Summary and Outlook

The growth rate of the US economy and corporate earnings declined in 2012, as consumers’ continue to battle low income growth and high debt levels. At 63%, workforce participation is at its lowest level since 1979, and four years into the recovery, short term indicators remain weak. Implementation of the tax increases and spending cuts promulgated by our “Fiscal Cliff” are expected to reduce GDP growth between 1.5% and 2% this year.

Monetary policy has transitioned from accommodative to expansionary, and we expect the Fed to continue monetary expansion until bank lending accelerates, or the economy demonstrates the ability to sustain a growth rate of at least 3%.

Throughout the world developed economies are confronted by economic weakness and are taking extraordinary measures to stimulate growth. Cypress was forced to confiscate customer deposits to fund the down payment required for an ECB bailout, setting a dire precedent and a bleak reminder of the Euro-zone crisis. New leadership in China will likely result in more market based reforms in an effort to boost domestic consumption and reduce their reliance on exports.

US diplomats and the Obama administration are working to reduce pressures building in the Middle East relating to Iran’s nuclear efforts and to diffuse tension and threats in the Pacific region emanating from North Korea.

Stock prices have set records this year as investors poured into equity funds during the first quarter, yet trading volumes receded as the quarter advanced and recent volatility is exposing a lack of conviction in the market. We expect the growth rate in corporate earnings to decline further this year, and are wary of the negative implications that higher interest rates will have on PE ratios. Furthermore, if politicians fail to approve policies that will stimulate spending and investment, our economy will continue to languish and financial markets may eventually riot, forcing action. There is plenty of room for positive surprise in our cautious outlook and we certainly hope to be surprised in the months ahead!

Economic Growth (Real GDP)

On balance our economy expanded at a 1.75% clip during the final two quarters of 2012 rate and for the year was up 2.2% compared to 2011. Consumer spending, which traditionally contributes in excess of 60% of total GDP growth, was limited to 1.6% last year as households continued to use excess cash flow to reduce debt levels. The Fed induced low interest rate environment combined with the liquidity generated by their monthly purchase of $40 billion in mortgages has provided the support required to lift the housing market solidly out of crisis. Growth in residential construction averaged 15% throughout 2012 the strongest performance of any sector. Business capital spending grew at a modest rate of 4.5% for the year. The most recent senior loan officer survey supports these numbers. Banks are experiencing strong demand for mortgage loans and very modest growth in demand for commercial and industrial credit.

Corporate earnings increased by approximately $15 billion, or 6.8% in 2012, compared to 7.7% growth in 2011. Non-financial corporations contributed $12 billion and financial corporation’s $43 billion. During the final quarter of 2012 financial profits declined by $3.5 billion, compared to a $24.8 billion increase in profits for non-financial profits. Productivity gains, more than offset price declines and resulted in expansion of profit margins during the fourth quarter

Short term economic indicators reflect mild expansion in our economy, yet capacity utilization is still below 80%, unemployment is 7.6% and there are a large number of people that have simply given up and removed themselves from the workforce. Participation in the US workforce is at a 63% level, the lowest since 1979. Assuming population growth of 1% and 2% inflation we must grow our economy at a rate in excess of to begin increasing employment. Most economists expect economic growth in the 1.5% to 2.5% range this year, well below the growth rate required to expand employment and reduce our deficit.

Monetary Policy, Inflation, & Interest Rates

In December the Fed transitioned from an accommodative policy stance whereby long term bond purchases were being offset by the sale of short term bonds to an expansionary phase, where they commenced purchasing an additional $45 billion of bonds per month without offset. This aggressive policy response has been driven by the addition of the employment mandate to the Fed’s primary responsibility of maintaining monetary stability. In In addition to more than doubling their monthly bond purchases the Fed has increased their inflation target from 2% to 2.5%.

Ben Bernanke was a student of the Great Depression and he recognizes the policy errors that contributed to the severity and duration of the Great Depression. He has made it clear that he favors extraordinary policy actions to circumvent deflation in slack economy. Our global economy with flexible exchange rates today is much more complex that the relatively closed US economy of the 1930’s. Virtually all developed economies have implemented expansive policy actions in an effort to depress their currency boost exports and stimulate economic activity. At the present time the US $ is strong and we are losing the “race to the bottom” of currency valuation. This provides the Fed with additional capacity to expand the monetary base. We expect continued expansionary policy from the Fed until the more traditional mechanism of bank lending begins to contribute to expansion of the monetary base, or until real GDP growth increases to at least 3% for an extended period of time.

