Download 2013 Archived Documents

Market Perspective Full Year 2012
and 2013 Outlook
Global equities markets rebounded in 2012, reviving one of the most impressive recoveries in the history
of the capital markets. Geopolitical and other external shocks to the global economy for the year
included on-going unrest throughout the Arab world, particularly in Benghazi, Libya and Syria;
continuing political clashes in the United States and Euroland over spending and taxes; and the
impending fiscal cliff and Superstorm Sandy in the U.S. Major uncertainties included fears of a Chinese
“hard landing” as the country’s economic growth slowed; the depth of the downturn in Euroland
economic activity; the on-going European debt crisis; and the upcoming U.S. Presidential election. The
shocks and uncertainties induced a global equity market downturn in the spring, and induced “risk-on,
risk-off” lock-step market movements as investors swung quickly and indiscriminately between “risky”
and “safe” investments. Global developed country governments, and especially in the U.S. and U.K.,
continued accommodative monetary policy to keep interest rates low to encourage investors to allocate
funds to risk-based assets and corporations to invest in inventory and human capital. This easy-money
policy proved to be more successful as the year progressed, assisted at mid-year by the European Central
Bank implementation of programs to preserve the euro and provide price support for European
government and bank-issued bonds.
Global stock markets garnered outstanding returns that were almost completely undifferentiated.
Results for the year were close to uniform across U.S., foreign developed countries, and emerging
markets as well as market capitalizations and management style breakdowns. The average diversified
U.S. equity fund returned 15%, and the average diversified foreign equity fund returned 18% according
to Morningstar. Fixed income securities posted generally solid returns, particularly for riskier bond
asset classes. The Barclays Capital U.S. Aggregate Bond Index rose 4%. U.S. government bonds
earned 2%, held back by Federal Reserve easy-money policy. Boosted by investors’ search for higher
yields, riskier credit-sensitive intermediate investment-grade bonds returned 8% according to Barclay’s
indexes. The average high yield bond fund returned 15% according to Morningstar. Finally, foreign
government bonds provided a total return of less than 2%, but emerging market bonds were big winners,
aided by favorable reassessments of their credit-worthiness, currency gains for U.S. Dollar investors,
and higher risk-adjusted yields.
Time is an investor’s best friend, and any year-end review is a snapshot of a short period. We must
remind ourselves that markets’ movements are cyclical; they retreat and rebound due to reversion to the
mean, and they move upward as rapidly as they move down. It is very easy to linger too long in the
perceived safety of a recently high-performing asset class. Particularly, it is easy to get comfortable
with a decreased exposure to stocks, thereby incurring an opportunity cost by missing the benefit of the
ensuing bull market run-up.
Economic Review
The U.S. economy continued to slowly improve during 2012 despite ending the year on a very slow pace
due to reduced government spending. The U.S. economy, as measured by gross domestic product
(GDP), expanded 2.2% during 2012 following expansions of 1.8% for 2011 and 2.4% for 2010. GDP
Market Perspective Full Year 2012 and 2013 Outlook
Page 2
declined .1% (annualized) during the fourth quarter of 2012, but rose 3.1% during the third quarter,
1.3% during the second quarter, and 2.0% for the first quarter. Due to the slower rate of expansion
expected during the first half of 2013, real GDP is projected to grow approximately 1.8% for 2013 and
2.4% for 2014.
The U.S. economy continued to show signs of improvement during 2012. The Manufacturing ISM
Index ranged from 49.5-54.8 during 2012 and finished the year at 50.7 in December. The NonManufacturing or Service ISM Index ranged from 52.1-57.3 during 2012 and finished the year at 56.1
in December. Readings above 50 indicate that the economy is generally expanding while readings
below 50 indicate a contracting economy. December was the 36th consecutive month of growth in the
service sector, and the 43st straight month of expansion in the overall economy according to the
indexes. The manufacturing sector also grew during 2012 despite moving back and forth across the
50% mark over the second half of the year. We note that although the economy has been expanding for
approximately 3.5 years, the rate of expansion is extremely low, particularly considering the very low
starting point at the bottom of the Great Recession. The Federal Reserve Board reported in its January
Beige Book national economic activity expanded at a modest to moderate pace during the reporting
period of late November through the end of December…and “activity in the New York and
Philadelphia Districts rebounded from the immediate impacts of Hurricane Sandy.”
The Fed announced a new quantitative easing program (QE3) in September 2012. Under the program,
the U.S. Central Bank will buy billions of dollars of mortgage backed securities each month in an effort
to stimulate the economy. The decision to focus on mortgage bonds reflects the Fed’s conviction that
the housing market still needs help, and that lower rates on mortgage loans will produce broad economic
benefits. The goal is to hold down interest rates, increase housing starts, and encourage spending by
U.S. consumers and businesses, thus creating more jobs and income.
The employment situation continued to improve slowly during 2012. According to the Bureau of Labor
Statistics, 2.2 million non-farm jobs were added to payrolls during 2012, including 160,000 in October,
247,000 in November, and 196,000 in December. Unemployment fell throughout the year from 8.5% at
the end of 2011 to 7.8% in December 2012.
The lowest unemployment rate in almost four years and cheaper gasoline appeared to be bolstering
consumer spending. Consumer spending is important, as up to 70% of the economic growth in the U.S.
has historically been driven by the consumer. The Consumer Confidence Index was 66.7 in December
2012 compared to 64.5 a year earlier. Nonetheless, the Consumers Expectation Index, a measure of
how individuals feel about their finances six months in the future, decreased to 68.1 in December 2012,
compared to 76.4 a year ago. In January 2013, both indexes declined dramatically: to 58.6
(Confidence) and 59.5 (Expectations). According to Lynn Franco, Director of Economic Indicators at
The Conference Board, “Consumers are more pessimistic about the economic outlook and, in
particular, their financial situation. The increase in the payroll tax has undoubtedly dampened
consumers’ spirits and it may take a while for confidence to rebound and consumers to recover their
initial paycheck shock.”
Lower mortgage rates, improved job conditions, and rising rents continued to help the housing market in
2012. New home sales rose 20% to 367,000 and existing home sales increased 12.8% to 4.38 million
units in 2012. Despite these significant gains in sales of new and existing home, sales are still far below
the new home target of 700,000 units that economists consider healthy and the existing home high of
5.03 million in 2007. According to Lawrence Yun, the chief economist of the National Association of
Market Perspective Full Year 2012 and 2013 Outlook
Page 3
Realtors, “Record low interest rates clearly are helping many home buyers, but tight inventory and
restrictive mortgage underwriting standards are limiting sales.” The inventory of new homes for sale
declined to a 4.9 month supply, the lowest level since 2005. A range of 7-9 months supply is generally
consistent with stable home prices.
Inflation continued but decelerated in 2012 as the Total Consumer Price Index (CPI) rose 1.7% versus a
3.0% increase in 2011. This was the third smallest December-December increase for CPI of the past ten
years and compares to a 2.4% average annual increase over the span. Core CPI (excluding food and
energy) rose 1.9% for the year, following an increase of 2.2% in 2011, and matching the average annual
increase of 1.9% over the past ten years. The slowdown in Total CPI was primarily due to low
increases in energy and food: the energy index was up .5 and the food index rose 1.8%. The Core CPI
was primarily influenced by a 3.7% increase in the medical care services. Contained inflation provides
the Federal Reserve much more latitude in stimulating economic recovery.
Asia’s fast growing economies continued to expand but at a lower rate in 2012, slowed by reduced
European demand. China, the world’s second largest economy, expanded at its slowest pace since 2001
as Europe’s debt crisis curbed export demand and the property market weakened. For 2012, China GDP
slowed to 7.8%, down from 9.2% in 2011 and 10.4% in 2010, just below the 8% rate that SinoPac
Financial Holdings Co. says would signal a “soft landing.” The Chinese government has set a target of
7% annual growth through 2015. China has been trying to curb inflation and rein in housing prices.
The slowing growth is expected to allow China to ease monetary policies to boost domestic demand
without setting back progress made in curbing inflation.
Japan has the world’s third largest economy. It officially entered a recession in 2012 as GDP contracted
-.9% and -.5% in the second and third quarters of 2012 due to weak exports, reduced consumer
spending, and fading public investment in areas damaged by the 2011 earthquake and tsunami. Japan’s
central bank has announced plans to stimulate the economy by devaluing the Japanese yen, thus
reducing the price of Japanese products overseas and increasing exports.
In Europe, the economy contracted in the second and third quarters of last year, meeting the technical
definition of recession, and the downturn is expected to have deepened in the fourth quarter. The
European economy is important because 1) its combined economy is the largest in the world, and 2)
because of the size and influence of the European financial sector. According to Eurostat, the statistical
office of the European Union, Euro area GDP decreased by -.3% in 2012. Even the normally strong
German economy was relatively flat in 2012; German GDP rose .7% for the year. France grew .2% for
the year. Please note all fourth quarter and 2012 annual GDP statistics are preliminary.
The European Central Bank (ECB) surprised markets in July 2012, announcing a commitment to do
whatever was necessary to support and preserve the Eurozone. Specifically, the ECB pledged to buy
unlimited amounts of Eurozone governments’ bonds to reduce countries’ borrowing costs. The
aggressive new program is similar the U.S. Federal Reserve’s QE2 and QE3 purchases of U.S. Treasury
and mortgage debt.
Equity Review
Stock returns were generally excellent for U.S. stock investors at home. Abroad, stock results were also
strong for local and U.S. dollar investors. The broad U.S. stock market gained 16.1% in 2012 as
measured by the Wilshire 5000 Index (equal-weighted). For U.S. dollar investors, the MSCI EAFE
Market Perspective Full Year 2012 and 2013 Outlook
Page 4
Index of large developed country foreign stocks was up 17.3%, and the MSCI Emerging Markets (EM)
Index gained 18.2%. The data indicate stocks moved together in high correlation, based more on central
bank actions and geopolitical events than on fundamental macroeconomic data for countries, industries,
or specific companies.
Price-to-earning ratios are one indicator of the level of stock valuations, be they either high or low.
According to Morningstar, from the end of 2011 to the end of 2012, the price-to-prospective earnings of
diversified equity mutual funds were little changed. None of the 2012-ending ratios were out of their
typical ranges. Data are as follows:
Type of Diversified
Equity Mutual Fund
Price-to-Prospective Earnings
2011
2012
Change
U.S. (All caps and styles)
14.7
13.6
-1.1
International (Excluding EM)
11.6
12.0
.4
Emerging Markets (EM)
10.3
10.9
.6
Emerging market (EM) stocks traditionally trade at lower P/E ratios than those of foreign developed
countries stocks due to the perceived additional risks of investing in emerging markets.
The year 2012 included three contrasting time intervals, as shown by the following table of global stock
returns; high correlations among asset classes are again in evidence:
Jan. 1, 2012Feb. 29, 2012
S&P 500
Mar. 1, 2012May 31, 2012
June 1, 2012Dec. 31, 2012
Full Year
2012
9%
-4%
10%
16%
Russell 2000
10%
-6%
13%
16%
MSCI EAFE
11%
-14%
22%
17%
MSCI Europe (part of EAFE)
11%
-15%
26%
19%
MSCI Emerging Markets
18%
-15%
18%
18%
Many U.S. stock sectors provided positive returns for the year, and the sectors that lost the most in 2011
were generally the winners in 2012. Global real estate (31.5%), financial (24.8%), industrials (19.0%),
communications (16.7%), and technology (13.1%) rebounded from losses in 2011 to double-digit gains
in 2012. Sectors that held value in 2011 generally had more muted results in 2012: utilities (6.9%), and
energy (1.2%). Health and real estate stocks were exceptions and provided excellent returns both years,
21.6% and 17.6%, respectively in 2012.
Among the more common ways to differentiate among stocks is by size (larger capitalization versus
smaller) and by style (value versus growth). Large-cap stocks are measured by the Russell 1000
Index and small-cap stocks are measured by the Russell 2000 Index. The U.S. market exhibited
almost no differentiation by market capitalization as both the large-cap and small-cap indexes
gained about 16%; small caps beat large caps by a scant .4 percentage point. This year’s results
continue the pattern, albeit weakly, of higher performance of small caps that has generally
Market Perspective Full Year 2012 and 2013 Outlook
Page 5
characterized markets since the Internet Bubble burst in 2000. For the full year, value style indices
moderately outperformed growth style indices by about 2 percentage points.
Results by style for mutual funds were somewhat at variance compared to the indices, but not materially
so. For example, large-cap growth funds beat large-cap value funds by about .8 percentage points.
However, this result may have been caused by one stock held by a large majority of growth funds,
namely Apple, which had a huge appreciation in 2012. As a further example, unlike the Russell indices,
the average diversified large cap fund slightly outperformed the average diversified small cap fund
(15.0% versus 14.7%, respectively). Please note that classifications of mutual funds by style have their
limitations.
Longer-term U.S. stock data reflect the deep 2008 slump and the extent of the 2000-2002 bear market
correction of the Internet Bubble, especially among larger capitalization and growth-oriented stocks.
