2012 Third Quarter Commentary: 3rd Quarter Review & What Lies Ahead


Generally, the better the market’s performance has been of late, the less I feel compelled to say in a quarterly commentary. This having been a decent quarter in the markets, and strong year to date, I’ll try to be brief, which I know I am often not.

Here’s a quick chart looking at the performance of various market indexes, both US and abroad for the quarter and year-to-date:

Overall, a very strong showing for both the quarter and year through September across almost all major equity asset classes – both here and abroad.

The Economic Data Underlying the Market’s Performance

There are several reasons why global equity markets performed well this past quarter:

  1. Continuing monetary stimulus (“QE3 / QE-Infinity”) by the Fed;
  2. Progress – however tentative that progress may be – in the Eurozone; and
  3. Continuing fiscal stimulus by many of the emerging market central banks.

That said, the economic data continued to be mixed:

  1. U.S. housing prices appear to have bottomed with signs of a nascent recovery and some reduction in inventories across many regions of the country;
  2. Manufacturing activity appeared to slowdown throughout the summer (although that trend reversed a bit with the release of September data in the first week of October);
  3. Consumer confidence also strengthened during Q3 (and then blew the doors off of anyone’s expectations with numbers just released today, October 12th, as I write this); and yet
  4. Globally, the economic data is very soft, with signs of weakening in many quarters.

Of course, the markets have presumably “priced in” most of that news – good or bad, and all in all, the positive news of the second quarter outweighed the negative, as evidenced by the strong performance of equities worldwide.

What Lies Ahead?

The Election: As always, there are large issues at stake in the upcoming presidential election, in particular: the distribution of the tax burden across various income levels; the amount of income and wealth to be redistributed; the role of the government in shaping health care policy, and disagreement over the best way to tackle a mounting deficit. Many people have strong convictions about how these decisions should be made, usually based on long-held convictions. However, what is not clear (and perhaps surprisingly to many) is the effect that election outcomes may have on domestic stock market performance. For example, several analyses show that, historically, US markets going back to 1900 have performed about 3% per year better under democratic presidents than republican presidents, BUT – and this is just as important – inflation has also been 2.8% per year higher under democratic presidents, bringing the net real (i.e., after-inflation) difference down to a mere 0.2% per year. As interesting as such analyses are, though, keep this in mind: 28 election cycles, even over 112 years, probably does not produce a result that is statistically significant enough from which to draw a meaningful conclusion. So, the bottom line? Don’t bet too many of your chips based on who wins or loses the upcoming election, regardless of your political stripes and how ebullient or distraught you may be over the eventual outcome.

The Fiscal Cliff: Despite the scary use of the word “cliff” in that phrase, the upcoming “fiscal cliff” is in reality more akin to a “fiscal slope” – and a gradual one at that. Were Congress to take no action to extend the Bush tax cuts and come to some agreement on target budget reductions, two things would occur by default: tax rates would revert to the pre-Bush era tax rates that were in place during the 1990s, and automatic federal budget sequestrations (cuts) would kick in starting on the first of the year. Together, these could potentially amount to enough of a hit to economic activity to reduce US GDP by 4% to 5%, which would likely trigger another recession, unless other unforeseen factors were to outweigh these hits to economic activity.

In reality, though, the effects of any such increases to taxes and cuts to spending would almost certainly be felt gradually and cumulatively throughout the year, and not all at once on January 2nd. Because of this, Congress will have time – quite likely after the inauguration – to eventually reach a compromise solution, but the question, of course, is: will they? Winston Churchill famously once said, “Americans can be counted on to do the right thing, after they have exhausted all other possibilities.” I tend to think of Congress in the same way, and unsurprisingly, they lived up to this expectation at the peak of the Fall 2008 credit crisis, when they initially voted down the TARP bill, only to pass it one week later, and then again in the summer of 2011 when they had threatened to allow the US government to technically default on its debt payments over a game of high stakes political chicken. As I write this, this would seem to be the market’s consensus as well, as the looming fiscal “cliff” seems to not be having much effect thus far on the market’s performance of late. (This is not to say that markets won’t get roiled eventually in anticipation of each party’s unwillingness to compromise, but is to say that I suspect Congress will eventually do what needs to be done and that any adverse effects on the market would likely be short-lived.)

Upcoming Tax Law Changes: Much of what I have to say about the ultimate outcome of the scheduled tax law changes is subsumed under the fiscal cliff discussion above, but I will add one other quick comment: I suspect that one of two outcomes on the extension of the Bush tax cuts is more likely than the alternatives: either Congress will extend the Bush tax cuts for another year or two, completely kicking the can down the road (yet again), or some semblance of the Bush tax cut plan will be extended at least partially for those making less than $250,000 per year. Neither party wants to see the tax rates raised on that group, although almost certainly, Republicans will use that as one of their bargaining chips in an effort to extend the cuts for all tax payers. In either case, I’d be surprised to not see some form of the current tax structure continued for a substantial number of tax payers. I have a short two-page summary of how the upcoming tax law changes may affect investors and their accounts should the Bush tax cuts be completely repealed, and I’ve included that along with this commentary.

That’s all I have to say for now. I am more than happy to talk over, so please let me know if you have any questions, or if there is anything we can do for you. I hope you’re enjoying the cooler weather and fall colors (while they last).