The stock market’s performance in the fourth quarter of 2012 was driven primarily by politics.  After reaching a five-year high in September, the S&P 500 Index retreated by 7.7% by mid-November.  This decline was largely attributed to President Obama’s reelection.  His proposal for higher taxes on the wealthy was regarded negatively by many market participants.  In addition, the so-called fiscal cliff – the automatic tax increases and spending cuts which were scheduled to take effect at year end if no budget agreement was reached – was coming into focus.  It seemed as if each market move for the last six weeks of the year was linked to news concerning a fiscal cliff deal.  On the second to last trading day the S&P 500 fell 1.1% on news of no progress, then on the last day of the year it rose 1.7% as a deal became likely.

While the fiscal cliff problem has been averted for the time being, probably the most significant benefit in dealing with this issue is that it brought attention to the federal budget deficit and related federal debt problems.   A poll taken in November by the Washington Post-Pew Research Center indicated that 58% of Americans understood the fiscal cliff issue either “very well” or “fairly well.”  The same poll showed that 62% believed that going over the cliff would have a negative effect on the economy.  Bringing this issue to the forefront of the public’s consciousness increases the likelihood that politicians will address the underlying fiscal problems and arrive at a long-term solution.

U.S. gross domestic product (GDP), the sum of all goods and services, is $15.8 trillion.  Of concern to many, GDP is now exceeded by the outstanding debt of the U.S., which is currently $16.4 trillion, or approximately $52,000 per citizen.  The debt has risen sharply as the U.S. government has produced a budget deficit in excess of $1 trillion in each of the past four years.  In the current 2013 fiscal year, the administration is projecting that the federal government will spend $3.8 trillion and collect $2.9 trillion in taxes, which will result in a deficit of $0.9 trillion.  The budget deal which is currently in progress can be considered a step in the right direction, but it is not a complete solution.

Large company stocks, as measured by the S&P 500 Index, produced a slight loss in the fourth quarter, while maintaining most of its strong performance for the full year.  The table below shows the performance of major equity and bond indices for various time periods.

Total Returns: Major Indexes for Periods Ending on December 31, 2012

			Annualized
Index	Sector	Quarter	1-Year	3-Year	5-Year	10-Year
S&P 500	Large US Stocks	-0.4%	16.0%	10.9%	1.7%	7.1%
MSCI EAFE	Large Foreign Stocks	6.2%	13.6%	0.5%	-6.6%	5.4%
Barclays Cap. AGG	US Bond Market	0.2%	4.2%	6.2%	6.0%	5.2%

Looking forward, it seems the most significant risk to global markets is that economic performance is highly dependent on the actions of politicians and bureaucrats.   Decisions and actions regarding monetary, fiscal, and tax policies will have an important influence on future economic growth.  The problems of budget deficits, large sovereign debt balances, high unemployment, and slow economic growth are considerable, but are solvable.

While these issues will take more time to resolve, the U.S. is well positioned to continue its economic recovery.  In the third quarter, U.S. demonstrated relatively strong GDP growth of 3.1%.  In November the unemployment rate declined to 7.7%, its lowest level since December 2008.  In 2012, the housing industry added to GDP growth for the first time since 2005 and further contribution is expected in 2013.  U.S. banks had their most profitable year since 2006.  New sources of domestic oil and natural gas are contributing to economic growth and reducing the trade deficit.  In November, the Chief Economist of the International Energy Agency predicted that the United States would overtake Russia as the leading producer of natural gas by 2015 and would pass Russia and Saudi Arabia to become the world’s largest oil producer by 2017.   Interest rates and inflation remain at levels which support economic growth.  The Federal Reserve’s current actions are intended to keep interest rates low and encourage investors to move money into riskier assets, such as stocks.

U.S. companies experienced modest earnings growth in 2012, as results from European operations detracted from overall performance.  For companies comprising the S&P 500 Index, earnings grew an estimated 3.0% in 2012.  The consensus forecast for 2013 is for roughly 11% earnings growth for the S&P 500 companies as the U.S. economy continues to recover and both Europe and emerging markets show improvement. With S&P 500 companies trading with an average price/earnings ratio of 12.9 on forward earnings and an average yield of 2.3%, stocks appear to be very reasonably valued compared to both historical norms and fixed income investments.

Interest rates remained at historical low levels in the fourth quarter.  The yield on the 10-year Treasury bond ended the year at 1.76%, up slightly from 1.64% the end of September, and down from 1.88% at the beginning of the year.  The Barclays U.S. Aggregate Bond Index, the broadest benchmark of the U.S. bond market, produced total returns of 0.2% for the fourth quarter and 4.2% for all of 2012.  The current low interest rate environment, coupled with the likelihood that rates will eventually increase, makes fixed income investments relatively unattractive.

Last year marked the fourth consecutive year of positive returns for the S&P 500 Index.  In three of those years, total returns exceeded 15%.   While the pain of the 2008-2009 crash still seems fresh, the strong recovery since then clearly demonstrates the merits of adhering to a disciplined investment process and maintaining a long-term perspective.  Considering that stocks are reasonably priced and the economy continues to show signs of improvement, equities appear to offer very attractive return potential going forward.

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

— Tom Franks & Kirk Weiss