Strong May marred by volatility at the end

May was another strong month for equity markets, with a total gain of 2.34 percent for the S&P 500 Index, 2.24 percent for the Dow Jones Industrial Average, and 3.82 percent for the NASDAQ. The S&P 500 and the Dow notched all-time highs, though the positive ultimate results masked a great deal of intra-month volatility. The first weeks of the month showed almost uninterrupted increases, while the last week was volatile, with multiple daily gains and losses of more than 1 percent and a noteworthy sell-off on May 31. Fundamentals were unchanged for the month, valuations crept higher with the market itself, and technicals remained relatively strong.

Volatility was driven largely by comments from Federal Reserve (Fed) Chairman Ben Bernanke, who seemed to suggest in a May 22 appearance before Congress that the Fed might reduce its bond purchases much sooner than had been anticipated.

Chairman Bernanke’s comments also caused volatility in the fixed income markets. The Barclays Capital Aggregate Bond Index lost 1.78 percent for the month, and 10-year U.S. Treasury yields rose from 1.66 percent to 2.16 percent. The floating-rate bank loan sector was the only fixed income sector to post a positive return, and long-duration Treasuries and TIPS were hardest hit.

Figure 1: U.S. 10-Year Treasury Yields, January 2013–May 2013

Source: Bloomberg

International stocks significantly underperformed U.S. equities in May. The MSCI EAFE Index was down 2.41 percent, and the MSCI Emerging Markets Index declined 2.94 percent. Japan experienced very wide swings, with large gains in the first half of the month erased and turned into losses in the second half. Brazilian equities struggled greatly, losing 7.11 percent.

The real economy continued to grow

Early in May, employment gains for April came in above expectations. Housing showed strength as well, with both new and existing home sales increasing. In addition, house prices climbed more than 10 percent year-over-year, per the S&P/Case-Shiller 20-City Home Price Index, and the supply of houses for sale remained well below normal. Tight supply and strong demand suggest that the home price trend may continue.

Rising home values and stock prices brought overall household wealth levels close to pre-crisis peaks. These factors, together with declining gasoline prices, pushed consumer confidence up.

Economic growth for the first quarter was revised slightly lower, from 2.5 percent to 2.4 percent. But this downward revision was mostly due to a larger-than-estimated decline in government spending.

Growing economy puts Fed on the spot

With the real economy growing and stock markets performing relatively well, the Fed is in a quandary. At some point, it will have to wind down its stimulus program. The question is: When? Chairman Bernanke’s comments on May 22 surprised financial markets, leading to market turmoil and a drop of more than 2 percent that day and a further decline the next day.

Real economy solid, markets less so

At month-end, the real economy appeared well positioned to continue growth at current levels, but financial markets appeared less stable. Much depends on when and how the Fed reduces its stimulus. Interest rates will be the primary channel. If rates tick up significantly, stock and bond valuations could be at risk.

Rate increases don’t appear likely soon, though they are inevitable at some point. Investors should be aware of this and plan for the volatility that may come when the Fed does move. When that day arrives, the recovery in the real economy should be more firmly in place, which may provide a firm foundation if markets wobble.

For investors, cautious optimism is the appropriate stance. The end-of-month market instability serves as a reminder to be positioned with long-term goals in mind rather than with the objectives of following short-term trends.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The NASDAQ Composite Index measures the performance of all issues listed in the NASDAQ Stock Market, except for rights, warrants, units, and convertible debentures. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners.

                                                                                                              ###

Sean Gross, CFP®, AIF® is a financial advisor located at Telos Wealth Management, LLC, 385 E. Penny Rd., Suite 103, Wenatchee, WA.  He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network^®, Member FINRA/SIPC, a Registered Investment Adviser. Sean can be reached by phone at 509-664-8844 or by email at Info@TelosWealth.com.

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research associate, at Commonwealth Financial Network.

© 2013 Commonwealth Financial Network^® 

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Markets strong as real economy slows

April was another month of strong equity performance. The S&P 500 Index was up 1.93 percent, trailed slightly by the Dow Jones Industrial Average at 1.94 percent and the NASDAQ at 1.88 percent. Technically, markets were robust, with all three indices well above their 50- and 200-day moving averages.

Stronger-than-expected corporate earnings drove markets up as the month closed. With more than half of companies reporting, earnings per share grew 2 percent, and roughly 70 percent of companies beat expectations. Corporate revenues were less encouraging, as more than half missed top-line expectations.

In overseas markets, the MSCI EAFE Index was up 5.19 percent, and the MSCI Emerging Markets Index gained 0.66 percent. Developed international markets were higher as good news came from several sources. Italian politicians elected Enrico Letta, a centrist and supporter of the European Union, their prime minister. Letta’s ascent led investors to buy Italian bonds, pushing the Italian 10-year yield to its lowest level in 30 months. Italian yields are lower now than they were in 2007, before the global financial crisis began (see chart).

Yield for Italy’s 10-Year Bond, 2007–2013

Source: Bloomberg

Japan’s central bank announced plans to double that nation’s monetary base in two years and end the deflationary spiral that has plagued Japan for more than a decade. Meanwhile, the European Central Bank was poised to cut rates in early May, a move supportive of stocks and risky bonds.

April was positive for fixed income investors. The Barclays Capital Aggregate Bond Index returned 1.01 percent, and longer-duration bonds performed quite well, as the 10-year U.S. Treasury yield fell, from 1.84 percent to 1.67 percent. Weaker-than-anticipated economic releases, combined with low inflation, reassured investors that the Federal Reserve is unlikely to discontinue its easing program in the near future.

