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Select Consulting, Inc. A Registered Investment Advisor Investment Commentary 1st Quarter 2013 Robert V. Sytz, Jr., CPA, CFP® Jeffrey A. Harrell, CFA Brett S. Miller, CPA, CFP® K. Warren Poe, Jr., CFP® Morgan C. Marvelli, MBA Below you will find our investment commentary for the most recent quarter. We hope you find it informative and will consider our investment services in the future. If you have any questions or concerns about the market or your investment portfolio, please call our office to schedule a meeting or conference call. Economic Review & Outlook Economic growth in the first quarter of 2013 picked up after an alarming Q4 2012 reading near 0%. According to The Wall Street Journal, the average economist forecast for Q1 2013 is 2.2%. The highest expectation is for 3.3%, with the lowest forecast expecting a mere 1.2% increase. This wide range of forecasts demonstrates the lack of consensus in the economic community as to where the economy is headed. It appears there are just as many economists telling you how much the economy is improving as the number telling you how it is weak. Now who is correct? Dare we suggest both? As you look at the economy socioeconomically, instead of homogenously, a very interesting and telling story begins to unfold. Increasing U.S. household net worth is one of the strongest pieces of evidence representing the recovering economy. As you can see from the chart, U.S. Households have almost fully recovered back to the peak of 2007. The stock market rebounding sharply from its 2009 low is undeniably a major contributor to this increase over the past couple of years. Additional signs of strength come from Corporate America. Profits at publicly traded companies set a record in 2012 and are forecasted to do so again in 2013. The real estate market is improving with both new starts and prices having risen sharply over the past year. Auto sales are picking up with monthly unit sales having more than doubled from the bottom in 2008. There are other positive data points coming from research groups such as the Institute for Supply Management, suggesting both the manufacturing and service sectors are strengthening. Interestingly, retail sales have started strong in 2013 despite higher taxes and the dreaded “sequester”. Even the financial obligations ratio (a measure of household debt relative to assets) shows significant improvement. This ratio currently stands at its best level since the early 80s. In conclusion, if you are looking for an economic recovery, there is countless data to support your claim. Case closed, right? The economy is clearly moving full steam ahead and anyone who disagrees simply has to look at the aforementioned data to be convinced. In this case, there truly are two sides to every story. A major flaw for those suggesting the economy is improving is the U.S. poverty rate. As the chart to the left depicts, the U.S. poverty rate has been steadily increasing since the recession officially ended in 2009. This seems difficult to reconcile if the economy is improving. Another piece of data contradicting an economic recovery is the percentage of Americans receiving food stamps, which now stands at 15%. This is up from 9% in 2008 and 6% in 2000. Since 2007, the percentage of Americans on food stamps has increased every year. Income growth is an issue as well. When the recession officially ended in 2009, real median household income had fallen over $2,000 from its 2007 peak of $56,063. In January, real median household income was reported at $51,584, fully $4,479 lower than the peak in 2007. As for net worth, while the chart above confirms it is rising, it is misleading. Only the top 20% have seen their net worth increase as a percentage of total net worth in the U.S., since the recovery began. Further, only the top 20% now have net worths higher than where it stood in 2007. The evidence is clear; the economy is growing at an uneven rate, not because it is recovering slowly, but because it is unbalanced. The long term ramifications of this type of improvement are impossible to forecast. The policies being undertaken by the Federal Reserve are having the desired effect to stimulate financial asset prices, but its benefit depends on where you stand socioeconomically. With these policies likely to remain in place for the foreseeable future, this type of “improvement” is something that could persist for an extended period of time. 8816 RED OAK BOULEVARD SUITE 260 CHARLOTTE NORTH CAROLINA 28217 PHONE 704.426.6100 TOLL-FREE 866.727.6100 FAX 877.500.6798 www.sconsulting.net Bond Market Review & Outlook While the bond market did not start 2013 with the same enthusiasm of the stock market, its long anticipated demise appears to remain in hibernation. High quality bonds