Market Newsletter 1st Quarter 2013

Happy Spring!

Nature’s shift toward warmer weather and longer days of sunlight are certainly welcome after another long winter. The weather in Cincinnati has been extremely volatile during the past few weeks. One day everyone is outside enjoying 60 degree temperatures and the next day brings snow flurries. This type of volatile temperature change often occurs during the transition from one season to the next.

Like the weather, the financial markets also seem to be more volatile when our economy is transitioning from one growth stage to the next. During the fourth quarter of 2012 (last season), the U.S. economy and our financial markets seemed to pause while Congress and the White House debated the best way to move forward with tax reform and fiscal policy. Most Americans were hoping for a quick answer to these budget questions following the November election. Instead, politicians from both sides dug in their heels and prepared to fight. This delay only heightened the level of fear and uncertainty for consumers, corporate leaders and investors. In this environment, many corporations were unwilling to hire for growth or begin capital improvement projects until they were more confident that our economy was not heading back into another recession.

On the last day of 2012, Congress and the Federal Government finally passed legislation and avoided the threat of a government shut-down due to the lack of a budget agreement. They did not achieve the “grand bargain” that had been discussed, but real progress was made toward deficit reduction. More importantly, by finally reaching a decision Congress was able to remove much of the uncertainty and thereby unleash a new period of growth for our economy (this season).

U.S. Economy and Stock Market Surge Higher

The stock market in the United States sprinted to record highs during the first quarter, with the S&P 500 index gaining 10% for the three month period. Investors started buying stocks in early January after they realized the U.S. had avoided going over the fiscal cliff. Stock buyers became even more confident in March after Federal Reserve Chairman Ben Bernanke reiterated that his “easy money” policies would continue for quite some time.

We do not expect the stock market to continue rising at the same torrid pace, but we do believe additional price gains can be achieved by the end of this year. Under normal conditions, the stock market takes two steps forward and then one step back. The S&P 500 index has not had a 5-10% correction in over six months. We believe there is a very good reason why this type of normal market correction has not yet occurred. Too many investors (and their advisors) had too much money sitting in cash and did not benefit from the 131% gain achieved by the S&P 500 since the market bottomed on March 9, 2009. With the media promoting new record high levels for U.S. stocks, many of these investors (and their advisors) are now convinced that it is a good time to move some of their cash back into stocks. They feel more comfortable investing into the stock market today because of the support provided by improving economic data, low interest rates, stable inflation and reasonable prices relative to the higher level of corporate earnings. However, instead of buying at the top, most of these investors would prefer to “buy the dip”. Over the past several months, whenever the stock market has experienced a 2-3% correction (dip), these investors who missed most of the earlier gains quickly invest some of their cash. We expect this type of investor behavior to continue, which could provide some protection against significant downside price corrections.

Plenty Of Cash To Fuel This Stock Rally

According to the Investment Company Institute, an estimated $227 billion dollars worth of stock funds were sold by investors since the equity market turn around began on March 9, 2009. What did these investors lose by selling? Lipper reported that $10,000 invested into the average stock fund in March 2009 would be worth $25,547 at the end of March 2013. The same amount invested into ultra-safe Treasury bills over the same time period would only be worth $10,040. The disparity of these results seems to have sparked some investors back to life. So far this year, an estimated $63 billion has flowed back into stock funds. However, that is only a small drop in the bucket.

As of the end of the first quarter, there is estimated to be $10.3 trillion sitting in cash, money markets and savings accounts inside the United States, according to J.P. Morgan. Short-term interest rates are still near zero and inflation is averaging 2% per year. That means that this record level of cash assets is currently providing investors with a negative (-2%) real rate of return.

We are convinced that a large portion of these cash assets will gradually be re-allocated into other investments such as dividend paying stocks, higher yielding corporate bonds, commercial and residential real estate or commodities which can provide a higher spendable yield and potentially enough capital appreciation to offset inflation over the longer-term.