The table below shows annualized thirteen-year returns for 2000 –2012 and covers two deep bear
markets, one bull market (2003-2007), and the 2009-12 rebound:
Value
Growth
Large Cap Mutual Funds
3.4%
-0.7%
Small Cap Mutual Funds
8.8%
2.7%
As noted previously, value stock returns should equal or exceed growth stock returns, and small cap
returns should equal or exceed large cap returns in the long run. The unwinding of the tremendous
disparity between the performance of small value funds and large growth funds over the first seven years
of this period has made considerable net headway over the last six years of the thirteen-year period.
In 2012, the strong returns for broad, capitalization-weighted market indexes were indeed representative
of performance at the level of individual stocks. For the three U.S. stock exchanges combined, 5,274
stocks advanced and 2,466 stocks declined. The corresponding advance/decline ratio of 2.14 places well
above the 1.76 mean and 1.45 median, in the 23-year period we have been tracking.
As reviewed in the past, the advance/decline ratio has its limitations. Nonetheless, the above-mean
value of the advance/decline ratio in 2012 after an extremely low value of .61 in 2011 and significantly
higher values in 2010 (2.75) and 2009 (4.09) provides some credence to investors’ hopes that U.S.
stocks can continue to appreciate over the next year.
Foreign stock markets modestly outperformed their U.S. counterparts in 2012 for the U.S. dollar
investor due in part to worries in the U.S. about the fiscal cliff. Developed countries stocks
outperformed emerging market stocks in local currencies, but currency gains boosted results for
emerging market stocks. For U.S. investors, foreign returns in local currencies are decreased by the
currency losses associated with any strengthening of the dollar, and vice versa when the dollar
depreciates. In 2012, the U.S. dollar was just below breakeven versus 6 major currencies tracked by
the U.S. Dollar Index, primarily due to losses against the euro and British pound; the dollar rose against
the Canadian dollar and Japanese yen. The small dollar depreciation thus generally helped results in
foreign developed countries, but only a little. Against emerging markets currencies, the dollar
depreciated significantly and boosted already excellent results in local currencies when translated to
U.S. dollars. This was particularly the case for emerging market bonds, less so for emerging market
stocks.
Market Perspective Full Year 2012 and 2013 Outlook
Page 6
The average mutual fund investing in developed countries international stocks gained 18.1% for the
year, somewhat better than the MSCI EAFE return of 17.3% in U.S. dollars. The MSCI EAFE Index
covers large companies domiciled in developed markets outside of the U.S. and Canada.
Emerging markets stocks’ excellent positive returns in 2012 benefited from “risk-on” periods during the
year as investors sought higher expected returns available in riskier asset classes. The average mutual
fund investing in emerging markets stocks gained 18.2% for the year, matching the return of the MSCI
Emerging Markets Index in U.S. dollars. Both were boosted by the currency gains noted above.
Over the five-year period 2008-2012, a period which includes the catastrophic equity losses of the
Financial Crisis and Great Recession and subsequent historic recovery, U.S. stocks have risen 2.3% per
year as measured by the MSCI U.S. Broad Market Index. Foreign developed country markets and
emerging markets have recovered at a slower pace, and have provided negative returns of -3.7% and .9% per year in U.S. dollars over the same period, as measured by the MSCI EAFE and MSCI EM
Indexes, respectively. Despite the unfavorable comparison over the last five years, the economies of
emerging countries have recovered faster and are expected to continue growing faster than those of
developed countries and will be prime beneficiaries when recovery of the global economy pushes up
demand for energy and commodities.
Looking at global stock performance over the past five years, as measured by mutual fund returns,
other salient observations are:
1.
Financial, natural resources, and communications sector stocks were the biggest losers in the U.S.,
down 4.5%, 3.2%, and 2.7%, respectively, per year, whereas health, real estate, and technology
stocks gained 6.5%, 4.9%, and 2.2% annually, respectively.
2.
European stocks declined an average of 4.6% per year.
3.
Japanese stocks lost 5.3% annually, whereas other Asian/Pacific stocks declined a lower 1.2% per
year.
Global stock returns are summarized in the table on the next page; please see footnotes for enhanced
understanding:
Market Perspective Full Year 2012 and 2013 Outlook
Page 7
Annualized Return*
One
Five
Year
Years
U.S. Stocks
S&P 500 Index **
Average Diversified U.S. Equity Mutual Funds
Russell 2000 #
Sector Mutual Funds
Technology
Health
Communications
Financial
Real Estate
Natural Resources
Foreign Stocks
MSCI Europe, Australasia & Far East (EAFE) USD ##
MSCI EAFE Local Currencies
Average Diversified Foreign Equity Mutual Fund
Regional/Specialty Mutual Funds
Europe
Japan
Diversified Pacific/Asia Except Japan
Diversified Emerging Markets
Alternative Strategies
Average Long-Short Mutual Fund
Average Market Neutral Mutual Fund
*
**
***
δ
#
##
16.0%
15.0%
16.4%
4.0%
1.6%
3.6%
13.1%
21.6%
16.7%
24.8%
17.6%
4.3%
2.2%
6.5%
-2.7%
-4.5%
4.9%
-3.2%
17.3%
17.3%
18.1%
-3.7%
-4.3%
-3.1%
20.9%
11.3%
23.6%
18.2%
-4.6%
-5.3%
-1.2%
-2.2%
5.2%
.2%
.3%
.2%
Mutual fund return data are from Morningstar.
Capitalization-weighted index of 500 very large U.S. companies. The 500 are chosen to achieve a fair cross-section of U.S.
industrial and service sectors. Recent median capitalization of approximately $54.8 billion.
Barclays index of U.S. Treasury bond total returns (i.e., interest plus or minus change in
price). Bonds in index have intermediate maturity of about 4-7 years. No mortgage-backed securities included.
Barclays index of U.S. investment grade corporate bond total returns (i.e., interest plus or minus change in price). Bonds in
index have intermediate maturity of about 4-7 years.
Index of small U.S. companies. Recent median capitalization of approximately $1.0 billion. Somewhat overweighted
toward financial stocks.
International stock index indicating return of large foreign companies of 21 major developed countries (Japan, UK, and
Germany have the highest weightings). Returns are unhedged and converted to U.S. dollars. No emerging market stocks
are included.
Stock Fund Managers Versus Indexes
Although they have beaten a passive or indexing approach for nine of the past fourteen years, active
U.S. stock pickers underperformed the large cap (S&P 500) and small cap (Russell 2000) indexes in
Market Perspective Full Year 2012 and 2013 Outlook
Page 8
2012. Even though manager underperformance was modest, it was somewhat surprising given that
many domestic-focused funds had at least a small allocation to outperforming foreign stocks.
As reported above, active international stock pickers outperformed the EAFE index of developed
country market returns. This outperformance probably had three causes. First, it resulted because most
diversified foreign funds include some emerging market stocks, which outperformed modestly versus
developed country stocks for the year. Second, foreign small caps typically have some representation in
international fund portfolios versus none in the EAFE index, and foreign small caps moderately
outperformed foreign large caps for the year. Third, most active managers have been underweight
Japan, which significantly underperformed compared with European and Asia/Pacific markets. Finally,
it is noteworthy that active stock pickers, whether U.S. - or international-focused, must overcome fees
for management of typically 0.6-2.0% per year versus zero cost for indexes.
Alternative Strategies
We began the year using five open-end funds. We replaced the long-short fund with two new ones in
the fall. The five and then six funds used during 2012 provided a weighted average return of about 4.8%
for the year. Consistent with their hedged, defensive positioning, they held back portfolio results given
2012’s excellent returns for stocks. Our alternative strategies grouping had results significantly lower
than the returns of global stocks but somewhat above those for global bonds. We note that our funds’
performance was slightly less than one of the two relevant Morningstar alternative strategies categories
but considerably better than the second: the category Morningstar calls Long-Short gained 5.2% in
2012, and the Morningstar category Market Neutral rose .2% for the year.
For a typical Caves & Associates portfolio, the inclusion of alternative strategies produced a moderate
decrease in 2012 return of about -5.1% (520 basis points) respecting the money allocated to
alternative strategies, plus an increase in stability due to limited correlation of results with stock and
bond markets. It should be noted that alternative strategies are particularly effective in down markets,
and they had their best quarter compared with traditional asset classes when stocks were at their worst
during May-June of 2012, when they added about .92 percentage points to investment results (again,
respecting only the money allocated to alternative strategies, not the total portfolio).
Looking at results covering the last five years of high market volatility, the alternative strategy fund
grouping provided a five-year return of about 8.0% (cumulative; not annualized). For a typical Caves &
Associates portfolio, the inclusion of alternative strategies therefore produced a decrease in the
cumulative, non-annualized 2008-2012 return of about -4.2% (420 basis points) for the money
committed to alternative strategies, including the impact of compounding. Most of this cumulative
detriment occurred in 2010 when stocks had a very strong year, and our grouping underperformed our
expectations. Again, however, the inclusion of alternative strategies helped smooth client returns and
thereby helped them “hold the course.”
We are continuing to evaluate our use of alternative strategies funds overall, the representativeness of
2012 results, and the weightings of each of the funds in the group. Even though our outlook for 2012 is
cautiously optimistic (see below), alternative strategies provide the requisite defensiveness for the
cautious part of our outlook and will continue to be a part of our efforts to help clients stay disciplined
and achieve long-term goals without losing any sleep.
Market Perspective Full Year 2012 and 2013 Outlook
Page 9
Fixed Income Review
Fixed income performance was fueled by investors stretch for higher yields, the Fed’s low interest rate
policies, and modest U.S. economic growth. High yield bonds were the best performers, with the
average high yield bond fund gaining 14.7% for the year. Investment grade bonds performed well while
Treasuries lagged due to the Fed’s ongoing stimulus programs and investors’ reach for yield. Long- and
intermediate-term corporate bonds returned 10.4% and 8.1%, respectively for the year. Long- and
intermediate-term Treasuries returned 3.6% and 1.7% including interest income for the year,
respectively, according to Morningstar.
Municipal bonds also provided positive returns for the year. Long-term and intermediate-term
California municipal bond funds returned 10.4% and 5.5%, respectively, for the year according to
Morningstar, including tax-free interest earnings. It should be noted that effective returns to investors
will be higher and depend on each investor’s tax bracket.
Unhedged foreign bond returns also reflected the global low interest rate environment as well as
investors’ search for yield and the relative economic strength of developed and emerging market
countries. As noted above, the U.S. dollar was essentially flat against many developed country
currencies. Emerging market countries currencies strengthened significantly against the U.S. dollar,
boosting the results of emerging market bonds for unhedged U.S. investors. The government bonds of
major developed countries returned 1.5% in U.S. dollars for the year, as measured by the Citigroup NonU.S. World Government Bond Index. Returns were hurt by fears of a spread of the European debt crisis
from Greece to other peripheral countries of Europe. Demand for the bonds of emerging markets
revealed continued strength due to their relative economic advantages discussed previously. The
average emerging market bond fund, which is typically unhedged, returned 18.0% according to
Morningstar.
For the 5-year period 2008-2012, compound annual results for all major categories of bonds were solidly
positive. Foreign developed countries bonds performed about on par with U.S. bonds. Emerging
market bonds outperformed U.S. bonds due to the weakening U.S. dollar versus emerging market
currencies and credit upgrades for many issuers.
Market Perspective Full Year 2012 and 2013 Outlook
Page 10
The following table and footnotes present fixed income results:
Annualized Return*
One
Five
Year
Years
U.S. Bonds
Barclays Intermediate Gov’t Bond Index **
Barclays Intermediate Credit Index ***
Intermediate Municipal Bond Mutual Funds
Intermediate Municipal Bond Mutual Funds (CA)
High Yield Bond Mutual Funds
1.7%
8.1%
5.6%
5.5%
14.7%
4.5%
6.7%
5.0%
4.8%
8.0%
Foreign Bonds
Citigroup Non-U.S. World Government Bond Index #
J.P. Morgan Emerging Bond Index ##
Emerging Market Bond Mutual Funds
1.5%
17.4%
18.0%
5.2%
10.1%
9.2%
*
**
***
#
##
Mutual fund return data are from Morningstar.
Barclays index of U.S. Treasury bond total returns (i.e., interest plus or minus change in price). Bonds in index have
intermediate maturity of about 4-7 years. No mortgage-backed securities included.
Barclays index of U.S. investment grade corporate bond total returns (i.e., interest plus or minus change in price). Bonds
in index have intermediate maturity of about 4-7 years.
Citigroup index of total return of foreign government bonds issued by major developed foreign countries (Japan,
Germany, France, and UK have the highest weightings). Returns are converted to US dollars.
J.P. Morgan index of total return of debt instruments issued mostly in dollars by 13 emerging markets countries
(Argentina, Brazil, and Chile have the highest weightings). Returns are converted to U.S. dollars, as needed.
Key Issues and Outlook for 2013
The resolution of the tax portion of the fiscal cliff temporarily alleviates a good part of market
uncertainty as we enter the new year. While addressing the most important immediate concern for the
economy, Congress nevertheless simply “kicked the can” on several important issues that, if not
resolved to the market’s liking, may serve as a significant cloud to the already tepid growth prospects
here in the U.S. More specifically, deep spending cuts (viz., the sequester), renewal of the continuing
resolution (for funding operation of the Federal government), and yet another debt ceiling remain
unresolved. Almost all pundits believe the new Congress will struggle to achieve bipartisanship; it will
likely walk us right up to, and possibly over, these cliffs as well. Even with the constant political
bickering evident throughout the fourth quarter, for a majority of the quarter consumer sentiment
remained surprisingly strong while market volatility was somewhat benign, at least until the final days
of the quarter. And, as previously noted, risk-based assets performed reasonably well despite the market
uncertainty. We mention this in the context of setting expectations for the first portion of 2013: markets
do have the potential to overcome political uncertainty. That being said, there was evidence that
companies, in particular small businesses, continued to limit spending in the fourth quarter amid the
uncertainty, and we remain concerned that this trend is continuing into 2013 as nervous business owners
wait for more fiscal resolution. This threatens to dampen GDP growth and any significant improvement
in the job market, which consequently, will likely lead the Fed to continue their bond-buying programs
for the foreseeable future.
