My F&M

Market Commentary 4th Quarter 2012

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2012 delivered better than average stock returns both domestically and internationally along with positive returns from bonds.  Stock returns for 2012 were better than we expected given that each of the elevated risks we have previously identified remain unresolved (Europe’s financial crisis, unsustainable US deficits, Iran’s nuclear threat, Japan’s ticking debt bomb, increasing risk of inflation longer term, etc.).  We’re pleased managed portfolios achieved strong returns in 2012 even as we’ve taken numerous steps to protect portfolios from these risks.

“Fiscal Cliff” drama (and failed opportunities to address long term problems) aside, we do see several positives in the economy:  1) housing is recovering, with prices having risen now for nine months (though housing is a small part of the economy), 2) deleveraging continues and household debt payments are at their lowest in 30 years,  3) corporate profit margins remain high (though longer term, a reversion to the mean will be a negative), 4) US energy production is at its highest in 14 years,  5) US manufacturing is becoming more competitive internationally. On the other hand, the “cliff” deal was essentially all taxes as spending cut decisions were postponed for barely two months, continuing the prospect of policy uncertainty and political risk.   

Longer term, the debt problem remains and it looms much larger than the political will to address it.  It’s likely to result in restrained economic growth for an extended period and, ultimately, in either a bond buyer “strike” (higher interest rates), or inflation (higher interest rates), or all of those together.  The prospect of both anemic growth and, eventually, higher interest rates is not encouraging for longer term investment return prospects.

Compounding that are unappealing valuations offered by traditional assets.  Bond yields are so low that long term bond returns are likely to be in the low single digits.  With a dividend yield on the stock market at just over 2%, long term US stock market returns look likely to be below average – materially more appealing than bond prospects, but still not appealing on a stand-alone basis.  Near term, however, we certainly can’t predict returns, yet we believe the range of possibilities may be wider than may be generally thought.  Given those prospects, we remain focused on very broad diversification and on identifying non-traditional investment opportunities – private real estate (where applicable) and alternative assets.

Alternative assets restrained portfolio returns in 2012, but we’re more interested than ever in both the inflation protection and the stock market volatility protection they can provide.  And given the low expected returns (and associated elevated risks) of bonds today, we’ve put considerable effort of late into finding non-traditional bond opportunities.

As we start the New Year, we’re pleased financial assets provided strong returns in 2012, but we remain mindful that reducing losses is a key to strong long term returns.