Counterpoint —
A Commentary of Jurika, Mills & Keifer LLC
Second Quarter: April 2013

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The Oasis.

At first blush, 2013 started off as 2012 did, with surprisingly strong returns for U.S. stocks in the first quarter.

A deeper look reveals similarities, but also some important differences between this year and last that provide insight into the relationship between risk and return, and some caution about what to expect going forward.

The Oasis

As Chart I shows below, whereas last year, the first quarter began with general optimism about a global recovery and most risk-oriented asset classes performed well, this year, the quarter started with renewed concerns about Europe and Emerging markets, as well as the prospect for commodities and bonds.

Chart 1

Other than Japan, the U.S. stock market was about the only good game in town, an oasis of hope and opportunity in a desert of low returns. European stocks produced mediocre results, emerging markets were negative, and gold and other commodities were even more-so. Most notably, the traditional safe haven of bonds produced negative returns.

Relative to the rest of the world, the U.S. economy and stock market has a lot going for it, and its performance is to a large extent, a rational result of improving economic fundamentals. But it is also a result of investment dollars flowing uphill in search of return, just as water flows downhill, following the pull of gravity. In a world of challenging economic growth, aggressive monetary policy by the world’s Central Banks, negative real interest rates, and geopolitical turmoil, the U.S. looks better and safer than the rest of the world, and U.S. stocks look more promising than bonds.

These forces explain the flow of investment dollars but do not necessarily reflect sensible or sustainable investment decision-making, especially in weighing the balance between price, actual and perceived risk, and expected return. If anything, the movement of investment capital and narrowing of performance from a relatively broad range of global asset classes to a relatively narrow set of markets and sectors is a red flag. The U.S. stock market cannot continue to do well if all other markets and economies are floundering or failing. Something has to give.

We continue to have a positive view of the U.S. economy and stock market over the long-term, but think that in the near-term, prices and sentiment have moved modestly ahead of fundamentals, especially in certain sectors and in light of overall economic conditions and potential geopolitical risks.

Whereas last year, investors seemed overly preoccupied with headline events like the election and fiscal cliff, and we argued that these fears were being overstated, this year investors have become increasingly inured to them. Crisis fatigue has taken hold: Political dysfunction in Washington and Europe, banking crises in Cyprus, threats of war by North Korea; no worries. For now, these things don’t seem to matter as the stock market moves higher and higher.

It may continue to do so. But to do so in a significant and sustainable way, prices need to be supported by three things: 1) Strong corporate earnings reports for the first quarter, and guidance for the rest of the year; 2) Improving economic fundamentals, not just in the U.S., but in the rest of the world; and 3) a lack of any major geopolitical or other hiccups.

Global Overview:

As a general statement, the U.S. and emerging and developing economies continue to grow and show improvement, while Europe continues to deteriorate. This can be seen in Charts II and III which show the Purchasing Managers Index for Manufacturing and Services for the U.S., China and Europe. A reading above 50 is consistent with economic expansion and a reading below 50 is consistent with economic slowing or contraction.

Chart 2
Chart 3

Most notably, the charts underscore what a mess the Euro zone is in economically. Forced austerity measures, political dysfunction, bad policy and enormous economic and social imbalances have taken their toll. The Euro zone and single currency may hold together, but growth is nowhere to be found and tensions are building within and between countries.

Moreover, human and financial capital continues to flow out of the continent into the U.S. and Asia which offer greater opportunity with less regulation and taxation. We think Europe will get worse before it gets better and the key question is what impact that will have on the U.S. and broader global economy and financial markets.

With respect to the U.S., economic growth has been largely better than expectations, although recent data shows some weakness in manufacturing and services, as well as employment.

Housing remains a bright spot as seen in Chart IV which shows existing and new home sales. Both have recovered nicely from their trough in 2010, but are significantly below pre-crash levels.

Chart 4

Consumer confidence is low, but consumer spending as measured by personal consumption remains modest but steady.

Chart 5

By contrast business investment has been generally weaker. Chart VI shows the growth rate in durable and capital goods orders which has been declining for several years, and recently turned negative. This is most likely because of economic uncertainty, regulation and low returns on new capital investment.

Chart 6

But despite a world seemingly awash in productive capacity, as well as excess savings, plant, equipment, and technology has a freshness date. In a highly competitive global economy, obsolescence pays little respect to depreciation tables. Businesses can only underinvest in plant, equipment, and technology for so long before it starts to take a toll on productivity and competitive advantage.

Another bright spot in the U.S. has been in the energy sector and especially in natural gas. The combination of abundant natural gas reserves, and horizontal drilling and fracking technologies - described by many as the “energy revolution” - has created an investment boom in energy resources, equipment, technology and services.

Over the coming decades, the abundance of cheap energy should give the U.S. economy a significant boost and competitive edge over other major economies including Europe, Japan, and China. Moreover, the U.S. is fast becoming energy independent and one of the world’s largest energy exporters.

Across the Pacific and below the equator, China and most Emerging and Developing markets are doing better, although somewhat below expectations. China, the world’s second largest economy dwarfs all others, and is expected to grow between 7% and 8% according to “official” estimates. One always has to take these estimates with a grain of salt: reported numbers come out the last day of the quarter and are never revised.

In the near-term, there may be more bumps in the road for Asia, including a potential trade war between China and Japan, another bird-flu outbreak, and hostilities on the Korean Peninsula.

