Stocks rebounded during the fourth quarter but only large US stocks were able to end the year in positive territory. The DJIA is up 8.4% year-to-date but the broader S&P 500 Index is up only 2.1% for the year. If not for reinvested dividends, the return on an investment in the S&P 500 Index would have been 0%. Small cap stocks in the Russell 2000 Index posted a -4.2% return for the year. International stock indices, including emerging markets, struggled even more. The MSCI EAFE Index had a return of -14.8% year-to-date.

Returns varied greatly across industries. It became apparent that investors favored dividend-paying stocks as utilities, consumer staples and healthcare were the only industries to post double digit positive returns (20.0%, 14.0%, and 12.7% respectively). Financials were at the other extreme and posted double-digit negative returns of -17.1%. The economically-sensitive materials and industrials also posted negative returns of -9.8% and -0.6% respectively.

The concerns over Europe’s debt problems continued and contributed to volatility in stock prices and bond prices. Although the markets have responded favorably to the partial solutions that have emerged, the issues are not entirely resolved. Volatility is likely to continue.

The US continues to fight its own debt battles as well. The Congressional Super-committee could not reach an agreement and failed at their task to cut $1.2 trillion from the debt over the next ten years. As a result, both sides got what they wanted because taxes were not raised and spending was not cut. Furthermore, the automatic spending cuts in defense and entitlement programs are not scheduled to kick in until 2013 - after the election.

In order to keep the debt from increasing both here and abroad, governments are looking towards spending cuts and increases in taxes to bring their deficits into balance.

Both options can serve as a headwind to economic growth.

Worldwide growth has slowed this year both in developed countries and emerging economies like China and Brazil. Many economists are expecting Europe to enter into a recession in 2012 as they deal with their debt issues. In the US, third quarter GDP grew by 1.8%, the highest quarterly rating of the year so far. Although not robust growth, we do not seem to be teetering on the edge of recession as was the concern this summer. Early analysts’ expectations for fourth quarter GDP growth range between 3% and 4%.

Sustained economic growth of 3% is the level economists have said is needed to meaningfully bring down the unemployment rate. Recent numbers showed November unemployment dropping from 9% to 8.6% - the lowest rate since peaking in 2009 at 10.1%. Some are skeptical of this drop and believe it is because more people have left the workforce rather than because more people found jobs. They are fearful that when the economy picks up, people will re-engage their search efforts and the rate will again rise or at least not see significant further improvement. Some progress has been made, though, as new claims for jobless benefits hit a 3 1/2 year low in mid- December.

Other economic indicators are also showing an improving trend especially regarding consumer spending which is a major contributor to GDP growth. As of November, personal income was up 3.9% over the past year while inflation was only up 2.5%. Consumer sentiment is also improving since reaching an almost-3-year low in August. December consumer sentiment was at its highest level in six months. Consumers spending is being supported not only by growing real incomes and stronger consumer sentiment, but according to economist Brian Wesbury also by the large reduction in households’ financial obligations. He states that recurring payments for expenses like mortgages and rent, cars, and other required payments on debt are at their lowest level as a percent of after-tax income since 1993. BCA economists debate this point by stating the reduction in debt has come mainly from mortgage defaults which is not a desirable way to reduce debt burdens.

Housing seems to be in a bottoming pattern still. New single-family home sales have increased at 1.3% in October and 1.6% in November but the median price has fallen 13.8% versus last year. The inventory of new homes on the market fell to a 6 month supply which is the lowest level since 2006 when the bubble was beginning to burst. Sales of existing homes (as opposed to new homes) were revised down 14% for the past few years as the National Association of Realtors determined some mistakes made had resulted in double counting. The median price has fallen 3.5% over the year. On the positive side, existing home sales in November were up 4%, and they are up 12% from a year ago.

If economic health was based solely on corporate earnings, investor fears would be allayed. Profit margins are near historical highs. Corporate earnings have continued to grow, and earnings on the S&P 500 are at new highs. We’ve seen corporate earnings grow without an accompanying increase in stock prices resulting in PE multiple contraction. Although we believe stock prices will continue to trade in a range for a while until Europe finds stability and economic growth is more robust, renewed confidence in stocks could spur a nice rally from current valuations.

Fear and uncertainty, though, will support the demand for US Treasury securities until then. The 10-year Treasury yield began the quarter and ended the quarter at 1.9%. If, or rather when, fear does subside, yields will likely increase and holders of these Treasury bonds will not like the result. According to JPMorgan, an increase in yield of 1% would create an 8.8% decline in the 10-year Treasury bond price. Other types of bonds, such as mortgage backed securities and corporate bonds, have less interest rate sensitivity than government bonds and may not see as large of a decline.

The Federal Reserve will keep the Fed Funds Rate at near 0% through mid-2013. As a result, money markets will continue to earn next to nothing. However, borrowers should be able to obtain attractive loan terms when purchasing homes or expanding businesses.

In this environment where the outlook can and does change quickly based on unfolding worldwide events, volatility is likely to persist. We continue to believe diversification across asset classes is the prudent strategy in this environment. Bonds provide stability, but stock exposure is needed for long-term growth. If you have questions about the strategy in your account, please do not hesitate to call us.

 

 

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