A Tale of Two Quarters

Transcription

1 Retirement Income Solutions Helping to grow and preserve your wealth A Tale of Two Quarters August 15, 2012 Summary Borrowing the title of this piece from the Charles Dickens novel, A Tale of Two Cities, seemed appropriate given a) the vivid difference in results between major market moves in the first two quarters of the year (+12.0% in the first quarter versus -9.9% in the second); and b) the importance of the political crisis in Europe and it s impact on financial markets this year. Despite the somewhat weak economic growth and recurring crises in Europe, the S&P 500 is nearing a new (post-2008 financial crisis) high. Correspondingly, many investors are wary of financial markets and the associated risks. As of July 31, the S&P 500 is up 9.7% for the year; however, if one were to judge this period based on newspaper headlines and investor sentiment, one would think that the market was down for the year S&P 500 Index 2012 year-to-date April June Dec 30-Jan 29-Feb 31-Mar 30-Apr 31-May 30-Jun 31-Jul Historical trends from seasonality and the presidential election cycle have matched expectations so far this election year. The S&P 500 rallied for the first several months and peaked on April 2 nd. After a correction of 9.9% that ended in June, the stock market recovered almost all of the losses from that period. In this presidential election year, economic conditions continue to be mildly positive. Corporate earnings growth is slowing since the effects of cost cutting may have reached their limits. Many large companies continue to hold their cash instead of re-investing in their lines of business, and some companies are taking on more risk to achieve a meaningful return on that cash. Unemployment has flattened out above 8% as modest private hiring is positive but not sufficient to produce reductions in the unemployment rate. Looking forward, there are a few indicators that provide us with enough concern to maintain our current neutral investment position. Economic conditions are positive but barely so. Many financial institutions are stronger than they were several years ago, but it would not take much to push financial markets back into a tailspin. The markets are approaching the most dangerous month of the year (September), when the stock market has averaged a 1% loss since 1950; given that historical trend and the rapid advance of the stock market during the past two months, some sort of Page 1 of 7

2 near-term pullback would not be surprising. The Chinese stock market has failed to realize the positive move of U.S. markets, which raises concerns about the global economic recovery. The crisis in Europe and the fiscal cliff in the U.S. are two important political matters that are still unresolved and likely to cause market angst in the second half of the year. The U.S. tax environment will be a common topic in coming months. Barring any legislative action this fall, the new 3.8% investment tax will become effective January 1 (details are on page 6). Corporate pensions have been in the headlines often in recent months; we are helping many clients analyze pension buyout offers from Ford, GM, and others. If you have a pension decision to make, we have several tools and analytical approaches that can bring some clarity to a complex topic. Economic Environment Corporate Profitability The S&P 500 is again testing the 1400 level, after a 100% increase from the March 2009 lows. Corporate earnings, after falling almost to zero in 2008, have increased substantially over the past few years. In fact, corporate earnings reached a new record high in 2011 and are now approaching $100 per share (annually). Although corporate earnings are at new highs, the stock market is still 10-15% below its 2007 peak. Concerns over the sustainability of earnings have kept stock prices lower since it is future earnings that are important to investors. 30 S&P 500 Quarterly Earnings Per Share, Jun-98 Jun-00 Jun-02 Jun-04 Jun-06 Jun-08 Jun-10 Jun-12 Newspaper headlines have focused on the oscillating opinions over earnings growth. Some of that focus is valid, since historically, earnings growth is rarely negative without encountering a recession and downward pressure on the stock market. Additionally, many investors are willing to pay higher prices for companies that grow their earnings at a faster rate. The same concept applies to the market in general; as expectations for earnings growth go up, so do stock market indices. During the past few years, many companies reduced their cost structure to survive in a low-growth world. In 2010 and most of 2011, a significant portion of corporate earnings were driven by margin expansion, or perhaps more simply, cost cutting. However, companies can only cut so many costs, and, therefore, future growth in earnings may depend more heavily on growth in revenue. This is one of the explanations for recent market volatility. If the global economy is expanding at a sufficient pace for companies to increase revenue and they are able to increase profits, the markets should respond in a positive fashion. If not, it may be difficult for the stock market to continue its recent positive trend. Page 2 of 7