A persistent modest decline in imported energy and other import prices together with slack in our economy resulted in inflation containment during 2012. Both nominal and core inflation rates for the twelve months ended February were 2% running at 2%. Fracking for oil and gas has resulted in a renewed supply of domestic crude oil and natural gas and this will keep a lid on imported petroleum prices. The risk of inflation remains intact, though with the greatest threat relating to government efforts to “monetize” the deficit, versus demand pull inflation supported by job and wage growth.

We expect interest and inflation rates to remain low throughout 2013. As of this writing 90-day Libor is .28%, the ten-year Treasury bond yields 1.78%, 30-year residential mortgage rates are in the 3% range and unregulated middle market, commercial intermediate term financing rates range from 3.7% to 5.5%. Candidates for the next price bubble, or crisis resulting from the sustained low cost of capital include college tuition (student loans), medical expenses (Medicare), US government bonds and real estate. It is worth noting that stock performance in the medical and real estate sectors have lead the market so far this year.

Fiscal Policy

We believe that monetary policy alone will not restore demand within our economy.

“Our federal budget deficit is currently $1.3 trillion and our annual GDP is $15.1 trillion, which translates to a deficit that is equal to 8.61% of our annual economic output. Therefore, reducing the deficit requires: 1) increasing our annual GDP growth to a level greater than 8.61%, 2) reducing the deficit by $785 billion (60%), or 3) some combination of these actions. Another popular GDP target is the 4% real growth rate proclaimed necessary to create job growth, which combined with an inflation rate of 1.7% equates to a GDP target of 5.7%. Either GDP target rate (8.61%, or 5.7%) are well above the current growth rate of 3.6% (1.9% GDP + 1.7% CPI). We must pursue policy measures that will stimulate GDP growth and control spending.”

This statement has appeared in our quarterly commentary for the past 1.25 years. It is remarkable that the pertinent data has not change much during that time, and even more remarkable that our elected officials have failed to take material actions to reduce spending, or stimulate demand. The administration is promulgating Keynesian economic policies that inspire to increase aggregate demand in our economy via increased government spending, versus the supply side policies implemented by the Kennedy and Reagan administrations. We believe that both policies have merit. Keynesian policies will result in short term improvement and help prevent further deterioration, yet the implication of increased government spending is higher taxes and no country has ever taxed its way to prosperity, therefore the favorable effect of Keynesian policies diminish over time. Supply side policies are focused on the long term benefits associated with lower taxation and less regulation, which stimulate corporate earnings, and lead to capital expenditures, growth and an expansion in the tax base via higher employment, a pure capitalistic approach that is painful to implement, yet produces enduring growth.

The results of the “Fiscal Cliff” negotiations to date include:

1. An increase in tax on all working people via a 2% increase in the employee portion of social security tax, and a series of increases applicable to “high income” taxpayers, generally those with earnings in excess of $200,000
2. Arbitrary spending cuts totaling $85 billion.

The “fiscal drag” created by the combination of these factors are expected to reduce GDP growth by 1.5% to 2% this year.

At this time is seems that there will be no end to the dysfunction within our government. Our economy struggles to move forward with the consumer sandwiched between heavy, post crisis debt loads, increasing taxes and no real income growth. The entitlement burden is accelerating as baby-boomers retire, and businesses must compete globally in an environment of increasing regulation. This has resulted in anemic growth, particularly considering we are entering year 4 of a recovery. If the politicos fail to implement policies that will stimulate spending and investment, economic conditions will continue to languish and financial markets will eventually riot, forcing politicians to take action

Geopolitics

China

The presidential succession in China from Hu Jintao to Xi Jinping, which began in November 2012 when Xi assumed the top position of China’s Communist Party, completed in March 2013, when Xi assumed the office of President. Last quarter we noted that, “Since China is a single-party state, and seeks to prevent or repress dissent, it seems that China will act to stimulate its economy to ease the transition and prevent economic problems as Xi takes over.”

