2013 Outlook. We help manage your family s financial life. Officer. Ashley M. McCarthy. Financial Consultant. 4 th Quarter 2012 Review

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1 2013 Outlook 4 th Quarter 2012 Review We help manage your family s financial life. Christopher W. Davis, CFP, CIMA Managing Director Investments Officer Harriet R. White, CRPC Financial Consultant Karen B. Kight Financial Consultant Christopher M. Senvisky, CFP Vice President, Investment Celeste I. Renaldo, MBA Financial Consultant Michael C. Davis Financial Advisor Ashley M. McCarthy Financial Consultant Wells Fargo Advisors, LLC 1

2 What is a Fiscal Cliff? January 1, 2013 Review & Outlook + Taxes: Expiration of Bush tax rates, payroll tax cut 3.8% increase on unearned income for some tax payers to help finance health care reform Maximum Federal tax rates Current 2013 Long-term Gains 15.0% 20.0% Short-term Gains 35.0% 39.6% Qualified Dividends 15.0% 36.6% + Spending: $1.2 trillion of spending cuts over 10 years resulting from the Budget Control Act of 2011 = Combination of increasing taxes and reduced spending creates a fiscal cliff the economy must overcome in 2013 Information attributed to Russell Investments What is fiscal cliff? The combination of a simultaneous tax increase plus spending cuts equals recession. Our take: This is big, visible and can be avoided should Congress have political courage. Generally, what hurts you is what you do not see coming. 2

3 Secular Stock Markets Explained This chart measures long-term investor optimism and pessimism. The red bars represent cumulative years of long periods of time investors are pessimistic. Green reflects periods of optimism. Optimists pay higher prices for stocks. Pessimists pay lower prices. The blue line at the bottom, when rising, is a long-term bull market. When falling, a long-term bear market. This reflects the price that investors pay for each $1 of earnings, known as a P/E, price/earnings. Our take: Investors can stay pessimistic only so long before a trend reverses itself. Given the duration of the red, we have a sense that we are approaching the beginning of a new bull market. 3

4 Source: Federal Reserve, St. Louis Fed, FactSet, Standard & Poor s, J.P. Morgan Management. 3Q2012 Cash Exceeds Household Mortgage Debt Consumers are holding cash. Should they become more optimistic, it only takes a little bit of this cash invested in stocks (see the far right column) to move them higher. Note that cash exceeds mortgage debt when looking at the entire United States consumer in aggregate. Our take: We speak of deleveraging in terms of baseball metaphors. The consumer, in aggregate, is in the 7th inning. Most corporations have completed their game. Political parties in government need to play ball! 4

5 Diversification Known as a quilt chart, this is a story of diversification. The top block of each year represents the best performing asset, and the bottom block represents the worst performing asset of that year. Note the gray boxes called Asset Allocation, which is a weighting of each of the boxes. Never at the top, never at the bottom, but over time, generates more reliable investment progress. Our take: The message is not to pick the best performing category, but to diversify and rebalance with an eye on the future as well. 5

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7 US continues to Outpace the Rest of the World Note the downward sloping line from 2002 to 2009 and then again from 2009 to 2010 suggesting that international securities outperformed domestic securities. Since then, especially in the last 12 months, the US stock market has dramatically outpaced the rest of the world. Our take: As global investors, we recognize that your portfolios have recently underperformed the US stock market, especially over the last two years. This does not change the fact that we believe it is the right thing to be globally invested, even if this continues into Could this chart also suggest that we are reaching the midpoint and that this trend should soon reverse? 7

8 U.S. centric investing is a thing of the past. U.S. centric investing is a thing of the past U.S. investing without global context may be short sighted. While these two globes are not quid pro quo, nor exactly replicas, they do work together to tell a story. The first globe represents the available stocks to be purchased in the entire world. The second chart represents world commerce, forecasted by Our take: The story is that investors should not ignore 57% of the world's equities (globe one). We should keep a keen eye on investing where future growth may be compelling (emerging markets, see globe on the right). 8

9 All or Nothing Days occur when the net daily advance/decline reading of the S&P 500 exceeds plus or minus 400. Data as of May 7, 2012 provided by Bespoke Investment Group S&P 500 "All or Nothing" Days The purpose of this chart is to illustrate the number of days in the last 4 years, since 2008, in which at least 400 stocks in the S&P 500 have either gone up or gone down. Financial journalists refer to these days as risk on or risk off days. When most stocks are either going up or going down across all sectors and geographies, diversification does not help as much as it could. The specific statistical phrase used to describe this phenomenon is that markets have become highly correlated. Our take: No trend continues forever, and it is best still to diversify portfolios, even when the last four years have not rewarded diversified investors. 9

10 Dividend Payers Offer Yield and Growth Potential The message of this chart is simple. $100,000 invested in the S&P 500 has produced dividends since 1985 to 2010 as illustrated in orange (growing income). The same amount of money invested in the Merrill Lynch Domestic Bond Master Bund Fund the bond index shows a declining income, over time, as interest rates have fallen. Our take: This chart illustrates a generally unnoticed risk. That is future income risk. Changes in value as seen in your monthly statement or daily online viewings do not reflect all risks. What about your future sources of income? 10