3 Corporate Cash Record low bond yields are having an interesting impact on the way corporations invest their excess cash. The policies of the Federal Reserve that lowered interest rates to record low levels were intended to encourage both businesses and individuals to invest in ways that stimulate the economy. One of the bottlenecks has been that corporations are still reluctant to deploy their cash. Many S&P 500 companies have large amounts of cash on their balance sheets and are neither investing those dollars back into the business (e.g. capital spending or hiring) or distributing the cash to their shareholders in the form of quarterly dividends. In the past, most companies have had very restrictive investment policies and were only able to invest cash into U.S. Treasury Bonds, highquality corporate bonds or other low-risk securities. With 10-year Treasuries yielding 1.4%, it is no surprise that corporations are looking for alternatives. Recently, some S&P 500 companies are investing cash into asset-backed securities (many of which are tied to automobile loans and consumer credit cards). One example is Google, which was cited recently in the Wall Street Journal as investing hundreds of millions of dollars into these securities. Companies such as 3M and ADP follow similar strategies. Until corporations are willing to invest cash into their own businesses, it will be hard to achieve a stronger economic recovery and continued reductions in unemployment. Employment & Payrolls After reaching a peak of 10% in 2009, unemployment steadily dropped and has hovered between 8.1% and 8.3% in recent months. The lack of further unemployment improvement may either be a natural pause in the normal cycle of improvement or a preview of a more concerning reversal, which would be a symptom of a second recession. Looking more deeply at the data, private payrolls continue to grow at a consistent pace; this is positive since it demonstrates businesses are hiring, even as unemployment has remained high. It is the government payrolls, in a time of deficit reduction, that are falling. Private vs. Government Payrolls Monthly, December June ,000 Private Payrolls (000's) 23,200 23,000 22,800 22,600 22,400 22,200 22,000 21,800 21,600 21,400 21,200 Total Government Payroll Total Private Payroll 116, , , , , , , ,000 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Gov't Payrolls (000's) The Fiscal Cliff and U.S. Politics A risk that will continue throughout the remainder of the year is the outcome of the U.S. election and it s convergence with several budget decisions. The term Ben Bernanke used the fiscal cliff describes the significant drop in U.S. fiscal stimulus measures if current laws play out with no political intervention. On January 1, 2013, several fiscal measures are set to change considerably: The Bush tax cuts will expire, resulting in increased tax rates for all income brackets, higher taxes on capital gains, and a significantly lower threshold for estate taxes. The 2% payroll tax holiday, recently through December 31, 2012, will end. Certain business tax holidays expire, such as accelerated capital depreciation and other tax incentives. Page 3 of 7

4 Automatic spending cuts (sequestration) are scheduled to kick in as a result of the Budget Control Act and the failure of Congress to pass a specific debt reduction plan. The combined budgetary impact of the items above is estimated to be $1 trillion in 2013 and 2014, which would result in a decline of approximately 3-4% of GDP (and a sizeable recession) for the next few years. It seems likely that the situation will be resolved near the end of the year, but that does not reduce the likelihood of significant drama in the meantime. However, if for some reason the fiscal cliff is not resolved by the end of the year, the impact on the stock market in the short-run is likely to be problematic. Regardless of the outcome of the election, it seems politically untenable for any politician to fail to act on all of those fiscal measures and lose 3-4% of GDP over the next two years. Financial Markets YTD Review For the first several months of the year, the stock market rallied to new, post-recession highs. In April, the stock market peaked amid concerns over three key issues: the European debt crisis, the effectiveness of monetary policy (Federal Reserve actions), and economic growth in China. After a 9.9% correction, the market bottomed in June and rallied to recover almost all of the losses realized in the spring selloff. The advance since June has been driven by reduced tensions in Europe and improved expectations for the world economy. In a speech at an investment conference in London, European Central Bank (ECB) President Mario Draghi boosted markets by the strength of his comments about monetary actions in the euro-zone, "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. Additionally, perception of the world economy is more positive, as demonstrated by slow but growing corporate earnings, positive real GDP growth, and modest private payroll numbers. Although the year is not over, our expectations from the spring were not too far off. This is an excerpt from our April commentary: [We] expect a shallow market correction (say, 5-10%) in the second quarter followed by a steady period of advance prior to the election. Markets rarely move in one direction without pausing to solidify recent gains. S&P 500 Index 2010, 2011 and 2012 year-to-date Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec So far in 2012, the S&P 500 has been more positive on a relative basis than either 2011 or The market has been less volatile (as measured by days where the market drops by more than 1%) and, Page 4 of 7