The key issue for the 2013 outlook involves right actions by policy-makers around the globe. We are
referring to central bankers and politicians. The former have been forced into more aggressive action
than is typical by inaction by the latter. Post-Financial Crisis headwinds remain, and we are in a period
Market Perspective Full Year 2012 and 2013 Outlook
Page 11
of assisted rather than self-sustaining global economic recovery. However, that assistance by the
world’s central bankers is somewhat unprecedented in scope, unison of action, and methods being
employed. Some have called it an “experiment” (per the Wall Street Journal. See WSJ.com: Inside the
Risky Bets of Central Banks; December 12, 2012). We are not so much concerned about continuing
policy effectiveness because the objective of very low interest rates has generally been achieved, but we
wonder if central bankers will maintain their coordination and conviction, if business leaders and
investors may lose faith amid political stalemate and policy uncertainty, or if politicians will set up
roadblocks to necessary monetary/fiscal stimulus, or some combinations of all three. Our conclusion is
that enough of these policy-makers will get it right in 2013, and business leaders will manage to grow
their businesses enough to sustain another year of gradual healing of the global economy.
We next face the daunting task of translating economic and political forecasts to returns of global debt
instruments and stock investments. Stocks are the foremost risk-based asset; we believe they continue to
look favorably positioned. Valuations across equity markets, on a global basis, look attractive on a
historical basis and certainly in comparison to the opportunities available within fixed income markets.
Fixed income securities and fixed income asset flows continued to defy the odds in 2012, despite
historically low yields and compelling opportunities in other risk-based assets, as investors continued to
seek return of their capital as opposed to return on their capital. As investors continue to grow weary of
receiving no-to-negative real returns on these investments into 2013, and resolution occurs on some of
the aforementioned issues, we believe there will be plenty of support for risk-based assets such as stocks
and real estate.
Accordingly, our outlook for 2013 is cautiously optimistic. Our economic forecast is not much changed
from last year. We expect another challenging year for the global economy with current recessions in
Euroland and Japan and no clear end in sight for their economic weakness. Further, the U.S. and China
are struggling to maintain momentum. Nonetheless, we expect growth of the global economy to slow
but not stop. The upshot is these economic conditions are not a threat to bond prices of high quality
issues, but nominal interest rates are so low as to strongly suggest only weak, mildly positive returns for
the year. Higher risk bonds offer better returns but with at least commensurate, if not
disproportionately, higher risk. While holding back bonds, low interest rates are quite favorable for
stocks and real estate, especially housing. We expect stock returns at or slightly above historical
averages (defined as 7-10%). Therefore, results for the year for a balanced portfolio should be positive,
say mid-single digits. Sadly, that’s all we should realistically expect. Due to high uncertainty, as further
described below, we must continue to emphasize defensiveness, and be very selective in going on the
offensive.
Let’s address one additional important issue, which is corporate profitability. It will be increasingly
difficult to sustain profits in a slowly growing global economy still on life support. Also, economists
continue to caution that further cost-cutting as an avenue to grow profits is increasingly unachievable,
and prior period earnings comparisons are becoming increasingly challenging (i.e., it becomes quite hard
to beat prior period results when they are at successively higher levels). Since profitability and stock
prices are highly correlated, we note a threat here to the positive outlook for stock market returns.
On the other hand, a potential upside pertaining to global stock prices in 2013 is their performance since
the previous market high in October 2007. Coming on the heels of very good stock price advances in
2012, we might be less than optimistic for 2013. Nonetheless, as reported above, cumulative global
stock returns since the previous peak in October 2007 remain mixed but generally have achieved a
weighted average of about breakeven. Thus, 2013 results have at least a good possibility of achieving
Market Perspective Full Year 2012 and 2013 Outlook
Page 12
our positive expectations. Cumulative, non-annualized stock index returns for a U.S. dollar investor for
2011, 2012, and the period November 1, 2007 to December 31, 2012 are as follows:
2011
2.1%
-4.2%
Period Return
2012
11/1/07-12/31/12
16.0%
3.3%
16.4%
10.5%
S&P 500 (Large U.S. companies)
Russell 2000 (Small U.S. companies)
MSCI EAFE (Large foreign companies
in developed economies)
-12.1%
17.3%
-21.7%
MSCI EM (Emerging economy companies)
-18.4%
18.2%
-11.0%
Unfortunately, predicting future stock prices for a relatively short time horizon based on past results is
an “analysis” we cannot give much credence.
In considering the multitude of issues pertaining to economic and market forecasts, we are swayed, as
usual, by what history reveals, namely, that economies and markets are cyclical and seek equilibrium
and that investment results regress to the mean. Therefore, historical patterns and averages will
ultimately prevail. The question is, when. Also, since the consensus outlook is already factored into
current bond and stock price levels, how differently will the future unfold compared with the consensus?
To save time, and because of the potential futility, we are again presenting a condensed version of our
outlook this year. Nonetheless, we continue to evaluate factors and issues that are important in 2013 and
beyond. Based on past reviews, these have been typically historical macroeconomic waypoints and
trends which can help us narrow the range of potential outcomes in the future. We monitor such key
factors as global economic strength, the monetary and fiscal policies of the governments of major
economic powers, and relative valuations of major securities markets, in the event they afford us
portfolio strategy opportunities or threats. Please refer to past discussions archived on our website, or
call if you want further information.
As you know, we don’t favor market predictions, especially in absolute terms. The interplay of socioeconomic and geopolitical factors is just too complicated to predict. Thus, it makes no sense to try to
time the market based on highly fallible forecasts.
Implications for Asset Allocation
Because an outlook is to a considerable degree an attempt to have a crystal ball, the prognostications are
very subject to error and need to be discounted. We must avoid the temptation to try to be prophetic.
Therefore, we are resisting this temptation, and we are continuing our emphasis on capital preservation,
by insisting on maintenance of very adequate liquid reserves for short term needs. We are keeping
tactical adjustments to a minimum, and we are avoiding anything resembling a significant departure
from client policy allocations.
Given our belief that the future is unknowable, we are again going to take only very small risks and
essentially avoid market timing. Accordingly, we will position client portfolios in 2013 predicated upon
1) the need for bonds to hedge against stock volatility, 2) careful selection of bond sectors and duration
to manage risk, and 3) reliance on our chosen bond and stock fund managers to navigate through the
challenges of investing in 2013.
Market Perspective Full Year 2012 and 2013 Outlook
Page 13
Over and over again, we have seen the unreliability of short-term economic and market forecasts and the
unpredictable nature of markets. As usual, geopolitical risks, poor policy implementation, and a host of
other factors could wreak havoc with any predictions, and there is always the risk of the totally
unexpected. Therefore, results in 2013 could be considerably better or worse, or at least different, than
indicated at the beginning of, and throughout this section.
Risks to Forecast, Especially Beyond 2013
We presented a lengthy presentation of longer-term risks in early 2011. One prominent issue concerned
U.S. fiscal and monetary policy “kicking the can down the road.” Since then, we have seen continued
can-kicking in the U.S. and also in many other developed countries. These policies have stimulated the
global economy but will exact a price in later stagnation. The various potential remedies for our
growing debt levels are tax increases or spending cuts. Many countries in Europe are currently suffering
the ill effects of forced austerity measures. In the U.S., we have seen the first, albeit modest pain: the
tax increases of ATRA. Much of the discussion of this and other risks is still relevant, and we refer the
reader to the Market Perspective Full Year 2010 and 2011 Outlook that accompanied the January 21,
2011 letter to clients and friends.
Inflation is the enemy of financial assets such as stocks and bonds. Central bank stimulative monetary
policies and government deficit spending will inevitably lead to an increase in inflation down the road,
with attendant deleterious impacts on financial assets. We don’t see the threat of inflation until 2014 at
the earliest.
Relevance of Market Review and Outlook for the Strategic Allocator
An outlook is really a best guess over 6-18 months, which is not a long-term period. Thus, most
outlooks support tactical maneuvering for short-term gain. Most outlooks are also trend following, not
contrarian. It is human nature to expect continuation of recent trends. It takes a brave soul to predict a
reversal. We try to develop our outlook to avoid this common problem, but we are human, too, as
evidenced the last several years.
Asset allocation is a long-term approach utilized to manage long-term money according to long-term
historical evidence. Asset allocation defined in this manner requires a disciplined adherence to a
relatively fixed asset mix. It is also quite contrarian, because when an asset class proportion declines
due to relatively poor performance, the asset allocator buys more. Hence, asset allocation entails
periodically selling your winners and buying your losers to maintain the strategic balance. This
rebalancing is done periodically and “religiously” and is definitely not “market timing” or “chasing
performance.” Therefore, near-term outlooks are of limited interest to the strategic asset allocator.
Outlook Scorecard, Strategies Employed, and Impact on Results
Last year was the fourteenth time we attempted something resembling an outlook. We have been
providing a scorecard to see if we are gaining anything from the effort. The 2012 outlook did not
contain any detailed asset class tactical forecasts, so we cannot provide a point-by-point report card.
Please refer to the accompanying letter for its comments about the low accuracy (it was far too
pessimistic) of last year’s outlook and yet, its almost negligible impact on performance of our 2012
strategies. An overview of past report cards follows.
Market Perspective Full Year 2012 and 2013 Outlook
Page 14
Our report cards until 2008 were generally favorable: we had more predictions right than wrong, and
our errors have not been harmful to returns. Unfortunately, we cannot say the same for our 2008 and
2009 outlooks and investment tactics. To be fair, both years were unprecedented and produced
investment results which were exact opposites. Respecting the 2010 Outlook, our assessment of the
global economy was accurate, but we were less optimistic than the consensus about equities, especially
U.S. equities, and were surprised by their strength in the second half of 2010. Our slight underweighting
of stocks negatively impacted results accordingly. The variance of actual 2011 results from the 2011
Outlook was a flip-flop from 2010. We had less concern about stocks than bonds, and a small
overweight of stocks was unsuccessful because bonds had considerably better returns relative to stocks
in a year when investors fled to safer investments.
Our 2012 Outlook way undershot the strong results for bonds and especially stocks. Nonetheless, an
important qualifier to our 2012 Outlook was as follows: “As to risks to this forecast, early and
convincing resolution of the European debt crisis…would be quite bullish.” Moves by Mario Draghi in
July roughly corresponded to such an early and convincing resolution and greatly reduced the main
cloud hanging over global markets last year. It is also noteworthy that Draghi’s strongest
pronouncement (do “whatever it takes”) was on July 26, 2012, just about a week after our mid-year
update of the 2012 Outlook on July 20, 2012.
The pessimism of our 2012 Outlook in hindsight is a moot point in the sense that an accurate, very
positive outlook would not have changed the returns of portfolios supervised by Caves & Associates.
That’s because last year we generally “ignored” our 2012 outlook and maintained client accounts at full
stock and bond exposure per their respective written investment policies.
We believe the scorecard highlights why we recommend strategic asset allocation rather than tactical
allocation or market timing. Over the long run, we are convinced that correct predictions will be largely
offset by incorrect predictions, especially when the predictions have to deal with such a broad scope as
global stock and bond markets. Thus, the effort adds little or no value but can reduce returns by
increasing capital gains taxes, transaction costs, and management fees if the effort induces a short-term,
tactical approach.
Mutual Funds Success
Respecting a scorecard for the mutual funds we employ in client portfolios, they remained highly rated
by and large. As evidence, two of “our” mutual funds were among the 20 recently nominated for
Morningstar’s 2012 managers of the year (Morningstar is highly regarded for its mutual fund databases
and mutual fund ratings). Historically, nominees and award winners have been well represented in the
portfolios of Caves & Associates clients.
2012 Year-End Commentary and Planning Ideas
February 28, 2013
By Caves & Associates
Preston S. Caves, CFP, CFA, MBA
Sandra K. Gafney, CFP, MBA
Dear Clients and Friends,
We are pleased to present Caves & Associates’ Market Perspective Full Year 2012 and Outlook.
The review indicates 2012 was a year of excellent investment results. Bonds earned solid returns,
and stock results were outstanding. U.S. large cap stocks, U.S. small caps, and foreign stocks all
experienced double-digit gains. Forceful actions mid-year by the European Central Bank (ECB)
were a watershed event and supplemented on-going stimulative monetary and fiscal policies around
the globe. ECB actions replaced previous inadequate attempts to shore up Europe’s finances and
created a foundation for global stock advances the balance of the year.
