments in the U.S. and around the world bode reasonably well for markets at the start of 2013. In the U.S., the risks are containable and the damage done by the fiscal cliff may well be limited. Cautious optimism is the appropriate stance. Investors should neither shun markets nor become overconfident but instead stay focused on their long-term strategic allocations and goals.

What does this mean for your 401(k) account or your other investments, following the advice of Mark Twain, “there are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can”. This commentary is intended to update our clients on where the Market has been and where it is projected to go. With “Projected” being the operative word. We cannot control the Market we can only control how we invest in it. From time to time we are all inundated with the Media telling us the sky is falling (or more accurately – the Market). Such news can strike fear in the heart of investors and force some bad investment decisions. Burton Malkiel, author of A Random Walk Down Wall Street, gives a great tool for investors to think about when the Market takes a tumble:

Short Quiz: if you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef?

Final Exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”

When we understand that over the last 100 years, the Market performed quite well (see chart) and although there were hills and valleys - if we draw a straight line from the starting point forward we see a definite ascension. Market timing can be detrimental
to your account - the total return for the S&P 500 was a gain of 16.0% in 2012. If you missed the 3 best percentage days last years, the 16.0% gains falls to a 8.4% gain.8

Further, how those funds are allocated in the Market is another major concern for investors, Malkiel continues:, “the most important investment decision you will probably ever make concerns the balancing of asset categories at different stages of your life. According to Roger Ibbotson, who has spent a lifetime measuring returns from alternative portfolios, more than 90 percent of an investor’s total return is determined by the asset categories that are selected and their overall proportional representation. Less than 10 percent of investment success is determined by the specific stocks or mutual funds that an individual chooses”.

Our goal at Pension Advisors is to make sure that as our clients’ age their AdviseMe portfolio continues to be in line with their suitability. To that end we are rolling out a campaign in 2013 to contact AdviseMe participants with updated suitability questionnaires to ensure that our participants continue to be invested in the portfolio most suited to their time horizon, investment goals, risk tolerance, while taking into account their total investment picture. Our mission is to continually manage and improve AdviseMe to benefit our clients for
today and into tomorrow.

As always, we are available at any time for individual consultations and look forward to meeting with you. Please do not hesitate to contact me directly at (216) 595-0700.

1 Markets Fluctuated on Fiscal Cliff Deadlock, By International Business Times
2 Fiscal Cliff Deal Will Raise Taxes On 77 Percent Of Americans: Tax Policy Center Analysis , By STEPHEN OHLEMACHER
3 LTRO-2 to power markets: Cheap funding for European banks from ECB may see some of the liquidity flowing to emerging markets . Business Standard.
4 In theory, quantitative easing should work in two ways. First, it injects more cash into banks, allowing them to lend more. And second, it lowers interest rates — if the Fed buys up a bunch of mortgage-backed securities, for example, that should make it cheaper to borrow money to buy a house. In practice, interest rates do drop. But it’s hard to figure out whether this translates into a boost in the actual economy. After all, low mortgage rates can only do so much if bank are scarred by the housing bubble and remain tightfisted about lending. QE3: What is quantitative easing? And will it help the economy?, by Brad Plumer
5 Economists: Housing recovery finally here, By Chris Isidore
6 U.S. Department of Labor.
7 Unemployment rate falls to lowest level since 2008m By Annalyn Kurtz
8 BTN Research.


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