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First Quarter 2013 - Pinnacle Investment Management, Inc.

First Quarter 2013

April 1, 2013 / Quarterly Newsletters

The US stock market continued its climb to record heights

The Dow Jones Industrials and Standard and Poor’s 500 index turned in double digit gains for the first quarter.  However stocks in most global markets   lagged the US by a significant degree. The S&P 500 has now gained over 150% since its March 9, 2009 financial crisis low.

Stocks overcame concerns about US tax increases, the US budget sequester and the European sovereign debt crises which now envelopes Cyprus.  Indeed, these concerns seemed to propel the market even higher.

The US stock market outperformed almost every other global market by a wide margin.  One exception was the Japanese Nikkei index which gained over 18% in local currency, but only 10.8% when valued in US dollars.

The US dollar strengthened against most major currencies as investors sought the relative safety of the US compared to Europe.  As a result, the US market did even better on a relative basis when returns from the foreign markets were translated to US dollars.  In contrast to the double digit returns of the US, the total international stock market excluding the US returned only 2.2% in US dollars.

Both the recovering economy and “quantitative easing” (“QE”) contributed to the 150% gain in the S&P 500 since 2009. The US economy has continued to grow as a result of the resilience and innovation of American businesses and entrepreneurs and in spite of governmental fiscal, monetary and regulatory policies.  New technologies are revolutionizing oil and gas production and other technologies have spread the use of smart phones, tablets and 3D printing.  Quantitative easing by central banks increased global liquidity, lowered interest rates, and made stocks much more attractive compared to bonds.

Interest rates remained at very low levels.  The yield on the ten year US Treasury bond rose slightly from 1.78% to 1.87% and the combination of low but rising rates, resulted in low bond returns and the Barclays Aggregate US Bond Index was slightly negative for the quarter.

Returns for key indexes (including dividends) were:

First Quarter 2013
Dow Jones Industrials 12.0%
S&P 500 10.6%
S&P 400 mid-cap 13.0%
Russell 2000 small-cap 12.0%
Total International, excluding U.S. 2.2%
Dow Jones World Stock 2.7%
Barclays Aggregate Bond Index -0.1%

Economic and Market Outlook

“The trend is your friend” is an old Wall Street maxim implying the gains in the stock market are likely to continue. Of course market advances do not occur without a few bumps and interruptions, including two corrections in 2012. There was nearly a 10% drop last spring and a 7% decline in the fall, but the market recovered quickly after each.

It’s estimated that investors have pulled $600 billion out of the stock market during the past five years.  Most of these funds still remain on the sideline waiting to be reinvested.  Once they are, it will provide an additional boost to the market.   The number of companies announcing stock buy-backs and cash take-over’s has been increasing.  This leads to a reduction in the number of shares for investors to purchases and potentially higher prices.

According to the “January Barometer”, January is a good indicator for the remaining eleven months of the year.  Since 1950 there have been 19 January’s with positive returns, and in 18 of those cases the S&P 500 was higher, with an average gain of over 14% during the remainder of the year.  Although the S&P 500 is up 5% since January, that still leaves room for further market advances before it reaches the 14% average gain it has achieved in the past.

By many measures US stocks are reasonably valued and European stocks are even more attractively priced.

Yields on bonds are near historic lows so investors should invest cautiously in bonds, since they will lose value when rates inevitably rise.

The attractive investment climate is mitigated by concerns of the possibility of governmental policy errors.  The Europeans have so far managed to avoid significant mis-steps while navigating their sovereign debt crises, but they are not out of the woods yet and face difficult choices.  Unemployment is 25% in Greece and Spain and 17% in Portugal.  These high levels of unemployment could fragment the Eurozone and result in counter productive government policies.

The US Federal Reserve has painted itself into a corner by aggressively using quantitative easing (QE) and low interest rates to spur economic activity at a time when the US is running a very sizable budget deficit.  If they allow interest rates to rise, it will result in a significant burden to the US budget as interest costs increase.  If they do not allow interest rates to rise, it will likely result in inflationary pressures.  Not only does the US face difficult decisions relating to monetary policy, Congress has made no progress in addressing the US budget deficit.

Balancing the positive investment environment with uncertainties mentioned above, we advocate a cautious investment strategy emphasizing high quality US investments, while reducing exposure to US Treasury bonds, and preparing for either very slow economic growth or rising inflation.  Since European stocks are attractively valued, they should perform well once the uncertainty regarding the sovereign debt is resolved, whenever that may occur.

Marty Zweig, a highly respected market guru, recently passed away.  He was noted for his book Winning on Wall Street, as well as for his prescient prediction of the 1987 stock market crash, when the Down Jones Industrial Average lost 29% in one day.  Marty was also a mutual fund manager who established his fund in October of 1986.  In spite of his correct call in 1987, his fund only returned an average of 6.8% (based on net asset value) from its founding until January 31, 2013 compared to 9.8% for the S&P 500.  Instead of trying to time the market, Marty (and other investors) could have chosen a lower risk portfolio.  For example, a portfolio allocated 30% to stocks in the S&P 500 and 70% to bonds would have achieved a 7.9% return during the same time, with much less effort, less worrying and lower taxes than trying to “time” the market.  If you are tempted to “time” the market in the future, think of Marty Zweig’s experience and instead focus on developing and maintaining a diversified portfolio with an allocation suited to your risk tolerance.

The impact of higher taxes on economic growth

Many states, especially those in the Northeast and California have chosen to raise taxes as a means of closing their budget deficit.  So far this approach has not been productive as business and individuals choose to relocate to sections of the country with more attractive economic policies.  Last year some of the fastest growing metropolitan areas were Austin, Las Vegas, Orlando, Charlotte, Phoenix, Houston, San Antonio and Dallas, where tax rates are low.  Those that lost the most population include Cleveland, Detroit, Providence, Buffalo and Rochester, where tax rates are higher.

This letter is for general informational purposes only and not specific advice for any one individual or situation. Future results may differ from past performance. Different investments and/or investment strategies involve varying degrees of risk, and there can be no assurance that any specific investment or investment strategy, including the suggestions in this letter will be either suitable or profitable for an individual.  Our firm and/or individuals within the firm may have an ownership in one or more of the investments discussed.

About the author

Pinnacle Investment Management: Pinnacle Investment Management, Inc. is a comprehensive investment management and financial planning firm committed to the financial future of our clients.

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