11 Choose your Scenario & Probability OPTIMISTIC BASE PESSIMISTIC 35% Probability 50% Probability 15% Probability The Economy Real GDP Normal, 3%-4% Slow, but positive, 1%-3% Recession/Stagflation, -1% - 2% QEIII QEIII works! QEIII "kicks the can down the road" QEIII consequences outweigh benefits Unemployment Less than 6% Glacial improvement to 6% - 7% Structural and persistently greater than 7% Inflation 2% or so 2% - 3% High Uncertainty Interest Rates Modest rise Bernanke's 2015 outlook High Uncertainty Gov't & Politics Debt State & Local Gov't, 7th inning State & Local Gov't, top of 5th inning State & Local Gov't, stuck in 4th inning Baseball analogy Federal Gov't passes Simpson-Bowles Fed. Gov't, rain delay till "fiscal Cliff" Federal Gov't, refuses to play No "Fiscal Cliff" "Drama" temporarily disrupts mkts "Drama" continues through st signs of "US of Europe" Europe "Kicks can down the road" Europe a mess for next 10 years Arab Spring Arab Winter Arab War China sees strong internal growth China slower growth, but grows China "hard landing" Corporate Earnings growth Robust Remains muted, but up Remains uncertain Profit margins Sustained high profit margins Sustained high profit margins Unsustainable high profit margins Revenue Growth Global consumer demand strong Tracks GDP Tracks GDP, thus declines Choose Your Own Scenario and Probability Starting at the left, with the words The Economy, we would encourage an investor to take a yellow marker and mark which of these statements they most agree with. These columns are labeled optimistic, base, and pessimistic. Our take: We will adapt to the your view. In the absence of your direction, Davidson Wealth Management, at this time, adopts the base probability and our clients' portfolios are broadly diversified, conservative, and with hedged strategies that account for potential inflation and price volatility. 11

12 Continued Asset Prices Optimism Returns quickly Slowly builds as 2014 approaches Remains dim Deleveraging Stocks soar Both RE and equities plod upward Outcome continues to be uncertain PE, currently 14 expansion Range bound Contraction Valuation Currently undervalued Relatively undervalued Overvalued if PE contraction S&P 500 (current range ) International stocks Outperform US dramatically Perform equal to US Underperform US PE, currently 11 Bonds Rational QE withdrawal Earn coupon, gradual rate rise Uncertainty; bubble burst or bonds soar more Volatility Returns exceed Volatility (R>V) Returns equal Volatility (R=V) Returns less than Volatility (R<V) Standard Deviation 5% 8% - 9% 15% S&P 10 Years Rule of 72 Individual Response Retirement age Retire sooner Current target Work longer Retirement distribution 5.0% 4.0% 2.5% Your Savings Less What is needed More Lifestyle "Bonus" Basic Reduce Basic Asset Alloc. Strategy Strategic Allocation Pragmatic: Strategic & Dynamic Cash, LT UST, Gold, Commodities * Retirement distribution is conceptual, based on age. The above is not intended as a forecast or recommendtion by Davidson Wealth Management or Wells Fargo Advisors. Neither does it intend to include all the variables which can be considered. It is simply a framework for discussion. 9/30/12 This is a continuation of page 11 with the importance of what it means to the individual investor at the bottom. Our take: Investors should focus what they can control; targeting retirement age, savings, lifestyle and asset allocation strategy. 12

13 Review & Outlook S&P 500 Scenarios Target EPS 10.0x 12.0x 12.3x 13.0x 14.0x 16.0x 17.0x 18.0x $ $ $ $ $ $ $ $ $ $ $ BEAR BASE BULL S&P 500 Scenarios Looking at S&P 500, estimated earnings per share (EPS) (vertical axis) and amount investors will pay each $1 of EPS (horizontal axis), the Red box represents our expected outcomes and trading range for the next one to three years using the pessimistic scenario. Yellow represents the base case scenario. Green represents the optimistic or bullish case scenario for the next three years. There is a serious relationship between earnings and optimism that draws boundaries around valuations thus our boxes. As of this writing, earnings per share estimates for 2012 are approximately $103. Estimates for 2013 are $108. Optimistic investors should pay between $16 and $18 for every $1 earnings, while pessimistic investors should pay $12 to $13 for every $1 of earnings, thus, establishing the green and red boxes. Note that earnings estimates can change! Our take: In his book, Dynamic Economic Decision Making, Economist John Silvia reminds us that investors become increasingly optimistic as time passes from economic disasters. Given this, we should not be surprised if P/E s continue to rise over the next 2 years. This may offset potential flat or declining earnings. 13

14 Disclosures: Wells Fargo Advisors did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request. Diversification does not guarantee profit or protect against loss in declining markets. 14