The View From the Fiscal Cliff: Economic Update and Thoughts on 2013 and Beyond

Transcription

1 The View From the Fiscal Cliff: Economic Update and Thoughts on 2013 and Beyond Presented by: Jeffery A. Acheson, QPFC, AIF Partner Schneider Downs Wealth Management Advisors, LP SD Retirement Plan Solutions Division

2 Important Information The views and opinions expressed are those of the speaker and are subject to change based on factors such as market and economic conditions. These views and opinions are not an offer to buy a particular security and should not be relied upon as investment advice. Past performance cannot guarantee comparable future results.

3 Important Information Performance quoted is past performance and cannot guarantee comparable future results; current performance may be higher or lower. Results shown assume the reinvestment of dividends. An investment cannot be made directly in an index. Investments with higher return potential carry greater risk for loss. Investing in small companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity. Foreign securities have additional risks, including exchange rate changes, political and economic upheaval, the relative lack of information about these companies, relatively low market liquidity and the potential lack of strict financial and accounting controls and standards. Investing in emerging markets involves greater risk than investing in more established markets such as risks relating to the relatively smaller size and lesser liquidity of these markets, high inflation rates, adverse political developments and lack of timely information. Fluctuations in the price of gold and precious metals often dramatically affect the profitability of the companies in the gold and precious metals sector. Changes in political or economic climate for the two largest gold producers, South Africa and the former Soviet Union, may have a direct effect on the price of gold worldwide.

4 Stock Market Fiscal cliff Total federal taxes would jump +20%. That would kill economic expansion. This just released study from the influential think tank in Washington is bound to alarm congressional legislators on both sides of the aisle. In my opinion, it s likely that they will enact legislation in their lame duck session to postpone the cliff until mid October 1, 2012

5 Economic Data Simpson-Bowles the guts of a grand compromise Medicare and Medicaid Social Security Other Federal Noninterest Spending Source: The National Commission on Fiscal Responsibility and Reform The Moment of Truth, The White House, December 2010 (aka Simpson-Bowles ).

6 Economic Data Simpson-Bowles the guts of a grand compromise Key Provisions: Taxes: Lower rates, broaden base, cut deductions, maintain or increase progressivity. (P. 28) Health Care: Reduce or eliminate tax exclusion for employer paid health insurance premiums. (P. 36) Pay providers based on quality, not quantity. (P. 36) Raise the annual deductible and patient co pay to reduce over utilization. Restrict first dollar coverage in Medigap policies. (P. 38) Eliminate states gaming of Medicaid tax gimmick. (P. 39) Medical malpractice reform (P. 39) Establish Social a Security federal healthcare spending growth cap of GDP +1%. (P. 41) Medicare and Medicaid Social Security: Gradual move to a more progressive benefit formula that slows future benefit growth. (P. 49) Gradual increase in retirement age, indexed to increases in life expectancy. (P. 50) Other Federal Noninterest Spending Source: The National Commission on Fiscal Responsibility and Reform The Moment of Truth, The White House, December 2010 (aka Simpson-Bowles ).

7 S&P 500 Index Stock Market Barely-believed bull S&P 500 TR index is up +18% YTD Jan 10 QE 1 Feb 10 4/23/ /6/10 Flash Crash 5/9/10 1st European Rescue Plan EFSF Mar 10 Apr 10 May 10 Jun 10 16% 7/2/ % 8/27/10 Bernanke's speech at Jackson Hole, hinting at QE2. 8/13/10 David Rosenberg: double dip recession is "a virtual certainty." Jul 10 Aug 10 Sep 10 Oct 10 12/19/10 Meredith Whitney: "You could see fifty to 100 sizeable defaults." Nov 10 Dec 10 Jan 11 Feb 11 QE 2 Mar 11 Apr 11 4/29/ May 11 May June 2011: softer economic data 7/21/11 2nd European Rescue Plan increased EFSF, 20% Greek haircut Source: Standard & Poor s. Data through October 5, Fed s September 13 th meeting statement: the Committee decided to continue through the end of the year its program to extend the average maturity of its holdings; buy $40 billion per month of mortgage-backed bonds, open-ended commitment (QE 3). 2 Barron s survey of 10 Wall Street strategists published December 19, % Jun 11 8/5/11 S&P cuts U.S. 10/3/11 debt rating 1,099 Jul 11 Aug 11 Sep 11 Oct 11 Nov % Dec 11 4/2/12 1,419 12/20/11 ECB institutes LTRO Jan 12 Feb 12 Mar 12 10% Apr 12 Weak March June jobs reports; European austerity fatigue 6/1/12 1,278 7/26/12 ECB says it will "do whatever it takes" to save euro 6/20/12 Operation Twist extended through YE Operation Twist 1 and QE 3 May 12 Jun 12 Jul 12 Aug 12 9/13/12 Fed announces QE 3 9/6/12 ECB announces unlimited bond buying program Strategists average beginningof year forecast for S&P 500 at 12/31/12 was Sep 12 Oct 12 Nov 12 Dec 12

8 Stock Market New highs what s behind the barely-believed bull? Better (and better than expected) economic data has been piling up: ISM PMIs strong Leading Economic Indicators (LEI) up ECRI s weekly LEI five straight up weeks Citi s economic surprise index up ADP s August new jobs > 200K Weekly unemployment claims consecutive down weeks Housing starts up Home prices up Car sales strong Consumer income and spending up Retail sales up Household net worth up Bank lending up S&P earnings estimates holding up CPI down Valuation room for P/E multiple expansion IMF s October global forecast shaved but holding up Copper rallied +12% from summer lows and stabilized See the following pages. The stock market rally from the June bottom has not only been fueled by QE. The more significant catalyst, in my opinion, has been the accumulation of better and better thanexpected economic data.