5 so far, has not dropped below the January 1 st index close. Despite achieving recent highs, low market volatility and positive returns so far this year, most investors feel more concerned than ever. This could be caused by fatigue over the European crisis or the pending fiscal cliff, two recurring headlines that are not close to conclusion. Investment Positioning Looking forward, there are several conflicting dynamics that result in our current neutral position. Since the stock market typically bottoms 2-4 months ahead of the election, the stock market low for the year may be behind us. However, we would not rule out a stock market pullback in September or October. On the positive side, mildly positive economic data is accompanied by the fact that the second half of election years tend to have very good odds of success. According to Ned Davis Research, historically, the market has been up in the second half of election years in 17 of 21 cases (81%). The median gain has been +6% (projects to 1444, S&P 500), with the median maximum rally +12%, and the median maximum decline -7%. The four cases where the S&P 500 was down in the second half of an election year were: 1948: -9.2% (a recession started in November 1948) 1956: -0.6% (large steel workers strike) 2000: -9.2% (tech bubble and Bush vs. Gore contested election) 2008: -29.4% (financial crisis) One troublesome indicator for financial markets is recent performance of the Shanghai stock market. As the world economy has become more connected, stock markets have followed suit and often times move in the same direction (i.e. the markets are correlated). However, in the past six months, the U.S. and Shanghai stock markets are moving in opposite directions (see chart below, dashed arrows indicate divergences). 1,600 1,500 1,400 1,300 1,200 1,100 1, S&P 500 vs. Shanghai Composite June August 2012 S&P 500 Shanghai 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2, , ,500 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 In 2007 and 2009, the Shanghai index was a leading indicator, pulling back before the S&P 500 in 2007 and bottoming before the S&P 500 in The divergence of the two indices could signal a few different things: a) the global economy is moving towards another recession, and the Shanghai index is the first to reflect that; b) the global economy is fine, and Chinese stocks may appreciate significantly over the next year; or c) the Chinese economy is headed for a hard landing and has decoupled from the world economy (this decoupling may be difficult to achieve without triggering a above). Page 5 of 7

6 Despite favorable historical trends and modest economic conditions, the June low will only remain intact if the current slow but positive market drivers can avoid being overshadowed by revived fears of a European meltdown and significant economic decline from fiscal cliff as a result of an extremely polarized Congress. An additional consideration is the relatively short nature of cyclical bull markets inside of secular bear markets, which typically last only months. The cyclical bull market that started in October 2011 will reach it s year anniversary before the fall election. Implications of the New 3.8% Investment Tax President Obama s health care overhaul, passed by Congress in 2010, includes a 3.8% tax on net investment income. The new rate is set to begin on January 1, 2013 for most joint filers with income over $250,000 (single filers over $200,000), and applies to capital gains and dividends as well as various other forms of investment income. Although the IRS has yet to provide guidance on the issue, generally experts believe the tax applies to the following: Dividends Interest (except municipal bond interest) Short and long-term capital gains Income from the sale of a primary home above the $250,000 / $500,000 exclusions Income from the sale of a second home Certain partnership income The tax does not apply to salary, social security or retirement account distributions. It only applies to investment income as described above. Even if an investor has low investment income, it is the total income (as measured by AGI, or Adjusted Gross Income ) that determines what portion, if any, of your investment income is taxed. The 3.8% heath care surtax has a few implications on investment selection and financial planning: 1. This tax increases the preference to have income generated in a retirement account (versus an account that is not tax-deferred or tax-free). 2. Certain securities, such as ETFs (exchange traded funds) may have small tax advantages due to their treatment of capital gains distributions. 3. For some investors, municipal bonds are doubly blessed because their income does not raise AGI and is also not subject to investment income tax. 4. If Congress revives the qualified charitable contribution option directly from retirement accounts, there may be more incentive to utilize that option to reduce AGI. 5. If Congress allows the tax rates set in 2001 and 2003 to expire, the top rate on capital gains could raise from 15% to 23.8%, and dividends will nearly triple to 43.8%. This could trigger capital gains harvesting (selling to realize the lower rates in 2012), and the increased selling could contribute to reduced investment returns in the fourth quarter. When the broader tax picture for 2013 becomes clearer, there may be other actions to consider. Please consult with your tax advisor to see how the new tax may impact you more specifically. Page 6 of 7