as measured by the Barclays Aggregate Bond Index were essentially flat over the first three months of the year, despite a slight move higher in interest rates. The coupon of most bonds offset much, if not all of the price decline in many segments of the bond market. The only real losers during the quarter were long term government bonds, suffering a 2% loss. Credit sectors of the fixed income market delivered positive returns across all quality and maturity segments. The top performing area was high yield, returning nearly 3% for the quarter. With yields near record lows, the long term outlook for most bonds is less attractive than in the past. This is admittedly making fixed income allocation decisions more difficult. Despite lower yields, bonds remain a vital component of a well diversified portfolio, serving as much needed ballast when the financial storms hit. Balancing out the defensive characteristics of high quality bonds versus their limited total return potential, suggests maintaining some exposure is necessary, but alternative strategies should also be employed. Over the past couple of quarters, we have made adjustments to our bond investments to address this issue. In our most conservative accounts, we have reduced our exposure to passively managed bond index funds which tend to have higher exposure to U.S. Treasuries. The proceeds from these adjustments were placed into shorter duration bond funds, with managers focused on capital preservation, yet willing to look into alternative strategies to generate higher yields. Although we are not convinced interest rates will rise sharply this year, we do believe a move lower in yields is unlikely. This should create an environment where top managers can deploy strategies such as duration management, credit quality adjustments and currency positioning to generate returns in 2013 higher than the stated yields of their funds. In our more aggressive accounts, we have eliminated all of our direct exposure to U.S. Treasury securities and will continue to emphasize managers with a minimal allocation to this segment of the bond market. All of our aggressive and neutral accounts have at least one credit sensitive bond fund, typically high yield or emerging market debt. With high yield returns near 3% to open the quarter, mid to high single digit returns are what we are expecting in 2013 for these funds. Spreads for high yield bonds remain near historical averages giving them a buffer should yields rise. Prior to the 2008 credit crisis, high yield spreads had reached a record low of just 2.5% over U.S. Treasuries. With spreads still near 5%, we think high yield remains very attractive in the context of a slow growth economy. Stock Market Review & Outlook 1st Quarter Index Performance 8.00% It did not matter what area of the stock market you were invested, gains were plentiful as stocks posted one of 6.00% their broadest rallies in recent memory to start the year. The benchmark Dow Jones Industrial Average and S&P 4.00% 500 indexes rose 11% and 10%, respectively. Small caps led the pack as the Russell 2000 rose 12%. The 2.00% technology heavy NASDAQ Composite underperformed the broader indexes, only rising 8%. The laggard was 0.00% the MSCI EAFE, up less than 4%, as international stocks continue to be weighed down by Eurozone concerns. -2.00% Common sense tells us that nothing goes up in a straight January February March DJIA S&P 500 Russell 2000 NASDAQ EAFE line, but the performance of the stock market to open 2013 might beg to differ. Through the first quarter of 2013, the Dow Jones Industrial Average has not suffered three consecutive down days and only suffered five back to back losses. It also made headline news in the middle part of March, when the index rose for 10 consecutive days. The streak ended just four days shy of the all time record of 14 days posted back in 1897!! Although the stock market may be partying like its 1999, most investors don’t seem to have the same enthusiasm as they did back then. The American Association of Individual Investors releases a weekly survey of individual investors by ranking those polled as bullish, bearish, or neutral over the next six months. The final reading of the quarter suggested investors remain no more bullish or bearish than normal. The percentage of investors indicating they were bullish over the next six months was 38.4%, below the long term average of 39.0%. The bearish camp stood at 28.7%, just slightly less bearish than the 30.5% long term average. These readings are typically used as contrarian indicators and have done an excellent job of identifying extreme tops and bottoms in the past. For instance, at the bottom of the market in March of 2009 the survey was at a record low bullish reading below 20%. More recently, in the market rally during January 