Download Issues Influencing the Markets

First – Quarter 2013 Securities Market Commentary
The first quarter of 2013 returned some impressive gains in the Standard & Poor's 500, the Dow Jones
Industrial Average and the NASDAQ, while the bond market produced slightly negative returns. In fact,
the equity markets have not performed at this level since the first quarter of 1998. The Standard &
Poor's 500 returned a positive 10.03%, the Dow Jones Industrial Average returned 11.25% and the
NASDAQ returned a positive 8.21%. Please note these returns are not inclusive of dividend income. The
Barclays Aggregate Bond Index returned a negative -0.315%. It appears as though this unabashed
upward movement in the equity markets is in large part due to the Federal Reserve banks’ continued
intervention/stimulus. Although, I find it quite worrisome that the stimulus appears to have less of an
effect on the markets. Approximately 40% of the income received by Standard & Poor's companies
comes from Europe, which is already in a recession, raising concerns about a reduction in the rate of
growth in domestic corporate earnings. Another concerning fact is that corporate profit is now 11% of
the total gross domestic product (GDP) with the historical average being only 6% of GDP. These
exaggerated levels are often precursors to significant market corrections. It is interesting to note that
the first quarter of 2012 was similar having the Standard & Poor's return of 12% and the Dow return of
8.14%, which were followed by a rather significant downturn starting in April 2012.
Technical Market Overview
The 200 day moving average is a long-term trend indicator that is often useful in determining the longterm direction of a specified market. If today's average price of the previous 200 days is higher than the
previous day’s average price of the prior 200 days, then the trend remains positive. All of the major
equity indexes remain significantly above their 200 day moving average. In fact, with the indices prices
so far above the average of the past 200 days, this may signal a correction. Historically, when the
Standard & Poor's 500 Index is between 10 and 13% higher than its average price of the past 200 days, a
near term down trend is often imminent. As of the writing of this letter, the S&P 500 is well in excess of
9% and over its 200 day moving average, signaling yet another early warning to a potential market
downturn.
Issues Influencing the Markets
Cyprus / European Economic Weakness
On March 30, it was announced that major depositors at the Bank of Cyprus would see 37.5% of their
deposits converted into bank shares, with the figure possibly set to increase by another 22.5 percentage
points if the bank required further injections of cash. Since the Bank of Cyprus will also absorb the
island’s second-largest bank Laiki, the same conditions are likely to apply to Laiki Bank accountholders as
well. This extraordinary confiscation of investor’s money combined with continuing economic weakness
in Europe is a very significant economic event. One may ask, how could such an event affecting a tiny
island unaffiliated with the United States have an effect on our economy. There are more than a few
reasons why this is significant to our economy. First, it sets a precedent that is unfathomable in which a
government can arbitrarily decide to confiscate assets of its citizens, to pay for its own extraordinary
financial mismanagement. Secondly, as mentioned above, about 40% of the revenue received by
Standard & Poor's 500 companies is derived from European operations. With Cyprus being part of the
European Union, this unprecedented “solution” to a country's economic woes may spread to other
troubled economies such as Spain and Portugal, two other members of the EU that are experiencing
economic difficulties. This could have a negative effect on the financial health of the entire European
Union.
Consumer Confidence Index
The University of Michigan’s Survey of Consumer Confidence Sentiment plunged during the fourth
quarter of 2012 with the consumer confidence index falling from 82.7 to 72.9. The first quarter of 2013
shows no improvement but in fact a slightly weaker reading of 72.3. This widely followed barometer of
the consumer's attitude of their current economic situation and perhaps more importantly their
expectations for their future, indicates a less than positive outlook for the future as a whole. Analysts
theorize that at least some of these reduced expectations may be due to the increase in Social Security
withholding taxes as well as higher marginal tax rates for many taxpayers. In addition, it’s important to
note that in excess of 2/3rds of the U.S. gross domestic product (GDP) is derived from domestic
consumption. Continued weakness in the consumer’s outlook may result in lower GDP over the next
several months.