9 Stock Market New highs what s behind the barely-believed bull? Quantifying better than expected economic data: The Citigroup Economic Surprise Indices are objective and quantitative measures of economic news. They are defined as weighted historical standard deviations of data surprises (actual releases vs Bloomberg survey median). A positive reading of the Economic Surprise Index suggests that economic releases have on balance beating consensus. The indices are calculated daily in a rolling three month window. The weights of economic indicators are derived from relative high frequency spot FX impacts of 1 standard deviation data surprises. The indices also employ a time decay function to replicate the limited memory of markets. Bloomberg Source: Citigroup. Data through October 4, 2012

10 Stock Market S&P 500 earnings estimates holding up $ $ and 2013 estimates have held steady despite all of the recent talk of weaker earnings. Sources: Yardeni Research, Inc. and Thomson Financial survey of consensus estimates.

11 Stock Market S&P 500 revenues estimates up 2012 and 2013 revenue estimates have turned up. Sources: Yardeni Research, Inc. and Thomson Financial survey of consensus estimates.

12 Stock Market S&P 500 earnings estimates holding up , See how grossly distorted valuations became in the bubble run from 1993 to 2000 the gap between the S&P Index (black line) and earnings (red line). S&P ,600 1,400 S&P 500 Earnings ($) ,200 1, S&P 500 Index S&P 500 Earnings Q3 10/1/2 2011Q4 2010Q4 2009Q4 2008Q4 2007Q4 2006Q4 2005Q4 2004Q4 2003Q4 2002Q4 2001Q4 2000Q4 1999Q4 1998Q4 1997Q4 1996Q4 1995Q4 1994Q4 1993Q4 1992Q4 1991Q4 1990Q4 1989Q4 1988Q4 1 Estimated 2012 and 2013 bottom-up S&P 500 earnings per share (left scale) as of September 27, 2012: for 2012, $103.37; for 2013, $ Sources: Yardeni Research, Inc. and Thomson Financial survey of consensus estimates. Standard and Poor s for index price data through October 1, 2012; and actual earnings data through June 30, 2012.

13 Economic Data Europe s leading economic indicators In August, the LEI for the Euro Area rose for the first time in six months, fueled by good stock market performance and improved business confidence. However, it seems too early to interpret this as a sign of stabilization, let alone as a sign of a sustainable recovery. Production related indicators remained in contraction territory and consumer confidence declined on rising unemployment fears. If European decision makers can maintain the momentum towards greater financial and fiscal stabilization, then these first signs of better business confidence may help to support somewhat stronger economic conditions later in the year or early LEI The seven components of The Conference Board Leading Economic Index for the Euro Area: 1) Economic Sentiment Index (source: European Commission DG-ECFIN) ; 2) Index of Residential Building Permits Granted (source: Eurostat); 3) EURO STOXX Index (source: STOXX Limited); 4) Money Supply (M2) (source: European Central Bank); 5)Interest Rate Spread (source: European Central Bank); 6) Eurozone Manufacturing Purchasing Managers Index (source: Markit Economics); 7) Eurozone Service Sector Future Business Activity Expectations Index (source: Markit Economics). Source: The Conference Board. Data through August 2012.

14 Economic Data China s leading economic indicators The improvement in the China LEI in August raises expectations for a moderate rebound in growth, even as current economic conditions remain subdued. The LEI s largest increase in seven months was primarily due to a rebound in real estate activity, with strong credit growth and an improvement in consumer expectations also adding to the uptick. The six components of The Conference Board Leading Economic Index for China: 1) Total Loans Issued by Financial Institutions (source: People s Bank of China); 2) 5000 Industry Enterprises Diffusion Index: Raw Materials Supply Index (source: People s Bank of China) ; 3) NBS Manufacturing PMI Sub-Indices: PMI Supplier Deliveries (source: National Bureau of Statistics) ; 4) Consumer Expectations Index (source: National Bureau of Statistics); 5) Total Floor Space Started (source: National Bureau of Statistics); 6) NBS Manufacturing PMI Sub-Indices: Export Orders (source: National Bureau of Statistics). Source: The Conference Board. Data through August 2012.

15 Economic Data World GDP growth forecasts 12 GDP Growth Forecasts 10 GDP Growth (% Change Y/Y) Actual Forecast Euro Area U.S. Japan China Brazil India Source: IMF, World Economic Outlook Update, October 8, 2012.