2011, bullish sentiment eclipsed 60%. The stock market was flat for almost a year after that. In the past, new stock market highs have almost always been accompanied with extreme investor enthusiasm. This time appears to be different, suggesting further gains may still be in order. For the most part, value outshined growth in the first quarter, which is a bit out of character since value stocks typically demonstrate more defensive characteristics and tend to lag when stocks deliver strong gains in short order. The top performing sector in 2013 has been health care, up 15%. This sector only represents 11% of the Russell 1000 Value Index, so this wasn’t a major contributor to the superior return. Instead, the outperformance by the value index was more a byproduct of what it didn’t own. Technology shares were amongst the worst performers during the quarter, only up 5%. This industry represents the largest sector weighting of the Russell 1000 Growth Index at over 25%. Russell Style Indexes Q1 Performance 15.00% 10.00% 5.00% 0.00% Russell 1000 Russell MidCap Growth Russell 2000 Value Mid and small cap stocks outperformed large caps as the “risk on” trade being propagated by the Federal Reserve’s quantitative easing (QE) policy continues to push investors further down the risk spectrum. Perception by the investment community is growing more emboldened by the day, as professional traders and portfolio managers become convinced the Federal Reserve will continue to support financial markets, leaving stocks with little downside risk. As long as interest rates remain at these levels, the Federal Reserve can continue to support asset prices through its QE policy. Until the fixed income markets react negatively to this policy, the stock market will remain the primary beneficiary. The performance of the stock market throughout the rest of the year is highly dependent upon the Federal Reserve. One major concern will be how the stock market reacts when they end QE. Since the bull market began in 2009, we have only experienced two corrections of more than 10%, both coinciding with the temporary conclusion of the previous QE policy. The subsequent stock rallies resumed, as the Federal Reserve indicated it would start the program again. This trend is evident by the 86% correlation between the size of the Federal Reserve’s balance sheet and the stock market. It appears as long as the Federal Reserve is printing money, stocks will likely keep moving higher. If the stock market is going to suffer a major setback this year it will probably be a result of Europe or higher interest rates. Should the European situation escalate further and reach critical mass in Spain or Italy, the European Central Bank will have to look for outside assistance. The recent news out of Cyprus should give investors pause, as large depositors bore the brunt of the bailout losses. If this triggers large European investors to withdraw money from banks in Spain or Italy, the fallout could be devastating. Interest rates are another concern. A rise of just 1% this year could dramatically affect the economy, most directly the housing market as buying a home would become significantly more expensive. Add this to the still uncertain affect of higher taxes, weak employment, subdued income growth, higher gas prices and the “sequester”, clearly economic growth could come in below expectations. Fortunately, even if interest rates were to rise 1%, stocks could still deliver decent gains because the investment alternatives will still remain comparatively unattractive. However, if interest rate rise more than 1% in 2013, stocks may react negatively. Finally, it should be noted that we did not discuss the prospects for corporate earnings as a driver of stock market performance. This is intentional as the correlation between these two variables is relatively low. In 2011, S&P 500 earnings rose 15%, yet the S&P 500 Index went nowhere. In 2012, earnings rose by a miniscule 0.5% and the index was up 16%. This observation perfectly illustrates the current lack of correlation between earnings and stock prices. Forecasts for 2013 S&P 500 earnings growth stand at 15%, but this number has been falling on almost a daily basis. This trend of revising down earnings expectations is something we commented on throughout 2012 and so far for 2013, it is following suit. When 2013 is all said and done, we would not be surprised to see earnings growth of 5% or less. Despite this negative earnings backdrop, in all likelihood this would not be enough of a catalyst to cause the stock market to sell off and this is due to the lack of attractive investment alternatives. Unless earnings suffer a major setback this year, the prospects for the stock market remain constructive. Sincerely yours, S Wealth Management Team Select Consulting, Inc.