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Third Quarter 2013 - Pinnacle Investment Management, Inc.

Third Quarter 2013

October 1, 2013 / Quarterly Newsletters

2013 is shaping up to be a solid year for global equities but a disappointing year for fixed income investments.  US stocks continued their strong performance in the third quarter, with many US equity indexes now up 20% or more since the beginning of the year.   Although most foreign stock indexes lagged the US earlier in the year, they outperformed in the third quarter.  The Japanese market, which has been strong all year, was joined by strong performances of European and other foreign markets.  Even gold and precious metals, which had declined significantly in the first half of the year, rallied. 

Following a jump in May and June, interest rates stabilized in the third quarter, with the yield on the ten year US Treasury bond rising only slightly from 2.5% to 2.6%.  Stable interest rates created a more favorable environment for bonds but unfortunately, many bond indexes are still underwater for the year. 

Returns for key indexes (including dividends) were:

 

1st Quarter

2013

2nd Quarter

2013

3rd Quarter

2013

Nine Months

2013

Dow Jones Industrials

12.0%

2.8%

2.2%

17.6%

S&P 500

10.4%

3.0%

5.3%

19.8%

NASDAQ

8.2%

4.1%

10.8%

24.9%

S&P 400 mid-cap

13.0%

0.6%

7.2%

21.9%

Russell 2000 small-cap

12.0%

2.7%

9.9%

26.4%

Total International, excluding US

2.2%

3.5%

10.3%

8.8%

Dow Jones World Stock

6.3%

1.1%

7.6%

13.1%

Barclays Aggregate Bond  Index

0.1%

2.6%

.6%

-2.0%

 

 

The Federal Reserve’s statements have confused investors and their reactions were unexpected.   The Fed has been buying $85 billion of bonds each month, and has repeatedly stated that they will reduce and eliminate the buying when they believe the economy is well enough to stand on its own.  This is akin to a doctor saying he will release a patient from the hospital when he is stronger.  In May when the Fed said they might begin to reduce purchases in the near future (i.e. release the patient from the hospital), investors took this as bad news.  In September, when the Fed said they were not ready to taper their bond purchases (i.e. not ready to release the patient), investors took that as good news.  Perhaps a psychologist might be able to shed some light on the matter, but the most important thing to remember is that an improving economy will lead the Federal Reserve to begin tapering.  Not only is that good, it is essential!  The Fed cannot continue to buy massive amounts of bonds without significant consequences down the road.  Both the stock market and bond market can continue to post gains even if the Fed reduces bond purchases and interest rates rise at a gradual pace.

Economic and Market Outlook

The US economy continues to grow at a relatively slow pace yet there are risks that even the slow growth may be derailed by imprudent government policy or a dysfunctional Congress unable to resolve US budget and debt ceiling issues.  Additional uncertainty surrounds the Federal Reserve, both in terms of who will be the next Chairman and whether they will begin to reduce and / or eliminate its bond purchase program before inflation or currency losses value.  The impact of the Affordable Healthcare Act (Obamacare) on employment, taxes and government and consumer spending is also unknown. 

US corporate profits are now growing much more slowly than they had over last few years, with US profits now only about 4% ahead of last year.  At the same time US stock valuations are now nearly 20% above their level twelve months ago.   As a result US stocks are not as attractively valued as they were a year ago.  

While risks in the US have grown due to the uncertainty of government actions, the risks of the sovereign debt crisis appear to be receding in Europe – both the financial risks and political risks.  It had not been clear whether the German government would continue to receive public backing in their efforts to provide financial support for other Eurozone countries, but the recent re-election of Chancellor Angela Merkel is a good indication that the German public will follow her lead.  Public protests over austerity measures in Spain, Portugal and Greece have been limited.   That said, unemployment remains alarmingly high in some European countries and an Italian political circus is making even the US Congress look good.   Yet the net result is that European and other foreign stocks are becoming more attractively valued, which suggests it could be an advantageous time to increase international equity allocations.

Although it is reasonable to expect interest rates to rise in the future, bonds should remain a less volatile investment than stocks.   Even if bond returns are expected to be lower in the next ten years, it may not be appropriate to change an overall portfolio allocation, since that would increase the overall volatility of a portfolio. 

The looming tsunami of aging baby boomers     A dysfunctional Congress cannot seem to put partisan politics aside to resolve the budget and the debt ceiling issues.  Unfortunately these issues will seem miniscule compared with the ones the country will face in 25 years unless action is taken soon.  The non-partisan Congressional Budget Office (CBO) is projecting that within 25 years, the US federal debt is likely to grow to 190% of GDP  (compared to 38% in 1999),  the result of massive increases in Social Security and Medicare payments for baby boomers.    This is higher than the debt level of Greece, which now has unemployment in excess of 25%.  The next ten years will be the calm before the storm, but that does not mean we should not address the problem now.   The sooner we start, the less painful the medicine and consequences will be.   

The US energy boom       As the result of innovation and new technologies, US oil and gas producers are extracting more fuels than ever before and, according to the Wall Street Journal, the US is slated to be the world’s top producer of oil and natural gas combined in 2013.   This has decreased US energy imports and helped reduce our trade deficit.  The immense amounts of oil and gas discovered in recent years suggests that the US energy boom could last a long time.


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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