Investment Review and Outlook

Spring 2013

U.S. stocks posted a robust 10.6% gain in the first quarter, beating both developed international stocks and emerging-markets stocks. Meanwhile, bonds were nearly flat.

Our actively-managed bond funds continued to add value relative to the core bond index.

Most parts of the bond market offer paltry longer-term return potential, particularly given our expectation for rising rates over the next five-years. We continue to favor actively-managed bond funds.

Supported by an accommodative Federal Reserve, U.S. economic fundamentals have continued to grudgingly improve. Unemployment is slowly falling, home prices have been rising, and corporate earnings and profitability are at near record highs. Fed actions have also continued to support—and drive—strong U.S. stock market gains.

 

Investment Review and Outlook

With U.S. stocks hitting new highs, many investors wonder if the market has reached a peak, or if there is still further to go.

There is an unusually wide range of possible outcomes for economic fundamentals and hence market performance. This includes some positive scenarios for U.S. stocks, as well as some severely negative outcomes, as the U.S. and the entire global economy works through the aftermath of the financial and debt crisis of 2008. Diversification is the prudent thing to do in an environment this uncertain.

Benchmark Funds	Q1 2013	12 Months Ending 3/31/2013
U.S. Large Cap Vanguard 500 Index Fund	+10.6%	+13.8%
U.S. Large Cap Value iShares Russell 1000 Value Index	+12.2%	+18.5%
U.S. Small Cap iShares Russell 2000 Index	+12.4%	+16.4%
U.S. Small Cap Value iShares Russell 2000 Value Index	+11.6%	+18.0%
International Vanguard Total International Stock Index Fund	+2.9%	+8.5%
Emerging Markets Vanguard MSCI Emerging Markets ETF	-2.6%	+1.6%
U.S. REITs Vanguard REIT ETF	+8.1%	+14.9%
Investment-Grade Bonds iShares Core Total U.S. Bond Market ETF	-0.1%	+3.7%

The Environment: Policy Uncertainty and Modestly Improving Economic Fundamentals

A major contributor to today’s uncertainty surrounds government policy, both fiscal and monetary. Specifically, what policies will be adopted, and what will be their ultimate economic and financial market impacts?

With respect to fiscal policy, in the first quarter the markets digested the sequester’s spending cuts without much drama. But the sequester’s impact (estimated at approximately a 0.6% hit to GDP growth in 2013) is small potatoes compared to the debt and fiscal policy challenges that still confront the nation. Although we would agree that there is not an immediate federal budget deficit crisis, and that there is a real risk of snuffing out a weak economic recovery with too much near-term fiscal austerity, there is clearly a short-term debt/deficit crisis, given the mismatch between federal revenue and spending. This calls for a strong and credible longer-term fiscal policy response, and the sooner the better. If our political leaders in Washington start to get the message, that could be a major positive catalyst for both the financial markets and the real economy. On the other hand, it may take a crisis to create the political will necessary to implement meaningful structural fiscal changes.

On the monetary policy side, there is more clarity at least in terms of the policies already in place. The leadership of the Federal Reserve (Chairman Ben Bernanke and Vice Chair Janet Yellen, among others) continue to be very vocal in stating that the Fed is not close to starting to unwind their stimulative policies, which involve purchasing $85 billion per month of Treasury bonds and mortgage-backed securities (quantitative easing) and holding the federal funds rate near zero percent. But there is significant uncertainty as to the medium- to longer-term ramifications of these policies, and whether or not the Fed’s ultimate exit plan will be executed successfully and without collateral damage.

In the meantime, Fed statements and actions continue to be an important support and driver of short-term stock market performance. While central bank actions have always influenced the stock market, the markets appear particularly reliant on ongoing highly-accommodative Fed policy. Over the near term, Fed policy is not likely to become restrictive. So that leg of support to the markets is likely to remain in place. But the uncertainty increases as the time horizon extends.

Supported by accommodative monetary policy, U.S. economic fundamentals have continued to grudgingly improve. The unemployment rate continues to slowly fall, although that’s partly driven by a sharp drop in the labor force participation rate, meaning there are fewer people working or seeking work. The housing market is strengthening, but mortgage lending to households remains tight. Household wealth is growing, driven by stock market and housing price gains—a key goal of the Fed’s quantitative easing program. Finally, corporate earnings and profitability are close to their all-time highs. (It is notable that S&P 500 earnings growth in 2012 was actually slightly negative for the year; the market’s 16% return in 2012 came from stock valuations getting richer, not profit growth.) Finally, the impact of global debt-deleveraging on economic growth and corporate profits remains a concern.

Bond Markets and Our Fixed-Income Positioning

The fixed-income marketplace, particularly the highest-quality parts, continues to offer paltry longer-term returns given our expectation for rising interest rates over a five-year investment horizon. Most areas of the bond market are trading at historically elevated prices, and yield levels are at or near historic lows. What this means for bond-oriented investors is that our balanced portfolios remain heavily underweight to core investment-grade bond funds. In their place we have large allocations to flexible bond funds that we expect to outperform the core bond index (and core bond funds) in the short- to medium-term.

Concluding Comments

Investing is a marathon, not a sprint. The key to success is to maintain discipline. We can analyze the longer term with far greater confidence than the short term. Realizing the stock market’s long-term benefits demands the discipline to ignore inevitable shorter term gyrations that are impossible to predict with consistency. Succumbing to the temptation to jump into “what’s working” based on a recent run of outperformance is a path to disappointment and subpar long-term investment results.

As always, we will continue to work hard to help you achieve your long-term financial goals, taking into account the level of risk you can accept.