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Potential Flare-Ups – Client Letter by Jeffrey Kleintop – March 5, 2013

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Article by, Jeffrey Keintop

We made it through the predicted Mayan apocalypse and the transition from the fourth “sun” to a fifth. But now scientists are warning that the sun is out to get us. According to NASA, the sun’s current cycle, known as Solar Cycle 24, is expected to reach its peak in early- to mid-2013. Powerful solar flares have begun to have a significant effect on Earth. They can cause long-lasting radiation storms in the atmosphere — disrupting electrical infrastructure and temporarily rendering cell phones useless.

But can they cause stock market pullbacks? The most notable stock market pullbacks of the past two years coincided with spikes in solar activity. In particular, recent stock market pullbacks have coincided with solar flares: August 2011, November 2011, May 2012, and October 2012. However, it was not the consequent electromagnetic storms that disrupted the stock market. Instead, it was flare-ups of a different sort: the debt ceiling debacle (August 2011), the European financial crisis (November 2011 and May 2012), and the U.S. election and fiscal cliff concerns (October/November 2012).

The potential flare-ups we are monitoring this year are:

  • §  European crisis: The scandal in Spain plaguing Prime Minister Mariano Rajoy, the deadlocked election outcome in Italy that puts economic reforms at risk, and the unwillingness of Germany to approve any more aid ahead of the fall elections in that country all raise risks. It was events in Europe that pulled stocks down 10% or more as measured by the S&P 500 in the spring of each of the past few years, and we are watching things closely for a repeat.
  • §  Spending sequester: The Congressional Budget Office estimates that the fiscal drag from the sequester
    in 2013 would be about $85 billion, or about 0.5% of gross domestic product (GDP). This adds to the roughly 1.5% drag on the economy from the fiscal cliff tax increases that went into place January 1, 2013. That is a materially negative impact for an economy that registered a contraction in the fourth quarter and is on track for only sluggish growth in the current one.
  • §  Government shutdown: The continuing resolution funding the government expires on March 27, 2013 and could prompt a government shutdown (though certain essential components like the armed forces will continue to operate). While tax collections will be reaching their seasonal peak as the April 15 deadline approaches, tax refunds processed by the IRS may take much longer than usual. In 2012, the average tax refund check was nearly $3,000, and refunds totaled hundreds of billions (according to the IRS), which triggered a wave of consumer spending. These processing delays could cause consumer spending to drop and negatively impact stocks in the consumer discretionary sector.
  • §  Debt ceiling: On May 19, 2013, the debt ceiling will be hit and “extraordinary measures” by the Treasury will begin—necessitating a deal to lift the debt ceiling this summer. While the market has become less

sensitive to debt ceiling talks given the ongoing extensions, the stakes are getting higher as little middle ground remains between the parties in Washington.

§ Quantitative easing: The Fed is likely to begin to slow or stop the current bond-buying program, known as quantitative easing (QE), later in 2013 or very early in 2014. These steps toward a return to a more normal monetary environment are likely to lead to higher interest rates and tighter credit conditions for borrowers that can weigh on the stock market. Changes to Fed programs—or even deliberations months ahead of the potential end of a program or start of a new one—have punctuated the volatile moves in the market over the past five years.

Exacerbating these potential flare-ups, currently high energy prices can make the economy and markets more vulnerable to a negative event that drives stocks lower. Every 10 cents gasoline prices rise takes more than $10 billion out of U.S. consumers’ pockets over the course of a year.

However, it is important to note that the potential negative impact of these risks is limited by the fact that they have been known for some time. Though they may contribute to market volatility this year, the forewarning of them makes a bear market unlikely. Bull markets do not tend to end with the S&P 500 stocks valued as low as they are today, which is the lowest price-to-earnings ratio at a bull market peak since World War II. Therefore, based upon these factors, while ups and downs may continue, we believe the bull market is unlikely to be over.

In an up-and-down market environment, investors may seek to benefit from volatility in several ways, including:

  • §  Buying the dips: Buying makes sense in fundamentally improving areas such as housing and manufacturing.
  • §  Seeking yield: Focusing on the yield of an investment rather than solely on price appreciation may potentially enhance total returns.
  • §  Going active: According to our research, using active management rather than passive indexing strategies may enhance returns as active managers tend to outperform their indexes when volatility rises.

    Despite these flare-ups, we believe the sun will still be shining by year end, and stocks and bonds may deliver modest gains for investors in 2013*. As always, if you have questions, I encourage you to contact your advisor.


    Jeffrey Kleintop



The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Standard & Poor’s 500 Index is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results.

Quantitative easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Stock investing involves risk, including the risk of loss.

The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

* Equity market forecast is for the S&P 500 Index and is based upon a low-single-digit earnings growth rate supported by modest share buybacks combined with 2% dividend yields and little change in valuations. Bond market forecast is for the Barclays Aggregate Index and is based upon a less than one percentage point rise in rates, with price declines offset by interest income. Please see our Outlook 2013 publication, published in November 2012, for details about our forecast.

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