7 Corporate Pension Buyouts Ford & GM Several of our clients have complicated decisions to make regarding pension buyout (lump-sum) offers from Ford and General Motors. There are several important considerations as part of an analysis of a buyout, and the assessment varies by individual. The lump sum offered by the employer may differ for different employees based on factors such as age, length of service, and seniority. A participant s decision may need to include analysis of various aspects of their situation, including: estate planning, income needs, flexibility (more or less control over cash flow), health status, martial status, gender, and percentage of pension from after-tax (employee) contributions. Please feel free to use us as a resource for any pension related decisions Ford, GM, or otherwise. We have some tools and approaches that can help customize the decision for each situation. If you have a friend or colleague that might benefit from an analytical approach to pension decisions, please feel free to forward these issues to them. The discussion above and elsewhere in the commentary reflects the changes in investments made for most but not all of our managed accounts at the time(s) shown above. The strategies used by RIS cannot in and of themselves be used to determine which securities to buy and sell, the amount to buy and sell, or when to buy and sell them for an individual account because client objectives differ. During this period, some clients lost money and others gained. Factors such as specific securities price movements, timing of investments, the amounts invested and withdrawn, cyclical and market trends, client growth or conservative objectives, economic conditions, interest rates and other factors all influence performance materially. For these reasons, the charts and commentary should not be considered the performance results of RIS or any RIS account. Losses can occur by using any investment strategy, including RIS's strategies. Welcome to Margaret Kephart We are pleased to announce that Margaret Kephart has joined our firm. She brings with her over 20 years of experience providing financial planning and comprehensive investment advice. Prior to joining our firm, Margaret was a nationally-ranked TIAA-CREF Senior Financial Consultant servicing university clients in the state of Michigan. We are excited to have her as part of our team! If you have questions on the investment environment or your portfolio, please call us at To find an electronic copy of this document and other recent commentaries, please visit our NEW WEBSITE at K. Larry Hastie R. Griffith McDonald Brock E. Hastie Karen Chapell Todd Kephart John Goff Margaret Kephart Managing Director Managing Director Managing Partner Managing Partner Managing Partner Managing Partner Sr. Vice President This letter represents a general economic outlook of this firm and does not constitute specific investment advice, nor should it be considered assurance of any future market performance. Our views on markets, investments, and portfolios change as new information is available. Past performance is not indicative of future results. The discussion above reflects the changes in investments made for most but not all of our managed accounts at the time(s) shown above. The Seasonal Strategy used by RIS cannot in and of itself be used to determine which securities to buy and sell, the amount to buy and sell, or when to buy and sell them for an individual account because client objectives differ. Losses can occur by using any investment strategy, including RIS's Seasonal Strategy. Past performance is not indicative of future results. This is for illustrative purposes only and is not indicative of any investment or strategy result. The S&P 500 is an index of 500 stocks representing major U.S. industry sectors. Indices are unmanaged, and one cannot invest directly in any index. Page 7 of 7