Financial markets diverge from real economy

The real U.S. economy showed signs of a slowdown. Only 88,000 jobs were added in April, well below the 268,000 new jobs reported for the month before. Weak durable goods orders also signaled a slowdown, and the reported gross domestic product (GDP) growth of 2.5 percent for the first quarter was below expectations.

Nevertheless, total labor demand stayed strong. According to the Ned Davis Research Group, the number of hours worked has increased at a level equivalent with having added 328,000 more jobs to the workforce. This suggests that overall demand is healthy, but that companies are reluctant to hire.

Consumer demand was vigorous early in the first quarter but slowed toward quarter-end, with a decline in retail sales for March. Housing has been positive for consumers. The S&P/Case-Shiller 20-City Home Price Index recently reported a 9.32-percent gain year-over-year, as prices climbed and demand outstripped supply.

During the first quarter, government spending likely declined 4.2 percent on an annualized basis—or 0.8 percent of GDP—according to Capital Economics. This figure was not inclusive of the sequester cuts, which took full effect in early April.

The economic impact of the sequester cuts is not yet known, but, so far, markets haven’t reacted negatively. In addition, the decrease in government spending is narrowing the deficit, which is projected to come close to stabilizing in 2014.

Risks around the world persist

The European economy stagnated, as several countries struggled to stabilize their banking systems. North Korea kept on rattling its cage, and several countries confirmed Syria’s use of chemical weapons. If chemical weapon use is deemed widespread, this could spur an intervention by the U.S. and its allies. None of these risks appears to pose an imminent threat to markets.

Recovery moves along but at a slower pace

The U.S. economic recovery continues, although the pace looks likely to slow. U.S. corporations also keep posting impressive profits, but future growth may not be as significant. Markets appear to be pricing in an optimistic future, but, if this doesn’t play out, equity market revaluation could lower levels. In short, there are reasons for optimism; however, this late in the cycle, investors should remain mindful of risk management.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The NASDAQ composite Index measures the performance of all issues listed in the NASDAQ Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities.

                                                                                                                ###

Sean Gross, CFP®, AIF® is a financial advisor located at Telos Wealth Management, LLC, 385 E. Penny Rd., Suite 103, Wenatchee, WA.  He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network^®, Member FINRA/SIPC, a Registered Investment Adviser. Sean can be reached by phone at 509-664-8844 or by email at Info@TelosWealth.com.

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research associate, at Commonwealth Financial Network.

© 2013 Commonwealth Financial Network^®

U.S. stock markets continue a bull run

March was another excellent month for U.S. markets, with the S&P 500 Index up 3.75 percent and the Dow Jones Industrial Average rising 3.86 percent. The NASDAQ showed slightly lower but still very strong performance, gaining 3.4 percent. For the quarter, the three indices climbed 10.61 percent, 11.93 percent, and 8.21 percent, respectively.

For the second year in a row, the U.S. stock markets started very strongly. Both the Dow and the S&P 500 hit all-time records in the first quarter (see chart). Technical factors remain supportive for all three indices, and the record highs indicate no remaining resistance levels to pierce. Fundamental factors, however, are less supportive of continued increases, with earnings growth estimates declining over the quarter, despite surging prices that left valuations higher at quarter-end.

Figure 1. In March, the S&P 500 Hit an All-Time Closing High

Source: Bloomberg

International markets performed less well, reflecting ongoing economic and political challenges outside the U.S. The MSCI EAFE Index rose 0.84 percent in March and was up 5.15 percent for the quarter—a respectable showing, especially given the turmoil in Cyprus at month-end. On a price return basis, the MSCI Emerging Markets Index lost 2.09 percent for the month, pulling it into the red for the quarter and leading to a 2.14-percent decline year-to-date. Technically, both indices are showing weakness, having penetrated their 50-day moving averages. Still, the EAFE remains well above its 200-day moving average, though the emerging markets index is approaching its 200-day moving average. 

Risk outperforms safety in fixed income markets

In the U.S., a positive month for stocks was mirrored by a good month for risky bonds. The Barclays Capital U.S. Corporate High Yield Index returned 1.02 percent in March, making it the best-performing U.S. fixed income sector, while bank loans also performed well. Meanwhile, municipal bonds actually lost a bit of ground, and longer duration bonds underperformed. The Barclays Capital Aggregate Bond Index returned 0.08 percent for the month and declined 0.13 percent for the quarter. March was essentially a continuation of what has occurred during the first quarter as a whole, with investors rotating out of lower risk assets and into yield plays. The one area where risk taking did not pay off was in global and emerging market debt. A stronger dollar was a large contributor to this discrepancy.

Despite increased investor appetite for risk, Treasury and mortgage yields remain at extremely low levels, thanks to monthly Treasury and mortgage purchasing by the Federal Reserve (Fed) of $45 billion and $40 billion, respectively. Fed officials have said that they will not stop the purchases until the unemployment rate declines to 6.5 percent. Given that the rate currently hovers around 7.7 percent, the buying is unlikely to stop anytime soon. Meanwhile, the 10-year Treasury closed the quarter yielding 1.85 percent.

Washington, DC and the dog that barked, but has not yet bitten…

A positive surprise for the quarter was the lack of damage that the fiscal cliff tax increases did to the economy. Although the increases reduced personal income, consumer spending continued strong, and the economy appeared to remain on track.

Similarly, the sequestration spending cuts that took effect in early March seem to have done little so far to hurt the economy. It is, however, still too early to tell how much growth could be affected by the cuts, as they will be implemented over time. Federal spending comprises from 20 percent to 25 percent of U.S. gross domestic product, and the 2013 cuts amount to roughly 2 percent of government expenditures.