Unemployment / Labor Force Participation
The unemployment rate has declined from 7.8% the final quarter of 2012, to 7.6% as of the end of
March 2013. Even the broader measure U6, as calculated by the Department of Labor, declined from
14.4% to 13.8%. U-6 includes people working part-time that are unable to obtain full-time employment.
The U6 also includes people that are considered “under-employed.” Under-employed refers to those
working in jobs that are well beneath their skill levels, or have much greater levels of education than can
be utilized in their current positions, because of economic reasons. While these numbers appear
encouraging, it is important to note that the reason the unemployment rates are contracting is due to
the fact that they are being calculated as a percentage of a smaller labor force. This contraction in the
size of our labor force is multifaceted, meaning a combination of more Americans being on various
government subsidies no longer consider themselves looking for employment. Perhaps a more accurate
measurement of the economic environment surrounding employment opportunities may be the Labor
Force Participation Rate. A term used by the U.S. Bureau of Labor Statistics (BLS) to describe the subset
of Americans who have jobs or are seeking a job, are at least 16 years old, are not serving in the military
and are not institutionalized; in other words, all Americans who are eligible to work every day in the U.S.
economy. The most recent labor force participation rate as of March 2013 is 63.3%. With an average
rate of about 65.8% historically, the current 63.3% has not been seen since 1979, a further indication of
very weak job creation.
Gross Domestic Product-GDP
Gross Domestic Product (GDP) is the total market value of all final goods and services produced in a
country in a given year, equal to total consumer, investment and government spending, plus the value
of exports, minus the value of imports. GDP numbers are widely watched because they are like a
speedometer that tells us the rate of (speed) growth or decline our economy is currently experiencing.
The long-term average growth rate of GDP in our country has been between 2.5 and 3%. As recently as
the fourth quarter of 2011, the annualized growth rate for GDP was 4.1%. However, by the third
quarter of 2012 the economy had slowed to an annualized growth rate of 3.1%. The most recent reading
as of the last quarter of 2012, was the rate of growth in our economy had slowed to just 0.4%. This trend
clearly indicates a dramatic deceleration in the rate our economy is expanding, indicating potentially
more difficult economic times ahead. This fact combined with the equity markets high valuations, an
obvious slowing in the rate of growth in our economy and very low labor force utilization rates, clearly
would indicate that cautious approach to portfolio management may serve investors well in the coming
months.
Looking Forward
As 2014 approaches, there are several events that have the potential to affect both stock and bond
markets. With the expiration of the Bush tax cuts, many Americans are directly feeling the impact of
higher marginal tax rates. As you can imagine, with less disposable income this may have a dampening
effect on both consumer confidence as well as discretionary spending. As consumers adjust to less takehome pay, combined with the implementation of our new national health care system, these
uncertainties may cause undesirable and unintended consequences to the economy. Sec. of Health and
Human Services Kathleen Sibelius recently stated that ”she underestimated how long the politics of
health reform would last and didn’t anticipate how much confusion the slow rollout of the legislation
would create”. In August of 2011, the Ohio Department of Insurance retained Milliman, the prestigious
actuarial consulting firm, to estimate the impact of the Patient Protection and Affordable Care Act
(Obamacare) on the private insurance market. Milliman’s 159-page report makes clear that
Obamacare’s wide range of insurance mandates and regulations will dramatically increase the cost of
individually-purchased insurance. Unfortunately, Ohio was cited as a state that may suffer the largest
increase. A non-partisan study found that, by 2017, individual premiums in Ohio will increase by as much
as 85 percent. The significant cost increases have a very sobering effect on consumer discretionary
spending which could quite possibly result in a further slowing in our economic growth rate.
