America the Beautiful

2Q 2013

With Fourth of July celebrations fresh in our memory, we’ve chosen to utilize one of our nation’s most popular patriotic hymns as the title and theme for our latest quarterly commentary. Originally published as a poem by Katharine Lee Bates in 1895, these descriptive words of a traveling English professor eventually evolved into lyrics. The accompanying tune, composed by church organist and choirmaster Samuel A. Ward, was first combined into song in 1910. Despite a century’s worth of wars and economic cycles, the familiar line “America! America! God shed His grace on thee” still rings true.

Indeed, as we now take the time to review the performance of global financial markets over the past 91 days, it’s clear that U.S.-based stocks maintained an advantage. Even with a roughly 6% decline from the all-time highs of late May, domestic stocks categories appreciated between 2% and 4% for the quarter. Given that June was the first notable down month since October 2012, the year-to-date gains of 12% to 17% are quite impressive, with small and value oriented holdings currently leading the way. The strength in the U.S. market is a continuation of the trend of the past three and a half years as stability and slow, steady economic growth have prevailed.

Returning for a moment to the S&P 500 Index pull-back of roughly 6% that occurred between May 21st and June 24th, we believe it’s important to view any such market event within the proper long-term context. Given the coincident timing of the pull-back relative to the Federal Reserve’s suggestion that an improving economy would eventually lead to a gradual r educ t ion in gov e rnment bond pur cha s e s (quantitative easing or QE), the term “taper tantrum” has been widely utilized by the media. Although the prospect of rising interest rates provided a modest shock to the market, it’s important to remember that pull-backs happen every year, and since 1980 the average magnitude of such intra-year declines is roughly 15%. Looking forward, it would not be a stretch to predict that investors in U.S. stocks may need to brace themselves for a potentially bumpier second half.

The international markets have already provided more historically normal degrees of volatility, making it four years in a row with late spring or early summer turbulence. Although the developed markets within core Europe and Japan have produced respectable mid-single-digit or better returns thus far in 2013, emerging market equities have weakened significantly. With multiple contributing factors, the resurgence of the “risk-off” trade manifest itself with category outflows and a peak-to-trough correction of roughly 18% during the quarter. Ongoing currency fluctuations had a negative impact overall, with the degree of U.S. Dollar strengthening becoming significant in certain key markets such as Brazil, India, and Russia. The near-term persistence of this trend would be a headwind to future gains, but we believe relative valuations and the multiple angles of diversification make ownership of international securities quite attractive.

In reviewing the statements that follow, you may be thrown off by the concept that bonds (a significant building block within virtually every portfolio) have actually lost value year-to-date. This is in stark contrast to the greater-than 6% per year annualized return our clients earned within Fixed Income during 2010-2012, and reflects the rapid rise in longer-term interest rates since early May. That said, we remain proactive with our bond allocations, employing more active management overall and utilizing nontraditional vehicles designed with the flexibility required to navigate an admittedly challenging environment. We are very aware of risk-adjusted returns, especially when stability is the primary purpose for owning bonds. Important to understand is that most bond managers view the world in a similar way, and the concept of being flexible or nimble is as much about reducing downside experiences as it is about creating excess returns.

Beyond the scope of “America the Beautiful”, it’s possible that the popularity of the overweight U.S. stocks idea is nearing an extreme. So should investors expect to be rewarded for investing in popularity? Isn’t it ironic that the most popular asset class is also the one with the highest recent returns? While unpopular moves (like owning foreign securities or sticking with bonds) don’t always pay off immediately, markets have historically rewarded the patient and disciplined.