Some progress has even been made by our divided government. Although at the beginning of the year Congress and the White House had appeared set to continue to battle, so far they have agreed to disagree and managed to avoid a government shutdown. The perceived reduction in political risk, combined with continued economic growth, has presented investors with an environment where most major risks seem less serious than a few months ago.

Housing and employment continue to strengthen

Thus far, the reduction in political uncertainty and continued consumer spending appear to be supportive of the real economy. Housing has been another principal driver, as a decline in the supply of homes for sale to historic lows has led to price increases at the national level. The declining supply has also led to higher levels of new home construction, which recently reached a five-year high. In fact, in 2012, for the first time in six years, new home construction added to—rather than subtracted from—economic growth.

The recovery in the housing market has also engendered gains in employment, which has improved significantly. According to Capital Economics, housing construction has accounted for about one-fourth of the new jobs created in the first quarter of 2013. That matters, particularly because many workers hired had been among the long-term unemployed.

Finally, some related effects of new housing construction have included gains in building material production, carpet production, and other sectors which sell into new homes. With housing affordability still at or close to record highs, this should continue to boost the economy going forward.

The rest of the world

The rest of the world still appears subject to significant headwinds. Continued recession in many European economies is depressing expectations, and the uncertainty associated with the rescue of the Cypriot banking system has reinforced the perception that the European crisis is not over. The initial rescue plan, which proposed taxing all existing bank account deposits, including those of small account holders, was rejected by the Cypriot parliament and eventually replaced by one that targeted only large account holders. The possibility that depositors could be subject to such losses rattled financial markets across the Eurozone, particularly in the peripheral nations whose economies are already under stress.

Emerging markets have suffered from the slowdown in Europe and also from country-specific issues. These include wage pressure and weak manufacturing in China, inflation in Brazil, and worries about natural gas prices in Russia. While threats from North Korea to attack South Korea and other nations, including the U.S., have been widely publicized, markets seem to believe that this is mere saber-rattling. Nevertheless, we believe the situation on the Korean peninsula must continue to be carefully monitored.

U.S. recovery continues but risks remain

The U.S. recovery is broad based, with rising employment, strengthening consumer spending, and a housing recovery that appears driven by fundamentals. At the same time, risks remain—domestically, in the form of a potential breakdown in the current bipartisan cooperation, and globally, as other major world economies struggle to resume growth. In previous years, we have had strong first quarters followed by weak second quarters, and that remains a risk this year.

Although the foundation of the real economy appears to be firming, financial markets are becoming less attractively valued. Tailwinds in the form of lower interest rates and company share buybacks have driven markets to new highs but may be less supportive going forward. In addition, technical factors remain solid, but the higher the markets go, the more potential there is for a setback.

Overall, we appear to be in a relatively good place, certainly better than other areas of the world. As such, investors seem to have reason for cautious optimism, but should remain mindful that the global economy is still very weak.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The NASDAQ Composite Index measures the performance of all issues listed in the NASDAQ Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities.                

                                                                                                                           ###

Sean Gross, CFP®, AIF® is a financial advisor located at Telos Wealth Management, LLC, 385 E. Penny Rd., Suite 103, Wenatchee, WA. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network^®, Member FINRA/SIPC, a Registered Investment Adviser. Sean can be reached at 509-664-884 or at Info@TelosWealth.com.

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research associate, at Commonwealth Financial Network. 

© 2013 Commonwealth Financial Network^®

Markets take a roller-coaster ride

After a strong January, the markets started February in much the same way but ran into trouble in the middle of the month. In the end, U.S. markets finished in the black, although international markets weren’t as lucky. The S&P 500 Index rose 1.36 percent, closing at 1,514, somewhat below its mid-month high of 1,530 but well above its low of 1,487. The wide swings reflected investor recognition of continuing risks in Europe and in Washington, DC.

U.S. corporate earnings remained strong, with two-thirds of S&P 500 companies beating expectations and about one-fourth of them missing the mark—in line with previous quarters. Technically, the S&P 500 remained above its 50- and 200-day moving averages, and there doesn’t seem to be any technical reason to anticipate a decline. But there does appear to be a resistance level at 1,565, the index’s 2007 high-water mark, suggesting that future gains might be challenging.

International markets were hit harder, reflecting greater exposure to European political and economic problems. The MSCI EAFE Index lost 0.95 percent, while the MSCI Emerging Markets Index declined 1.35 percent. Among the factors affecting foreign markets were the results of the Italian elections, interpreted as a vote against the country’s austerity-based economic stabilization plan. This raised the possibility of another Eurozone political crisis.

Events in Asia also contributed to weak performance. The Japanese plan to boost inflation and weaken its currency pushed the Nikkei average higher. In China, however, manufacturing slowed, leading emerging markets downward.

Long-duration bonds performed very well, as the 10-year U.S. Treasury yield contracted from 2.01 percent early in the month to about 1.9 percent at its end. The Barclays Capital U.S. Aggregate Bond Index returned 0.5 percent. On a sector basis, investment-grade bonds performed best, while Treasury Inflation-Protected Securities and mortgages lagged.

U.S. economy continues to strengthen

The U.S. economy added 157,000 new jobs in January. Additionally, there were upward revisions to previously released data, which showed that payrolls had increased at an average of 201,000 jobs per month in the fourth quarter of 2012.

