Quarterly Market Update
The More Things Change, the More They Stay the Same
Throughout 2013, we have highlighted that the underlying strength for the equity markets has been provided by both worldwide monetary accommodation and improved corporate operating fundamentals (Tailwinds). On the other hand, concerns about conflicted U.S. fiscal policy, sequestration, implementation of the Affordable Care Act, moderate GDP growth and high unemployment data (Headwinds) persist. With the Federal Reserve maintaining its current quantitative easing efforts, we believe the Tailwinds will continue to outweigh the Headwinds.
During the third quarter of 2013, the broad financial markets posted gains across all major asset categories. Small capitalization (as measured by the Russell 2000 Index) and International (as measured by the EAFE Index) posted double-digit returns. Part of this performance is related to continued market interest in higher growth, higher beta securities and improved investor sentiment regarding international markets.
Figure 1. Major equity indexes post positive returns for third quarter and year-to-date 2013.
In the First Quarter 2013 Market Outlook, we cited several factors that remain the same today as then. Investment opportunities associated with the international and emerging markets were likely to become more attractive than had been the case in previous years. The recent price strength of these stocks in third quarter seems to suggest investors are increasing their focus on these markets. We discussed that U.S. small-cap stocks could continue to narrow the performance differential relative to mid-cap and large-cap stocks. Not only did the narrowing occur, the small-cap sector (as measured by the Russell 2000 Index) has become the year-to-date leader in performance.
Last, we discussed that the positive impact of cost restructuring efforts would have less impact on earnings and greater emphasis would be on revenue growth, market share position and balance sheet strength. While the prevailing investor expectation had been for the Federal Reserve (Fed) to begin tapering its fixed income purchases, this event did not happen in September. The reasons for this decision primarily relate to the Fed’s data dependency focus (job growth, inflation outlook, overall economic strength). Regardless of the specific decision rationale, the resulting impact for the broad equity markets was that it appears to have heightened investor interest in maintaining the “risk on” trade. That is, this monetary accommodation is emboldening investors to favor higher potential growth, higher beta, lower financial quality stocks. As we move into 2014, we maintain our perception that the focus on quality and market leadership is likely to become an important theme.
From a valuation perspective, we have seen a gradual increase in the price/earnings multiples of the major market indices. The forward price-toearnings (P/E) ratios are beginning to be more in-line with the 10 year median p/e ratios.
Figure 2. A comparison of price-to-earnings ratios and earnings-per-share across capitalizations and developed and emerging countries.
Does this mean that stocks are approaching over-valuation levels? We would suggest no. Clearly, the broad market averages are not as cheap as they were in 2009. Is it possible that, given the strong overall year-to-date returns for the broad averages, a market correction could occur? Yes, it is possible as stock prices do not move in a straight line (up or down). Yes, the on-going Washington political dysfunctional behavior may begin to negatively impact investor sentiment. Yes, overall U.S. economic growth rates are anticipated to remain in the 2.0 -2.5% annualized range. Yes, an external unknown shock to the system could occur. These are not new concerns for investors but a continuation of the Headwinds that have existed for much of 2013. We are maintaining our outlook that the Tailwinds of global monetary accommodation, solid corporate operating conditions and reasonable valuation levels will provide fundamental support to the broad equity markets.
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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).