The Quarter in Review
Continued economic instability, uncertainty surrounding the outcome of the upcoming Presidential Election, saber‐rattling from Iran, and violence in North Africa are an unlikely recipe for higher stock prices. Yet, these are just some of the headwinds that investors have been facing as the market continues to climb a “wall of worry”. Despite the fact that September is historically the worst month of the year for U.S. stocks, September 2012 provided positive results while many of the indexes hit multi‐year highs. In 3Q 2012, the S&P 500 Index and the Dow Jones Industrial Average gained +6.35% and +5.01%, respectively. The tech‐heavy, and often more volatile, NASDAQ Composite was even better, with a +6.54% return for the quarter. Foreign equities, as measured by the MSCI EAFE Index, performed in‐line with U.S. markets, posting a +6.14% gain. Interest rates gyrated throughout the quarter but finished slightly lower for the three‐month period as fixed income markets produced small gains. The Barclays Intermediate Government/Credit Bond Index and the Barclays 5‐Year Municipal Bond Index gained +1.40% and +1.36%, respectively.
Europe remained a key area of focus throughout the quarter. While the data show that the Eurozone is clearly in recession, the market has increased confidence that the European Central Bank (ECB) is taking the necessary measures to avert crisis. Here in the U.S., our economy continues to grow at a moderate pace, and recently released data offer support for both positive and negative viewpoints as to both its current health and prognosis. Bears will emphasize that GDP growth in 2Q 2012 was revised down from an initial reading of 1.7% to growth of only 1.3%. Further, durable goods orders fell 13.2% in August, the biggest monthly drop since 2009. Bulls will draw attention to the fact that the Conference Board said consumer sentiment soared to 70.2 in September and the Commerce Department reported that median home prices have risen to their highest levels since March 2007.
There is an old adage on Wall Street that says “don’t fight the Fed.” As can be seen in the chart to the right, Federal Open Market Committee (FOMC) announcements regarding monetary policy action have helped boost equity prices. Back in 2009, The FOMC announced a significant program of quantitative easing (QE) ‐ a practice of buying financial assets to inject money into the economy. This initiative, now commonly referred to as “QE1”, was followed by QE2 in August 2010, and “Operation Twist” last October. Twist is best explained as a program designed to lower long term yields by selling short‐term treasuries and buying long‐term instruments. The most recent FOMC actions outline specific commitments to mortgage bond buying intended to put downward pressure on longer‐term interest rates, and a commitment to a zero interest rate policy (ZIRP), ensuring short‐term borrowing rates will remain very accommodative until 2015. Translation: “the Fed” is in the market’s corner for another two years.
Promote the Vote
Much research has been done on stock market returns during certain years of a President’s term, election years, etc. The U.S. has a long list of great Presidents who have served, with incumbent Barack Obama currently being the 44th to hold the office. The election, on November 6th, will be the 57th of its kind. In our country’s great history, we have had twenty‐four Presidents serve one term or less (due to death or assassination), five serve more than one full term (but not two), twelve serve two full terms, and one, Franklin D. Roosevelt, serve three full terms (1933‐1945) before dying just two months into his fourth term. The 22nd Amendment to the U.S. Constitution, ratified in 1951, put in place the current restrictions that limit a President to being elected to no more than two four‐year terms.
A recent article in Forbes, prognosticated that “the outcome of this presidential election, in addition to many of the concurrent congressional races will have a large impact on tax policy, health care reform and federal regulations for months and years to come. This has created a great deal of uncertainty in the mindsets of many small business owners and households across the U.S.” While this may be true, we would prefer to frame today’s events in a historical perspective when determining key investment strategy decisions. Findings from a MFS Investment Management research report entitled, “Primaries, Caucuses, and Elections…Oh My!,” using data from Ned Davis Research, reveal that perhaps the most important factor to stock market performance is not so much who occupies the Oval Office, but which political party is in control of Congress. As can be seen in the table below, the combination that has produced the best results for stocks has been that of a Democratic President and a Republican Congress. We can not predict who will win the U.S. Presidential Election in November, or for that matter, how the balance of power in Congress may change after the ballots are cast, but as of the end of September RealClearPolitics.com is calling for an Obama victory, Republicans to retain control of the House of Representatives, and control of the Senate as “too close to call”.
Despite recent gains, equity investors remain skeptical. Perhaps this is due to the unknowns surrounding the upcoming election, or maybe it is due to the continued concern over the approaching “fiscal cliff”. Expectations for 3Q 2012 earnings are not overly optimistic, with consensus estimates calling for a decline of ‐3% when compared to 3Q 2011. However, Argus Research estimates that total earnings for the S&P 500 Index will be $103.50 this year and $113.50 in 2013. If correct, this represents +10% earnings growth in an economy growing at a meager +2% pace. These estimates also imply stocks are trading at a modest 13x multiple of next year’s earnings, below historical averages. Another encouraging sign for the markets, from a contrarian perspective, is that only 36% of respondents from a recent American Association of Individual Investors (AAII) poll are bullish on the prospect for the stock market. When everyone is bullish, the market is near a top. The average investor is bearish, fundamentals are strong, and valuations are reasonable. This is a favorable combination of factors as we enter the closing months of 2012.