Quarterly Commentary – March 2014

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The first quarter of 2014 has been slightly positive for US Equities. After being flat for the first three weeks of January, the S&P 500 Index took a 5% dip in the last week of January. It has since rebounded and has closed up 1.81% for the year and near an all-time high level. The Dow Jones Industrial Average is down 0.15%. International equities as represented by the MSCI World Ex U.S. Index are up 0.75%. Fixed Income as represented by Barclay’s Aggregate Bond Index did relatively well and returned 1.84% year to date.

Despite markets bouncing around for the first three months of the year, U.S. stocks are hovering near the level at which they started the year. There appears to be a lack of conviction among investors as the current state of affairs is being assessed. The harsh winter has affected the economic data and some of the earnings will most likely be impacted. The question is to what extent the underlying strength in the economy has been masked by this weather. As things thaw however, the U.S. economy is showing signs that the impact was largely weather-related with February reflecting an increase in manufacturing output, retail sales rising and new claims for unemployment falling to the lowest levels in several months. With the transition at the Federal Reserve investors have been trying to get a feel for how much longer rates will be held unchanged. During Janet Yellen’s first meeting as Chairman there was a comment which roiled the treasury markets on speculation that a hike in the Fed Funds rate may come sooner than investors thought. Looking at current rates however they are actually lower across the yield curve relative to the start of the year. The situation with Russia and the Ukraine is a geopolitical risk that has not affected the U.S. nor European equity markets thus far, but certainly has the potential to affect economic growth in Europe through the impact on energy imports. Growth in China and its impact on the global economy has also been a concern. China has experienced double digit growth rates in decades past with those growth rates falling to high single digits. It is expected that under such scenarios they would face the outcome of over expansion in real estate, and over expansion in a number of areas including credit issuance and have to adjust to a new reality. On the plus side, China has the wealth and ability to deal with some of its problems with a fair level of control over its economy. They are implementing a wide range of reforms that make this part of the emerging market segment attractively valued.

While U.S. equity valuations are not as attractive as we saw them last year, they are still attractive and despite the run up we’ve had, not considered at over valuated levels by historical standards. The main concern about earnings has been the degree to which the growth in earnings has outpaced revenue growth since the recovery bringing into question the continued sustainability of future earnings growth. This is a particular concern if one believes this has primarily been from the impact of cost cutting since there is a limit to the ability to continue to cut costs. Although no one can deny the impact of cost cutting on the bottom line during hard times, a major factor in the growth in earnings outpacing is operating leverage. Businesses in the U.S. are typically capital intensive. Large investments in technology and machinery allows companies to do more with fewer people. This approach has a tendency to raise the fixed costs of doing business. Maintaining the equipment and servicing the debt for example are costs that cannot be adjusted downward during hard times, whereas a business model that is more reliant on labor can typically adjust their labor force through layoffs. Heavy machinery cannot be laid off. It is important to recognize that when business conditions improve and additional revenue comes in above the ability to cover these costs, the bottom line can grow very quickly and at a much faster rate than revenues. The reverse was also true on the downside when a revenue drop caused a much larger drop to the bottom line. The silver lining here is that as the economic situation continues to ameliorate, incremental revenue increases will have a magnified impact on the bottom line and the pace of earnings growth being greater than revenue growth would be more sustainable.

Overall, the bull market is still on. We cannot rule out a near term pullback, but these can be healthy and are not unusual after such run ups. The economy continues to be on the right track. We remain optimistic with a hint of caution. We are thankful for the opportunity to serve you.