Despite these issues, we continue to believe that China and other developing economies will account for the majority of real global GDP growth in the coming years, and that it is important to maintain a meaningful allocation to them. They are well capitalized and have large and growing middle classes with lots of room to grow.

Putting it all together, we continue to see a world with slow growth in the developed world and faster growth in the developing world. Among developed world economies, the U.S. looks the best, and Europe looks the worst. The U.S., Europe and Japan all have Central Banks that are aggressively trying to devalue their currencies to stimulate economic growth and devalue their massive debt loads. The Japanese central bank is the most aggressive of the lot, and the European Central Bank (ECB) is the most reluctant player. At some point the ECB will likely need to go “all-in” like their Japanese counterparts and overcome their fears of inflation. The alternative - austerity - just isn’t working.

In the U.S., we have become accustomed to extraordinary monetary policy and some measure of the current pricing of stocks and bonds is a direct result of this policy. At some point - perhaps in the next year or two - the Federal Reserve will need to signal an end to quantitative easing programs and other extraordinary measures, especially if the economy continues to pick up steam. Although we have confidence The Fed will endeavor to do this in the most graceful and clearly telegraphed way possible, we think it will be hard to do this without some market impact. At the very least, it will involve a repricing of risk premia between stocks and bonds.

Investment Strategy

We think the U.S. economy and stock market are still the best game in town, but also think that at current levels, the U.S. stock market is pricing in a significant rebound in economic activity which may be overly optimistic.

Chart VII shows the actual and projected operating earnings per share of the S&P 500 index, as well as the index itself. Companies now have higher levels of sales and profits than they did before the crash, but corporate profitability rates are at historical peak levels and the rate of growth in earnings and sales has been declining in recent years.

Chart 7

In the wake of the crash, companies were able to boost profits by cutting costs, laying off people, shrinking operations, and restructuring debt. From here on out growth in earnings needs to be driven primarily by increases in sales, something that is likely to be more tied to the health of the overall economy.

Although revenues are only expected to grow 3% next year, projections are for S&P operating earnings to rise 15% from $97 in 2012 to $111.00 after flat growth last year. This suggests that either revenue growth estimates are too low, in which case the economy is doing better than the experts think, or that profit estimates are overstated, in which case the stock market is due for a disappointment.

We will learn a lot in the coming weeks as companies report earnings and give their comments about the U.S. and other economic regions, and their outlook for the rest of the year.

Another near-term concern is the divergence in the financial markets between the U.S. stock market and most everything else.

Money has been flowing from elsewhere in the world to the relative refuge of the U.S. economy and financial markets in search of safety and return.

Within the U.S. financial markets, for the first time in several years, stock mutual funds and ETFs have experienced net inflows of capital, as seen in Chart VIII.

Chart 8

Within the U.S. equity market we have seen important divergences between sectors. Certain sectors of the stock market such as consumer staples, telecommunications services and utilities have become overloved, overowned and overvalued because of their defensive reputation.

Conversely, emerging and developing markets, and sectors like technology and basic materials have been passed by because of their higher perceived economic sensitivity and risk.

The narrowing of the financial markets and divergences among and within them is not a sign of well-being, and these divergences will ultimately correct themselves. If the broader global economy is doing better than expectations, more economically sensitive sectors and emerging/developing markets should start to outperform the defensive sectors.

We currently think the odds favor a modest correction on a fundamental basis, but also know that markets can always swing further than they rationally should, especially when stoked by aggressive monetary policy by Central Banks. Eventually prices have to come back into rational balance with fundamentals, but this can take much longer than you might think it should.

Our job is to take the longer-term view, and from this perspective, as long as Central Banks and Treasuries are intent on devaluing their currencies and their debts, which we think is an inexorable trend, we continue to believe that investors need to own productive and real assets such as stocks, real-estate, and natural resources, and need to have a very different and more guarded view about bonds and cash and the role they play in an investment portfolio.

We also think it is important to be very intentional in positioning client portfolios to benefit from long-term growth trends, while taking steps to mitigate near-term volatility and risk.

With this view, we continue to like the U.S. stock market and are balancing high quality core equity investment strategies that have strong defensive qualities, with specialized managers focused on areas of secular innovation and growth such as biotechnology, technology, media and communications.

We remain cautious about Europe, and European equities, at least until we see more steps by governments or the ECB to stimulate meaningful growth.

And, we continue to overweight our exposure to emerging and developing economies which will likely drive the majority of GDP growth in the coming decade. Relative to the debt-laden developed world, they are in a class by themselves and should do very well over the longer term.

Finally, we are slightly underweight bonds and are focused on “total return” strategies and managers who have broad latitude to invest across the global credit markets, within a conservative risk objective. We have also invested a portion of our bond allocation to “alternative” strategies that include absolute return funds and portfolio hedges. These are designed to produce a higher return than conventional bonds are likely to produce, and to mitigate overall portfolio volatility.

As always, we welcome your questions and comments.

Jurika, Mills & Keifer, LLC
April, 2013

That's All Folks?

Important Disclosures

Opinions expressed are those of Jurika, Mills & Keifer, LLC, and are subject to change.

Investments in securities involve the risk of loss. There can be no assurance that investment strategies referenced will be successful, or that investment objectives will be achieved. Past performance is no guarantee of future results.

This communication is neither an offer to sell nor the solicitation of an offer to buy a security or advisory services, which can only be made by the appropriate offering document.