Housing continued its recovery, with price increases accelerating, available supply declining, and new home sales speeding up. Improvements in home prices, stock prices, and employment opportunities caused consumer confidence to rise for the first time in four months.

U.S. Consumer Confidence, 2008–February 2013

Source: Haver Analytics

But the news was not all good. Negative factors included tax increases and the steady rise in gasoline prices, which reduced consumer incomes. In light of these, the tiny 0.1-percent increase in January retail sales was a fairly positive development.

Watch out for Washington, D.C.

Washington continued to grab the headlines, as sequestration spending cuts were scheduled to hit the economy in March. Despite ratcheting up the rhetoric, politicians on both sides seemed resigned to allowing the cuts to proceed.

The most recent release of Federal Open Market Committee meeting minutes spooked investors, who learned that some committee members had concerns regarding the effectiveness and long-term effects of continued debt purchases. Nevertheless, most members still appear to believe that the economy is better off with monetary easing than it would be without it.

International risks resurface

As previously noted, risks that plagued Europe last year recently resurfaced. A Spanish government mired in scandal, a newly split Italian parliament, and a 0.6-percent contraction in Germany’s gross domestic product all added to uncertainty—both political and economic.

Other areas also face headwinds. The China/Japan faceoff over disputed territory, North Korean nuclear testing, and the civil war in Syria are all geopolitical risks which could derail investor  confidence.

Signs remain positive, but caution is still important

In spite of renewed risks, U.S. stock markets closed the month with a gain. Investors can take comfort in continued U.S. economic growth and the persistent health of U.S. companies. Yet volatility is a reminder of the need for caution. Investors should continue to balance their long-term goals against their ability to tolerate the risks that come with investing.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Nikkei Index is a stock market index for the Tokyo Stock Exchange. It has been calculated daily by the Nihon Keizai Shimbun newspaper since 1950. It is price-weighted (the unit is yen), and the components are reviewed once a year. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities.

                                                                                ###

Sean Gross, CFP®, AIF® is a financial advisor located at Telos Wealth Management, LLC, 385 E. Penny Rd., Suite 103, Wenatchee, WA. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network^®, Member FINRA/SIPC, a Registered Investment Adviser. Sean can be reached at 509-664-884 or at Info@TelosWealth.com.

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research associate, at Commonwealth Financial Network.

© 2013 Commonwealth Financial Network^®

In 2010, the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act were passed into law. One of their important provisions is a new Medicare tax designed to help pay the cost of health care reform. The new tax is effective in 2013, so it’s important to start planning now if you haven’t done so already.

What’s changing?

Medicare contribution tax: The 2.90-percent Medicare tax will continue to be applied to wages and net self-employment income. Half of the tax (1.45 percent) is paid by the employer and the other half (1.45 percent) by the employee. Effective in 2013, an additional 0.90-percent tax will be levied on wages and self-employment income above certain thresholds.

Wages or net earnings above $200,000 (single), $250,000 (married), or $125,000 (married but filing separately) will be taxed at an overall rate of 3.80 percent. The 0.90-percent rate increase applies only to the employee’s (or self-employed taxpayer’s) share of the Medicare tax. Unlike the social security tax, which has a “wage base” ceiling, there is no compensation limit. Each dollar is subject to the Medicare tax.

Example: Tom earns $300,000 and Janet earns $150,000. Tom’s employer will withhold 0.90 percent (or $900) on the $100,000 earned in excess of $200,000. Janet’s employer will not withhold any additional Medicare tax. Rather, the additional Medicare tax will be computed based on the couple’s combined wages over the $250,000 threshold for married taxpayers (or $200,000), resulting in a tax of $1,800. This would leave them with an additional $900 tax when filing their return, over and above the $900 that Tom’s employer withheld.

Tax on investment income. Higher-income taxpayers will also be subject to a 3.80-percent tax on most net investment income over the thresholds, in addition to any other applicable tax. The exceptions are distributions from retirement accounts—including pensions, 401(k)s, and IRAs—and income generated from municipal bonds. Keep in mind, however, that distributions from retirement accounts can push your adjusted gross income over the threshold, thus subjecting you to a 3.80-percent tax on your other investment income.

The following types of investment income will be affected: 

• Taxable interest
• Capital gains
• Dividends
• Nonqualified annuity distributions
• Royalties
• Rental income

In addition, the new Medicare tax on investments will affect homeowners with appreciation greater than $250,000 ($500,000 if married) on their personal residences. The new law will also apply to estates and most trusts. The threshold for estates and trusts is currently $11,950, the amount at which their highest tax bracket begins.

Calculating the tax

For individuals, the 3.80-percent Medicare tax is applied to the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over the applicable threshold ($200,000 for single filers, $250,000 for married filers, and $125,000 for married filing separately).

Example: Mark and Sue have earnings from wages of $175,000 and investment earnings of $100,000. The couple’s total wages and investment earnings (MAGI) equal $275,000. According to the rule, the 3.80-percent Medicare tax will be applied to the lesser of net investment income ($100,000) or the excess of MAGI over the applicable threshold ($25,000). In Mark and Sue’s case, then, only $25,000 will be subject to the Medicare tax. The entire $100,000 in investment income will be subject to either capital gains or ordinary income tax, depending on the nature of the income.

Planning strategies for the new Medicare tax

If you believe that your income tax rate will be higher in the future than it is today, you may want to consider taking some kind of action to minimize the impact. One possibility might be a Roth IRA.

