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Share First Quarter Review and Outlook

U.S. stocks posted robust gains in the first quarter, with large caps returning 11 percent, beating both developed international (+4%)  and emerging markets stocks (-4%).  Bonds were lackluster, posting flat total returns as modest coupon interest was offest by a small increase in market interest rates (causing a drop in values). 


In 2012 and early 2013, an accommodative Federal Reserve combined with an improving U.S. economy to push domestic shares higher.  While unemployment is falling only slowly, construction fundamentals have rebounded sharply. Home prices have been rising, and corporate earnings and profitability are near record highs.  This was a good recipe for stocks, but caused a little consternation among bond holders. 


Fixed Income:  We find it hard to define a scenario that is positive for the core taxable bond markets, so we favor corporate credits over government debt.  Municipal bonds have added to their attraction in light of the increases in income tax rates.  Furthermore, state fundamentals continue to improve, notching 11 straight quarters of improving revenue.  A recent uptick in property tax revenue, along with improving housing prices, bodes well for municipalities.


Equity markets are also a mixed bag.  In recent weeks, we have seen a divergence in corporate performance that suggests tougher comparisons to come. While earnings continue to positively "surprise" analysts with better than expected numbers, the top line (revenue) has been less robust. This may not be enough to derail the bull market, but it may cause an uptick in volatility and short term weakness in the coming months.


Have the markets moved too fast?  Yes, but perhaps not totally.  To answer that question, Russell Investments looked at all periods of double-digit first quarter returns going back to 1926.  A solid first quarter usually led to a good finish.  In fact,  final three quarters of those years averaged a 7.6% return.  In only two of fifteen years were the returns actually negative.  In other words, the trend was maintained (but not without volatility along the way.) 


We expect positive returns for the balance of 2013.  We won't get there with significantly higher valuations, however...  According to research from Morningstar, US large cap stocks are priced at 99% of fair value.  Earnings growth will have to power us along to new highs.


International markets:  As Americans, we spend much of our time thinking about the US markets, economy and interest rate environment.  In aggregate, US investors remain deeply underweight foreign shares -- and don't understand the degree of underexposure.  The MSCI All Country World Index has a 9% allocation to emerging markets.  Another 45% of the index is accounted for by "developed" markets of Europe, the Far East and Australia (the so-called EAFE markets). For investors to accurately reflect the opportunities available to them (both foreign and domestic), they would have less than half of their equity portfolios in domestic stocks! The number is closer to 75%.


We don't suggest this course of action, of course, since as domestic investors we spend dollars...  However, we should be aware of the opportunities available.  We should also recognize the diversification and risk reduction from adding foreign assets, both equity and fixed income, are well documented. 


Foreign markets and economies are more important than is commonly understood.  While emerging market account for 9% of global market cap, they more than 38% of the world's economic output (GDP)! Yes, our portfolios remain underweight international markets but his won't always be the case.  We watch this closely.


Raw materials :  Commodity prices (oil, copper, gold, etc.) have come under pressure as global economic growth remains modest.  China has been slowing and Europe has been struggling to right its own ship from debt overhang and austerity measures. The US continues its pattern of self-inflicted pain from political uncertainty and policy irrationality (sequestration). As such, global growth remains an illusive quantity. At the present time, our portfolios have no exposure to direct commodity investments.


In this environment, emerging-markets stocks have suffered.  They are the both commodity oriented (large owners of resources) and export focused.  They are like the world's temporary workers -- the first to be hired back, but often the first to be let go.  Despite growing domestic economies, they still depend to a large degree on foreign buyers for much of their activity.  Over our five-year time horizon, however, we think emerging markets will be an attractive area for portfolio investors.  Unlike domestic stocks, foreign shares appear to be undervalued.


Summary:  We expect hightened market volatility in the coming quarters but see little likelihood of a violent interest rate increase or severe corporate profit dislocations. External shocks, such as further debt crises in Europe are, of course, possible.  But we are somewhat heartened by the fact that valuations are not extreme.  As the graph to the below explains, valuations in this range have been decent, but not outstanding, entry points for US equities.  Stocks have made new highs, but so have earnings.  This doesn't mean we won't take profits or rebalance from time to time. But we feel good enough about current fundamentals to maintain our overall mix of stocks, bonds, alternatives and cash for the present time.