Third Quarter, 2012 Economic and Market Commentary

The Importance of Investment Policy

We suggest that the process of investment policy development avoid predications or sentiments regarding either macro micro-economic events or directions. This would most likely be a value losing proposition in terms of portfolio return due to the overwhelming range of outcomes necessary to accurately anticipate. Instead, investment policy should be developed within the scope of your financial plan using time and diversification to provide real return while mitigating risk.

Nevertheless, although we remain committed to suggesting an investment policy that is designed to allow indifference to such events, this is not meant to imply that one should be oblivious to such conditions either. In this regard what follows is a brief summary of current economic conditions as well as a discussion regarding cash, bond and equity markets.

Economic Conditions

Developed economies, including the U.S., continue their post-crisis, private-sector deleveraging, with the trend more advanced in the U.S. than in Europe. In the U.S., incentivized sales activity and a decline in real mortgage rates have stabilized real estate prices and allowed the residential housing market some self-sustaining momentum. Although lending remains constrained, housing starts have rebounded off low levels, and construction activity is contributing positively to GDP growth. Job growth domestically continues to be positive, but not prolific. The unemployment rate currently stands at a stubbornly high 7.8%, which, if you have been watching the presidential debates, has been a major point of emphasis by the GOP. One problem that persists is that many U.S. based multinational companies are adding significantly more jobs overseas than they are at home.

Corporations continued to enjoy strong balance sheets, with ample access to credit at low interest rates. Credit access improved for both corporations and consumers as banks eased their standards for new loans during the third quarter. However, earnings growth has moderated, and near-record-high profit margins may leave little room to expand.

Overseas, the major concern has been the state of Europe and the announcement of a new bond-buying plan by the European Central Bank sparked a significant improvement in Eurozone financial conditions. Implementation risks for the program remain, but the global easing cycle continued to gather steam amid additional policy moves by Japan, Brazil, China, and others. Expanding liquidity from the latest escalation of global monetary easing buoyed financial markets and supported expansion in equity markets.

The U.K. enacted steep fiscal austerity measures beginning in late 2010 which contributed to a slip back into recession. The U.S. may face a similar fate if the entire impending fiscal cliff is hit head-on. Certainly, a more gradual fiscal consolidation would be preferable. Nevertheless, stock volatility and news headlines indicate that investors are mostly unconcerned about this risk.

Inflation, Cash and Fixed Income Markets

Money market yields continue to provide nominal returns and after adjusting for inflation and taxes, provide a negative real rate of return. Record agricultural commodity prices - caused in part by the U.S. drought - will put upward pressure on headline inflation in the coming months, though the impact is likely to be felt more acutely in poorer developing economies. In the U.S., with low money velocity and high unemployment largely unchanged, core inflation remains well contained.

High-quality bonds have consistently produced positive real returns during the past three decades. But with the Federal Reserve's efforts to keep nominal interest rates low while reflating the economy, Treasury yields have fallen below the current inflation rate, creating a challenging environment for fixed income investing. Exceptionally low interest rates worldwide have pushed yields in many fixed-income categories to near record lows; nevertheless, yield spreads are at historically reasonable levels.

Although fiscal challenges still exist for many municipalities, state revenues have improved for nine straight quarters, and the recent uptick in property tax revenues is a positive sign for localities. Highly rated municipal bonds offer comparable pre-tax yields to Treasuries, and currently legislated tax changes for 2013 would further enhance their after-tax yield advantage.

Equity Markets

Since December 2007, investors have poured more than $1.1 trillion into bond mutual fund and ETFs, but added almost nothing to equities. Over the past five years, the risk-adjusted returns for stocks have been far below their long-term average, while risk-adjusted bond returns have been far above. Historically, this condition has proven to be mean-reverting.

Owning stocks when valuations are below average has typically resulted in higher-than-average subsequent five-year real returns, and expensive valuations have suggested the opposite. Current valuations are somewhat average or below average depending on the measure of earnings, which suggests reasonable intermediate-term return expectations.

Boosted by significant monetary easing, U.S. equities posted robust gains in the third quarter and added to their solid year-to-date returns. There was little differentiation among major categories, although larger caps tended to fare better. REITs underperformed the other categories during the quarter, but have strong gains so far in 2012.

It is interesting to note that the S&P 500 dividend yield is above bond yields for the first time since the 1050s. Stocks with higher payout ratios have enjoyed higher valuations as the market has paid a premium for the stability of distributed earnings, indicating a potential long-term shift in investor preferences. Many stocks still have low payout ratios and may benefit from raising their dividends.

Highly accommodative monetary policies helped lift most categories of international equities during the third quarter, bringing all into positive territory for 2012. The dollar lost value relative to many currencies, augmenting foreign equity returns for U.S. investors. Although earnings multiples ticked up in both emerging and developed markets, they remain below long-term averages continuing to signal that investors have already priced in slower growth in corporate profits.

In summary, the data reflects a probability of continued sluggish economic growth in most developed economies and perhaps slightly stronger growth, albeit below recent historical rates, in developing economies. Equity valuations appear to have conservatively factored in this limited growth scenario. Inflation and interest risk appears to be muted. In short, the slow slog continues while governments and investors try everything not to get stuck in the mud.