Roth IRAs have become popular alternatives to traditional IRAs. Not only does money held in a Roth IRA grow tax-deferred for federal income tax purposes, but distributions are also tax-free if certain requirements are met. (Please note: State tax treatment of Roth IRAs differs. Consult your tax advisor about your state’s rules.) Another advantage is that no minimum distributions are required upon reaching age 70½. Thus, you may avoid having retirement distributions increase your adjusted gross income over the threshold and exposing other income to the new Medicare surtax.

For more information on how the new tax will impact you and your family, please contact our office: info@teloswealth.com

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

IRS CIRCULAR 230 DISCLOSURE:

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

                                                                                                                               ###

Sean Gross, CFP®, AIF® is a financial advisor located at Telos Wealth Management, LLC, 385 E. Penny Rd., Suite 103, Wenatchee, WA. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network^®, Member FINRA/SIPC, a Registered Investment Adviser. Sean can be reached at 509-664-884 or at Info@TelosWealth.com.

© 2013 Commonwealth Financial Network^®

On January 2, 2013, President Obama signed the American Taxpayer Relief Act of 2012 into law. The act makes significant changes to the tax code that will primarily affect upper-income taxpayers. Now that we have some finality, it’s important to take a look at the changes to understand how they may impact you. 

Itemized deductions phaseout

Under the act, itemized deductions will be phased out for taxpayers whose income exceeds certain thresholds. For married taxpayers filing jointly, the phaseout begins at $300,000 of adjusted gross income (AGI). Taxpayers filing single will have a threshold of $250,000 of AGI. Beyond these thresholds, allowable itemized deductions will be reduced by 3 percent of the amount by which the taxpayer’s AGI exceeds the threshold amount. The reduction cannot exceed 80 percent of previously allowable itemized deductions.

For example, Jim and Sandy are a married couple filing jointly. With a combined AGI of $750,000, they have exceeded the threshold for their filing status ($300,000) by $450,000. Therefore, their allowable itemized deductions will be reduced by $13,500 ($450,000 x 0.03, with a maximum 80-percent reduction).

Where it might really count. Charitable donations are one of the five biggest categories of itemized deductions. If you are a high-income taxpayer who has historically made large charitable contributions, you may be surprised by how the new phaseout affects your deduction. Assume a married taxpayer has an AGI of $2,500,000 and contributes $100,000 to charity. Because this taxpayer is $2,200,000 over the threshold, his $100,000 deduction is reduced to just $34,000.

New 10-percent floor on medical expenses. The medical expense deduction is also one of the five biggest itemized deductions. Because the floor is now 10 percent of AGI, you’ll want to be cognizant of expenditures like dental work and eyeglasses. For example, if you can push the purchase of a new pair of glasses into a tax year when you know you are scheduled for expensive medical procedures, you may be able to bundle these costs to take advantage of the deduction. 

The effect on capital gains

Taxpayers with taxable income above $400,000 (individual) and $450,000 (married filing jointly) will see an increase in their long-term capital gain and qualified dividend tax rates, from 15 percent to 20 percent. It’s important to note that this significant increase will be compounded by legislation that takes effect in 2013; see “The Medicare surtax” below.

The only real way to manage this tax increase is to minimize your taxable income or take gains in years when you have not exceeded the threshold. Look to maximize contributions to your retirement accounts, as well as other above-the-line deductions, to reduce taxable income.

The Medicare surtax

The Patient Protection and Affordable Care Act of 2010 extends a 3.8-percent Medicare surtax to the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over $200,000 (individual) or $250,000 (married filing jointly). It also adds a 0.9-percent surtax on earned income above $200,000 (individual) or $250,000 (married filing jointly). Net investment income includes net rental income, dividends, taxable interest, net capital gains from the sale of investments, the sale of second homes and rental properties, royalties, and passive income from investments in which the taxpayer does not actively participate, including partnerships and the taxable portion of nonqualified annuity payments.

For example, Robert and Emma are married taxpayers filing jointly, with a MAGI of $400,000. Of this, $350,000 is wages and $50,000 is net investment income. Their MAGI is $150,000 over the $250,000 threshold for married couples filing jointly, so they’ll owe 3.8 percent on their $50,000 in net investment income, as it is less than $150,000. They’ll also owe 0.9 percent on the $100,000 by which their wages exceed the $250,000 earned income threshold for married couples filing jointly. The couple’s total Medicare surtax will be $2,800—3.8 percent of $50,000 ($1,900) plus 0.9 percent of $100,000 ($900).¹

What to consider in planning around the surtax. As mentioned above, pay attention to when you take capital gains. If you can spread gains over different tax years or take them in years when your earned income is lower or under the threshold, you may be able to minimize your tax liability. Also consider your unearned income and how it is affected by the surtax. If the tax hit is substantial, you may want to consider tax-free income sources like municipal bonds.

New top individual rate higher than corporate rate

Because the American Taxpayer Relief Act has added a new 39.6-percent income tax bracket, the top individual income tax rate is now higher than the top corporate tax rate, which is 35 percent. If you are self-employed, you may want to revisit your business entity selection. Depending on your income level, the choice of entity could result in a net tax savings.

Be aware that determining whether C corporation status makes sense from a tax perspective will require an in-depth analysis of the business. If you find yourself exposed to the new 39.6-percent individual income tax bracket, seek the advice of a tax expert who specializes in this area to help you decide on the best course of action.

Defer income, if possible

Considering the impact a higher individual income tax bracket can have on your financial situation, you may want to explore income deferral strategies to help reduce your taxable income. You may already be contributing to a qualified retirement plan, such as a 401(k), but if your employer offers a nonqualified deferred compensation plan, that may be worth considering as well.