The review provides information on five-year returns for perspective; for many stock markets, the
2008 bear market was so severe that cumulative five-year returns are still not much above
breakeven, as for the U.S., or remain negative, as for foreign markets. We encourage you to read
the Market Perspective for a fuller review of 1) major economic and market events in 2012, and
2) longer-term trends as well. The Market Perspective also presents 1) an Economic Review of
2012, 2) our 2013 Outlook, 3) history of our scorecard rating the accuracy of our annual outlooks,
and 4) a brief evaluation of the 2012 performance of Caves & Associates recommended mutual
funds.
In late January, we forwarded a Market Review for 2012. In a way, the review was a “sneak peek,”
and the accompanying Market Perspective provides considerably more in-depth analysis and
commentary. The table accompanying the Market Review provided data to evaluate results for
2012’s fourth quarter. The year ended with mixed but moderately positive returns for the globally
diversified investor.
Another enclosure, or attachment, is Timely Topics. It summarizes tax changes that resulted from
last minute December 2012 negotiations in Washington to mitigate and delay the fiscal cliff. It also
covers changes by a 2010 tax law which became effective this year.
The year 2012 might have been a repeat of the poor results of 2011 if not for aggressive actions by
the world’s central banks, most of all actions by the European Central Bank (ECB). Global stock
returns were quite strong through February, probably benefitting from upward momentum of stock
prices in late 2011 after the major losses in the summer of 2011 (an example of reversion to the
2012 Year-End Commentary
February 28, 2013
Page 2
mean). The result was double-digit gains for the first two months of the year. Then, signs appeared
that the global economic recovery from the Great Recession might be faltering notwithstanding ongoing massive U.S. fiscal and monetary stimulus. European leaders continued to disagree about
who would suffer the consequences and who would come to the rescue of profligate behavior by
Euroland consumers and governments, especially in peripheral countries, as well as dubious loan
underwriting by European banks. The delay in finding solutions and increasing uncertainty over
outcomes and secondary effects further unnerved investors. As a result, global equity markets
swooned in March-May. Losses for March through May generally eliminated the positive results
for January and February: five-months year-to-date results remained slightly in the black for U.S.
stocks, but foreign stocks sunk decidedly into the red. Next, a bit like a good Hollywood Western,
the calvary rode to the rescue in the form of ECB head Mario Draghi. Under his direction, the ECB
abandoned any concern for fighting inflation and initiated unmistakably aggressive programs to
prop up the euro, the European banking system, and markets for European government bonds. In so
doing, it successfully allayed prevailing fears about the credit-worthiness of European banks and
sovereign bonds of Europe’s peripheral countries (Greece, Ireland, Spain, Italy, and Portugal).
These programs supplemented those already taking place in the U.S., U.K., and a number of Asian
countries. Generally good corporate profitability, solid since the Great Recession due largely to
cost-cutting and further aided by low interest rates, continued to provide support for global stock
markets, and the definitive palliative and stimulative efforts by the ECB restored investor
confidence during the last half of the year. As a result, global stock markets moved strongly
upward, though U.S. equities lagged somewhat due to concerns about the so-called “fiscal cliff.”
See also the Economic Review section and separate sections on stocks, bonds, and alternative
strategies in the accompanying Market Perspective for further information.
As a reminder, the fiscal cliff was the name given the December 31, 2012 confluence of automatic
Federal spending cuts and tax increases. Both had been feared to be a substantial drag on the U.S.
economy, a sort of double-whammy of fiscal de-stimulus, possibly returning the U.S. to recession.
On January 2, 2013, actually after the proverbial 11th hour, Congress and the Obama Administration
resolved the tax portion of the fiscal cliff. Passage of the American Taxpayers Relief Act of 2012
(ATRA) legislated the largest tax increase in the past two decades, but the increase is considerably
lower than what would have occurred had the Bush-era tax cuts been allowed to simply expire. The
increases mitigated substantially higher rates for investment and earned income and shifted much of
the increase from the middle class to the wealthy.
The yearend negotiations did not reach agreement on reduction of the spending cuts. Instead, the
automatic cuts (called the sequester) were delayed until March 1 to allow additional time for
discussions between Republicans and Democrats. Accordingly, ATRA “left a host of issues
unresolved and guaranteed continued budget clashes between the parties” (Wall Street Journal,
January 2, 2013). At this writing, no mitigation of the spending cuts is at hand, and at least some
fiscal drag on the U.S. economy is expected due to the ripple effects of projected Federal and state
job cuts, furloughs, and reduced payments to vendors and contractors.
Governments and central banks have continued high levels of economic stimulus into 2013. In
retrospect, it appears that economic and market fundamentals took a back seat to government policy
2012 Year-End Commentary
February 28, 2013
Page 3
initiatives in 2012. As in prior years, policy makers kept “kicking the can down the road.” That is
not to say we think they stubbed their toes: the global economic recovery has been too weak to
remove government stimuli just yet. Nonetheless, painful adjustments lie ahead, though their
timing and magnitude are subject to conjecture. For additional commentary, see the summary of the
2013 Outlook below and refer to the accompanying Market Perspective.
A key observation is that diversification worked in 2012. Bonds and alternative strategies provided
a smoother ride during the year’s major drop in mid-March through the end of May. Again in
October, foreign stocks climbed when U.S. stocks were hit by fiscal cliff fears.
Caves & Associates discourages focusing much attention on short-term results because a broadly
diversified portfolio is structured for the long-term. As we often state, there is no way to
completely eliminate short-term risk from an investment portfolio.
Outlook Summary and Caveats
As noted above, the 2013 Outlook is included in the accompanying Market Perspective. The
outlook is cautiously optimistic. We expect muted results for bonds but reasonably good results for
stocks. We continue to have powerful positive and negative forces impacting the economy and
stock markets. On balance in 2013, it’s hard to argue with the on-going benefits of low interest
rates on stock prices. As usual, the timing and future magnitude of gains and losses are impossible
to reliably forecast.
We are cautious because global imbalances remain, economic recoveries are government-supported
rather than self-sustaining, and long-term problems have not been addressed. The partisan stand-off
in the U.S. capital seems endless, and it is not clear how much longer the U.S. can itself
successfully “kick the can down the road.” On Friday (i.e., tomorrow), inaction in Washington on
the sequester (automatic U.S. government spending cuts of $85 billion) may render our optimism
much less warranted because it depends on decent economic growth which could be de-railed by
Federal government austerity.
We also face the continuing uncertainties about 1) impact of the inevitable eventual withdrawal of
government stimulus programs around the world, now an issue globally and not merely in the U.S.,
and 2) sustainability of the strength of emerging economies like China, India, Russia, and Brazil.
These uncertainties make it again difficult to provide definitive forecasts for next year, and at this
point we have declined to make a point-by-point forecast for 2013. As a result of these
uncertainties and our usual aversion to market timing, we are planning to refrain from
overweighting or underweighting stocks. See the Outlook section in the Market Perspective for
elaboration on various key issues and relevant government policy positions in 2013 and beyond.
We have been commenting on external shocks for 12 years. We believe it is useful to observe the
obstacles which have been ultimately overcome by the resiliency of the global economy and
financial markets. In most cases, policy initiatives have been at least somewhat instrumental in
supporting the long run progress. Each year from 2001-2012 included multiple external shocks
which hurt financial markets, the two most severe being 2001, when we endured the terrorist attacks
2012 Year-End Commentary
February 28, 2013
Page 4
of September 11th, and 2008, when the housing and credit crises revealing a shockingly
overleveraged, undercapitalized global financial system and an equally overextended U.S.
consumer. During these years we also faced major corporate, mutual fund, and accounting
scandals; escalating geopolitical tensions in countless countries and regions; additional terrorist
attacks; terrible natural disasters, the most recent being Superstorm Sandy’s devastation of part of
the U.S. eastern seaboard; spikes in energy prices; and credit rating downgrades to major western
governments, including the U.S. in the summer of 2011, France early last year, and the U.K. only
days ago. Nonetheless, returns for all major global asset categories were positive for the 12 years,
albeit at levels considerably less than long-term historical averages for most stocks. We can only
wonder what potential disruptions and unexpected economic twists lurk for 2013. As we have often
indicated, investing in the capital markets involves not only understanding risks that may be
apparent, but also planning for risks that are not.
As a reminder, most outlooks are saying the same thing. Also, there is typically a certain serial
correlation in their thinking, meaning what they project is never significantly different from what
has just happened. Further, since the consensus is already reflected in the prices of today’s
securities, it is the unexpected and very hard to predict events that will determine the future
direction of stock prices, interest rates, etc. Accordingly, the consensus will in all likelihood be
wrong. The same can be said of the Caves & Associates outlook.
Brief Evaluation of Last Year’s Predictions and Strategy
This section is a brief scorecard of the predictions in last year’s Outlook and an evaluation of the
success of Caves & Associates’ investment strategies and portfolio supervision in 2012. Generally
speaking, the accuracy of economic predictions was good but market projections were way off the
mark. It is important to note that “muted results” were predicted predicated on an inadequate ECB
stimulus program or one that was too late. Thus, the shoring up of conditions in Euroland was not
predicted, leading to a weak forecast for stocks that way undershot their ultimate strength. Our
prediction for bonds was closer to the ensuing reality, especially for global government bonds,
which did have muted results. However, riskier bonds such as investment grade and noninvestment grade corporate bonds had quite good returns on increased demand from yield-hungry
investors. Riskier bonds also benefitted from the actions of Draghi to calm the European financial
crisis and U.S. government policy initiatives to push down interest rates further which pushed up
prices at all levels of credit quality.
We are very happy to report that we have not “left any money on the table.” We had no cash
position and underweighted neither stocks nor bonds during 2012. We also made various small
adjustments that were helpful. For example, we maintained a relatively high average maturity of
clients’ bond mutual funds based on our forecast that the global economy would not be robust.
Compared to previous years, we also increased our weighting of emerging market bonds and their
composition, which was quite beneficial.
We note that our outlooks have been off the mark for the past several years. They have had a
tendency to project about what had just happened and therefore suffered from one of the typical
forecast failings noted above. As a result, we have been almost completely ignoring our outlooks
2012 Year-End Commentary
February 28, 2013
Page 5
and sticking to clients’ policy allocations for their investment supervision. Let’s hope our cautious
optimism about 2013 is warranted, and we do not suffer from the same shortcoming as prior
forecasts.
Overall, the excellent performance of client portfolios in 2012 was gratifying, especially when riskadjusted. See the Market Perspective for additional reporting and analysis. Also, the Market
Perspective has information about the success of our mutual funds during 2012.
Additional Perspective and Cautions
As we review very long-term periods of past stock and bond results, we note that bonds have had
extraordinary compound returns dramatically above their historical averages. Meanwhile stock
compound returns have been about at historical averages. Over a 28-year period for which global
data are available, we note an anomaly: stock returns have been only modestly higher than bond
returns. Thus, stocks have earned a much smaller than usual equity premium. At its core, the
abnormally low equity premium is due to the outstanding returns of bonds. Accordingly, as broad
asset allocators, we must be psychologically ready for lower total portfolio absolute returns in the
future. We can hope for satisfactory results for stocks going forward, preferably with lower
volatility and above average returns, but we can’t be certain this will occur. On the other hand,
bonds cannot repeat the wonderful results of a 30-year bull market, and we must recognize going
forward that a traditional portfolio combining publically traded stocks and bonds will very likely
provide returns below historical averages for many years to come.
Investors should develop and maintain a plan that has the potential to work over most future
scenarios. Thus, we believe in a broadly diversified investment plan customized to your specific
time horizon which can meet your investment objectives over a variety of potential scenarios.
Further, we continue to believe that a disciplined investment approach and regular rebalancing will
provide the best possible long-term investment returns.
Our Usual Guidance Regarding Attainment of Long-Term Life Goals
We need to hope for the best, but also align our expectations lower just in case, to be ready for the
possibility of reduced results. Prudent behavior includes: 1) reasonable reductions in spending and
increases in our savings rates whenever possible, and 2) maintenance of reserves for all foreseeable
large portfolio withdrawals, whether recurring or not.
Mutual Fund News
Our mutual fund managers continue to receive well-deserved plaudits. In both the Asset Allocation
and International Stock Manager of the Year competitions, one of “our” managers was among five
finalists in each category. Fund families we use had multiple nominations, and a bond manager
from PIMCO won the award for Fixed Income Manager of the Year. We are proud our clients have
been so well served.
2012 Year-End Commentary
February 28, 2013
Page 6
Planning Ideas
ATRA raised taxes but also made permanent quite favorable estate tax provisions, a prominent
example being the $5,250,000 lifetime gift tax exemption. In general, pre-ATRA strategies and
techniques that pertained in 2012 are still beneficial, some even more so.
Higher tax rates make tax-advantaged techniques even more beneficial. The following highlights
some long-standing tax-saving techniques that are even better now:
1.
2.
3.
4.
Contributions to IRA’s, 401(k)’s, and other tax-qualified retirement plans.
Investments in cash value life insurance and deferred annuities.
Purchases of municipal bonds.
Section 529 college-funding programs (like California’s ScholarShare).
Tax rates have gone up, but the differential between ordinary, capital gain, and qualifying dividend
rates has remained approximately the same. In other words, they’ve all gone up, but about
proportionately. Thus, we should continue to position investments with tax advantages in personal
accounts and those with the most onerous tax consequences in IRA’s, retirement plans, and taxadvantaged products from the insurance industry.
