2012 Fourth Quarter
Last year was a strong year for our stock and bond funds. And who would have thought that at the beginning of 2012? Our concern at that point was for the European Union and the countries that were going to be booted from the E.U. within the first few months of the year. In 2011 we witnessed the credit downgrade of U.S. debt which, ironically, led to a bigger demand of that very same debt (U.S. treasuries) worldwide. We were expecting that debt to make up a bigger portion of the front pages around the country in 2012; although, we also realized it was an election year and our fine friends running the country in the District of Columbia normally like to be a bit more on the voter-friendly side of things during presidential elections. Ever since 2008 we knew that corporations slashed expenses and we knew that they were skittish due to the large amounts of cash sitting on the sidelines, but we also knew that they were not willing to invest this money until they had a better feeling for what was going to take place at the end of the year. After all, unless Congress and President Obama came to some agreement, we were facing huge increases in tax rates and steep cuts in government spending that many economists estimated would have shaved three points off our meager two-percent growth rate and would have thrown us right back into a recession - albeit a shallow recession. The "fiscal cliff" was something that had to be reckoned with at some point down the line - whether it was at midnight on December 31st, 2012 or at some point in 2013.
As you all know, Senator McConnell did some last minute negotiating with Vice President Biden and Congress and President Obama eventually agreed to keep tax rates the same for all but the top 1% of the United States taxpayers. This agreement also postponed the January 1st automatic spending cuts, also known as the sequester, for two months. I believe that the spending cuts will be a much more difficult and divisive issue than the tax rate portion of the agreement. With the sequester deadline approaching next month and the debt ceiling debate (think summer of 2011) taking place in March, I believe the next couple of months could be very volatile for the stock markets in which we invest our hard-earned savings. As long as you are comfortable with your current allocation of stocks-to-bonds, I am advising to stay the course.
As I mentioned above, 2012 was a good year for our stock and bond mutual funds. Our large-cap stock benchmark, the S&P 500, rallied 16% while the small-cap benchmark, the Russell 2000, was up 16.35%. Foreign stocks, as measured by the MSCI EAFE index, were up 17.32%. The Barclays Aggregate Bond index was up 4.22%. As I touched on in my last quarter-end letter, through 09/30/12 the S&P 500 returned an average of 5.3% over the past five years. If you exclude Apple, the S&P 500 is only up 1.5% on average over the past five years! Nevertheless, it was an amazing year and while we never know what the short-term will bring - especially considering the government deadlines in February and March of 2013 - I am optimistic that the stock market will be able to produce mid to high single digit average-annual returns over the next ten years.
Where does that optimism come from? First, please study the enclosed Selected Funds piece showing the "Worst 10 Year Periods for the Market Since 1928 with Subsequent 10 Year Returns" chart at the bottom of the page. I believe this chart speaks for itself.
Moreover, according to the October 12, 2012 Primecap Management Company's advisor report (the Primecap team runs Vanguard Primecap Core fund among other funds we use), 46% of the S&P 500 revenues in 2011 came from outside the United States. They continue with their letter stating: "Prospects for international growth are particularly attractive for companies in the information technology, health care, and industrials sectors." They also believe that innovation in the information technology and health care sectors over the next few years is not being accounted for in current income expectations. I've read several comments from fund managers that high quality balance sheets are not receiving respect right now because it is so cheap for corporations to borrow money with the Federal Reserve holding interest rates down. As it becomes more expensive to finance corporate improvements and expenditures going forward, the firms that paid down their debt in the low interest rate environment, thus having the stronger balance sheets, will look better in investors' eyes. Their stock prices should begin to receive the respect that they have so far been denied. By the way, all of the managed mutual funds within our portfolios focus on companies that have strong balance sheets.