Most U.S. stock market indices advanced to record levels during the first quarter of 2013.  The S&P 500 Index set a new record on the final trading day of the quarter, exceeding its previous peak set on October 9, 2007.  This milestone is particularly significant, since the S&P 500 Index represents about 72% of the market value of all publicly traded U.S. companies.  The Dow Jones Industrial Average (30 large blue chip companies) and the Russell 2000 Index (small companies) also reached record levels during the quarter.  The NASDAQ Composite Index closed the quarter 14.3% above its October 2007 peak level of 2859. However, as a reminder of the dangers of speculation, the NASDAQ would need to advance another 54.5% to reach its March 2000 all-time high of 5049. 

The quarter’s performance was also noteworthy because of its magnitude.  The 10.6% first quarter return for the S&P 500 Index exceeded its average yearly return of 9.3% since 1927.  

The table below shows the performance of major market indices for various time periods.

Total Returns: Major Indexes for Periods Ending on March 31, 2013

Stock market performance is extremely sensitive to investors’ collective psychology.   Investor sentiment can vary significantly, ranging from greed to fear.  Strong markets can encourage greed, which can eventually produce bubbles, such as those experienced for technology stocks in the late-1990s and the housing market in the mid-2000s.  The fear factor causes investors to panic and markets to crash.  However, during most periods investor sentiment is more mixed.  Although the investing industry’s most important disclaimer warns investors that “past performance is not a guarantee of future results,” it seems that for most market participants past performance heavily influences investment decisions. 

Considering the tendency of investors to chase performance (or run from bad results), recent market highs have likely encouraged investors to shift money to U.S. stocks from underperforming assets.  In addition, the advance to new highs has been a relatively smooth ride, with the VIX Volatility Index hitting its lowest level since early 2007.  Also, as shown in the previous table, U.S. stocks have significantly repaired their historical track record.  Considering these factors, investors now seem to have a more positive view of stocks as an asset class, especially in contrast to several years ago.

With the U.S. stock and real estate markets rebounding, a significant portion of household wealth (about $16 trillion or the size of national debt) that was lost during the Great Recession has been restored.    Many investors who have deferred major expenditures, such as vehicles, homes, and vacations, will begin to spend more freely.  The increase in the stock market, especially if sustained, is likely to have a positive impact on economic growth.

The strong performance of U.S. stocks has occurred in the face of a fairly long list of negative headlines.  While a crisis has been averted regarding U.S. budget and debt issues, these matters remain largely unresolved.  The expiration of the payroll tax cuts this past January and higher gasoline prices could have a negative impact on U.S. consumers.  Europe is still mired in a prolonged recession, with continuing concerns over sovereign debt and political turmoil.  The recent problems in the Cyprus banking sector have investors worried about the financial strength of other European banks. Nuclear threats from North Korea and Iran have added to global political instability. 

Offsetting the bad news are generally positive trends for the U.S. economy.  According to a recent Wall Street Journal survey of economists, GDP is expected to grow by 2.3% in 2013 (steady but not spectacular).  The unemployment rate has declined to 7.7%, its lowest level since December 2008.  Housing starts are at their highest point in 4 ½ years.  The banking industry is well capitalized and profits are at their highest level since 2006.  The Federal Reserve is still committed to keeping interest rates low until unemployment declines further.

During the first quarter, interest rates inched up slightly but remained at historical low levels.  The yield on the 10-year Treasury bond ended the quarter at 1.85%, up slightly from 1.76% at the end of 2012.  The Barclays Aggregate Bond Index, the broadest benchmark of the U.S. bond market, generated a small loss of -0.1% for the first quarter of 2013 and a positive return of 3.8% for the past 12 months.  Fixed income investments, especially those with longer maturities, are unattractive due to the current low interest rate environment and the risk from a possible increase in rates over the next several years.  (Morningstar recently reported that they found 300 bond funds that were holding stocks, probably due to higher yields, and lower interest  rate risk).

Despite the general euphoria that comes with reaching new records for the major indices, some caution is warranted for U.S. stocks.  Markets tend to move through various cycles, going from out-of-favor and undervalued, to fairly valued, to overpriced and speculative.  After years of being undervalued due to the market crash in 2008-2009, stock prices now appear to be more fairly priced.  The S&P 500 currently sells at a price which is 14.3 times its estimated earnings and has a dividend yield of 2.2%.  By these metrics, the overall market appears to be appropriately priced, considering that global economic conditions are slowly improving, but significant risks remain.  In other words, longer-term stock performance should be positive, but a correction along the way would not be unexpected.

While international stocks have significantly underperformed U.S. stocks for the past five years (as shown in the previous table) they appear to offer attractive potential for patient investors.  The International Monetary Fund forecasts emerging market economies will grow at rate that is more than double the pace of advanced economies for each year of its forecast period of 2013 through 2017.   By most valuation metrics, international stocks appear cheaper than U.S. companies.  It would not be surprising to see foreign stocks, especially those exposed to fast growing emerging markets, close some of the performance gap over the next year.

Please contact us if you have any questions about the markets or your accounts.

— Tom Franks & Kirk Weiss