October 2013
INVESTMENT UPDATE Executive Summary i
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The U.S. stock market advanced further in the third quarter, driven by moderate economic growth, steady increases in corporate profits, and modest valuation expansion (higher price/earnings ratio). For the 16th time since 1976, but the first since 1995, the U.S. Government has failed to reach an agreement on the federal budget causing a shutdown of nonessential government services. While the bitter political squabbles in Washington increase stock market volatility, the silver lining is that gridlock and the budget sequester have resulted in a significant reduction of the federal budget deficit over the past few years, providing evidence that spending control along with modest economic growth and improving employment can shrink the budget deficit without major tax increases. Despite the Fed’s recent decision to delay tapering of its program of quantitative easing, longer term interest rates have risen by nearly 1% in anticipation of an eventual end to the Fed’s low interest rate policies. A defensive, short duration bond strategy remains appropriate as rates will likely continue to rise. Although the price/earnings valuation for equities has increased over the past year, it is still below the longterm average of about 15x. With solid balance sheets, continued profit growth and low interest rates, stocks remain attractive for long-term investors. We continue to recommend equity allocations near the middle of one’s appropriate range.
International stocks, which had lagged the first half of the year, posted strong results in the third quarter with the MSCI EAFE Index up +11.6%, bringing its year-to-date return to +16.1%. Emerging market equities (MSCI EM Index) produced a third quarter return of +5.9% but still lagged significantly behind the developed markets with a year-to-date return of -4.2%. The third quarter was not free of volatility, however, as a number of factors dominated headlines including the Federal Reserve’s discussions of an eventual unwinding of its low interest rate monetary policy, the partial government shutdown in Washington, and another looming showdown over the debt ceiling. While this caused volatility in stock prices, it was modest in comparison to the gyrations witnessed in the past several years. Investors seem to have become less sensitive to these types of events and have gained more confidence in the economic recovery and the strength of corporate balance sheets and growth potential. Although economic expansion has been slower than many would like, the moderate pace of GDP growth with its lack of excesses in hiring, capital spending, and inventory accumulation, increases the likelihood of a more prolonged period of growth. This could potentially result in more consistent stock price appreciation than a boom/bust economic cycle would provide.
U.S. Federal Budget Deficit is Improving Rapidly Chart 1: U.S. Budget Deficit is Still Too Large, But Gridlock and the Sequester are Working.
Stock Market Advance Driven by Solid Fundamentals Despite new tensions in the Middle East, the stock market continued its upward trajectory in the third quarter, driven by moderate economic and corporate profit growth, modest valuation expansion, and a quiet and slowly recovering Europe. All of the major U.S. stock indices finished the quarter in positive territory, adding to the gains of the first half of the year. For the third quarter, the S&P 500 was up +5.2%, bringing its year-to-date gain to an impressive +19.8%. Smaller U.S. stocks, as measured by the Russell 2000 Index, outpaced large cap equities with a +10.2% return in the quarter and a +27.7% nine-month return.
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59 Racine Street, Suite A, Menasha, WI 54952 fax: (920) 729-7904 website: www.northstarinvestments.com
The silver lining in the dark cloud of Congressional bickering, gridlock and the current shutdown of nonessential government services is the impressive progress made in reducing the federal budget deficit. After excessive growth in government spending over the prior ten years, the debt ceiling agreement reached between House Speaker John Boehner and President Obama in 2011 capped spending and created this year’s budget sequester. This has resulted in federal budget declines over the past two years totaling $150 billion, which represents the first back-to-back declines since the Korean War. When combined with increasing tax revenues brought about by economic growth, this reduction in spending has significantly reduced the budget deficit. The past fiscal year budget deficit of approximately $640 billion is less than half of the nearly $1.5 trillion deficit reached in 2009 (See Chart 1), which was an unsustainable 10.2% of GDP. While this deficit is still too large, further reductions to $450-$500 billion are expected in 2014 based on continued tax revenue growth and the spending restraints hammered out in what seems to be an endless grind of political bickering, threats, and eventual compromise. At less than 3% of GDP, this level of deficit spending would be much more manageable and could lessen the pressure to raise taxes that could hamper further economic growth.
Interest Rates Rise as Markets Anticipate Fed Taper Since the end of 2008, the Federal Reserve has instituted various bond buying programs (quantitative easing) in an effort to expand the monetary base and improve economic growth. While this has had little impact on economic growth, it has artificially lowered interest rates which has helped borrowers to the detriment of savers. The current level of Fed asset purchases is unsustainable and anticipation of tapering this program has led to a sharp rise in interest rates this year (see Chart 2). The yield on the 10-year U.S. Treasury Note began the year at 1.75% and rose to nearly 3.0% in early September as speculation and commentary about the timing of tapering intensified. Surprisingly, the Fed then delayed tapering on the grounds that economic recovery has not yet proven strong enough, causing interest rates to back off to the current level of 2.61% which is still up nearly +1% from the beginning of the year. This increase in interest rates has had a negative impact on bond returns with the Citigroup Broad Bond Index down nearly -2.0% year-to-date. We believe that interest rates will continue to rise as the Fed eventually begins to unwind its low interest rate policies. We
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recommend that investors maintain defensive bond portfolios with relatively short durations. Chart 2: Interest Rates Beginning to Rise.
Equity Valuations Rise But Remain Attractive for Long-Term Investors Investors have become less sensitive to the constant noise from Washington and more confident in the durability of the economic recovery and continued growth in corporate profits. This has resulted in a moderate rise in valuations (See Chart 3), as stock prices have increased faster than earnings. However, valuations are still attractive with the price/earnings (P/E) ratio of the S&P 500 Index at 14.2x 2014 estimated earnings per share of $118, which is below the long-term average of about 15x. With solid balance sheets, continued profit growth and low interest rates, stocks remain attractive for long-term investors. We continue to recommend equity allocations near the middle of one’s appropriate range. Chart 3: Stock Valuations Still Attractive.
In accordance with SEC Rule 204-3(b), our Form ADV is available upon request. Please call or write to Susan C. Beaver, North Star Asset Management, Inc, 59 Racine St., Suite A, Menasha, WI 54952
59 Racine Street, Suite A, Menasha, WI 54952 fax: (920) 729-7904 website: www.northstarinvestments.com