16 With the fiscal crisis, net government job formation has been a damper on total new job formation. Government sector job formation is unlikely to pick up much given budget constraints. Economic Data Private jobs rising, government jobs still contracting 2010 census hiring spike The recovery in private sector new job formation has been sluggish but not too atypical. Total 114 Private 104 Government 10 Oct 12 Jul 12 Apr 12 Jan 12 Oct 11 Jul 11 Apr 11 Jan 11 Oct 10 Jul 10 Apr 10 Jan 10 Oct 09 Jul 09 Apr 09 Jan 09 Oct 08 Jul 08 Apr 08 Jan 08 Oct 07 Jul 07 Apr 07 Jan 07 Oct 06 Jul 06 Apr 06 Jan 06 Oct 05 Jul 05 Apr 05 Jan 05 Oct 04 Jul 04 Apr 04 Jan 04 Oct 03 Jul 03 Apr 03 Jan 03 Oct 02 Jul 02 Apr 02 Jan Source: Bureau of Labor Statistics; data through September Jobs by Category 1 month change (000) 1 month change (000)

17 Economic Data ADP jobs survey private jobs recovery looks pretty normal ADP private sector jobs reports showing higher lows, higher highs. ADP estimate k (ADP) 104k (BLS) Note the last two summer slumps. 100 Sep 12 Apr 12 Nov 11 Jun 11 Jan 11 Aug 10 Mar 10 Oct 09 May 09 Dec 08 Jul 08 Feb 08 Sep 07 Apr 07 Nov 06 Jun 06 Jan 06 Aug 05 Mar 05 Oct 04 May 04 Dec 03 Jul 03 Feb 03 Sep 02 Apr 02 Nov 01 Jun 01 Jan BLS estimate Source: ADP, Bureau of Labor Statistics. Data through September Private nonfarm payrolls 1 month change (000)

18 Non manufacturing comprises the vast majority of the U.S. economy. Economic Data Goods vs. Services % of GDP 16,000 64% of GDP 12,000 Services 8,000 7% of GDP Structures 4,000 29% of GDP Goods IV 2011 I 2010 II 2009 III 2008 IV 2008 I 2007 II 2006 III 2005 IV 2005 I 2004 II 2003 III 2002 IV 2002 I 2001 II 2000 III 1999 IV 1999 I 1998 II 1997 III 1996 IV 1996 I 1995 II 1994 III 1993 IV 1993 I 1992 II 1991 III 1990 IV 1990 I Source: Bureau of Economic Analysis. Data through March, Contribution to GDP by Category ($billions) (stacked chart)

19 Economic Data Vehicle sales recovering pent-up demand Total Cars and Light Trucks September s 14.9 million annual run rate was above estimates and set a new recovery high water mark. August 2009 cash for clunkers Jul 12 Jan 12 Jul 11 Jan 11 Jul 10 Jan 10 Jul 09 Jan 09 Jul 08 Jan 08 Jul 07 Jan 07 Jul 06 Jan 06 Jul 05 Jan 05 Jul 04 Jan 04 Jul 03 Jan 03 Jul 02 Jan 02 Jul 01 Jan 01 Jul 00 Jan 00 Jul 99 Jan 99 Jul 98 Jan 98 Jul 97 Jan 97 Jul 96 Jan 96 Jul 95 Jan 95 Jul 94 Jan 94 Jul 93 Jan 93 Jul 92 Jan 92 Jul 91 Jan 91 Jul 90 Jan Source: BEA, WardsAuto. Data through September New Unit Sales SAAR (millions)

20 Economic Data Housing starts recovering 1,900 1,700 1,500 1,300 1,100 Housing Starts (estimated) Housing Starts (actual) 900 April 2010 End of tax credit May 2009 First-time homebuyers tax credit announced 300 Q3 13 (E) Q1 13 (E) Q3 12 (E) Jul-12 May-12 Mar-12 Jan-12 Nov-11 Sep-11 Jul-11 May-11 Mar-11 Jan-11 Nov-10 Sep-10 Jul-10 May-10 Mar-10 Jan-10 Nov-09 Sep-09 Jul-09 May-09 Mar-09 Jan-09 Nov-08 Sep-08 Jul-08 May-08 Mar-08 Jan-08 Nov-07 Sep-07 Jul-07 May-07 Mar-07 Jan-07 Nov-06 Sep-06 Sources: U.S. Census Bureau, data through July 2012; Mortgage Bankers Association s housing starts forecast dated August 20, (000's)

21 Economic Data Housing starts: the big picture very positive 4,000 3,500 U.S. Population Growth (actual) U.S. Population Growth (projected) 3,000 (000's) 2,500 2,000 1,500 1, Housing Starts Basic housing arithmetic: the U.S. adds about 3 million bodies per year we need to build about 1.5 million new units per year. New home construction will substantially recover Source: U.S. Census Bureau. Actual population data through 2008; projections Actual annual housing starts through 2011.

22 Economic Data Construction and vehicles combined tailwind for GDP growth % of GDP (stacked) 16% 14% 12% 10% 8% 6% Vehicles Structures Historically these two categories have contributed >12% of GDP. Today, they are ~10%. There is good reason to think both will continue to recover, providing a lift to GDP in the quarters ahead. 4% 2% 0% 2012-I 2011-I 2010-I 2009-I 2008-I 2007-I 2006-I 2005-I 2004-I 2003-I 2002-I 2001-I 2000-I 1999-I 1998-I 1997-I 1996-I 1995-I 1994-I 1993-I 1992-I 1991-I 1990-I Sources: Bureau of Economic Analysis. Data through June 2012.

23 Economic Data Household debt Household debt The stock of household debt is high by historic comparison. This is often taken to mean that Americans are struggling under an unsupportable debt load. ($ trillions) Disposable personal income (DPI) Because DPI has steadily increased and interest rates are far lower than in previous decades, in fact, Americans are in the best shape with respect to servicing their household debt than they ve been in a long time. See next slide Q4 2011Q1 2010Q2 2009Q3 2008Q4 2008Q1 2007Q2 2006Q3 2005Q4 2005Q1 2004Q2 2003Q3 2002Q4 2002Q1 2001Q2 2000Q3 1999Q4 1999Q1 1998Q2 1997Q3 1996Q4 1996Q1 1995Q2 1994Q3 1993Q4 1993Q1 1992Q2 1991Q3 1990Q4 1990Q1 Source: Federal Reserve. Data through June 2012, released September 20, 2012.

