Presented by Joe Smalley, Accredited Investment Fiduciary®

U.S. stock markets continue a bull run

March was another excellent month for U.S. markets, with the S&P 500 Index up 3.75 percent and the Dow Jones Industrial Average rising 3.86 percent. The Nasdaq showed slightly lower but still very strong performance, gaining 3.4 percent. For the quarter, the three indices climbed 10.61 percent, 11.93 percent, and 8.21 percent, respectively.

For the second year in a row, the U.S. stock markets started very strongly. Both the Dow and the S&P 500 hit all-time records in the first quarter. Technical factors remain supportive for all three indices, and the record highs indicate no remaining resistance levels to pierce. Fundamental factors, however, are less supportive of continued increases, with earnings growth estimates declining over the quarter, despite surging prices that left valuations higher at quarter-end.

 

International markets performed less well, reflecting ongoing economic and political challenges outside the U.S. The MSCI EAFE Index rose 0.84 percent in March and was up 5.15 percent for the quarter—a respectable showing, especially given the turmoil in Cyprus at month-end. On a price return basis, the MSCI Emerging Markets Index lost 2.09 percent for the month, pulling it into the red for the quarter and leading to a 2.14-percent decline year-to-date. Technically, both indices are showing weakness, having penetrated their 50-day moving averages. Still, the EAFE remains well above its 200-day moving average, though the emerging markets index is approaching its 200-day moving average.

 

Risk outperforms safety in fixed income markets

In the U.S., a positive month for stocks was mirrored by a good month for risky bonds. The Barclays Capital U.S. Corporate High Yield Index returned 1.02 percent in March, making it the best-performing U.S. fixed income sector, while bank loans also performed well. Meanwhile, municipal bonds actually lost a bit of ground, and longer duration bonds underperformed. The Barclays Capital Aggregate Bond Index returned 0.08 percent for the month and declined 0.13 percent for the quarter. March was essentially a continuation of what has occurred during the first quarter as a whole, with investors rotating out of lower risk assets and into yield plays. The one area where risk taking did not pay off was in global and emerging market debt. A stronger dollar was a large contributor to this discrepancy.

Despite increased investor appetite for risk, Treasury and mortgage yields remain at extremely low levels, thanks to monthly Treasury and mortgage purchasing by the Federal Reserve (Fed) of $45 billion and $40 billion, respectively. Fed officials have said that they will not stop the purchases until the unemployment rate declines to 6.5 percent. Given that the rate currently hovers around 7.7 percent, the buying is unlikely to stop anytime soon. Meanwhile, the 10-year Treasury closed the quarter yielding 1.85 percent.

Washington, DC and the dog that did not bark

A positive surprise for the quarter was the lack of damage that the fiscal cliff tax increases did to the economy. Although the increases reduced personal income, consumer spending continued strong, and the economy appeared to remain on track.

Similarly, the sequestration spending cuts that took effect in early March seem to have done little so far to hurt the economy. It is, however, still too early to tell how much growth could be affected by the cuts, as they will be implemented over time. Federal spending comprises from 20 percent to 25 percent of U.S. gross domestic product, and the 2013 cuts amount to roughly 2 percent of government expenditures.

Some progress has even been made by our divided government. Although at the beginning of the year Congress and the White House had appeared set to continue to battle, so far they have agreed to disagree and managed to avoid a government shutdown. The perceived reduction in political risk, combined with continued economic growth, has presented investors with an environment where most major risks seem less serious than a few months ago.

Housing and employment continue to strengthen

Thus far, the reduction in political uncertainty and continued consumer spending appear to be supportive of the real economy. Housing has been another principal driver, as a decline in the supply of homes for sale to historic lows has led to price increases at the national level. The declining supply has also led to higher levels of new home construction, which recently reached a five-year high. In fact, in 2012, for the first time in six years, new home construction added to—rather than subtracted from—economic growth.

The recovery in the housing market has also engendered gains in employment, which has improved significantly. According to Capital Economics, housing construction has accounted for about one-fourth of the new jobs created in the first quarter of 2013. That matters, particularly because many workers hired had been among the long-term unemployed.

Finally, some related effects of new housing construction have included gains in building material production, carpet production, and other sectors that sell into new homes. With housing affordability still at or close to record highs, this should continue to boost the economy going forward.

The rest of the world

The rest of the world still appears subject to significant headwinds. Continued recession in many European economies is depressing expectations, and the uncertainty associated with the rescue of the Cypriot banking system has reinforced the perception that the European crisis is not over. The initial rescue plan, which proposed taxing all existing bank account deposits, including those of small account holders, was rejected by the Cypriot parliament and eventually replaced by one that targeted only large account holders. The possibility that depositors could be subject to such losses rattled financial markets across the eurozone, particularly in the peripheral nations whose economies are already under stress.

Emerging markets have suffered from the slowdown in Europe and also from country-specific issues. These include wage pressure and weak manufacturing in China, inflation in Brazil, and worries about natural gas prices in Russia. Threats from North Korea to attack South Korea and other nations, including the U.S., have been widely publicized as well. Markets seem to believe that this is mere saber-rattling, but the situation on the Korean peninsula should nonetheless be monitored carefully.

U.S. recovery continues but risks remain

The U.S. recovery is broad based, with rising employment, strengthening consumer spending, and a housing recovery that appears driven by fundamentals. At the same time, risks remain—domestically, in the form of a potential breakdown in the current bipartisan cooperation, and globally, as other major world economies struggle to resume growth. In previous years, we have had strong first quarters followed by weak second quarters, and that remains a risk this year.

Although the real economy seems to have a firm foundation, financial markets are becoming less attractively valued. Tailwinds in the form of lower interest rates and company share buybacks have driven markets to new highs but may be less supportive going forward. In addition, technical factors remain solid, but the higher the markets go, the more potential there is for a setback.

Overall, we are in a relatively good place, certainly better than other areas of the world. As such, investors have reasons for optimism, even as they should be mindful of the risks.

 

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities.

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Joe Smalley is a financial advisor located at 2900 West Road, Suite 222, East Lansing, MI 48823.  He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 517-487-4850 or at www.smalleyinvestments.com.

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research associate, at Commonwealth Financial Network.

© 2013 Commonwealth Financial Network®