One of the simplest yet most effective techniques to reduce one’s estate is to regularly give away
wealth to children and grandchildren. The annual exclusion from gift taxes per donee increased
from $13,000 last year to $14,000 in 2013. (Technically, this was not due to ATRA, just the
operation of an inflation adjustment under prior law.) Gifts of this size are a “no-brainer” for
wealth in excess of one’s lifetime needs.
The on-going low interest rate environment is also quite beneficial for many estate planning
techniques and combines nicely with ATRA’s estate tax provisions. The low rate environment
presents unique wealth transfer opportunities that allow business owners and high net worth
individuals to pass large amounts of wealth to future generations gift and estate tax-free. Large
gifts, loans, and sales to a Grantor Trust remove future growth of values from one’s estate and also
benefit from the high likelihood of achieving rates of return in the trust higher than low interest
rates mandated by the IRS.
Please be aware these ideas are general in nature and may not apply to your specific situation.
Please contact us, your tax advisor, or your attorney before undertaking any of these ideas.
Staff News
Preston’s son, Rob Caves, who joined the firm in June, 2012, is now working towards his Certified
Financial Planner (CFP) designation through UCLA. After completion of the UCLA program, Rob
will sit for the CFP exam. In addition to passing the rigorous, nationally-administered exam, a total
of three years working in financial planning is required to be awarded the designation.
2012 Year-End Commentary
February 28, 2013
Page 7
Last December, Sandra Gafney completed her eighth year with Caves & Associates. Very
importantly, at the start of this year Sandra became a part owner of Caves & Associates,
commensurate with her integral role in client counseling and firm management. Further, the other
members of our team, Jeanne Oshiro, Valerie Trumbull, and Karen Chan, all added another year of
professional service to clients. Together, they have an average of more than four years experience
with Caves & Associates.
All the above signal our commitment to providing quality investment and financial planning
services far into the future. We want to be your “wealth coach” as long as you need us.
What’s Topical or Timely
We remain committed to continuing education as well as keeping you abreast of anything crucially
affecting your wealth management. As noted above, a separate enclosure or attachment provides a
primer on recent tax law changes. We would also like to use this opportunity for our usual annual
reminder regarding the 2012 IRA contribution deadline, which this year is Monday, April 15.
Remember, use it or lose it.
Blog Department
The Blog Department is our occasional expression of opinion. Whereas Timely Topics may involve
some disagreement among experts, its primary purpose is to educate in the realms of financial
planning and wealth management. The Blog Department ventures into broader topics which may be
more controversial. We have been too busy to publish anything new from the Blog Department,
even though of course, controversy abounds.
Need a Planning Update?
If something important has changed in your personal situation (career, family, health, cash needs,
etc.), don’t hesitate to let us know. A significant change in your life may indicate you need a
review of your insurance, financial, or investment planning. Examples are family matters (births,
deaths, divorces, and marriages), business matters (promotions, lay-offs, sale, and impending
retirement), and significant changes of your health or that of family members.
Quotes for Our Times and All Time
Benjamin Franklin:
Be always at war with your vices, at peace with your neighbors, and let each New Year find you a
better man.
Unknown Author:
The secret of financial success is to spend what you have left after saving, instead of saving what is
left after spending.
2012 Year-End Commentary
February 28, 2013
Page 8
Roger Caras:
Dogs have given us their absolute all. We are the center of their universe. We are the focus of their
love and faith and trust. They serve us in return for scraps. It is without a doubt the best deal man
has ever made.
Company Brochure Available for Your Review
Previously, we annually offered our Form ADV for your review. The ADV is our registration as an
investment advisor with the SEC. New SEC rules have required us to prepare a similar but more
user-friendly document, the Company Brochure. Like the ADV, it shows fees and services and
other information that may be of interest. It is available free upon request. Please call if interested.
In Conclusion
We are providing these materials for your information and as a means to educate and stay in touch.
We hope you find this information helpful, and we would be pleased to hear your feedback.
We are always grateful for our many clients, and we are especially thankful for your continued
confidence. This coming year, we will continue to focus on doing everything we can to help you
preserve your hard-earned wealth, grow it in appropriate ways, and ensure your money is supportive
of the most important values and goals in your life.
You are welcome to share our views with your family and friends if you think they will benefit.
This letter and the enclosures, as well as an overview of our staff, advisory philosophy, and
methods, are available on our website, http://www.cavesassociates.net. We appreciate your
referrals and suggest you steer those who might be interested to our website as a convenient
and private way to initially make our acquaintance.
The information in this letter and accompanying materials is of a general nature and should not be
acted upon without further details and/or assistance.
Best wishes for a happy, healthy, peaceful, and successful 2013.
Thanks and credit go to the many sources for this letter and accompanying materials, including Managers and PIMCO
mutual fund families, Morningstar, the Wall Street Journal, and the Los Angeles Times.
This publication does not constitute an offer or solicitation of any transaction in any securities. Information contained
in this publication has been obtained by sources we believe to be reliable, but cannot be guaranteed.
There is no guarantee that the views and opinions expressed in the newsletter will come to pass, and they are not meant
to provide investment advice. There is also no guarantee of future results. These views are as of February 28, 2013 and
are subject to change based on subsequent developments.
Timely Topics – February 28, 2013
The Affordable Care Act of 2010 (ACA) and American Taxpayer Relief Act of 2012 (ATRA) resulted
in significant changes to the tax code effective for 2013. Here is a summary of the changes most likely
to impact individual taxpayers. There is some good news on alternative minimum taxes, estate and gift
tax exclusions, charitable donations, and retirement plan contributions.
End of the Payroll Tax Holiday
The 2 percentage point reduction in the employee’s share of the Social Security tax withholding rate on
earned income in effect for tax years 2010-2012 was not renewed for 2013. As a result, withholding
for employees and self-employed individuals has returned to 6.2% or 12.4%, respectively, on the first
$113,700 of wages or self-employment income. Please note that self-employed individuals should
increase their estimated tax payments accordingly.
Medicare Surtax on Earned Income
The ACA included a .9% Medicare surtax on wages and self-employment income effective January 1,
2013. This change applies to earned income over $200,000 for singles and heads of household, and
$250,000 for married couples filing jointly. The surtax applies only to the employee’s share of
Medicare tax.
Medicare Surtax on Net Investment Income
The ACA also included a 3.8% Medicare surtax on net investment income effective January 1, 2013.
This change applies to unearned income of single filers and heads of household with a modified
adjusted gross income (MAGI) over $200,000, and over $250,000 for married couples filing jointly.
MAGI is AGI plus any tax-free foreign earned income.
This surtax is levied on the smaller of the taxpayer’s net investment income or the excess of MAGI
over the applicable dollar threshold. Investment income includes interest, dividends, payments of
substitute interest and dividends by brokers, capital gains, annuities, royalties, and passive rental
income. Tax-free interest is exempted, along with payouts from retirement plans such as 401(k) s,
IRAs, deferred pay plans and pension plans.
NOTE: We previously provided a review of the Medicare surtaxes. Please see the Timely Topics
promulgated with our July 2012 communication for more in-depth information.
Tax Rates on Ordinary Income
Tax rates on high-income earners increased under ATRA for the first time since 1993. A 39.6% rate
will apply to taxable income over $400,000 for singles, $425,000 for heads of household, and
$450,000 for married couples filing jointly. The previous top tax rate was 35%.
Long Term Capital Gains & Dividends
The top tax rate on capital gains and dividends rose to 20% for individuals with taxable income above
$400,000 for singles, $425,000 for heads of household, and $450,000 for married couples filing jointly.
Timely Topics – February 28, 2013
Page 2
In conjunction with the new Medicare surtax on net investment income, the tax rate will be as high as
23.8%. The rates for taxpayers under these income thresholds are unchanged. Filers in the 25-35% tax
brackets will continue to pay 15%, and those in the 10% or 15% tax bracket can still qualify for a 0%
rate.
Phase Out of Deductions
The Personal and Dependent Exemption Deduction and Itemized Deduction will be phased out for
high income taxpayers. Phase outs begin at AGI of $250,000 for singles, $275,000 for heads of
households, $300,000 for married filing jointly, and $150,000 for married filing separately. Itemized
deductions may be reduced by up to 80% for mortgage interest, state and local income and property
taxes, and charitable contributions.
Alternative Minimum Tax (AMT) Adjustments Permanent and Tied to Inflation
ATRA eliminated the annual AMT “patch” by automatically adjusting future exemption amounts
based on the rate of inflation. Exemptions for 2013 increased to $80,750 for couples and $51,900 for
singles and heads of household. Personal tax credits, such as those for tuition and dependent care, will
continue to offset alternative minimum tax liability.
Estate and Gift Tax Exemptions Increased
The annual gift tax exclusion rose to $14,000 per recipient in 2013. A married couple can gift $28,000
per recipient to reduce the size of their taxable estate.
ATRA permanently increased the unified federal and estate and gift tax exclusion to $5.25 million.
The exclusion will be adjusted annually for inflation. A married couple can exclude $10.5 million
from their taxable estate. In addition, the exclusion is now “portable” between spouses.
Charitable Donations from IRAs Extended through 2013
In 2013, IRA owners aged 70½-plus may make charitable donations of up to $100,000 directly out of
their IRAs. The donations count as IRA required minimum distributions and could reduce taxes.
Retirement Plan Contributions
Retirement plan contribution limits increased for 2013. The maximum contribution for 401(k), 403(b),
and 457 plans is $17,500 this year. Individuals born before 1964 can put in as much as $23,000. The
ceiling on SIMPLE IRAs will rise to $12,000 ($14,500 at age 50). Finally, the IRAs and Roth IRAs
contribution limit is $5,500 ($6,500 at age 50), with phase-out at AGI’s of $59,000-$69,000 for singles
and $95,000-$115,000 for couples ($178,000-$188,000 if only one spouse is covered by a plan).
Other
Please note there are other changes that may affect your personal tax situation. Please contact us or
your tax advisor for additional information regarding your specific tax situation.
Market Review
First Quarter 2013
Global equity markets rallied sharply during the first quarter, and bond markets produced mixed and
generally weak returns as measured by results of performance indexes. Positive equity results were
broad-based, and pro-growth monetary policies were a major contributor. Policies by U.S., European,
and Chinese central banks kept interest rates low to promote corporate investment, housing market
recovery, and lower borrowing costs for smaller, struggling Eurozone countries. However, actions by
Japan’s central bank to devalue the yen and increase domestic economic growth caused the U.S. dollar
to strengthen somewhat against most developed and emerging market currencies, decreasing returns of
foreign stocks and bonds for unhedged U.S. dollar investors. U.S. bonds provided returns generally
just above breakeven and foreign bonds declined moderately for the U.S. dollar investor. Due to their
hedging nature, alternative strategies returns were positive but held down results.
Equity Review
U.S. stock markets soared and provided double-digit returns across the usual analytical breakdowns.
Investors modestly preferred small-cap stocks over their large-cap counterparts. The Russell 2000
(small cap) and Russell 1000 (large cap) indexes returned 12.4% and 11.0%, respectively, for the
quarter. Value stocks outperformed growth stocks. The Russell 3000 Value and Russell 3000 Growth
indexes rose 12.3% and 9.8%, respectively. Based on mutual fund averages, defensive stock sectors
such as health, industrials, and utilities were the best performers, gaining 16.1%, 11.7%, and 11.3%,
respectively. Cyclical stock sectors such as global real estate, communications, and technology rose a
lower 4.9%, 5.9% and 6.9%, respectively.
Foreign developed countries stocks also delivered healthy results for the quarter. In local currencies,
the MSCI Japan Index was up 20.4%, the MSCI Pacific Ex-Japan Index gained 6.0%, and the MSCI
Europe Index rose 7.0%. In contrast, emerging market stocks did not participate in the broad equity
rally. The MSCI Emerging Markets Index fell -.8%.
As noted, the dollar generally strengthened during the quarter. It gained 3.9% versus 6 developed
market currencies tracked by the U.S. Dollar Index. The greenback also strengthened .2% versus 21
emerging market currencies tracked by the MSCI EM Currency (USD) Index.
Fixed Income
Fixed income markets within the U.S. experienced virtually flat returns for the second straight quarter.
The Barclays Capital (BarCap) U.S. Aggregate Bond Index returned -.1%. Quality (or the lack
thereof) drove relative performance. High-yield bonds was the best performing domestic fixed income
class for the third straight quarter as investors continued their search for yield; the BarCap High Yield
Corporate Bond Index returned 2.9%. Municipal bonds performed slightly better than taxables thanks
to increased investor demand for higher after-tax yield; the BarCap Municipal Bond Index rose .3%.
Finally, the BarCap U.S. Intermediate Treasury Index and longer-term BarCap U.S. Treasury Inflation
Note returned .1% and -.4%, respectively.
Outside the U.S., fixed income markets struggled. The Barclays Global Aggregate x-U.S. Index fell
3.5% in U.S. Dollar terms, the negative return partially attributable to the strengthening dollar.
Emerging market countries bonds were also in the red but outperformed their foreign developed
countries counterparts for the quarter. Emerging market bond mutual funds fell .6% according to
Morningstar.
