Stocks advanced strongly in the first quarter of 2013. The US stock market, as represented by the S&P 500 stock index, rose 10% to 1569 from 1426 at end of 2012. This marked an all-time high for the index. The previous high of 1565 was recorded on October 9, 2007. The advance was underpinned by a better than expected economic performance, a relatively benign outcome to the “fiscal cliff” expiration of the Bush-era tax cuts, and a general de-escalation of the fiscal conflict in Washington. The yield on the benchmark ten-year US Treasury note rose 9 basis points (hundredths of a percent) to 1.85% from 1.76% at the end of 2012. Gold fell 5% to $1,596 per ounce from $1,675 per ounce as its safe haven appeal faded, while oil advanced 5% to $97 per barrel from $92 per barrel.
As outlined above, the stock market rose on the shoulders of a better than expected economy, a relatively favorable outcome to the “fiscal cliff”, and de-escalation of the fiscal conflict in Washington. Throughout 2012, we felt investors were too negative on the performance of the US economy. In the first quarter, the strength of the economy became manifest in strong job creation and auto and home sales. The recovery in housing is particularly significant in that it led us into recession and had been a persistent headwind to recovery. It is now contributing positively to the economic recovery. Meanwhile, the “fiscal cliff” at the beginning of the year was resolved with limited damage to investment income. Taxes on capital gains and dividends rose modestly from 15% to 20%, only for those taxpayers earning more than $400,000 per year individually or $450,000 per year jointly. Investors had feared worse. Finally, the conflict between the parties regarding fiscal policy moderated. While the budget “sequester” was allowed to go into effect, there was not a showdown on the debt ceiling, nor was there a government shutdown. This was seen as an improvement over the brinksmanship of 2011 and 2012. The hope is that the relative truce holds throughout 2013 and that politics does not sabotage the markets and economy.
In our view, the market faces three primary risks for the second quarter and the remainder of 2013. First, the economic and financial situation in Europe remains an ever present danger. Much of the continent remains mired in recession, while the banking systems of major economies such as Italy and Spain are highly fragile. This is a combustible mix and can flare at any moment, as the recent crisis in Cyprus illustrates. Europe is America’s number one trading partner and has many financial links to the USA. Any severe duress on the continent could have a significant impact on our markets. Second, having rallied so much off of its low point in November 2012 (a 16% advance), the market may be ahead of itself. While investors had previously underestimated the performance of the economy, we believe this is no longer the case. Telling will be the first quarter earnings reports. Many companies have been guiding their earnings forecasts lower, yet investors to this point have basically ignored them. Finally, while it seems both sides are standing down to some degree, the fiscal showdown in Washington is doing the economy no favors. For example, the “sequester” spending cuts were allowed to go into effect, thus lowering economic growth by up to 0.6%, as per the Congressional Budget Office, in the context of an already tepid global economy. If the political conflict were to re-escalate, the impact on the economy would be even greater, and the market would likely react negatively, as it has previously to political showdowns.
For the remainder of the year, we see the S&P 500 trading in a range from 1450 to 1675. It closed the quarter at 1569. Having already discussed the risks, the primary rationale for the higher end of our range is that while corporate earnings are widely seen growing at a modest single digit pace, the price paid per dollar of earnings tends to increase as a bull market matures. As we are moving into the fifth year of the bull market, such an outcome is a reasonable possibility.
Thank you for trust you have placed in us and your business. As always, do not hesitate to contact us with any questions or concerns.