Nonqualified deferred compensation plans provide an opportunity for taxpayers to defer income on a pretax basis, and accumulated investment earnings will grow tax-deferred, much like they do in a qualified retirement plan. There are also no IRS limits on contributions. The idea is to defer the income while you are in a higher tax bracket and then have it pay out when you move into a lower bracket, such as during retirement.

What hasn’t changed?

Gift tax exemption. In 2012, many wealthy taxpayers took advantage of the $5,125,000 gift tax exemption to pass assets to the next generation. Fear that the exemption would revert to $1,000,000 and the top estate tax rate would jump to 55 percent was the catalyst for many of these transactions. In a somewhat surprising move, the American Taxpayer Relief Act made the $5,000,000 exemption permanent and indexed it for inflation. The 2013 exemption amount has increased to $5,250,000 per individual, while the top estate tax rate has increased to 40 percent from 35 percent. The annual exclusion amount has also increased, to $14,000 per donee in 2013.

Although the gift tax exemption is now permanent, it continues to be a strategy you should consider today. As Congress searches for deficit-reducing revenue, the exemption will remain a target, and it’s always possible that future legislation will reduce the exemption amount. Also, because future appreciation of gifted assets has now been removed from the estate, you may want to consider the impact of appreciation when deciding which assets to gift.

GRATs and dynasty trusts. The last few years have been fraught with proposed legislation designed to limit the benefits of grantor-retained annuity trusts (GRATs) and dynasty trusts. Fortunately, the act didn’t incorporate any of those proposals. GRATs remain a viable planning tool in this historically low-interest-rate environment. And there continues to be no limitation on the length of dynasty trusts. That said, there may be a shelf life on these planning techniques if previous legislative proposals resurface, so it would be wise to consider them now.

The American Taxpayer Relief Act has resulted in numerous changes to our country’s tax code, and it’s important to understand when and how you may be affected. Be sure to seek the advice of your tax advisor or lawyer to help ensure that you are properly positioned to both minimize your tax burden and take advantage of new opportunities.

¹Fidelity, “The new Medicare tax and you,” January 4, 2013.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Investors should consult a tax preparer, professional tax advisor, and/or a lawyer.

IRS CIRCULAR 230 DISCLOSURE

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax information contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code; or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

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Sean Gross, CFP®, AIF® is a financial advisor located at Telos Wealth Management, LLC, 385 E. Penny Rd., Suite 103, Wenatchee, WA. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network^®, Member FINRA/SIPC, a Registered Investment Adviser. Sean can be reached at 509-664-884 or at Info@TelosWealth.com.

© 2013 Commonwealth Financial Network^®

January got the year off to a great start. The S&P 500 Index was up 5.18 percent, and the Dow Jones Industrial Average climbed 5.91 percent. The perceived successful resolution of the fiscal cliff sparked the best January market performance since 1997. The beaten-down energy sector led markets upward, while the technology sector lagged. The S&P 500 ended the month only about 2 percent below its 2007 peak, having posted double-digit returns in three of the past four years.

The strong market action continued on good corporate earnings data and in spite of mildly disappointing revenue results. As of the most recent data, 71 percent of S&P 500 companies beat earnings expectations in the fourth quarter of 2012, but only 43 percent beat on revenues. Since late 2009, when nearly 80 percent of companies beat earnings estimates, the trend has been downward. According to Bloomberg, only 64 percent of companies beat in the third quarter. So the possible rebound to 71 percent may be another reason why investors have been optimistic.

Technically, equity markets show signs of continued strength. The S&P 500 remains above both its 50- and 200-day moving averages and briefly crossed a key price level of 1,500. Other technical market factors are also positive. The strong performance of the Dow Jones Transportation Average and the breadth of stock price appreciation suggest that bullish investors are enjoying significant momentum.

Developed international markets beat U.S. markets, but emerging markets lagged. The MSCI EAFE Index rose 5.27 percent, and the MSCI Emerging Markets Index returned 1.31 percent on a price basis for the month. Given the diversity of markets and economies included in these indices, it is difficult to draw general conclusions. It does appear, however, that continued economic recovery and the reduction in political uncertainty have made the U.S. and developed markets relatively more attractive.

Value stocks outperformed growth stocks across the globe, and European peripheral countries such as Italy and Portugal were top performers. Analysts expect European gross domestic product (GDP) to contract 0.1 percent in 2013, but investor spirits continue to be buoyed by the European Central Bank’s pledge to buy sovereign debt if necessary.  

Bonds lost ground over the month, as investors moved out of lower-risk assets. The Barclays Capital Aggregate Bond Index declined 0.7 percent. Both Treasuries and investment-grade corporates sold off. Only municipals and high-yield posted positive performance. The Barclays Capital U.S. Corporate High Yield Index returned 1.34 percent. Yields have risen year-to-date. The 10-year Treasury began January at 1.75 percent; by month-end, it had increased to 1.98 percent. Though still extremely low, Treasury yields are at their highest levels since last April (see chart).

Source: Bloomberg

Signs of life in the U.S. economy

On the whole, economic data was positive in the first month of the new year. Most notably, employment continued its slow but steady recovery, adding 155,000 jobs for December, which left the unemployment rate unchanged at 7.8 percent. Retail sales continued to grow, and housing continued to improve, with prices increasing even as the supply of homes for sale dropped to multiyear lows.

Results for the fourth quarter of last year, released in January, were also positive. Consumer spending, which is about two-thirds of the economy, was up 2.2 percent—an acceleration over the previous quarter’s figure of 1.6 percent. This took place despite the dual headwinds of Hurricane Sandy and the fiscal cliff. Business investment, which had been a piece missing from the recovery, increased 8.4 percent, more than reversing its 1.8-percent decline in the third quarter. Finally, residential investment popped by more than 15 percent, as a result of the housing recovery.

