Chief Investment Officer, John Sawyer, CFA looks at the sustainability of the current stock market rally. Investor focus has shifted from European headlines to the expansion of the U.S. economy which is being propelled by nascent, but geographically widespread, improvements in the job market. Mr. Sawyer believes the U.S. economy is experiencing a sustainable expansion, having moved beyond the initial recovery phase, and into the growth stage of the business cycle.

On the eve of the presidential election, Chief Investment Officer John Sawyer looks ahead to the next term, expressing confidence that the U.S. economy will continue to expand and, following four years of stimulus, policymakers will begin to restore fiscal responsibility. Read more about his observations below.

1. Presidential Election Theory contends that presidents focus on pushing through their platforms via tougher legislation in the first two years of the term and on fiscal stimulus to pump up the economy during the last two years of the term. Politics aside, what do you foresee for 2013?

It would be difficult to say what the world would have looked like today without the stimulus programs of the last four years. The Federal Reserve (the Fed) has telegraphed very explicitly that stimulus will continue into 2013 as the economy is still precarious. However, we believe a renewed fiscal discipline around tax revenue and government spending is in the works. Federal tax revenue has fallen in the years following passage of the Tax Relief and Job Creation Act of 2010 which, among other things, lowered the FICA payroll tax for employees. After four years of stimulus with little attention to fiscal responsibility, in the new term government policymakers will likely demonstrate an increased willingness to address fiscal issues. As a result, a return to the Clinton-administration era tax rates is possible.

2. The Fed’s move to institute Quantitative Easing 3 (QE3) differs from previous easing in that it establishes job growth as a specific benchmark. How might that affect investor expectations?

The Fed is far more explicit about what they are trying to accomplish with this round of easing. Increased transparency definitely leads to more stability because it removes an element of uncertainty. In the same announcement, the Fed also stated that they expect to keep short-term interest rates near zero through mid-2015, six months further out than previously announced. By continuing to push these dates further out on the horizon, the Fed is taking yet another step to reduce investor uncertainty. They do not want people to speculate and grow concerned towards the program’s end about what will happen afterwards. Throwing the ball out of the park removes the action from everyone’s radar screen, and reduces the point of concern from an investment horizon perspective. The market is looking for this degree of precision, and is reassured by it, so it appears to be working in terms of enhancing confidence.

However, such moves have also led some to speculate that Fed action is counter-productive. In the 1990’s former Federal Reserve Chairman Alan Greenspan warned against the so-called “Fed Put,” or Federal Reserve moves enacted to provide downside economic and market protection. During his terms, the markets assumed that the Fed Put was a possibility to ameliorate economic downturns, but Greenspan was pretty guarded with his communications. In comparison, the Fed today has to almost write and publish the put contract – we know what the amount is, the term is, and the objective. From that perspective, we are seeing an unparalleled level of transparency at the Federal Reserve, but we are also mindful that the 2008 economic downturn has been unlike anything we have experienced since the Great Depression.

3. In your opinion, does QE3 seriously impact the U.S. fiscal deficit?

Without question the two previous rounds of quantitative easing have acerbated the deficit. Clearly the Fed is betting on the growth side of the balance sheet; that the economy is going to outgrow the debt problem. The implied goal is to restart the economy and get the gross domestic product (GDP) up to a number that closes the deficit back into a reasonable percentage of overall GDP. While there is every expectation that the annual deficit will begin to subside as we discontinue spending a trillion dollars a year, no one anticipates that we will run a surplus. And few believe that we are actually going to start paying down the overall outstanding debt. Instead, the deficit will be rationalized, as it was after the Great Depression, through prolonged economic expansion.

4. We’ve discussed this in the past, but do you foresee a handoff of monetary policy’s dominance of stock prices to company fundamentals?

While much investor sentiment is based on this, stock prices aren’t solely the direct result of Fed action. Corporate stability and increased earnings are the fundamental basis for current equity valuations. Fed action has helped stabilize the macroeconomic foundation which made these increases possible. If stock prices were at higher than average price to earnings ratios, then stock prices would be attributable to the likelihood that Fed action will drive increased economic growth and continued earnings appreciation. But at multiples of 14, investors are likely only valuing equities based on current earnings and putting little faith in an overall expansionary phase.

