Market Commentary

by David C. Blough, Senior Vice President, Investment Management

Election Season

The elections are now over and the next three or four months should be very interesting and important. Much has been said about the “fiscal cliff” our country faces come January 1, 2013. Unless a political compromise is reached by year end the “Bush tax cuts”, that have been in effect for nearly ten years, will expire. That will have significant effects on the U.S. economy, since marginal tax rates will jump for most Americans. Also, today’s low maximum capital gains tax rate of 15% will increase to 20%. Stock dividends will lose their favorable 15% income tax rate and revert back to ordinary income, which for high income investors, could be taxed at nearly 40%! Furthermore, the estate tax exemption, now at $5 million per person, would revert back to just $1 million, if nothing is done. 

Since Congress has not been able to reach a compromise on deficit reduction, sequestration, with its automatic across-the-board spending cuts, will take the place of reasoned agreement. That fact may well prove a key to reaching a compromise, since neither Republicans nor Democrats want cuts in their highest priority programs. In the end, we see a reasoned compromise as the most likely scenario. It is not in either political party’s interest to push the slow growing U.S. economy back into recession. If a political agreement cannot be fashioned in December, it is likely that the current tax laws will be extended to at least the end of 2013’s first quarter, to provide breathing room for the new Congress to work on a solution.

Meanwhile, the U.S. economy seems stuck in first gear, moving slowly forward at a 2% or slower rate of annual growth. 2012 will be the third year in a row of such labored progress. Modest improvement is certainly much better than stagnation or decline.  For those who are unemployed or have homes that are still “underwater”, faster growth can’t come quick enough.

Stocks Climb the “Wall of Worry”

Despite the fiscal cliff and Europe’s ongoing debt problems, stock markets in the U.S. and around the world have rallied strongly year-to-date.  For the nine months ended September 30, 2012, the Standard and Poors’ 500 Stock Index returned 16.4%. The S & P 400 Stock Mid-Cap Index returned 13.8% and the S & P 600 Stock Small-Cap Index 12.4%. International stocks rose nicely, but still lagged their U.S. counterparts. The MSCI EAFE (Europe, Australia and Far East) Index returned 10.1%, while the MSCI Emerging Markets returned 12.0%. Large company U.S. stock prices at quarter-end were only about 6% below their former highs reached in October, 2007. Meanwhile, corporate earnings have exceeded their levels of five years ago, so today’s price-to-earnings ratio is only about 14-15 times. That puts stock valuations slightly below their long term average of about 15 times the latest 12 month earnings. Stocks are an even better value, when compared to competing investments. When stocks hit their peak the first week of October 2007, ten year U.S. Treasury Bonds were yielding nearly 5%.  Today they pay a yield of only 1.75%. With inflation low (CPI up 2% from a year ago) and interest rates languishing near all time lows, stocks are not nearly as risky as many investors perceive. It can be argued that purchasing a “safe” ten-year U.S. Treasury with a 1.75% interest rate (when inflation is likely to average 2% or more), is perhaps even more risky than Blue Chip stocks! Looking at the past 12 years, when bond returns were high and stock returns low, may be as hazardous as driving forward while looking in the rear view mirror.

We continue to favor high-quality large U.S companies over both International and small U.S. stocks. We favor good quality stocks paying a 2% or better dividend yield with decent growth potential. We also like alternative investments such as marketable pipeline MLPs paying nearly 6% dividend yields and diversified REITs with yields approaching 4%. As always, high quality and diversification are key elements in reducing risk and achieving long-term investment success.