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Global equity markets picked up the new year where they left off in 2012 – with solid upward momentum. After subdued growth in the 4th quarter, economic growth in the U.S. has strengthened. Combined with gains in residential real estate, consumer sentiment and employment, these factors have helped to fuel strong equity market returns in domestic markets through the first quarter and into the second quarter. Generally, small cap stocks outperformed large cap stocks and value style has outperformed growth strategies. After posting a strong 10.6% return in the first quarter, the S&P 500 has continued to climb into the second quarter, reaching new highs and breaking the psychological 1600 level.
Despite the lofty returns, valuations remain quite reasonable from a historical perspective. Current year earnings estimates for the S&P 500 at quarter-end were $117/share. As of quarter-end, the current-year P/E ratio for the S&P 500 was just 13X. In comparison, the long term average P/E ratio of the S&P 500 is 14-15X. Valuations appear to be in a fairly valued range.
Solid corporate earnings growth has been one of the primary drivers of equity returns in recent quarters. For the first quarter of 2013, companies in the S&P 500 continued to report earnings growth, in general, and 72% of companies beat earnings expectations. As state and federal governments continue to cut spending and corporate earnings continue to grow, corporate profits have reached 50-year highs as a percentage of GDP. The historical average of corporate profits as a percent of GDP is 6.2%, and it currently stands at 9.9%.
The other primary driver of solid equity returns in recent quarters has been Federal Reserve action affecting interest rates (Operation Twist, QE 4). As rates of longer maturity fixed income securities have declined to historically low levels, return prospects from bonds and other interest-bearing assets are relatively less attractive than equities and other riskier asset classes. Not surprisingly, this environment has been and continues to be quite favorable to the equity markets. In fact, the first quarter of 2013 saw U.S. equity mutual fund inflows of $52 billion, the highest quarterly inflow in nine years.
Given the current valuations and recent market performance, the question for investors is: what should we expect for equity returns going forward? Current earnings reports (for Q1) are beating estimates at an impressive rate, despite weak sales growth which has caused earnings estimates to be revised downward for the remainder of the year. Even with tepid sales growth, the corporate earnings growth story remains intact for 2013 and 2014 because U.S. companies have become very productive. The other growth factor is Federal Reserve policy, which will likely remain in place for some time. Both earnings growth and equity market inflows may temper their pace throughout the remainder of 2013, but for long term investors, stocks play an integral long term growth role in portfolios, particularly when compared to other asset classes.
Continuing recession in the Eurozone and declining growth and export levels in China have led to international developed market and emerging market stock returns trailing domestic stock markets recently. While international stocks outpaced U.S. stocks over the last six months of 2012, U.S. markets have handily outperformed in the most recent quarter and trailing twelve months. In the first quarter, U.S. large cap stocks outperformed developed international market stocks and emerging market stocks by 5.5% and 12.2%, respectively. As economic conditions improve overseas, the relative returns are likely to reverse as international stocks continue to be inexpensive relative to U.S. equities on a variety of valuation metrics. Both emerging markets and developed market P/E levels are currently well below their historical averages. Additionally, long-term economic growth prospects for emerging market economies continue to be much higher than those in the U.S.
We continue to invest client portfolios in a wide range of asset and sub-asset classes to achieve returns in a manner which strongly controls overall portfolio volatility. On the equity side, we have been rebalancing international and emerging market stock positions upwards to their target weights. The rebalancing discipline is designed to take advantage of the relative value offered in international stocks and will capture gains realized in the U.S. equity markets.
Over the past several quarters, we have added several components to our bond portfolios in an attempt to further diversify the risks of concentration in U.S. government and agency bonds. We have increased our corporate bond exposure and added Treasury Inflation Protected Securities (TIPS), international bonds, and high yield bonds. We continue to look for other avenues for further diversification, including the potential for increasing relative exposure to alternative assets.
Fixed income markets in the first quarter of 2013 were virtually unchanged from recent prior quarters in terms of yield, demand and issuance. Current interest rates remain near historic lows in nearly every bond market segment. Because of this, the total return of taxable bonds is likely to remain low relative to historical performance. High yield bonds and emerging market debt strongly outperformed broad market bond indices in the first quarter. Municipal bonds continue to offer strong relative value to taxable debt along the yield curve, however, strong demand and low issuance has compressed yields in the past several quarters.
In April, Indiana Trust & Investment Management Company welcomed three new members to our board of directors: George S. Cressy, Jr., D. Dwight Gipson, and Jud Fisher.
A resident of Mishawaka, George S. Cressy currently serves as CEO of Grubb & Ellis / Cressy & Everett, a full-service commercial real estate, development and management company serving northern Indiana and southwestern Michigan for more than half a century; he also serves as president of Cressy Land Planning Associates. A graduate of Notre Dame with an MBA from the Northwestern University Kellogg Graduate School of Management, Cressy was recently named one of the region’s best leaders by Northwest Indiana Business Quarterly. In addition to his business interests, Cressy is deeply invested in his community: he is a current board member of the Women’s Care Center, the Laidig Foundation, and the Community Foundation of St. Joseph County, of which he is also a past chairman.
D. Dwight Gipson, of Elkhart, is a retired CPA and tax partner with Crowe Horwath, LLP, where he worked extensively with closely held businesses and their owners. Like Cressy, Gipson has also faithfully served the Michiana community through various leadership roles in organizations including the Elkhart County United Way, Elkhart Riverwalk Association, Inc., Elkhart County Estate Planning Council and Reason Enough to Act (RETA), a pregnancy and family resource center in Elkhart County. Dwight is a graduate of Indiana University with a B.S. degree in accounting.
A prominent and longstanding member of the Muncie business and nonprofit communities, Jud Fisher is president and COO of the Ball Brothers Foundation, a role he’s held since 2003. He also serves as executive director of the Edmund F. and Virginia B. Ball Foundation. Prior to that, he worked for several years in a leadership role at Old National Trust Company. Fisher’s philanthropic and civic service extends beyond the Ball Brothers and Edmund F. and Virginia B. Ball foundations; he is also actively involved with the Red-Tail Conservancy in Muncie, the Methodist Health Foundation and the IU Health Ball Memorial Hospital Foundation. He earned his bachelor’s degree from DePauw University and his master’s degree from Indiana University.
We are proud to be joined by these business leaders and look forward to the role their considerable experience will play in the future of our business. Their individual reputations for excellence in leadership and community service, as well as keen business perception, make them valuable additions to the Indiana Trust board.