First Quarter 2013 and Twelve Months Year-to-Date
Table of Stock and Bond Returns
Period Return to 3/31/13 *
12 Months
First
Ending
Quarter
3/31/13
U.S. Stocks
S&P 500 Index **
Average Diversified U.S. Equity Mutual Fund
Russell 2000 Index #
10.6%
10.9%
12.4%
14.0%
12.7%
16.3%
6.9%
16.1%
5.9%
10.8%
6.8%
11.2%
0.2%
24.4%
13.4%
17.0%
13.6%
8.1%
5.1%
9.7%
4.0%
11.3%
16.7%
9.8%
2.6%
14.2%
5.5%
-0.3%
9.2%
12.1%
12.2%
3.4%
5.1%
0.4%
4.4%
-0.4%
U.S. Bonds
Barclays Capital Intermediate Gov’t Bond Index ***
Barclays Capital Intermediate Credit Index δ
Intermediate Municipal Bond Mutual Funds (National)
Intermediate Municipal Bond Mutual Funds (CA)
Inflation-Protected Bond Mutual Funds
High Yield Bond Mutual Funds
0.1%
0.5%
0.3%
0.3%
-0.3%
2.8%
2.3%
6.0%
4.5%
4.5%
4.8%
11.8%
Foreign Bonds
Citigroup Non-U.S. World Gov’t Bond Index ###
J.P. Morgan Emerging Bond Index ####
Emerging Market Bond Mutual Funds
-3.8%
-2.3%
-0.6%
-2.2%
10.1%
9.4%
Sector Mutual Funds
Technology
Health
Communications
Financial
Real Estate
Energy
Foreign Stocks
MSCI Europe, Australasia & Far East (EAFE) Index ##
MSCI EAFE Local Currencies
Average Diversified International Stock Mutual Fund
Regional/Specialty Mutual Funds
Europe
Japan
Diversified Pacific/Asia except Japan
Diversified Emerging Markets
Alternative Strategies
Long-Short Mutual Funds
Market Neutral Mutual Funds
*
**
***
δ
#
##
###
####
Mutual fund return data are from Morningstar.
Capitalization-weighted index of 500 very large U.S. companies. The 500 are chosen to achieve a fair cross-section of U.S. industrial
and service sectors. Recent median capitalization of approximately $58.1 billion.
Barclays Capital index of U.S. Treasury bond total returns (i.e., interest plus or minus change in
price). Bonds in index have intermediate maturity of about 4-7 years. No mortgage-backed securities included.
Barclays Capital index of U.S. investment grade corporate bond total returns (i.e., interest plus or minus change in price). Bonds in index
have intermediate maturity of about 4-7 years.
Index of small U.S. companies. Recent median capitalization of approximately $1.1 billion.
International stock index indicating return of large foreign companies of 21 major developed countries (Japan, UK, and Germany have
the highest weightings). Returns are converted to U.S. dollars. No emerging market stocks are included.
Citigroup index of total return of foreign government bonds issued by major developed foreign countries (Japan, Germany, France, and
UK have the highest weightings). Returns are converted to U.S. dollars.
J.P. Morgan index of total return of debt instruments issued by 13 emerging markets countries (Argentina, Brazil, and Chile have the
highest weightings). Returns are converted to U.S. dollars.
Economic Review and Market Perspective – August 7, 2013
Global growth is expected to remain subdued at slightly above 3% in 2013 according to the
International Monetary Fund. In the U.S., the final, vital stage of economic recovery, signaled by
significant job creation and emergence of self-sustaining consumer demand, continues to be
threatened by weak consumer confidence and concerns over the debt crisis in peripheral European
countries. In Euroland, the entire region remains in recession, with near depression conditions in
peripheral countries such as Greece and Spain. In addition, the inability of emerging countries to
generate growth within their own borders has slowed economic growth in the BRIC economies
(Brazil, Russia, India, and China) and pushed other emerging market economies near or into
recession. Global central bank actions to promote domestic growth at other countries’ expense have
only added to global economic uncertainty. In the U.S., the sequester did not seem to have been too
detrimental to a slow four-year recovery. Then, in late May and June, U.S. bond markets were
rocked by investors’ negative reaction to the U.S. Fed’s May and June announcements that the
economy had improved sufficiently to begin slowing its quantitative easing bond-purchase
programs, assuming specific employment and inflation targets were met. The slowing is being
widely called tapering.
Economic Review – Recent Situation
The U.S. economy continued its slow but steady growth, accelerating from .4% GDP growth in the
fourth quarter 2012 to 1.8% and 1.7% in the first and second quarter of 2013, respectively (these
figures are annualized; the percent for the second quarter is preliminary). The increase was
attributed to the ongoing expansion in household spending and business investment in equipment
and software exceeding contraction in government spending and exports.
Over the last twelve months, the Consumer Price Index (CPI) increased by 1.8%. The Core
readings (ex food and energy) were slightly lower than the headline numbers and were reported at
1.6% over the last twelve months. This figure has been falling over the last three months even
though rising energy prices have boosted the overall CPI. The Energy Index is up 3.2% over the
last twelve months.
Many second quarter U.S. economic indicators continued the first quarter’s moderately positive
course. Based on the ISM Manufacturing PMI, the overall economy grew for the 49th consecutive
month. The PMI rose to 50.9 in June. Employment data for the second quarter was also
encouraging. The U.S. Bureau of Labor reported that 199,000, 195,000, and 195,000 non-farm
payroll jobs were added in April, May, and June, respectively. The second quarter average of net
new jobs of about 196,300 per month compares with a monthly average of about 168,000 in the first
quarter. Finally, the Confidence Board’s consumer confidence index increased for the third
consecutive month in June and is at its highest level since January 2008.
The Federal Reserve’s July Summary of Commentary on Current Economic Conditions (“Beige
Book”) reported modest to moderate economic growth in most of the twelve Federal Reserve
regions as the unemployment rate held steady at 7.6% during the second quarter. The U.S.
economy continues to face two major risks: 1) the banking and fiscal crisis in Europe (that the U.S.
and Fed cannot resolve), and 2) increased taxes and lower government spending resulting from
sequestration.
Economic Review and Market Perspective – August 7, 2013
Page 2
Based on the improving U.S. economy, particularly the housing and auto sector, and a reasonable
employment situation, in mid-May the Fed announced its plans to start slowing its bond-buying
program later this year and perhaps end it completely in mid-2014, provided the unemployment rate
declined to around 6.5% and inflation remained below or near 2% over that timeframe. Following
Fed Chairman Ben Bernanke’s June press conference to clarify the Fed’s plans, bond prices
plummeted amid massive selling as bond investors headed to the exits, worried that longer-term
interest rates would increase without the bond purchases by the Fed. The yield on the 10-year
Treasury rose from 1.66% in early May to a high of 2.73% in early July. Mortgage interest rates
climbed rapidly too. Bankrate.com reported an increase of the 30-year fixed rate by about 1 full
percentage point from 3.60% in early May to 4.61% by the end of June. The 15-year rate increased
from 2.82% to 3.73% over the same timeframe. Higher mortgage rates, increasing home prices, and
competition from investors make it harder for first-time buyers to find affordable properties, and
may inhibit move-up buyers. Stocks also declined briefly before resuming the four-year rally that
began in early March 2009.
Throughout June and July Fed Chairman Ben Bernanke repeatedly attempted to clarify the
parameters for reducing or expanding the quantitative easing program. In July, Bernanke informed
Congress that should the economy weaken, the Fed “would be prepared to employ all its tools,
including an increase [in] the pace of [bond] purchases for a time, to promote a return to maximum
employment in a context of price stability.” Bernanke also said he believes “the markets are
beginning to understand [the Fed’s] message, and volatility has obviously moderated.” Overall, the
financial markets seem to have calmed somewhat after a whip lash reaction to Bernanke’s June
press conference.
The International Monetary Fund has labeled the global recovery “subdued” and lowered its growth
forecast for 2013 to 3.1% and 2014 to 3.8%. Outside the U.S., the European debt and fiscal crisis
continued to wreak havoc on the global economy. The recession in the euro area was deeper than
expected as low consumer demand, depressed confidence, and weak government balance sheets
combined to impede growth. Japan announced its own stimulus programs in early April, including
increased government spending and a central bank quantitative easing bond-purchase program, with
the stated intent of increasing inflation to 2% within two years. The net effect of the Japanese
programs has been to weaken the yen and increase exports as Japanese products become cheaper in
foreign currencies. Gross domestic product (GDP) rose an annualized 3.5% in the first quarter of
this year and early reports suggest second quarter growth was even higher. Annualized GDP had
been one percent in the fourth quarter of 2012 and had actually contracted for two quarters earlier in
the year. It is important to note that Japan’s moves are risky given the country’s very high ratio of
debt to GDP (about twice as high as the U.S.’s).
Emerging market economies were generally hit hard by lower import demand in developed
economies, weak domestic demand, lower commodities prices, and currency depreciation. China’s
economy grew at a 3-year low of 7.8% during 2012 compared to 10.1% in 2010. China took a
major step in mid-July toward reforming its tightly regulated banking industry by loosening
government control on lending rates to encourage banks to compete on price in an effort to promote
growth. The remaining BRIC economies - Brazil, Russia, and India – grew .9%, 3.4%, and 3.2%,
respectively, in 2012. And many Asian countries are considering stimulus measures to boost
growth.
Economic Review and Market Perspective – August 7, 2013
Page 3
Economic Review- The Long View
Our outlook for markets and our current portfolio strategies are supported by the following brief
global economic history since 1990:
1.
The 1990’s were the longest period of growth in American history. The U.S. government
experienced several years of budget surplus during this period. The collapse of the
speculative dot-com bubble, a fall in business outlays, and the September 11th attacks
brought the decade of growth to an end. Growth in emerging markets was gaining steam
during this period, most notably in China. Off-shoring and globalization were becoming hot
topics. U.S. unemployment started the decade at 6.3% and ended it at 3.9%.
2.
The U.S. entered recession in March 2001 but a determined Fed under Alan Greenspan
instituted stimulative monetary policies. These, coupled with fiscal stimulus from mounting
Federal deficits, caused the recession to be brief and shallow. The recession lasted only
8 months, and GDP dipped only .3%. Nonetheless, the U.S. unemployment rate climbed to
5.7% by yearend 2001.
3.
The Bush tax cuts, the new Medicare Part D prescription drug benefit, and the start of the
War in Iraq added greatly to Federal deficits, further stimulating the U.S. economy. With
the Japanese economy still stalled, the U.S. consumer was the primary driver of global
economic growth. Inflation hawks raised occasional alarms. The flood of cheap Asian
goods helped the U.S. continue to consume despite weakening employment due to
offshoring. The U.S. unemployment rate rose to 6% by yearend 2002 even though the
previous recession had officially ended in November 2001. China’s spectacular growth
continued, putting upward pressure on the world’s commodity prices, which stimulated
growth of other emerging markets.
4.
The War in Afghanistan added further to the U.S. deficit. Except in Japan, the world
economy hummed along. Inflation was contained by a combination of increasing excess
capacity worldwide in some key industries and even more sourcing from low-wage
countries. Interest rates declined due to generally easy money policies and low inflation.
Recycled export profits from China, loose regulation, and a new paradigm of low cost
borrowing led to major and unsupportable increases in debt by consumers, governments, and
many businesses. The U.S. economy expanded for six years but unemployment dropped
only modestly. It bottomed at 4.4% during 2006 and ended 2007 at 5.0%.
5.
The unintended consequences of a laudable goal of increased home ownership led to the
Financial Crisis of 2008-2009. Culprits included Wall Street greed, very lax underwriting of
home loan applications, especially subprime mortgages, the false assumption by credit rating
agencies that home prices could not fall significantly, and the massive overhang of debt
globally described above.
6.
The Great Recession ensued, which led to even worse government budget deficits as tax
revenues contracted dramatically. U.S. GDP declined 5.1%, and unemployment jumped to
9.9% at the end of 2009. Euroland did not fare any better, and even China experienced a
Economic Review and Market Perspective – August 7, 2013
Page 4
decrease in its growth rate, albeit rather brief. Greece became a symbol of what was all too
common: Sovereign governments unable to service their debt. It also became clear that the
global banking system was at risk as declining values of consumer, corporate, and sovereign
debt held by banks exposed severe undercapitalization.
7.
Since the Financial Crisis, the Federal Reserve and other central banks have been deploying
aggressive policy measures in their efforts to inject liquidity into the global economy and
stimulate growth. In the U.S., the Fed has pursued two paths: 1) it has maintained the fed
funds rate at close to zero, and 2) it has embarked on a series of quantitative easing (QE)
programs, purchasing massive amounts of Treasuries and agency mortgage-backed
securities. These purchases, more than $1 trillion worth, have been coming at a rate of
$85 billion a month, since December 2012.
It is possible that the following graph summarizes with reasonable accuracy the history we have
been describing, a history of steadily declining interest rates, which abetted U.S. and worldwide
economic growth. Also, it certainly evidences the current situation of very low rates foretelling
future rock-bottom returns for traditional bond investments.
Interest rates - The long descent
Market Perspective
Intervention by central banks in the U.S., Europe, England, and Japan has largely succeeded in
suppressing market volatility and encouraged investors to move into riskier assets such as stocks
and high yield bonds. Prices soared in 2012 and through April 2013.
Some market watchers have been warning about the growing risks of ongoing central bank “check
writing.” The economy has not recovered as robustly as was hoped, leading to a widening gap
between policy-supported valuations and economic fundamentals. While the surge in riskier asset
prices has not approached the 2006 bubble levels, such assets have risen enough to heighten the
impact of any major shock to the system.
