Where we stand in 2013: Learning from the past, looking to the future

As we enter 2013, I’m writing to summarize what happened in markets last year and to share my thoughts on positioning portfolios for the year ahead.

The year 2012 saw a continuation of the volatility that’s characterized markets since the global financial crisis, which will be marking its fifth anniversary in September. At the same time, the U.S., Europe, and emerging markets all showed strong gains in the mid-teens, despite concerns about Europe’s finances and worries that the U.S. would fall off the “fiscal cliff” and go back into recession.

Much of 2012’s volatility was driven by the ebb and flow of good and bad news about Europe. Positive indications for Europe’s economy in the first quarter led to the strongest start for markets in recent memory, which was promptly given back as concerns rose in the second quarter. Markets then rallied in the second half of the year when the European Central Bank announced that it would provide liquidity to governments and financial institutions—to the point that for 2012 as a whole, Europe’s stock market actually outperformed the U.S.’s.

The chart below shows returns for the past five years, all in local currency. Note that when including dividends, the United States and emerging markets ended 2012 above their point five years ago, shortly after global markets hit all-time highs in the fall of 2007.

Annual Returns 2008-2012
All in local currency

Year

U.S.

Europe

Emerging
markets

World
markets

2012

16.2%

16.4%

17.2%

16.6%

2011

2.0%

-8.8%

-12.6%

-6.1%

2010

15.5%

7.5%

14.7%

11.1%

2009

27.1%

28.6%

60.6%

30.1%

2008

-37.1%

-38.5%

-45.7%

-39.2%

Average annual return:
5 years*

1.8%

-2.0%

0.3%

-0.8%

Average annual return:
10 years*

7.3%

7.0%

14.9%

7.2%

*Returns to Dec. 31, 2012, including dividends

Source: MSCI.com

Putting big-picture problems in perspective

It’s easy to feel discouraged by all the bad news and problems facing the world. Recently, though, I came across a December 1990 article from the Knight-Ridder newspaper chain that helped provide some interesting perspective on today’s issues.

Here’s what was going on at the end of 1990:

       In August of that year, Iraq invaded Kuwait. It was not until January of 1991 that a coalition of Western and Arab nations led by the United States responded. In the meantime, there was huge uncertainty about what would happen, and oil prices doubled as a result.

       Starting early that year, Western economies went into a significant recession, which hit its peak in the fourth quarter of 1990. In the four months from July to October, the stock market was off 15%—for the year as a whole, the market was down almost 7%.

       In the aftermath of $500 billion in write-offs in the savings-and-loan sector, there was a widespread view that the U.S. was on the threshold of a full-fledged banking crisis. Loan defaults were up and bank profits were down. Some 900 U.S. banks had failed in the past five years, and another 1,000 were on the problem list. In response, banks were cutting back on loans—even to creditworthy borrowers.

Prices of bank stocks such as Citibank and Chase Manhattan Bank dropped by half from July to December. An editorial in Business Week had a typical view: “The banking sector is under enormous strain. Should it begin to unravel, recession could become an economic disaster.”

Of course, we now know that the period that followed saw strong growth in the economy and a buoyant stock market. This is not to suggest that the same will happen today, but we have worked through significant problems before, including the issues in the early 1990s, the shock in oil prices that led to a global recession in the 1970s, and numerous other big-picture challenges.

The outlook for 2013

Even in the face of all the global problems, many analysts entered the new year cautiously optimistic about the outlook for stocks. The reason is not that there is any expectation of an easy resolution to the developed world’s debt woes, unemployment, or slow economic growth; on the contrary, there is universal agreement that it will take years to work through these issues.

The reason for optimism arises from the fact that around the world, companies are generally in very good condition, with strong operating margins and solid balance sheets. An October interview in Barron’s magazine gave a good example of the positive mood on stocks as 45-year industry veteran and former Morgan Stanley strategist Byron Wien explained the reasons for his positive forecast for the U.S.:

       The U.S. housing market has hit bottom and will be a positive force in 2013.

       Growth in the middle class in emerging markets will continue to provide opportunities for investors and for companies selling into those markets. (Wien is especially positive about agricultural commodities.)

       Dramatic new oil discoveries will put a cap on the price of oil and help buoy the U.S. economy.