Negatives for the month included a drop in consumer confidence, which seemed driven by the tax increases in the fiscal cliff deal, and a surprising end-of-month report that the economy had contracted 0.1 percent in the fourth quarter of 2012. The decline was due to three official factors: weak inventory spending, a decrease in net exports, and the largest drop in defense spending in 40 years. So the basis for this anomaly appears to have been a mix of one-time factors, seasonal adjustments, and revisions.

Fourth-quarter 2012 GDP, despite being unexpectedly feeble, does not seem to represent a substantial long-term weakening of the economy. The biggest risk is that the headline might shake consumer confidence. For last year as a whole, GDP grew 2.2 percent, up from 1.8 percent in 2011. The recovery, while slow, continues to strengthen in spite of the occasional statistical blip. In summary, this doesn’t appear to be the start of a new recession.

Washington, DC remains a factor

The fiscal cliff deal at the start of 2013 made the Bush tax cuts permanent for the majority of the population, but the expiration of the payroll tax waiver meant that everyone saw his or her taxes increase anyway. Lower paychecks led to reduced consumer confidence early in the month. Meanwhile, politicians failed to address expenditures, putting off sequester spending cuts for two months and leaving substantial political uncertainty in place.

Another source of uncertainty, the debt ceiling, was postponed, as Congress agreed to raise the ceiling for the next couple months while budgets are negotiated. Again, nothing has actually been settled, but the decision to negotiate rather than issue ultimatums was rightly seen by the markets as a positive step.

In the face of persistent uncertainty and still elevated unemployment, the Federal Reserve (Fed) maintained its support of the markets by continuing to buy about $85 billion per month of Treasuries and mortgage securities, a rate of about $1 trillion per year. At this point, the Fed is buying a very large proportion of the new securities issued. There is speculation that this intervention could end sometime in 2013, although it will depend on the health of the economy.

Looking forward into 2013

From the perspective of equity market performance, the beginning of 2013 has mirrored the start of 2012. While political and economic concerns remain, a modest economic recovery appears well under way. The housing market should continue to improve, and there are reasons to believe that employment growth may accelerate.

In the U.S., government spending is the biggest item to watch, as cuts appear increasingly likely. Nevertheless, the overall signs for the U.S. economy and markets are generally positive. We encourage investors to make sure their portfolios are invested in a manner consistent with their risk tolerance and long-term goals, and to take the opportunity provided by recent market strength to make any necessary adjustments to their investment allocations.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Dow Jones Transportation Average is a price-weighted average of 20 U.S. transportation stocks. The average as it is known today began on October 26, 1986. It was formerly known as the Dow Jones Railroad Average. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

                                                                                                                           ###

Sean Gross, CFP®, AIF® is a financial advisor located at Telos Wealth Management, LLC, 385 E. Penny Rd., Suite 103, Wenatchee, WA. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network^®, Member FINRA/SIPC, a Registered Investment Adviser. Sean can be reached at 509-664-884 or at Info@TelosWealth.com.

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research associate, at Commonwealth Financial Network.

© 2013 Commonwealth Financial Network^®

The S&P 500 Index notched a 16-percent gain for the year. International markets performed even better, as the MSCI EAFE Index returned 17.32 percent and the MSCI Emerging Markets Index posted a price return of 15.15 percent. The strong performance of stocks reflected economic recovery in the U.S., political improvements in Europe, and a successful leadership transition and economic “soft landing” in China.

In December, markets fluctuated with news from Washington, DC. At year-end, a small compromise on the fiscal cliff seemed in the making, with an agreement to raise income taxes for households making $450,000 or more annually.

The S&P 500 rose 0.91 percent in December. Midsized companies outperformed large- and small-caps, and value beat growth during the year. Financial and consumer discretionary stocks did best, while the utilities and energy sectors lagged. The strong performance of international markets continued in December, as the MSCI EAFE and MSCI Emerging Markets indices rose 3.2 percent and 4.78 percent, respectively (see chart).

Fixed income markets performed well in 2012, with the Barclays Capital Aggregate Bond Index gaining 4.22 percent for the year and the Barclays Capital U.S. Corporate High Yield Index returning 15.81 percent. High-quality bonds lost ground in December, with the Aggregate Bond Index declining 0.14 percent. Treasuries traded in a relatively narrow range throughout the year.

Valuations vary across asset classes

As we enter 2013, U.S. stocks appear fairly valued based on short-term indicators, such as the trailing 12-month price-to-earnings ratio, but less attractive according to other metrics, such as the Shiller P/E ratio. The most value to be found is in developed Europe and Japan, though emerging market stocks also look attractive, particularly in cyclical sectors.

Bonds appear expensive. High-yields and municipals rallied significantly in 2012. With respect to their spread over Treasuries, they may offer opportunities, but they’re less attractive now than in early 2012.

A slow global economy spurred government intervention

The overarching factor in all markets in 2012 was the influence of governments and central banks. The European Central Bank (ECB) launched its Long-Term Refinancing Operation, and the U.S. Federal Reserve (Fed) continued Operation Twist. Both spurred rallies in risk assets. Later, the ECB announced a willingness to buy sovereign debt of distressed peripheral nations, the Fed promised a third round of quantitative easing, and China and Brazil cut lending rates.