Economic Review and Market Perspective – August 7, 2013
Page 5
As chronicled above the shock came in May, when Fed Chairman Ben Bernanke outlined a plan for
eventually tapering QE purchases as the economy begins hitting certain growth targets. The
markets reacted dramatically to the possibility of cessation of the Fed bond purchases. A broad selloff was triggered, with liquidity falling across virtually all asset classes, in the second half of May
and through June.
While bonds struggled in late May and June, stocks had mixed but generally solidly positive results.
U.S. stocks were only briefly affected by interest rate concerns, and notwithstanding a brief
pullback in June, the S&P 500 returned 2.9% in the second quarter and 13.8% over the first half of
2013. Foreign stocks results were mixed, with a strengthening dollar holding down local currency
results for U.S. dollar investors. After being an engine for growth over the last decade, returns for
emerging market stocks were also depressed by slowing global economic growth, poor domestic
consumer spending, and lower commodity prices.
Volatility increased during May and June. However, it was much less than the volatility seen in
2010 and 2011. Correlations across asset classes remain elevated as investors flocked between
“risk-on” and “risk-off” positions upon new news or rumors. Over the last few years, perceived risk
reflecting macro themes has been the key performance determinant. Herd behavior has
overshadowed, or even prevented, superior stock-picking by any one investment manager.
As indicated in the table below, U.S. financial markets began at a market top in March 2000 and
since then have experienced one additional market top and two bottoms.
Time Period
Market Cycle Description
March 2000 – End of 2002
Deep Bear
Early 2003 – October 2007
Long, Steady Bull
November 2007 – March 9, 2009
Very Deep Bear
March 10, 2009 – Present
Bull, Sharply Upward Initially and
Moderate Since
Rolling 12-month returns have been excellent for U.S. and other developed countries stocks.
Disappointing results for bonds and emerging market stocks reflect the interest rate sensitively of
these asset classes. Longer-term results are mixed. They are shown in a table at the end of this
writing. The returns suggest the benefit of broad global diversification: the strong results for some
asset classes were offsetting the weak results of others.
Updating some past information, the negative impact on asset class returns of the two deep bear
markets continues to be dramatic and also differentiated; almost all the returns reported below are
well below long-term historical averages. Annualized returns for U.S. and foreign large company
stocks were not much above breakeven over the entire 13.25-year period covered by the text tables
above and below (S&P 500 up 2.5% and MSCI-EAFE up 2.0%, annually). Small cap U.S. stocks
fared considerably better (+6.0% per year), outperforming large caps, and value beat growth, both
results consistent with the seminal Fama-French research. Over the 13.25-year period, global bonds
provided solid results; they provided annualized returns in the vicinity of 6% (depending on one’s
Economic Review and Market Perspective – August 7, 2013
Page 6
U.S./foreign allocation); they were fairly consistent performers (except for the second half of 2008
and May-June 2013); and they beat many categories of stocks. Emerging market stocks were quite
good performers over the 13.25 years. However, with the high returns of emerging markets comes
high volatility; they were especially negatively impacted by the global economic slowdown over the
last few years. Finally, only the tangible category achieved annualized double-digit returns since
March 2000. U.S. real estate funds were extremely strong over the period, providing total returns of
11.5% annually. However, a substantial part of the gain occurred before the latest 5-year period; in
other words, real estate funds were also hard hit by the November 2007 - March 2009 bear market.
Energy funds had similar performance, with even more skewing of higher returns toward the earlier
years.
The table below shows the 13.25-year data and also one-year and five-year returns as of June 30,
2013. It is important to note that the rolling forward of five-year returns means they no longer
include all of the very deep bear market beginning November 2007.
Index or Mutual Fund Average
Global Bonds
Barclay’s Aggregate U.S. Bond
Citigroup Non-U.S. Bond
Emerging Market Bond Funds
U.S. Stocks
S&P 500 (U.S. Large Caps)
Russell 2000 (U.S. Small Caps)
Russell 3000 Value (All Caps)
Russell 3000 Growth (All Caps)
International Stocks
MSCI-EAFE (Developed Economies)
Europe Funds
Japan Funds
Pacific Asia Ex-Japan Funds (Dev’d Econs)
Emerging Markets Funds
China Region Funds
Latin America Funds
Tangibles Stocks
Energy Funds
Real Estate Funds
Goldman Sachs Commodity Index
One-Year
Return
Ending
6/30/13
Annualized Returns
Five Years
April 2000 Ending
June 2013
6/30/13
(13.25 years)
-2.4%
-7.1%
1.8%
5.2%
2.6%
7.3%
5.8%
5.4%
9.6%
13.8%
15.9%
25.3%
17.6%
7.0%
8.8%
6.8%
7.6%
2.5%
6.0%
5.7%
-0.1%
18.6%
21.3%
-.6%
-.4%
2.0%
2.4%
27.2%
-4.2%
-7.8%
-6.2%
-1.3%
2.8%
-1.4%
1.3%
-4.0%
6.5%
6.3%
6.4%
-14.9%
-9.3%
9.0%
10.8%
4.7%
2.0%
-7.2%
6.7%
-15.2%
9.6%
11.5%
3.0%
Timely Topics – August 7, 2013
1. Finding the Magic Number: Safe Level of Retirement Withdrawals
We begin this article by laying out the key retirement planning questions retirees and their advisors
face. After noting a new study is strongly suggesting safe withdrawal rates should be significantly
lower, we explain and critique the methods financial advisors have been using to address their
clients’ key retirement questions, especially the safe withdrawal rate. We then describe results of
the new study. Next, we indicate how Caves & Associates is planning to revise the advice it gives
regarding safe withdrawal rates and how withdrawal reserves help extend the life of nest eggs.
Finally, we submit to the reader that there is no magic number and that retirees need on-going
monitoring of key factors such as health and net worth to adjust their withdrawal rate up or down as
appropriate.
Seniors face crucial questions as retirement approaches and once they retire. In evaluating the
decision to retire in the first place, they wonder if they have enough money in their nest egg to
continue living the lifestyle they currently enjoy. A related question is how much they can safely
withdraw from their nest egg annually and not outlive it. While in retirement, whenever markets
suffer serious declines, they wonder if expenditure cutbacks will be needed to ensure sufficient
capital. As they grow older, they wonder if they need to plan for the possibility they live beyond
their life expectancy. Finally, in these changing times, are safe levels of retirement withdrawals the
same as they were 10 or 20 years ago?
To the last question, the short answer is “no”. A new study of thousands of Monte Carlo
simulations is waving a cautionary flag on previously held ideas about safe withdrawal levels.
As Americans have aged and continue to live longer, the Financial Advisory industry has become
increasingly sophisticated in assisting clients with these important retirement planning questions.
Initial methods were simple present value rates of return run on financial calculators. They gave
only a very rough idea about retirement feasibility. They provided essentially no probabilistic
results. They often ignored inflation, and they modeled a world of uniform rates of return (i.e., the
same positive return each year of retirement). Thus, they did not take into account volatility of
returns or the order/sequence of negatives and positives during retirement years, including negative
returns. In summary, if these early calculations indicated a prospective retiree had enough money to
retire, there was only a 50% chance of not running out of money before dying. In other words, a
50% failure rate. Not very reassuring!
Monte Carlo simulation provided a big step forward. It definitely produces more reliable answers
to the questions of when to retire and what is a safe withdrawal rate. Monte Carlo (named for the
famous casino with games of chance exhibiting random behavior) excels at approximating the
probability of certain outcomes by running multiple trials, using random selection of model inputs
made from distributions of actual historical results for variables. This approach is effective in
simulating the uncertainty and variability of the real world.
Monte Carlo avoids the major weaknesses of the financial calculator, namely modeling unvarying
positive returns for the whole analysis period and ignoring the timing of negative returns. The real
Timely Topics – August 7, 2013
Page 2
strength of Monte Carlo simulation is that it models varying high and low returns during retirement,
and also takes into consideration the sequence of good and bad returns. What if a retiree’s portfolio
experiences very bad (or even just below average) returns in the early years of retirement? A period
of negative returns early in retirement can have a disastrous effect on retirement savings because
they may be so diminished that they cannot recover even though returns trend upward considerably
in the latter part of the retirement analysis period. To cover this very real possibility, the answer
from a Monte Carlo simulation is a lower withdrawal rate. Here is an example:
Based on Monte Carlo simulation, a 4% withdrawal rate that is increased every year
at the rate of inflation gives a 95% chance of success (not running out of money) for
a couple at age 60 with a 30 year time-horizon. The old financial calculator
approach would have indicated about a 5.5% safe withdrawal rate. Remember, this
“old” method only provides a 50% probability of success and disregards the potential
financial misfortune of retirement at the inception of a deep market downturn such as
in 2000 or 2008.
Despite its strides, Monte Carlo still has its short-comings, and no model that must be simplified for
practical reasons is perfect. To be normative, and as a necessary simplification, users of Monte
Carlo assume a steadily increasing rate of portfolio withdrawal. However, when markets go down,
people often withdraw and spend less. When markets are up, they often spend a little more. The
rational behavior of spending less when markets drop leads us to conclude that somewhat higher
rates than Monte Carlo calculations could nonetheless be “safe” (i.e., continue to have 95% chance
of success).
Another concern about Monte Carlo is possible misinterpretation of the simulation result, namely in
an excessively conservative manner (conservative meaning a lowering of the withdrawal rate).
Monte Carlo treats a trial (one of thousands run during the simulation) as a failure even if the retiree
runs out of money one day before their death. Certainly, such an outcome would be considered a
success in the real world. Monte Carlo also assumes the same longevity for both spouses.
However, by the 20th year of retirement statistically, there is more than a 50% chance that one
spouse will have passed on, reducing the level of retirement outlays. Further, Monte Carlo assumes
each spouse lives to the study age, but after 30 years of retirement, there is only a 20% chance either
spouse will still be alive to draw on the portfolio. That means that even with a 50% failure rate,
there is only about a 10% chance that a living retiree will run out of money. Finally, Monte Carlo
models may not properly account for reversion to the mean of investment returns that is commonly
observed in the real world.
New research may be bringing important refinements to retirement planning analysis. According to
the authors* of a new paper, “Asset Valuations and Safe Portfolio Withdrawal Rates” that studied
thousands of Monte Carlo simulations, a model that takes into account current bond yields and
stock market valuations when determining the probability of success for different initial
withdrawal rates over different time periods provides a more accurate and relevant result given the
global securities markets in which we live. Furthermore, the new paper suggests as much as a
* David Blanchett, the head of retirement research at Morningstar Investment Management, Michael Finke, a professor and Ph.D.
coordinator at the department of personal financial planning at Texas Tech University, and Wade Pfau, a professor of retirement
income at the American College.
Timely Topics – August 7, 2013
Page 3
50% failure rate for the same 4% withdrawal rate in the example mentioned previously, the 4%
being the “safe” withdrawal rate determined by Monte Carlo simulation. This failure rate per the
new paper is dramatically higher than the 5% failure rate found by a traditional Monte Carlo
approach.
The reason for the higher failure rate versus a Monte Carlo simulation is that the new study factors
in an assessment of current capital markets, particularly regarding bonds. The present global
situation, with arguably high stock prices (stimulated by central banker loose money) and
historically low bond yields, implies quite low future returns for a quite lengthy time period. If
stocks and bonds don’t have good prospects, probability of retirement capital adequacy declines.
One way to offset this is to withdraw less during retirement. The new study finds that if retirees can
decrease their withdrawals to 2%, there is a 99% chance they will not run out of money in
retirement given a 30 year retirement and a 60%/40% bond/stock mix (we note that the higher 99%
probability has lowered the safe withdrawal rate below that for a 95% probability, thus producing
the very low 2% withdrawal rate respecting which only the very rich could live an acceptably high
retirement lifestyle).
One thing is clear: The higher failure rate in the new study of Monte Carlo simulations suggests a
bleaker picture in which there is an increased likelihood retirees will not have enough to last the
duration of their retirement. While each retiree’s situation will be different, if markets
underperform history during retirees’ early years, they will be forced to cutback withdrawals so they
maintain enough capital through retirement. Whereas the thousands of simulations of a Monte
Carlo approach do take into account that very poor investment results may occur in early years, the
new study is in effect saying they will occur.
While we believe there is no magic number that settles the issue of safe withdrawals once and for
all, our evaluation is that the new study has merit. A somewhat-more conservative approach may
take some of the sting out of future economic conditions, and we believe lower withdrawal rates
reflecting the new study should replace the “old” Monte Carlo results. For example, for the 60-year
couple described above, the initial withdrawal should be set at one percentage point lower, or 3%,
instead of 4%, to be “safe.”
Unadjusted, or adjusted downward as above, Monte Carlo can still give a good estimate of possible
outcomes, but in the end client flexibility and good behavior are also very important. For example,
the simulations assume that clients do not “misbehave” by buying high and selling low, thus
permanently destroying part of their retirement nest egg. See the next Timely Topic article and
accompanying client letter for amplification about “good behavior.”