24 Financial Obligations as a Percent of DPI (%) Economic Data Consumers Financial Obligations Ratio record low 19% 18% 17% 16% 15% 14% The financial obligations ratio consists of estimated required payments on outstanding mortgage and consumer debt plus automobile lease payments, rental payments on tenantoccupied property, homeowners insurance and property tax payments divided by disposable personal income. 1980Q1 1981Q1 1982Q1 1983Q1 1984Q1 1985Q1 1986Q1 1987Q1 1988Q1 1989Q1 1990Q1 1991Q1 1992Q1 1993Q1 1994Q1 1995Q1 1996Q1 1997Q1 1998Q1 1999Q1 2000Q1 2001Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 2009Q1 2010Q1 2011Q1 2012Q1 15.7% Comparing consumers monthly flow of income to their fixed recurring monthly expenses, including debt service, gives a more accurate measure of consumers financial health. Here s the shocker: consumers ability to cover the monthly nut has seldom been better as incomes have recovered, household debt has been reduced and interest rates remain low. Source: Federal Reserve, data through June 2012; released September 27, 2012.

25 Economic Data Retail sales pause in powerful recovery from recession $ billions Retail Sales (monthly) 10,000 9,000 8,000 7,000 6,000 5,000 The recovery in retail sales was at odds with the widely accepted new normal hypothesis that consumer spending would be substantially constrained ,000 3, summer soft patch followed by reacceleration , Clear bands represent recession. 1, Jul 12 Feb 12 Sep 11 Apr 11 Nov 10 Jun 10 Jan 10 Aug 09 Mar 09 Oct 08 May 08 Dec 07 Jul 07 Feb 07 Sep 06 Apr 06 Nov 05 Jun 05 Jan 05 Aug 04 Mar 04 Oct 03 May 03 Dec 02 Jul 02 Feb 02 Sep 01 Apr 01 Nov 00 Jun 00 Jan 00 Source: U.S. Census Bureau; data through August 2012.

26 Economic Data Personal income and spending by quintile 50% 45% 40% 35% 30% 25% 20% 15% 10% Percent of Total Income After Tax Percent of Total Consumer Spending Because income and spending are skewed to the upper brackets, the recovery in spending growth is significantly a function of spending behavior in the higher brackets. The top two income quintiles account for 62% of total spending; the bottom two account for 21%. 5% 0% Lowest 20 Second 20 percent ($10,034) percent ($26,966) Third 20 percent ($45,189) Fourth 20 percent ($71,220) Highest 20 percent ($150,144) Income Quintiles (average income in parentheses) Sources: Bureau of Labor Statistics, Consumer Expenditure Survey. Data for 2010, released September 2011.

27 Economic Data U.S. Index of Leading Economic Indicators (monthly) Index (2004=100) The economy continues to be buffeted by strong headwinds domestically and internationally. As a result, the pace of growth is unlikely to change much in the coming months. The Conference Board September 20, 2012 Clear bands indicate recession. 60 Jan-12 Jan-11 Jan-10 Jan-09 Jan-08 Jan-07 Jan-06 Jan-05 Jan-04 Jan-03 Jan-02 Jan-01 Jan-00 Jan-99 Jan-98 Jan-97 Jan-96 Jan-95 Jan-94 Jan-93 Jan-92 Jan-91 Jan-90 Jan-89 Jan-88 Jan-87 Jan The Conference Board Leading Economic Index (LEI) components: 1) average weekly hours worked, manufacturing; 2) average weekly initial unemployment claims; 3) manufacturers new orders consumer goods and materials; 4) ISM index of new orders; 5) manufacturers new orders, nondefense capital goods; 6) building permits new private housing units; 7) stock prices, S&P 500; 8) Leading Credit Index ; 9) interest rate spread; 10-year Treasury less fed funds; 10) index of consumer expectations. Source: The Conference Board. Data through August 2012.

28 Economic Data Gross Domestic Product (GDP) Growth 9 Economists see higher growth in the quarters immediately ahead. Actual and Forecast III(E) 2013-I(E) 2012-III(E) 2012-I 2011-III 2011-I 2010-III 2010-I 2009-III 2009-I 2008-III 2008-I 2007-III 2007-I 2006-III 2006-I 2005-III 2005-I 2004-III 2004-I 2003-III 2003-I 2002-III 2002-I 2001-III 2001-I 2000-III 2000-I 1999-III 1999-I 1998-III 1998-I 1997-III 1997-I Sources: Bureau of Economic Analysis, actual data through June, 2012; Wall Street Journal survey taken September 7-11, Q/Q % change(annualized)

29 Economic Data This is a big story shale is re-industrializing America! The economic benefits of rising energy production are spreading far beyond the traditional oil patch Manufacturing plants are returning to the U.S. to take advantage of cheap natural gas, spurring major investments in petrochemical and steel production in the Gulf Coast and Midwest. We think lower natural gas prices are creating a structural economic advantage for the U.S. it s a new competitive strength for U.S. manufacturers Asian companies paying up to six times what their competitors are paying in Texas and Louisiana. Consumers throughout the U.S. are paying lower bills for heating and electricity because of cheap natural gas. Augusta ME consumers to switch to low cost gas from high cost home heating oil, keep local paper mills going. The U.S. balance of payments is improving because of the new energy economy. For every new job working in the oil and gas sector, another four are supported by the energy supply chain and by workers spending more money on goods and services (one economist s estimate). Consumer psychology: People believe this is a game changer for the region, resulting in more spending on dining out and entertainment. Source: Wall Street Journal, February 8, 2012.