Now that economic growth for the first quarter of 2013 has slowed to 7.7%, below expectations of 8.0%, it seems now even more likely that China will take some action to increase its economic activity. For many years, there has been a consensus opinion among economists that China must act to increase its domestic consumption in the next decade for two reasons: first, China is beginning to lose its competitive edge as a low-cost manufacturer against poorer countries as its average wages increase, and second, increased consumption will provide China with a more stable source of economic activity and future growth.

The prior generation of leadership in China, which was led by Hu Jintao and Wen Jiabao, was notable because the entire corps of leaders had backgrounds in engineering. The new generation of leadership, led by President Xi Jinping and Premier Li Keqiang, has a more varied background, with a number of leaders, including Li, having formal schooling in economics. This generation of leaders came of age at the very end of Mao Zedong’s life and their early adult careers were heavily influenced by Deng Xiaoping’s reforms that moved China away from communism and more toward a market economy. As a result, it seems that China is poised to address some of the significant structural risks in its economy, including its dependence on exports, its underdeveloped domestic consumption, and possible over-spending on infrastructure and real estate. If this is the case, our ability to invest and prosper in China could improve significantly over the coming years.

North Korea

North Korea has recently issued a variety of threats against South Korea and the United States, which is the first test of North Korea’s new President Kim Jong-un, who is, at 29 years old, the youngest national leader in the world. Although North Korea is in the habit of periodically throwing diplomatic tantrums, it seems that its actions this time around are of a more pernicious nature. Unlike in times past, North Korea claims to have ended its cease-fire agreement with South Korea, which had stayed in place since the 1953 armistice. It also severed one of its three communications lines with South Korea and closed the Kaesong industrial zone, its factory complex it shares with South Korea.

What makes these events potentially more dangerous than in the past is that new leadership in North Korea could end up leading over the brink rather than to brinksmanship. Jong-un is young enough to be brash and inexperienced enough to have surrounded himself with “true believers” in North Korean military supremacy, so that he may have insulated himself from being talked back to reality, in which case the normal resolution of talks with China, Japan, South Korea, Russia, and the United States would not appeal to Jong-un. The truth about North Korea is that nobody knows the truth, and that any prediction about what might happen is based only on what has happened in the past. We are watching this situation closely.

Europe

During March, Cyprus presented itself as a fresh facet of the European financial crisis, after its largest banks invested heavily in Greek government bonds and were wiped out, leading to capital flight and the need for a bailout by the ECB. The end result of wiping out equity, debt, and large depositors appears to have been taken in stride by the markets, although it seems that this will make the next few moments of crisis in Europe to be even more delicate because of the new risk of depositor flight and repatriation. This is the first time that bank deposits have been used to pay for a bailout, and if American investors have paid little attention to this fact, it seems that European depositors are acutely aware of the implications for their savings, and have probably started actively seeking to protect their money by moving it around to different banks, moving it offshore, and taking it out of the banking system altogether.

United States

Higher taxes were combined with sequester spending cuts during the first quarter, resulting in something similar to the fiscal cliff, although in a two-stage fashion. Predictions of massive job losses in the wake of sequester cuts are likely to be overstated, and we are less anxious about the effect of spending cuts than we are by the prospect of prolonged massive deficit spending and further tax increases in the United States.

Little is said about the likely effects of the tax increases enacted in January 2013 and the mandatory health insurance regulations set to begin in 2014, which we believe may be an important oversight by investors. As of March 31st, the S&P 500 index had a trailing 12-month price-to-earnings (PE) ratio of 16.39 and a forward PE of 14.17, which implies that there is an expectation of 15.7% earnings growth over the next year. This seems overly optimistic in an environment of already-sluggish global growth, combined with tax increases and sequester spending cuts that are expected to reduce growth by about 1.5%.

We maintained portfolio asset allocations near neutral throughout the first quarter.  During March, we increased investment allocations in twelve core holdings and added IPG Photonics (IPGP) as an augment holding in growth portfolios, which increased equity allocations by about 5%.  In income portfolios, we focused on maintaining fixed income holdings.  The dividend yield for our core equity holdings is approximately 3% and we have been able to maintain a yield over 4% in balanced income portfolios.