A handoff will occur when the current government programs end. For example, in 2008 there were half a dozen or so, bank liquidity programs. Today there are none, outside of normal operations by the Federal Reserve and Government Agency programs that existed before the financial crisis. While there has been a return to normalcy from the government lending program perspective in the banking market, there has been generally little acknowledgement of this. People are no longer talking about the banking industry teetering on the edge of a cliff because the banks have stabilized, earnings have returned and people are no longer worried about deposits.

We are likely to see something similar when QE3 and other stimulus programs end. As conditions normalize, these programs will quietly go away without much fanfare. As the Fed continues to move the retirement date for low interest rates further out, by the time the programs expire, investors will have lost interest.

5. Technological advances in the past four years have allowed the U.S. to become less dependent on foreign energy. Do these advances lower gas prices or boost employment?

Technological advances can have a counter-productive impact related to attaining some degree of energy independence by finding more efficient ways to utilize the energy that we consume. Many advances have a tendency to lower demand and as a result oil prices and prices at the pump which reduces the economic incentive to create new technologies. For all the advancement we have had, there are still no cheaper substitutes to our traditional combustible engines. For example, for all the advancements over the past decade in wind turbines technology, kilowatt production is still more expensive than electricity derived from coal and natural gas plants. Prolonged high oil prices, much higher than they currently are, would be required to generate vigorous investment into alternatives. The thing about oil is that its production costs are still at a substantial discount to the economic value of the energy it produces.

That said, the revival of the energy sector is positively impacting the national job market,particularly in states with proven reserves like Texas, Wyoming, the Dakotas, and Pennsylvania. And it is at least tangentially beneficial to other states because of the mobility of workers looking for these new jobs.

6. Do you consider the drivers behind growing diplomatic tensions between the U.S. and the Middle East as well as Japan and China to be primarily social or economic?

Economic distress is the real catalyst in the Middle East. Throughout the world, where there is economic disperity, social issues become the excuse, not the driver. Middle-class conditions, however you define middle class, do not lend themselves to broad civil unrest and continued property damage. Countries in the Middle East are far from stable, they are adolescent democracies on the eve of significant social change. While many people believe there is some linear path for the development of a democracy, such development is far from guaranteed. There are many paths that democracy can take, and they are not necessarily the ones that we have experienced from a Western Civilization perspective.

In China, thousands have taken to the streets in protest regarding territorial claims over islands in the East China Sea which the Japanese government recently nationalized. There has long been conflict over who owned the islands, but the recent action by the Japanese has been viewed as an overtly hostile act. To some extent, the disputed islands’ situation is being exploited by both governments to rouse nationalist sentiment and distract the populous from increasing economic and social tensions. If you are a member of the Chinese Communist Party and are about to experience a leadership change in the midst of your economy weakening, do you want the citizens upset over food prices or the Japanese control of your perceived property? Similarly, Japan’s prime minister is experiencing record low popularity and the islands have created a high-profile diversion.

7. Since Lehman Brothers failed in 2008, investors have pumped $900 billion into bond funds and withdrawn $410 billion from equities according to the Investment Company Institute. Please address the implications for investors.

These numbers are only the tip of the iceberg; they do not encompass institutional and retail US direct bond buying, foreign based mutual funds, or global investors, none of whom are investing in U.S. bond mutual funds. Investors, particularly those who are retired and living off the income from their portfolios, are hurting. Many are buying bonds, often based on fear or the misperception that recent gains will continue. Investors lost money in the tech bubble of early 2000 and again during the 2008 credit crisis and few have really recovered psychologically from these events, although the stock market has advanced since 2009. All too often investors wrongly believe they are insulated from market volatility while holding bond funds. There are so many buyers of high-grade bonds now that there is no possible way to get any yield which has obviously created a supply/ demand imbalance.

Former Federal Reserve Chairman Greenspan coined the term “irrational exuberance” about the stock market. We have certainly reached a place where bond prices are exhibiting irrational exuberance although it could be a number of years before the bubble bursts. What happens when the economy improves and we get a slight uptick in rates? Bond funds don’t mature and it can be very traumatic to investors when rates rise. The longer this lasts and lower rates fall, thus extending duration, the worse it is going to be when there is even a modest uptick in interest rates.

Yet in the stock market we continue to see consistent corporate earnings performance, especially in large cap U.S. companies, and multiples are reasonable. It is conditions like these that continue to support taking a long-term view when building an investment portfolio and reinforces the value of following prudent, diversified strategies that are consistent with historic market performance.

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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.

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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.

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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).