Risk Management/ Portfolio Strategy
At the beginning of the fourth quarter of 2012, a typical growth oriented portfolio had significant equity
exposure however, by the middle of the fourth quarter the models allocations had added significant
bond exposure to the portfolios. This shift from greater equity exposure to increased bond exposure
came in large part due to a rather abrupt sell-off in stocks from October 5 through November 14, 2012.
During that five-week period, the Dow Jones Industrial Average declined 7.64% and the Standard &
Poor's 500 fell 7.22 %. During the same time, long-term government bonds appreciated between 6 and
6.5%. This allocation worked well through much of November and as December unfolded, equities
again emerged as the more productive asset category. It is often stated in this quarterly correspondence
that our modeling technology is an observation tool that analyzes price behavior in an effort to identify
emerging, intermediate and long-term trends. From time to time, what “appear” to be emerging trends
end up being short term price disruptions. These short-term and often sharp price movements are
usually based on emotional reactions to some stimulus which causes fear among investors. The abrupt
sell-off in equities and the up spike in bonds certainly seemed to fit this profile.
As 2012 drew to a close, stocks began again to outperform bonds and continued that outperformance
through most of the first quarter of 2013. As the first quarter of 2013 drew to a close, we again began
to see equities flatten out as they achieve new highs and bonds yet again began to emerge as the
investment of choice, as investors digest the justification for stock indices being at all-time highs. With
the information discussed in this letter combined with macroeconomic data, it appears as though the
equity markets may have advanced as far as can be economically justified at this point. That is not to say
that stocks may not continue to rise, however unless corporate earnings far exceed expectations, this
market may become riskier than the potential gains would justify. One of the many telltale signs that a
market is nearing a peak is when good news, is viewed by the market as good news and bad news also is
viewed by the market as good news. With stocks being expensive from a valuation perspective, as well
as the state of the global economy and the unknown impact of our nation's new healthcare plan, I
believe the market is oblivious to the many negative factors that would normally affect stock prices.
The modeling technology used to manage your portfolios is comprised of 11 separate models that
recommend one mutual fund at a time. It should be noted that each model has a unique "minimum hold
period.” Simply stated, once a model makes a specific recommendation, that investment will be held to
the end of that minimum hold period. The minimum hold period’s in Edgetech’s modeling system range
from about 30 calendar days to as long as nine months. When abrupt changes occur in the direction of
stock or bond markets, the models will not respond immediately unless they have passed their
minimum hold period. This works quite well by not causing unnecessary, frequent trading. However,
from time to time there are situations where part of a portfolio may be in nonproductive asset classes
for a period of time until the model that recommended them reaches the end of its minimal hold period.
It is important to remember this technology is not designed to market time or forecast the next market
moves. It is however, designed to identify emerging trends and allocate portfolio assets accordingly.
In the first quarter, we saw a significant departure between the performance of bonds and stocks.
Stocks were clearly the most productive asset category while bonds were not and in fact in some cases
had a mildly negative effect on overall portfolio performance. This is a significant departure from the
last several years when bonds and stocks were relatively equal in their overall productivity on an
annualized basis. If this trend continues the models are designed to identify which asset class has the
best chance of risk appropriate productivity and allocate portfolio resources accordingly. I continue to
believe the most appropriate strategy for all investors is to manage risk rather than focus on maximum
exposure to either stocks or bonds and the inherent risk associated with over concentration in either
asset class. I remain confident that this portfolio management process will effectively help us mitigate
risk as well as return risk appropriate performance.
Disclaimer Notice
No investment strategy can guarantee profits or protection from losses as securities are subject to
market volatility. The analysis, ratings and/or recommendations made by the Edgetech Analytics, LLC
computer models do not provide, imply or otherwise constitute a guarantee of performance. No
guarantee is offered by Edgetech Analytics, LLC regarding the accuracy, market predictive powers,
suitability or profitability (either expressed or implied) of any information provided. Indices are
unmanaged and direct investment in them is not possible. Actual investment performance of any
trading strategy may frequently be materially different than the pursued results.
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