As an endnote, and to pull disparate concepts together, the reserves regimen practiced by Caves &
Associates, including timely establishment of adequate reserves and strategic replenishment, is
designed to prevent clients from having to sell temporarily beaten down holdings to fund
withdrawals when markets are down. This allows risk-taking capital to be preserved and rebound
before it is needed. It also helps avoid panic selling. Thus, we believe our reserves regimen helps
stretch clients’ nest eggs, permits higher safe withdrawal rates, and reduces the risk of bad behavior,
which would certainly significantly reduce clients’ standard of living in retirement.
Timely Topics – August 7, 2013
Page 4
We will continue to periodically monitor factors that should be taken into account in retirement
analyses so that we can provide the most timely and useful advice on our clients retirement
challenges. Please let us know if you want to re-evaluate your current retirement planning.
2. ‘Shallow Risk’ and ‘Deep Risk’ Are No Walk in the Woods
The Intelligent Investor by Jason Zweig
Earlier this week, the Dow Jones Industrial Average hit 15567.74, a new high. That was the 28th
time this year the Dow closed at a record.
At these all-time-high prices, just how much riskier stocks are than alternatives like bonds, cash or
gold depends largely on how you define “risk.” William Bernstein, the author of several books on
investing and financial history, says risk takes two basic forms—and understanding the difference
can help investors figure out what they should be afraid of.
What Mr. Bernstein calls “shallow risk” is a temporary drop in an asset’s market price. Shallow
risk is as inevitable as weather. You can’t invest in anything other than cash without being hit by
sharp falls in price. “Shallow” doesn’t mean that the losses can’t cut deep or last long—only that
they aren’t permanent.
“Deep risk,” on the other hand, is an irretrievable real loss of capital, meaning that after inflation
you won’t recover for decades—if ever.
In a forthcoming e-book, “Deep Risk: How History Informs Portfolio Design,” Mr. Bernstein sifts
through decades of financial data and global history to identify what creates deep risk. The four
Timely Topics – August 7, 2013
Page 5
causes he came up with are: inflation, deflation, confiscation and devastation. “These forces can
make assets lose most of their value and never recover,” he told me this week.
Imagine, suggests Mr. Bernstein, that you are a homeowner with a fixed annual insurance budget. If
you live in a dry part of Kansas you probably should tilt your insurance spending toward tornado
and fire coverage; if you live in Southern California you should cover earthquake and fire first;
along a river, flood insurance matters most. Likewise, you should insure against deep risks based
both on how likely and on how severe they are.
Devastation—war or anarchy—is a long shot with horrific consequences, but there isn’t much you
can do about it. If you hoard gold, you are as likely to be killed for it as to be protected by it. “For
Armageddon, what you really need is an interstellar spacecraft,” Mr. Bernstein quips.
Confiscation—a surge in taxation, or a seizure by the government as happened to bank depositors in
Cyprus—is more common. There, says Mr. Bernstein, your best option is to own real estate abroad,
since governments rarely reach beyond their boundaries to seize assets of law-abiding citizens.
Deflation, the persistent drop in the value of assets, is extremely rare in modern history, Mr.
Bernstein says. It has hit Japan but almost nowhere else in the past century, thanks to central banks
that print money to drive up prices. The best insurance against deflation is long-term government
bonds. Diversifying your portfolio into international stocks also helps, since deflation often doesn’t
hit all nations at once.
While bonds protect you from deflation, they expose you to inflation—far and away the likeliest
source of deep risk. Mr. Bernstein notes that inflation can destroy at least 80% of the purchasing
power of a bond portfolio over periods as long as 40 years. That is deep risk at its deepest—a hole
so profound most investors can’t get out of it in a lifetime. That happened in, among other places,
France, Italy and Japan from 1940 through 1979, Mr. Bernstein says. The best insurance against
inflation, he says, is a globally diversified stock portfolio with an extra pinch of gold-mining and
natural-resource companies. Treasury inflation-protected securities, U.S. bonds whose value rises
with the cost of living, also can help.
But holding stocks to insure against deep risk drives your shallow risk through the roof. While
stocks should protect you against inflation in the long run, they are guaranteed to expose you to
frightening price drops in the shorter run. That, in turn, could push you into the final frontier of deep
risk: your own behavior.
Most investors can’t survive the pain of plunging prices, Mr. Bernstein says, unless they have a
surplus of both cash and courage. If you have plenty of each, hang on. If you don’t, a sudden drop
from record highs could lead you to bail out near the bottom, thereby inflicting a permanent loss of
capital on yourself.
Look back, honestly, at what you did in 2008 and 2009 when your stock portfolio lost half its value.
Then ask how likely you are to hang on in a similar collapse. Your own behavior can turn shallow
risk into deep risk in a heartbeat.
Caves & Associates Privacy Statement
Caves & Associates (C&A), an independent financial planning and investment advisory firm, is
committed to safeguarding the confidential information of its clients. We hold all personal
information provided to our firm in the strictest confidence. These records include all personal
information that we collect from you in connection with any of the services provided by C&A.
We have never disclosed information to nonaffiliated third parties, except as permitted by law,
and do not anticipate doing so in the future. If we were to anticipate such a change in firm
policy, we would be prohibited under the law from doing so without advising you first. As you
know, we use health and financial information that you provide to us to help you meet your
personal financial goals while guarding against any real or perceived infringements of your
rights of privacy. Our policy with respect to personal information about you is listed below.
1.
We permit employee access to information only to those who have a business or
professional reason for knowing, and only to nonaffiliated parties as permitted by law.
(For example, federal regulators permit us to share a limited amount of information about
you with a brokerage firm in order to execute securities transactions on your behalf, or so
our firm can discuss your financial situation with your accountant or lawyer). All
employees are required to sign Confidentiality Agreements which prohibit disclosure of
nonpublic personal information of clients and prospective clients.
2.
We maintain a secure office and computer environment to ensure that your information is
not placed at unreasonable risk.
3.
The categories of nonpublic personal information that we collect from a client depend
upon the scope of the client engagement. It will include information about your personal
finances, information about your health to the extent that it is needed for the planning
process, and information about transactions between you and third parties.
4.
For unaffiliated third parties that require access to your personal information, including
financial service companies, consultants, and auditors, we require strict confidentiality in
our agreements with them and expect them to keep this information private. Federal and
state regulators also may review firm records as permitted under law.
5.
We do not provide your personally identifiable information to mailing list vendors or
solicitors for any purpose.
6.
Personally identifiable information about you will be maintained during the time you are
a client, and for the required time thereafter that such records are required to be
maintained by federal and state securities laws, and consistent with the CFP Board of
Ethics and Professional Responsibility and the Code of Ethics and Standards and Rules of
Professional Conduct of the Association for Investment Management and Research.
After the required period of record retention, all such information shall be destroyed.
Market Review
Third Quarter 2013
Global equity and bond markets rallied broadly late in the quarter in response to the Federal Reserve’s
decision to continue fully its $85 billion-a-month bond purchase program (aka, QE3) for the immediate
future. U.S. stocks earned outstanding returns well above historical averages. Foreign developed countries
results were similar to U.S. stocks in local currencies and outperformed U.S. stocks somewhat for the U.S.
dollar investor due to beneficial currency gains on dollar depreciation. The local and U.S. dollar returns for
emerging markets stocks were somewhat lower but still solid. Bond prices were little-changed, as the yield
curve rose only slightly during the period on the long end of the curve and among riskier bond categories
such as emerging markets. The U.S. dollar weakened moderately against most developed and emerging
market currencies, increasing returns of foreign stocks and bonds for unhedged U.S. dollar investors.
Alternative strategies returns were positive but held down results slightly due to their hedging nature.
Equity Review (Return percentages are not annualized)
U.S. stock markets rallied in the third quarter with the majority of their outperformance for the period
concentrated in September. Investors preferred small-cap stocks over their large-cap counterparts. The
Russell 2000 (small companies) and Russell 1000 (large companies) indexes returned 10.2% and 6.0%,
respectively. Growth stocks outperformed value stocks. The Russell 3000 Growth and Russell 3000 Value
indexes rose 8.5% and 4.2%, respectively. Based on mutual fund averages, health, technology, and
industrials were the best performers, gaining 13.1%, 12.2%, and 10.9%, respectively. The rate-sensitive real
estate and utilities sectors returned -2.5% and 2.9%, respectively.
Foreign developed countries stocks also delivered outstanding results (the following returns are in local
currencies unless otherwise indicated). The MSCI EAFE Index of developed countries gained 7.5%. Due to
favorable political and economic news, the MSCI Europe Index rose 8.1%. Japanese central bank actions to
weaken the yen in order to stimulate export growth continued but were less impactful this quarter; the MSCI
Japan Index was up 4.7%. The MSCI Pacific Ex-Japan Index gained 7.3%. The somewhat lower results for
emerging market stocks were likely attributable to doubts about global economic growth and a mixed
outlook for commodities prices. The MSCI Emerging Markets Index rose about 5-6% in local currencies
and U.S. dollar terms. Factoring in currency gains, the MSCI EAFE index was up 11.6%.
The U.S. dollar generally weakened during the quarter. It fell -3.5% versus 7 developed market currencies
tracked by the U.S. Dollar Index. The greenback also weakened -1.2% versus 21 emerging market
currencies tracked by the MSCI EM Currency (USD) Index.
Fixed Income (Return percentages are not annualized)
Fixed income markets within the U.S. rallied in September but still experienced generally flat returns for the
quarter. The Barclays Capital (BarCap) U.S. Aggregate Bond Index, which measures results for taxable,
investment grade issues, returned .6%. Quality (or the lack thereof) drove relative performance. High-yield
bonds was the best performing domestic fixed income class as investors searched for yield; the BarCap High
Yield Corporate Bond Index returned 2.3%. Time to maturity drove relative performance inversely. The
BarCap U.S. Long Term Treasury Index and BarCap Government Credit 1-3-Year Index were examples of
longer-term versus short-term. They returned -2.2% and .3%, respectively. Finally, the BarCap U.S.
Intermediate Treasury Index and BarCap U.S. Treasury Inflation Note returned .4% and .7%, respectively.
Overseas, fixed income markets rallied, and developed country bonds provided considerable higher returns
than U.S. bonds. The Barclays Global Aggregate x-U.S. Index rose 4.4% in U.S. dollar terms, the solid
positive return helped by the weakening dollar. Emerging market bonds were just above breakeven,
underperforming their developed countries counterparts due to diverging credit and currency factors.
Third Quarter 2013 and Nine Months Year-to-Date
Table of Stock and Bond Returns
Period Return*
9 Months
Third
Ending
Quarter
9/30/13
U.S. Stocks
S&P 500 Index **
Average Diversified U.S. Equity Mutual Fund
Russell 2000 Index #
Sector Mutual Funds
Technology
Health
Communications
Financial
Real Estate
Energy
Foreign Stocks
MSCI Europe, Australasia & Far East (EAFE) Index ##
MSCI EAFE Local Currencies
Average Diversified International Stock Mutual Fund
Regional/Specialty Mutual Funds
Europe
Japan
Diversified Pacific/Asia except Japan
Diversified Emerging Markets
5.2%
7.9%
10.2%
19.8%
22.6%
27.7%
12.2%
13.1%
6.4%
5.5%
-2.5%
6.0%
23.0%
36.7%
15.8%
22.1%
1.9%
17.6%
11.6%
7.5%
10.3%
16.1%
19.3%
13.8%
11.8%
7.5%
3.1%
5.0%
16.6%
24.9%
-1.1%
-3.0%
`
Alternative Strategies
Long-Short Mutual Funds
Market Neutral Mutual Funds
3.4%
0.8%
9.7%
1.5%
U.S. Bonds
Barclays Capital Intermediate Gov’t Bond Index ***
Barclays Capital Intermediate Credit Index δ
Intermediate Municipal Bond Mutual Funds (National)
Intermediate Municipal Bond Mutual Funds (CA)
Inflation-Protected Bond Mutual Funds
High Yield Bond Mutual Funds
0.4%
1.0%
0.2%
0.7%
0.6%
2.2%
-0.8%
-0.9%
-2.6%
-1.8%
-6.3%
3.6%
Foreign Bonds
Citigroup Non-U.S. World Gov’t Bond Index ###
J.P. Morgan Emerging Bond Index ####
Emerging Market Bond Mutual Funds
4.1%
1.2%
0.1%
-3.4%
-6.7%
-7.3%
*
**
***
δ
#
##
###
####
Mutual fund and index return data are from Morningstar.
Capitalization-weighted index of 500 very large U.S. companies. The 500 are chosen to achieve a fair cross-section of U.S. industrial and service
sectors. Recent median capitalization of approximately $60.0 billion.
Barclays Capital index of U.S. Treasury bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate
maturity of about 4-7 years. Includes returns of agency bonds but not mortgage-backed securities.
Barclays Capital index of U.S. investment grade corporate bond total returns (i.e., interest plus or minus change in price). Bonds in index have
intermediate maturity of about 4-7 years.
Index of small U.S. companies. Recent median capitalization of approximately $1.3 billion.
International stock index indicating return of large foreign companies of 21 major developed countries (Japan, UK, and Germany have the
highest weightings). Returns are converted to U.S. dollars. No emerging market stocks are included.
Citigroup index of total return of foreign government bonds issued by major developed foreign countries (Japan, Germany, France, and UK have
the highest weightings). Returns are converted to U.S. dollars.
J.P. Morgan index of total return of debt instruments issued by 13 emerging markets countries (Argentina, Brazil, and Chile have the highest
weightings). Returns are converted to U.S. dollars.