30 Economic Data U.S. manufacturing renaissance? Labour costs are growing less and less important: a $499 first generation ipad included only about $33 of manufacturing labour, of which the final assembly in China accounted for just $8. Offshore production is increasingly moving back to rich countries not because Chinese wages are rising, but because companies now want to be closer to their customers so that they can respond more quickly to changes in demand. And some products are so sophisticated that it helps to have the people who design them and the people who make them in the same place. The Boston Consulting Group reckons that in areas such as transport, computers, fabricated metals and machinery, 10 30% of the goods that America now imports from China could be made at home by 2020, boosting American output by $20 billion 55 billion a year. Source: The Economist, April 21, 2012.

31 Economic Data Manufacturing value added by country U.S. 1.8E E+12 China 1.4E+12 Western Europe 1.2E+12 1E+12 Japan 8E+11 6E+11 The U.S. is still the world s largest manufacturer. 4E+11 India 2E+11 Brazil Source: United Nations. Data through E+12 = 1.8 trillion. Constant 2005 Prices ($)

32 Economic Data Share of global manufacturing value added by country 30% 25% U.S. 20% China Western Europe 15% Japan 10% The U.S. has done a remarkably good job of holding share of global manufacturing against China s onslaught. 5% India Brazil 0% Source: United Nations. Data through Share of World Manufacturing Value Added (%)

33 Economic Data Benign Inflation Expected to Continue Percent Change Y/Y Jan 72 Jan 70 Jan 74 Jan 76 Jan 78 Jan 84 Jan 82 Jan 80 Actual Jan 86 Jan 88 Jan 90 CPI and Core CPI Jan 02 Jan 00 Jan 98 Jan 96 Jan 94 Jan 92 Jan 04 Jan 06 Jan 08 Jan 10 Jan % +1.7% With crude oil prices expected to decline a bit from their current levels, the boost to retail food prices from the current drought in the Midwest anticipated to be only temporary and relatively small, longer run inflation expectations remaining stable, and substantial resource slack persisting over the forecast period, the staff continued to project that inflation would be subdued through PCE Price Index Percent Change Y/Y (%) Fed's central tendency forecast range 2015 III 2015 I 2014 III 2014 I 2013 III 2013 I 2012 III 2012 I 2011 III 2011 I 2010 III 2010 I 2009 III 2009 I 2008 III 2008 I 2007 III 2007 I 2006 III 2006 I 2005 III 2005 I 2004 III 2004 I 2003 III 2003 I 2002 III 2002 I Federal Reserve s personal consumption expenditures (PCE) inflation forecast. 2 1 FOMC s August 1, 2012 meeting minutes. 2 FOMC s latest economic projections released with September 13, 2012 meeting minutes. Sources: Bureau of Labor Statistics; data through August 2012 (top chart). FRB St. Louis; data through March 2012 (bottom chart).

34 Economic Data Federal budget deficit You re in luck, in a way. Now is the time to be sick while Medicare still has some money.

35 Market Data Low interest rates disguise the federal debt bomb the federal debt has soared during the Obama years, yet net federal interest payments are lower than they were in 2007 and lower than they were in nominal dollars even in 1997 when public debt was a mere $3.8 trillion. CBO adds that every 100 basispoint rise in government borrowing costs over the next decade will trigger almost $1 trillion in new federal debt. Source: Wall Street Journal, March 12, 2012.

36 Economic Data Federal debt 120 Federal Debt Held by the Public % of GDP WWII 100 Alternative Fiscal Scenario 1 80 % of GDP 60 Medicare and Medicaid Great Depression Rising Deficits 1980s Baseline Scenario 1 40 Revolutionary War Louisiana Puchase Civil War WWI Social Security 20 0 Other Federal Noninterest Spending Actual Forecast Source: Congressional Budget Office (CBO), The 2012 Long-Term Budget Outlook, June 5, CBO's baseline revenue and spending projections reflect the assumption that current laws generally remain unchanged, implying substantial scheduled tax increases and spending cuts. The alternative fiscal scenario assumes that current policies are maintained, as opposed to current law, implying that lawmakers will extend most tax cuts and prevent the scheduled automatic spending cuts.

37 Economic Data Government debt-to-gdp ratios - comparative Debt / GDP (%) (E) 2011 (E) Medicare and Medicaid This slide shows the IMF s latest government debt to GDP ratios, actual and forecast. For now, the U.S. is better off than some. But, if we follow the AFS 1 trajectory in the preceding chart the U.S. would become Portugal, then Italy. 60 Social Security Other Federal Noninterest Spending 0 Greece Japan Italy Portugal France United Kingdom Ireland United States Germany Spain Brazil Canada Australia Source: IMF, World Economic Outlook Database, April Alternative fiscal scenario.