The backdrop for these interventions was a soft global economy. The eurozone fell into mild recession, the Japanese economy struggled, and global manufacturing stagnated. The U.S. economy grew slowly, mostly as a result of an improving housing market and consumer spending.

U.S. housing and consumer spending recover, business lags

Housing slowly improved, with home values increasing year-over-year for the first time since 2006. Inventories remained below historical levels, suggesting that prices would continue to rise, and there were signs that household formation was starting to recover.

Employment also improved. The unemployment rate (U3) dropped from 8.5 percent at the start of the year to 7.7 percent near the end.

Consumer spending moved above the peak of the previous cycle, and though consumer savings rates fell, they remained reasonable. Consumer debt and debt service levels declined to multiyear lows. But business spending was much weaker, driven by uncertainty with respect to taxes and federal spending.

On to 2013

U.S. economic trends look encouraging. The political and economic risks in Europe remain but have been reduced. China and other emerging markets are showing signs of stronger growth.

A major risk for the U.S. is government dysfunction, as a debt ceiling debate approaches. Another risk is the reduced scope of policy responses available to central banks, so investors must rely on individual consumers and businesses to drive the economy forward.

Nevertheless, developments bode reasonably well for markets. In the U.S., the risks are containable and fiscal cliff damage may be limited. Cautious optimism is the appropriate stance. Investors should stay focused on their long-term strategic allocations and goals.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. 

                                                                                  ###

Sean Gross, CFP®, AIF® is a financial advisor located at Telos Wealth Management, LLC, 385 E. Penny Rd., Suite 103, Wenatchee, WA. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network^®, Member FINRA/SIPC, a Registered Investment Adviser. Sean can be reached at 509-664-884 or at Info@TelosWealth.com.

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research associate, at Commonwealth Financial Network.

© 2013 Commonwealth Financial Network^®

November was a month of politics throughout the world, and market action reflected this. In the U.S., the government wound up looking pretty much as it had before the election and equity markets ended November not far from where they began. The S&P 500 Index returned 0.58 percent. This small change masked quite a bit of volatility, including a significant post-election sell-off and a sharp rebound later.

In addition to politics, technical factors came into play. The post-election tumble took the S&P 500 below its 200-day moving average, and momentum carried stocks downward, for a total loss of more than 5 percent. Thereafter, investor confidence rebounded. By month-end, U.S. indices were back above their 200-day moving averages.

International equities outperformed U.S. stocks in November—with returns of 2.42 percent for the MSCI EAFE and 1.18 percent for the MSCI Emerging Markets indices, respectively—but showed similar volatility. On U.S. Election Day, the European Commission released a report anticipating a 0.3-percent contraction in European Union gross domestic product (GDP) for 2012 and GDP growth of only 0.4 percent throughout 2013. International markets reacted badly, declining in unison with U.S. markets.

Since then, developed and emerging equities have recovered. In particular, outperformance has come from troubled European nations—Greece, Portugal, and Italy.

Demand for U.S. Treasuries has remained high. During November, 10-year yields fell from 1.69 percent to 1.6 percent. High-yield spreads tightened slightly, too. For the month, the Barclays Capital Aggregate Bond Index returned 0.16 percent, while the Barclays Capital U.S. Corporate High Yield Index returned 0.8 percent. The most notable development in the fixed income realm was a sharp drop in municipal bond yields, from 2.5 percent to 2.25 percent by month-end (see chart).

Political volatility continues to drive market volatility 

At the end of November, expectations in the U.S. were generally positive but seemed subject to change daily. It was unclear whether a compromise over the fiscal cliff could be reached.

Similarly, Europe has had no resolution to its problems, just agreement on a series of half-measures. This uncertainty is likely to create ongoing market volatility. Other areas of concern include the Middle East and Asia.

U.S. economy doing well, despite uncertainty

Probably the best news has been the U.S. economy.  Growth has been revised up to 2.7 percent for the third quarter, largely attributable to housing and consumer spending. 

Housing prices have been up for eight consecutive months, per the Case-Shiller indices, and by a 3-percent average over the past year. Home sales nationwide were up 17 percent year-over-year in October.

Consumer spending has also stayed reasonably strong, buoyed by consumer confidence, which increased to a near five-year high in November. One area that has particularly improved is auto sales, where pent-up demand drove sales in October to another four-year high. Housing and auto sales are foundational components of any recovery, and their combined strength provide support for continued growth.

If stronger housing and consumer spending numbers are expected to continue, what’s the problem? The fiscal cliff. While consumers are spending as if the cliff did not exist, businesses have essentially stopped hiring and investing unless absolutely necessary. Should the cliff be resolved successfully, a pickup in investment and hiring could spur growth.

Looking good, but politics remain a risk

The U.S. economy looks to be performing okay, but risks remain. The third quarter was probably stronger than the fourth will be, and 2013 remains subject to spending cuts and tax increases that could slow growth. Even if we avert the cliff, the expiration of extended unemployment benefits and the 2-percent payroll tax waiver will negatively affect the economy.

Nonetheless, the fundamentals look good, and the expectation is for continued recovery, despite risks. We will be watching the politicians closely, but we remain cautiously optimistic that the U.S. will stay on its current positive trajectory.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. 

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Sean Gross, CFP®, AIF® is a financial advisor located at Telos Wealth Management, LLC, 385 E. Penny Rd., Suite 103, Wenatchee, WA. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network^®, Member FINRA/SIPC, a Registered Investment Adviser. Sean can be reached at 509-664-884 or at Info@TelosWealth.com.

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research associate, at Commonwealth Financial Network.

© 2012 Commonwealth Financial Network^®