       Large multinational stocks offer predictable growth, solid balance sheets, and attractive yields at reasonable valuations.

       Even in the face of challenges on budget deficits and debt levels, Wien points to the resilience of the U.S. and its history of repeatedly working through what he refers to as “disasters.”

The other hot topic in markets is the direction for bond prices. There is growing concern among many leading strategists about the prospect for bonds based on current record-low interest rates, despite their “flight to safety” appeal; indeed, a recent New York Times article, “Bond Craze Could Run Its Course in New Year,” pointed to research from Morningstar that bonds have grown from 14% of U.S. investor portfolios five years ago to 26% today. Of note, this is at a time when Warren Buffett in his annual letter to investors last spring said that due to today’s low rates and inflation, “bonds are among the most dangerous of assets.”

What this means for your portfolio

       Taking the right level of risk. My starting point with clients is to identify the rate of return they need in order to achieve their retirement goals and then to construct a portfolio based on that return objective. My goal is to take the right level of risk for each client —enough that we can be fairly confident that over time you will achieve your objectives, without taking more risk than is necessary. For retired clients, I believe in maintaining secure, liquid funds to cover three years of expenses. Having that buffer means we reduce the risk of having to sell holdings at depressed levels.

       Adhering to your plan. Regardless of what happens to markets in the short term, barring a significant change in your circumstances, we should stick to the investment parameters on which we have agreed. Some of you may recall my advice in early 2009, as we faced what appeared to be an end-of-the-world scenario and some stocks hit lows they hadn’t seen in 20 years. At that time, I urged clients to maintain a core level of equity exposure, something that ended up working out well.

In light of stock valuations and the risk in bonds, for some clients earlier in 2012 we increased equity weights to the upper end of their range. Given strong stock performance in the last half of the year, for some clients at the top of their range last spring, we recently rebalanced holdings to bring the equity weight back down within portfolio guidelines. Of course market reversals from current levels are always possible; however, taking a long-term view, at current levels, there is a strong case for stocks over bonds.

       Diversifying portfolios. When building equity portfolios, I’ve always advocated strong diversification outside the U.S. This helped my clients through most of the 2000s, and it hurt them in other periods, such as the 1990s and 2010 and 2011, when the U.S. outperformed.

Going forward, I have no idea whether the dollar and our market will do better or worse than global markets, but I do know that we represent less than half of investing opportunities around the world and we need to stay geographically diversified as a result.

I hope you found this overview helpful. Should you have questions about anything in this note or about any other issue, please feel free to give me or one of the members of my team a call. 

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About billriley

Chief Executive Officer, Chief Compliance Officer A co-founder and shareholder, William Riley is a 33 year industry veteran, who observed, many years ago, that over time institutional investors typically outperform individual investors while accepting less risk. In his role as Chief Executive Officer, Bill works tirelessly to make the wealth management strategies used by the world’s wealthiest families and largest institutions available to our firm’s individual clients. Bill combines fundamental and technical analysis to minimize investment portfolio risk and maximize potential returns. He uses a variety of non-correlated asset classes, including alternative investments, to minimize portfolio volatility and seek absolute returns in down or flat markets. Finally, Bill believes in a comprehensive approach to wealth management that fully coordinates and seamlessly integrates portfolio management, risk management and asset protection, trust, estate, tax and charitable planning. Prior to co-founding Riley Wealth Management ,LLC, Bill held management positions at Merrill Lynch, UBS, Raymond James, Paine Webber and J.C. Bradford. Bill founded Fort Worth branches for Raymond James and J.C. Bradford. Prior to entering the financial services industry, Bill ran his families closely held businesses. Bill’s experience operating family businesses combined with his wealth management experience makes him uniquely qualified to advise entrepreneurs and business owners on a variety of matters including complex and sensitive issues relating to business succession. Bill’s degrees and designations included a Masters Degree in Business Administration (MBA), the Chartered Financial Consultant designation (ChFC), the Chartered Life Underwriter designation (CLU) and the Wealth Management Specialist designation (WMS). A Fort Worth native, Bill is a TCU alum and active in many civic and charitable organizations. Bill and his wife, Marsha, now reside in Colleyville, and they have four grown children and four grandchildren. When he is not working on portfolios or studying financial markets, Bill can be found on the golf courses of Ridglea Country Club.
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