38 Economic Data Projected federal spending entitlements to grow >5%/year 1 6,000 CBO's Baseline Federal Spending Projections by category with compound annual growth rates in parentheses 5,000 4,000 ($ billions) 3,000 Medicare and Medicaid 2,000 Social Security 1,000 Other Federal Noninterest Spending All other discretionary (+0.0%) Defense (+0.4%) Source: Congressional Budget Office (CBO), The Budget and Economic Outlook: Fiscal Years 2012 to 2022, January CBO's baseline spending projections reflect the assumption that current law will not change. 1 CBO projects compound annual growth in GDP of 4.65% over the same period.

39 Economic Data Social Security here s the problem Social Security Revenues and Outlays 6.5 Outlays 6.0 Percent of GDP (%) Medicare and Medicaid Tax Revenues Social Security 4.0 Other Federal Noninterest Spending Actual Projected Source: CBO s 2011 Long-Term Projections for Social Security: Additional Information, August 2011.

40 Market Data Bond yields: record lows Baa Index Aaa Index 10 year Treasury Source: Federal Reserve. Data through September Yield (%)

41 Market Data Municipal Bonds Municipal Bond Index Muni spread over/under 10 year Treasury Source: Federal Reserve Bank, bond buyer GO 20-bond municipal bond index. Data through September Municipals spreadto Treasuries is attractive

42 Market Data Stocks vs. Bonds Warren Buffet 1 : Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: Source: Wall Street Journal, January 9, CNN Money, February 9, 2012 Warren Buffett: Why stocks beat gold and bonds.

43 15,000 Source: Wall Street Journal, August 1, 2012; Dow Jones Inc.; DJIA data through September 7, Stock Market August 2012: Bill Gross wrote "stocks operate like a Ponzi scheme" Note how Bill Gross last big splash market call of 2002 turned out. 14,000 13,000 Dow Jones Industrial Average 12,000 11,000 10,000 9,000 8,000 7,000 September 2002: With DJIA at 7600 Bill Gross wrote "Dow 5000" 6,000 5,000 3 Jul 12 3 Jan 12 3 Jul 11 3 Jan 11 3 Jul 10 3 Jan 10 3 Jul 09 3 Jan 09 3 Jul 08 3 Jan 08 3 Jul 07 3 Jan 07 3 Jul 06 3 Jan 06 3 Jul 05 3 Jan 05 3 Jul 04 3 Jan 04 3 Jul 03 3 Jan 03 3 Jul 02 3 Jan 02 3 Jul 01 3 Jan 01 3 Jul 00 3 Jan 00

44 Stock Market Arithmetic Total Return = 7% earnings-driven price + 3% dividends reinvested 7000 If the cult of equity is dying among average investors, it s probably because stocks have seemingly gone nowhere since That happened because market valuation got so overheated during the preceding bubble run from 1993 to S&P 500 Total Return (dividends reinvested) 10% growth path Ratio Scale (1970 = 100) 700 Market valuations having now spent over a decade coming back into line with underlying fundamentals, it seems to me that now is precisely not the time to declare the death of equities. S&P 500 Index 7% growth path 70 01/ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /2012 Source: Standard and Poor s. Data through June 2012.

45 Stock Market Arithmetic GDP growth and earnings 5000 What drives stock prices? Corporate profits. What drives corporate profits growth? GDP growth. Nominal GDP and profits growth have followed a 7% long term growth path. 7% growth path Ratio Scale (1960=100) 500 Higher inflation that peaked in 1980 drove higher nominal GDP growth. Nominal GDP 1 Corporate Profits 2 50 I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I Nominal GDP. 2 Corporate profits after tax with inventory valuation and capital consumption adjustments. Source: U.S. Department of Commerce, Bureau of Economic Analysis. Data through March 2012.

46 Conclusions Economic data: Economists see continued economic expansion despite Europe. Slow but steady progress on new job formation. Consumers savings and liquidity have risen substantially. The negative wealth effect may be overestimated. Significant skew in income, spending is relevant to economic recovery. Retail sales have come roaring back. The U.S. economy is positioned to continue its +2½% to +3% long term trend rate of growth. Positive changes in manufacturing. Inflation is subdued and will probably remain so for at least a few years. Commodity inflation is transitory. The CBO projects massive budget deficits. It s just a correction. The fundamentals are still good. Market data: ECB s bank bailout proposals have been catalysts for stocks; but Europe s challenge is to build a stronger fiscal union. Better, and better than expected, U.S. economic news has been a catalyst for stocks. Stocks are still attractively valued on estimated earnings. Total return on bonds cannot continue recent years returns. Municipal bonds are attractive.

47 Saving and Investing for Retirement Winning is crucial to my retirement plans.

48 Saving and Investing for Retirement Saving is key the powerful arithmetic of compounding Compounded 7% of $10,000 Saved in Each of Years ($50,000 total) $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 A simple concept, maybe, but your children and grandchildren need to understand and appreciate the power of compounding. If a 25 year-old managed to put away $10,000 in each of his first five working years - $50,000 total - he d have over $600,000 by age 65. More than 10 times the original amount saved! $ Year

49 Investment Strategy Wall Street s Call for 2012 Should you take heed? Barron s 2012 Forecast 1 Survey of 10 stock market strategists sector picks and pans for 2012 Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecom Services Utilities Federated Blackrock Barclays Capital Putnam Goldman Sachs JPMorgan Citibank Morgan Stanley Prudential BofA Merrill Lynch Net (+/-) Actual 2012 Sector Returns YTD 3 (Rank) +14% (4) Big Miss +10% (6) +4% (9) Mistake +15% (3) Big Miss +11% (5) +9% (7) +18% (2) Good call +7% (8) +19% (1) Big Miss +4% (10) Good call 1 Published Dec. 19, Big money center financials. 3 Through August 13, 2012.