Foreign Stock Markets Also Improve – But Gains Are Modest

Foreign stock markets around the world also improved during the first quarter, but their gains were more modest with the International EAFE index gaining 4.4%. While U.S. stock markets hit record highs, this international stock index is still 29% below the peak level it reached back in 2007. This divergence in performance can be attributed to the speed in which the U.S. government and corporate sector responded to the 2008 crisis. Simply put, we addressed the credit issues faster and with more ferocity than the rest of the world. We believe that credit for these bull market gains should be given to the Federal Reserve for quickly bailing out and revamping our nations banking and financial systems. Credit is also due to the Federal Reserve for their decision to pump massive amounts of money into our economy through large scale asset purchase programs known as “quantitative easing.” Foreign political leaders were initially concerned that U.S. easy money policies might ignite global inflation. But now, other Central Bankers including Europe and Japan are following Ben Bernanke’s lead. We expect the foreign banking crisis and debt issues to slowly diminish over the next several years. In the meantime, Europe is mired in a recession and Japan is lowering the value of the yen to promote exports and eliminate deflation. Just like the United States, we expect these foreign stock market prices to move higher 6-9 months before their economies actually improve. Our Portfolio Research Team intends to selectively purchase more foreign stock funds which pay generous dividends and are currently trading at a steep discount to their fair value.

Bond Market Faces Challenges Ahead

Looking ahead, we remain confident in our view that the next ten years of bond market returns will not be as good as the last ten years have been, when the broad bond market returned about 5% per year. It is almost mathematically impossible to replicate those returns because the government bond yields are currently so low. History tells us that the current yield for bonds is one of the best predictors of their future return. So, logically, with yields near historic lows today, investors should have a much lower expectation for bond returns in the years ahead. We are not suggesting that investors abandon a sensible allocation to bonds. Bonds play a very important role in your portfolio by generating a consistent source of spendable income. Bonds also provide the benefit of lowering risk through asset class diversification.

We do want to go on record for trying to set realistic return expectations - when interest rates rise again, most bond prices will decline. The last time this occurred was in 1994, when interest rates spiked up quickly and the broad bond market delivered a negative return of -2.9%.

Money Masters Deliver Strong Quarterly Results

As an independent advisory firm, one of the valuable resources we deliver to our clients is a comprehensive economic and market outlook.. During the past quarter, our Portfolio Research Team correctly identified that mild growth would continue in the United States economy, that interest rates would begin to gradually increase and that U.S. stocks would perform better than foreign markets. We were also able to correctly identify several improving stock sectors including healthcare, real estate, consumer staples and consumer discretionary. Throughout the last quarter, managed portfolios contained an overweight position to large U.S. and international dividend paying stocks in order to provide our clients with additional spendable income while maintaining moderate levels of risk.

In fixed income, we focused the bond allocation upon better performing high yield corporate bonds, real estate investment trusts and mortgage bonds. We also introduced a new Bond Money Master named Mark Egan who runs a bond fund called Scout Unconstrained, which we believe will perform well during a period of gradually rising interest rates.

By diversifying among several proven fund managers (who we call our Money Masters) that specialize in these bond and stock areas, we were able to deliver very strong portfolio results for our clients.

Specific net performance results for each of your Money Masters Investment Portfolios (after the deduction of all fees and expenses) over several time periods are located within the Report Section of the website.

Economic Outlook: 2013

We expect the U.S. economy to grow at a gradual rate of 2-3%, which is better than the 1.7% GDP growth achieved last year. Chairman Bernanke has stated his intention to hold short-term interest rates “exceptionally low” until levels of U.S. employment improve and growth becomes self-sustaining. New home construction and existing home sales have already showed strong signs of improvement due to record low mortgage rates and reasonable prices. Innovative methods of oil and gas drilling, such as fracking, are also beginning to generate sizable increases in our domestic energy production. We expect both of these sectors to generate strong job growth in 2013, allowing our economy to slowly move toward the desired virtuous growth cycle. Headwinds to growth in our economy during 2013 will likely come from the public sector. At this point, it isn't clear how the federal budget sequester, which started on March 1, will play out. The continuing resolution passed by lawmakers to keep the government running through September 30 provides the administration with some spending flexibility, which may help minimize damage to individual programs and the economy overall.

In our view, the global economy remains in reasonably good shape and should be able to achieve our targeted growth rate of 4%. China’s growth slowed down to 7%, but most indicators suggest they have sidestepped a hard landing. New Chinese leaders are currently working on a transition from what has been an export-driven economy to more of a consumer-driven economy, with an emphasis on urbanization. Other emerging markets like India, Brazil and Africa also have a favorable growth outlook. Europe is still mired in a recession and has a long way to go toward promoting a fiscal and banking union. It may take many more years to achieve real progress toward their political integration.

