While it is always tempting to focus on the immediate, we believe it is appropriate to take a brief look at the past thirteen months. In August 2011, the market’s principal focus was on the fiscal situation, the Treasury downgrade, Eurozone issues and forecasts of a possible U.S. recession. One cannot argue that many of these headwinds remain today, yet the broad market has risen significantly. (See Figure 2).

Figure 2 – The broad equity markets have advanced in the past 13 months despite significant headwinds.

Why has the market performed so well despite persistent headwinds? Is it due to continued accommodative worldwide monetary policy, positive corporate earnings, improved corporate liquidity, or relative asset class investment alternatives? Yes, all of the above. Recently, the Federal Reserve (the Fed) announced its decision to launch a new $40 billion a month bond purchase program (QE3) with the specified intent of remaining an open policy aimed at improving employment. Does the policy decision create the “Bernanke put” – a potential floor favoring risk assets? The three prior quantitative policies did favor equities, according to Ned Davis Research. (See Figure 3).

Figure 3 – S&P 500 Index returns following Federal Reserve monetary stimulus policies.

Will QE3 have the same trend impact as previous policies, or are market conditions different this time? Will the market’s appetite for growth stocks and cyclical-oriented companies increase at the expense of value stocks and dividend-oriented companies? At the moment, we believe the answer to these questions is more complex than a simple yes or no. What we do know is market performance did respond well to QE1, QE2 and Operation Twist but the exact sectors that were bolstered by these three policies differed. For example, during QE2, the energy, telecommunication and utility sectors were exceptional performers. During Operation Twist, consumer discretionary, technology and financials were the strongest performing sectors. Suffice to say, the equity market impact of this policy has been, and will continue to be, a much debated topic.

In the 1980’s, corporations struggled with a lack of pricing power, slowing organic growth and balance sheet quality. One of the most frequently used corporate buzzwords was “rationalization”. Simply put, corporations needed to grow earnings and the method of choice was to reduce costs to offset slowing top line revenue growth and rebuild overall liquidity. Since 2008, we’ve seen “déjà vu all over again.” While there are certainly differences between the 1980’s and 2008-2012 period, it is clear that corporations have done a solid job of reducing costs, improving liquidity and reorienting business lines.

Figure 4 – U.S. corporate fundaments remain strong following the 2008 credit crisis.

As evidenced in Figure 4, earnings growth rates have continued to exceed that of sales, resulting in improving EBIT (Earnings before Interest and Taxes) margins. From a balance sheet perspective, we have seen ROE and ROA rise and total debt to total assets decline significantly. As we saw in 2008, financial flexibility is important, and today companies have the capital and solid cash flow necessary to better adjust to changing global economic activity in either direction.

In addition to improved earnings and the rebuilding of balance sheets, dividend growth has accelerated. Why is this important? Dividends have played a major role in total return in the long run, but also helped soften the blow during bad years. (See Figure 5).

Figure 5 – Dividend income as a percentage of income is increasing.

As we have discussed in previous quarters, valuations remain at relatively attractive historic relationships. (See Figure 6).

Figure 6. Price–to–earnings ratios (P/E) and earnings per share (EPS) both for the past 12–month period (trailing) and the forecasted 3–to–5 year period, across large–, mid– and small–cap stocks and in developed and emerging countries, remain at relatively attractive historic values.

For the past year, we have cited improved profitability, balance sheets and dividend growth, and we continue to believe these factors remain favorable for equities. Yes, there has been some reduction in earnings momentum as top line revenue has been somewhat impeded by the moderating economic conditions. Nonetheless, we believe opportunities in equities (both as relative value among asset classes and within the specific capitalization sectors) exist. When we began 2012, our strategic outlook focused on U.S. centric companies (both domestic and multinational companies) with a limited exposure to international securities. The relative strength of the U.S. compared to other countries was an advantage that we believed would benefit such companies. Nothing has changed to cause us to alter this viewpoint. We maintain our U.S. centric focus.

BBVA Compass is the trade name for Compass Bank, which is a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, and are NOT bank guaranteed. May LOSE value, are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).