50 Investment Strategy Wall Street s Call for 2011 Heed Not the Talking Heads! Barron s 2011 Forecast 1 Survey of 10 stock market strategists sector picks and pans for 2011 Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecom Services Utilities Oppenheimer JP Morgan BofA Merrill Putnam Credit Suisse Morgan Stanley Barclays Capital Wells Capital Goldman Sachs UBS Net (+/-) Actual 2011 Sector Returns 4 (Rank) +4% (4) +11% (2) +3% (5) -18% (10) +10% (3) -3% (8) +1% (6) -12% (9) +1% (7) +15% (1) Miss Big Miss Big Miss Big Mistake Mistake Big Miss 1 Published Dec. 20, Oil services. 3 Railroads 4 These are S&P 500 sector returns for calendar Past performance is not a guarantee of future results. For Illustrative purposes only.

51 Investment Strategy Wall Street s Call for 2010 two colossal mistakes Barron s 2010 Forecast 1 Survey of 12 stock market strategists sector picks and pans for 2010 Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecommunication Services Blackrock U.S. Trust Putnam Morgan Stanley Wells Capital Management Prudential BofA Merrill Barclays Goldman Sachs JPMorgan Citigroup ISI Group Net (+/-) Utilities Actual 2010 Sector Returns 3 (Rank) +26% (1) Big miss +11% (7) +18% (4) Good call +11% (6) +1% (10) +24% (2) Good call +9% (8) Big mistake +20% (3) Good call +12% (5) +1% (9) 1 Published Dec. 21, Media. 3 These are S&P 500 sector returns for calendar Past performance is not a guarantee of future results. For Illustrative purposes only.

52 Investment Strategy Wall Street s trading mentality DavidSwensen,PhD,Yale schiefinvestmentofficer 1 : Y: I was hoping you d mention Cramer. In the new edition of Pioneering Portfolio Management, you write: Educated at Harvard College and Harvard Law School, Cramer squanders his extraordinary credentials and shamelessly promotes stunningly inappropriate investment advice to an all too gullible audience. S: Jim Cramer exemplifies everything that s wrong with the advice and I put advice in quotation marks that is given to individual investors. Investing is a serious business. We re talking about retirement security of American citizens, and he turns it into a game. It s a game where his listeners lose. It s ridiculous. These high turnover, rapid trading strategies enrich the brokers. If you look at Jim Cramer s approach on an after fee, after tax basis, the individual doesn t have a chance. Unconventional Success 2 is a book for the overwhelming number of individual and institutional investors who cannot manage a portfolio actively. Almost everybody belongs on the passive end of the continuum. A very few belong on the active end. Y: Maybe we need new language, David. No one wants to be in the passive group. S: No, they don t. The basic problem is, it s boring. The approach that I recommend is going to give you absolutely nothing to talk about at a cocktail party. You re going to be in a corner by yourself, and no one will pay any attention to you. But you ll end up with a better funded retirement. 1 Yale Alumni Magazine, March/April Unconventional Success: A Fundamental Approach to Personal Investment, 2005 Free Press, a division of Simon and Schuster, Inc.

53 Investment Strategy Investors bad behavior Dalbar s 2012 QAIB Excerpt: 1 Investor Irrationality on Display The following charts illustrate that investors continue to react to market movements and the news. One of the most startling and ongoing facts is that at no point in time have average investors remained invested for sufficiently long periods to derive the benefits of the investment markets. The result is that the alpha created by portfolio management is lost to the average investor, who generally abandons investments at inopportune times, often in response to bad news. Over the years, there has been a huge gap between what [mutual fund] investors could have done versus what they put in their pocket, says Louis Harvey, CEO of Boston based investment research firm Dalbar. The reason is most investors fail to hold mutual fund investments for long enough, and instead try to time their investments. But they tend to enter the market after it has risen, Mr. Harvey says. So they are likely buying at a higher price. They also are apt to leave the market after it has dropped, therefore selling at a lower price. The result: investments that will massively underperform against their benchmarks. The average equity fund investor saw annual returns of only 3.49% in the 20 years through 2011, according to the latest analysis from Dalbar. Compare that with the average 7.81% annual return of the S&P Quantitative Analysis of Investor Behavior prepared by Dalbar, Inc. April Dalbar offers a $99 version of this study for financial advisors distribution to clients and/or posting on their password-protected websites. 2 Wall Street Journal, April 7, 2012.

54 Investment Strategy Investors classic capitulation Modern Portfolio Theory is dead Barron s Modern Portfolio Theory Ages Badly The death of buy and hold. 2/16/09 Wall Street Journal More Investors Say Bye Bye to Buy and Hold 4/8/09 Advisers Ditch Buy and Hold For New Tactics 4/29/ Mar 12 Jan 12 Nov 11 Sep 11 Jul 11 May 11 Mar 11 Jan 11 Nov 10 Sep 10 Jul 10 May 10 Mar 10 Jan 10 Nov 09 Sep 09 Jul 09 May 09 Mar 09 Jan 09 Nov 08 Sep 08 Jul 08 May 08 Mar 08 Jan 08 Nov 07 Sep 07 Jul 07 May 07 Mar 07 Jan 07 S&P 500 Index

55 Investment Strategy Modern Portfolio Theory Wall Street strategists dismal track record with their S&P 500 sector recommendations illustrates how extremely difficult it is to systematically add α with tactical asset allocation ie. trying to guess which sectors, styles, markets (foreign vs. domestic) or asset classes ( eg. stocks, bonds, commodities, gold, etc.) are going to outperform and which are going to lag. In my opinion, MPT is still the best investing mousetrap yet devised. Your mother called to remind you to diversify.