In summary, we are looking for a continuation of slow but steady economic growth throughout 2013. We anticipate that there will be some set backs along the way – but not enough to push the U.S. or global economy back into a recession. High levels of uncertainty have been a key inhibitor to investment spending by global corporations over the past few years. Recently developing clarity should provide more companies with the confidence to begin implementing their strategic growth plans. It may also allow them to make more rational investment decisions about what to do with their mountain of idle cash assets. According to Moody’s, U.S. companies held a record $1.45 trillion in cash at the end of 2012, up 10% from 2011’s level.

Active Asset Allocation Strategy

We plan to maintain our strategy of active asset allocation in order to adjust equity risk exposure or try to take advantage of discounted purchase opportunities. Stock market sectors we are currently researching include energy services, technology and residential real estate construction. We are also spending time with various managers to understand growth prospects in Europe and various emerging markets.

In the fixed income area, we have positioned the bond portfolio to protect against the threat of rising interest rates. At the end of the first quarter, the bond funds selected for our managed portfolio were delivering generous annual yields near 4%.

It is worth noting that during the first three months of 2013, our Portfolio Research Team completed more than 40 meetings or phone calls with our existing fund managers, 20 meetings or phone calls with potential fund managers, and 15 phone calls or conferences regarding the global economy. We devote substantial time and resources toward these research calls and office visits in order to closely track any changes taking place by the Money Masters in their overall investment strategy or economic outlook. These discussions also allow us to affirm our confidence in their ability to deliver consistently superior longer-term performance results.

We believe that obtaining knowledge from our selected Money Masters about current events taking place in the global economy allows us to navigate through these volatile market conditions in the best way possible.

The Importance of Diversification

Virtually every investment has some type of risk associated with it. The stock market rises and falls according to changes in the economic and corporate earnings cycles. An increase or decrease in interest rates will cause a change in the value of bonds. Inflation erodes the purchasing power of money left in a cash savings account. No matter which asset is purchased, risk must be carefully considered.

We believe the key to achieving successful long-term results is to manage the level of risk but still maintain the potential for an adequate return on your investments. As noted earlier, we believe the most effective way we can manage risk is through active asset allocation and broad diversification: spreading your investments among a variety of stocks, bonds, real estate, commodities and cash.

The philosophy behind diversification is really quite simple: “Don’t put all of your eggs in one basket.” Spreading risk among a number of different investment categories, different geographies and different industries can help to offset the loss experienced by any one investment. Likewise, the power of diversification can help smooth your returns over time. As one investment increases, it may help offset the decline in another.

This is exactly what took place within the portfolios during the first quarter. The stronger performance of the U.S. Stock Money Masters was able to offset the less robust performance from Foreign Stock Money Masters like Richard Goa of Matthews China Fund. Looking ahead, we plan to maintain a broadly diversified managed portfolio but we will be ready to buy, sell or trim account positions (as required) in our most diligent effort to successfully deliver consistently superior long-term investment results.

Our goal is to reduce the impact of market fluctuations upon your portfolio, providing a less volatile performance result under various economic conditions. We will strive to provide you with peace of mind despite the various challenges that financial markets, politicians or life in general may send your way.

Thank you for your continued confidence in our firm.

Sincerely,

Daniel C. Kiley, CFP^®
Chief Executive Officer

Important Disclosure: This newsletter contains the current opinion of the author and is subject to change without notice. While we believe the information provided in this newsletter is reliable, we cannot warrant its accuracy and completeness. Statements concerning financial market trends are based on current market conditions, which fluctuate. Actual events may turn out differently than projections delivered in this report. This newsletter has been distributed for informational purposes only and should not be considered as a substitute for personalized investment advice from the author or RCA. It has not been written as a recommendation of any particular security, strategy or investment product.

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or investment strategy will be suitable or otherwise appropriate for your specific investment portfolio. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of extreme market volatility. If you have any questions regarding how any issue discussed in this newsletter may impact your individual situation, please contact RCA at dan.kiley@moneymasters.com.

The Money Masters Stock and Bond Composites reflect performance of the stock mutual funds and fixed income mutual funds managed according to the Money Masters Balanced Plus Strategy. Results provided are gross of all advisory fees and other investment charges. Specific details for these composites are available upon request.