We enjoyed the market’s advance in the first quarter, but remain cognizant of risks to the global economy.  During March, the European crisis took a turn into uncharted waters as the government of Cyprus seized bank deposits to pay for part of their bailout.  This is the first time that deposits have been used to finance a bailout, and could lead to further instability in Europe.  The sequester spending cuts are either not as big a deal as they were made out to be, or investors expect them to be reinstated at a later date. Nevertheless, the January tax increases and implementation of the March spending cuts are expected to create a 1.5% drag on U.S. economic growth this year, which will lead to volatile economic reports.  Since 2010 stock indices have enjoyed strong performance during the first and fourth quarters and weak performance during the summer and fall months.  Conditions are set for a repeat performance of this pattern this year.

Please contact us if you have questions, or if you would like to discuss investment strategy.

Sincerely,

Daniel A. McAdams
Chief Investment Officer

David S. Hodge, CFA
Security Analyst

During February we sold gold miner Barrick and energy company Apache due to disappointing performance and an uncertain outlook. We bought Omega Healthcare, a REIT focused on nursing homes, and Olin Corporation, a chemical company that also makes Winchester ammunition.  In our augmented holdings, we sold Genworth, booking short term gains, and Darling after a disappointing earnings report at a small loss.  We are maintaining portfolio equity allocations near neutral and working to find suitable income-producing investments for our balanced portfolios.

Ben Bernanke and the Fed are taking extraordinary measures and risks in an effort to stimulate our economy via monetary policy because fiscal policy and regulation are working against the economy at present.  Although necessary, the closing of the federal deficit will be painful, and the combination of tax increases and lower government spending will challenge the economy in the coming months.  We will continue to monitor events closely and remain proactive in managing risk in our client portfolios.

Sincerely,

Daniel A. McAdams
Chief Investment

David S. Hodge, CFA
Officer Security Analyst

We entered the month with equity allocations slightly below neutral levels. Late in the period we added core positions in Eaton Corporation an auto supplier focused on power transmissions and Sturm Ruger a leading firearms manufacturer. Bonds that meet our criteria are once again hard to find and we developed a small ETF portfolio, which includes a price hedge and yields approximately 2.7% to invest excess cash balances.

Negotiations on the spending portion of the Fiscal Cliff will commence soon and we expect some turbulence in February. Partisanship and political posturing for mid-term elections will likely result in implementation of the sequestered spending cuts. The Fed is clearly committed to maintaining liquidity and interest sensitive sectors of our economy including real estate and banking are gaining some traction. Our buy-list has expanded and we are evaluating small cap prospects for investment when fundamental risks subside.

Sincerely,

Daniel A. McAdams
Chief Investment Officer

David S. Hodge, CFA
Security Analyst

In December, the flat return for the S&P 500 TR Index masked significant volatility. Markets weakened during the final quarter of the year as uncertainty related to major economic issues led to emotional trading based upon corporate earnings, economic reports, and media coverage of the “Fiscal Cliff”. The S&P 500 TR returned over 15% during 2012, yet this apparently good year for stocks delivered uneven and inconsistent performance among sectors. Early in the year, we trailed the market because we were underweight banks and large-cap technology issues that performed exceptionally well. Late in the year, we gained against the market as risk aversion increased, ending with a very strong fourth quarter, in which all three of our composites beat their benchmarks.

During December, we bought Aflac, a specialty insurance company, in our core holdings, and established small augmented positions in Genworth and Heckmann. After a long drought, we began to find bond issues that meet our stringent standards during the final days of the year. Portfolio equity allocations are at, or below neutral levels and we will not add to them near term. We do have an active “buy-list” and over time we will invest cash reserves in these stocks, or into bonds that meet our credit criteria.

Our economy is being carried on the back of massive stimulus efforts by the Federal Reserve and our Federal government, which has resulted in improvement in the housing industry and a modest increase in consumer spending. Yet profit growth has stalled, business spending has contracted and hiring plans have been curtailed. Fiscal Cliff, part II, culminating March 2, 2013 requires action on the US debt ceiling and spending cuts. This will result in continued market volatility in the weeks ahead and fourth quarter corporate earnings reports will add to this volatility. Risk levels remain elevated and we will continue to exercise caution and patience.

Sincerely,

Daniel A. McAdams
Chief Investment Officer

David S. Hodge, CFA
Security Analyst