56 Investment Strategy Modern Portfolio Theory = Asset Allocation Modern portfolio theory was introduced by Harry Markowitz with his paper Portfolio Selection, which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection. Modern Portfolio Theory Diversify Optimize Rebalance Asset allocation and diversification do not guarantee a profit or eliminate the risk of loss. Source: Riskglossary.com

57 Investment Strategy Asset Allocation An Example Let s construct a global balanced portfolio using 7 asset classes Commodities (14%) Large U.S. Stocks Real Estate (14%) Cash (14%) Stocks (43%) Small U.S. Stocks Non-U.S. Stocks Bonds Cash Real Estate Commodities Bonds (14%) Source: 2012 The 7Twelve Portfolio powerpoint presentation, by Craig Israelsen. Used with permission. Indexes used in this illustration: Large cap US equity represented by the S&P 500 Index. Small cap US equity represented by the Ibbotson Small Companies Index from , and the Russell 2000 Index starting in Non US equity represented by the MSCI EAFE Index. Real estate represented by the NAREIT Index from and the Dow Jones US Select REIT Index starting in 1978.Commodities represented by the Goldman Sachs Commodities Index (GSCI). As of February 6, 2007, the GSCI became the S&P GSCI Commodity Index.U.S. Aggregate Bonds represented by the Ibbotson Intermediate Term Bond Index from and the Barclays Capital Aggregate Bond index starting in Cashrepresented by 3 month Treasury Bills.

58 Investment Strategy Asset Allocation An Example 5000 Diversified Portfolio CAGR 1 = +10.3% S&P 500 CAGR 1 = +9.8% Index (1/1/70=100) (logarithmic scale) Large US Equity Small US Equity Non US Equity Aggregate US Bonds Cash Real Estate Commodities Equally Weighted Diversified Portfolio Compound annual growth rate. Past performance is not a guarantee of future results. An investment cannot be made directly in the indexes used in this illustration. Source: 2012 The 7Twelve Portfolio powerpoint presentation, by Craig Israelsen. Used with permission. Indexes used in this illustration: Large cap US equity represented by the S&P 500 Index. Small cap US equity represented by the Ibbotson Small Companies Index from , and the Russell 2000 Index starting in Non US equity represented by the MSCI EAFE Index. Real estate represented by the NAREIT Index from and the Dow Jones US Select REIT Index starting in 1978.Commodities represented by the Goldman Sachs Commodities Index (GSCI). As of February 6, 2007, the GSCI became the S&P GSCI Commodity Index.U.S. Aggregate Bonds represented by the Ibbotson Intermediate Term Bond Index from and the Barclays Capital Aggregate Bond index starting in Cashrepresented by 3 month Treasury Bills.

59 Investment Strategy Asset Allocation MPT has delivered 12 Risk vs. Return by Asset Class Real Estate Compound Annual Return (%) Aggregate US Bonds Equally Weighted Diversified Portfolio Large US Stocks Small US Stocks Non US Stocks Commodities 6 5 Cash Standard Deviation of Annual Returns (%)

60 Investment Strategy FundQuest BNP Paribas Study 1 73 Fund Categories Analyzed Out of the 73 categories in our study, we recommend a bias to active management in 23 categories and a bias to passive management in 22 categories. Twenty eight (28) categories were deemed neutral. Passive 22/73 Neutral 28/73 Active 23/73 Bank Loan, Bear Market Commodities Broad Basket, Communications Conservative Allocation Consumer Discretionary, Consumer Staples Convertibles, Currency, Diversified Emerging Mkts Diversified Pacific/Asia, Emerging Markets Bond Equity Energy, Equity Precious Metals Europe Stock, Financial Foreign Large Blend, Foreign Large Growth Foreign Large Value, Foreign Small/Mid Growth Foreign Small/Mid Value, Global Real Estate Health, High Yield Bond, High Yield Muni Industrials, Inflation-Protected Bond Intermediate Govt Bond Intermediate-Term Bond, Japan Stock, Large Blend Large Growth, Large Value, Latin America Stock Long Government, Long-Short, Long-Term Bond Mid-Cap Blend, Mid-Cap Growth, Mid-Cap Value Miscellaneous Sector, Moderate Allocation Multisector Bond Muni National Interm, Muni National Long Muni National Short, Muni Single State Interm Muni Single State Long, Muni Single State Short Natural Resources, Pacific/Asia ex-japan Stk, Real Estate Retirement Income, Short Government Bond Short-Term Bond, Small Blend, Small Growth Small Value Target Date Target Date ; ; Target Date ; ; Target Date ; Target Date Technology, Ultrashort Bond, Utilities, World Allocation, World Bond, World Stock 1 FundQuest BNP Paribas Group study dated June 2010, Jane Li, author. When Active Management Shines vs. Passive Examining Real Alpha in 5 full market cycles over the past 30 years.

61 And Don t Believe Everything You Hear A study by Media Research Center of a year s worth of economic coverage on ABC, CBS and NBC found more than twice as many stories and briefs focused on negative aspects of the economy (62%) compared to good news (31%). Source: Media Research Center, Bad News Bears, October We were wondering if now would be a good time to panic?