Investor Letter July 2012

The market’s pattern YTD in 2012 resembles the market’s action in 2011 while a number of key issues continue to hang over the financial markets. In our second quarter 2011 Investor Letter, we discussed the debt ceiling debate in Washington and Standard & Poor’s subsequent negative outlook and downgrade of U.S. government debt. We also wrote about serious weather related issues that greatly influenced the commodity markets. As was the case last summer, the Euro Zone crisis continues to be an issue as many of the southern European countries attempt to get their fiscal houses in order. As Yankee great, Yogi Berra, once said, “It’s déjà vu all over again.” The most pressing current policy issue is the need for Congress to address raising the U.S. debt ceiling. Similar to last year, the debt ceiling is expected to be reached in early September. It’s not surprising that investor confidence is fragile and waning with multiple unresolved issues.

Our newsletter covers recent impacting the the investment markets.

The Letter can be accessed directly from our website at the following link: 2nd Quarter 2012 Investor Letter

From The Blog of HORAN Capital Advisors

We hope you find the content of our letter insightful as 2012 continues to unfold.

A Repeat Of History?

The market’s pattern year to date in 2012 resembles the market’s action in 2011. A number of the issues impacting the market this year are similar to those that impacted the markets in 2011. Last year investors had to digest the impact of the debt ceiling debate in Washington and S&P placing the government’s debt on negative watch (and subsequently issuing a one notch downgrade), weather related issues influenced commodity markets with flooding in a number of countries around the globe, including in the Midwest of the U.S. and wildfire and droughts impacted the southwestern and southeastern parts of the U.S. These events are again top of mind for investors this year.

From The Blog of HORAN Capital Advisors

The policy issue at the forefront of investors' minds is the need for Congress to take action on raising the U.S. debt ceiling. The debt ceiling is expected to be reached in early September and the debate around this issue will certainly impact individual investor and business confidence. Couple the debt ceiling debate with the upcoming presidential election and the “fiscal cliff” at the end of the year, it is not surprising sentiment and investor confidence is waning.

Large Decline In Individual Investor Bullish Sentiment

The American Association of Individual Investors reported investor bullish sentiment fell over eight percentage points this week. The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months. The bullish sentiment reading of 22.19% was the lowest level since August 26, 2010 when the bullish reading was reported at 20.74%. In August of 2010 the S&P 500 Index was trading at 1,055.33. In the subsequent 12-months, the S&P rose 9.8% to 1,159.27. This one behavioral measures tends to be a contrarian indicator.

From The Blog of HORAN Capital Advisors

 Maybe this reduced bullish sentiment is warranted given the uncertainty surrounding economic growth or lack there of. Yesterday The Conference board reported the Leading Economic index declined .31% in the month of June. This was the second decline in the last three months. The Conference Board noted, "The strengths among the leading indicators have become less widespread as consumer expectations and manufacturing new orders offset gains in the financial, labor, and construction-related components. Meanwhile, the coincident economic index, a measure of current economic conditions, has risen slowly but steadily in the last three months.” The report goes on to note, “The U.S. economy is growing very slowly. The CEI basically reflects this steady but soft pace of overall economic activity. The LEI is pointing to no strengthening over the next few months, as the economy continues to sail through strong headwinds domestically and internationally.”

From The Blog of HORAN Capital Advisors

Mega Cap Stocks May Be Poised To Outperform

The market's recent pullback certainly seems warranted given the lack of positive news flow both economically and fundamentally. The euro zone continues to struggle in dealing with its debt issues, corporate earnings reports for the second quarter have been less than exciting and policy uncertainty out of Washington is weighing negatively on consumer and business sentiment. This seems like a replay of last year. In spite of these headwinds the S&P 500 Index remains higher on the year by 7.9%. From a pure technical standpoint, the S&P 500 Index does remain in a short term uptrend beginning in early June but in a downtrend since May as noted in the below chart. There is resistance at the 1,374 level and support at the 50 day moving average of 1,335. Additionally, the recent decline has not occurred on large volume.

From The Blog of HORAN Capital Advisors

Caution does seem warranted for a number of reasons as outlined in earlier posts. However, when the market does begin to rally it could be mega cap stocks that lead the market higher. A recent Fidelity report, "Capitalizing on Inefficiences in Mega Cap Equities," highlights some positive attributes of these larger cap equities. In evaluating mega cap stocks, Fidelity used the 200 largest stocks in the Russell 1000 Index. On a relative valuation basis, compared to the other 800 stocks in the Russell 1000 Index, the mega cap stocks are trading at a 26% discount to the midcap stocks of the Russell 1000 Index.

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On a P/E basis the mega caps are trading at valuation levels last seen in late 1991. Further, on a forward P/E basis, mega caps appear more attractive than their midcap counterparts.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

In looking at performance, mega cap performance has trailed significantly versus the midcap stocks.

From The Blog of HORAN Capital Advisors

And lastly, investors receive attractive dividend yields from these 200 mega cap holdings. The mega caps are yielding over 4% while the mid cap stocks yield just under 2.5%.

Volatility in the equity market seems more the norm today; however, investors seeking equity exposure might find an opportunity in these larger capitalization stocks. In Fidelity's report they evaluated the top 50 mutual funds and found the mega cap stocks were consistently under owned by most active managers.

Source:

Capitalizing on Inefficiences in Mega Cap Equities
Fidelity Investment Insights
By: Matthew Fruhan, Naveed Rahman, Alex Devereaux
June 2012
https://www.fidelity.com

Obama's Tax Platform Putting Retirees At Risk?

The current low level of CD and bond interest rates has resulted in retirees allocating more of their investment dollars to higher yielding equity and lower quality bond investments. President Obama's pledge to increase taxes on the rich ($250,000 and above in income) will likely have a negative impact on retiree incomes after 2012.

• The 2013 top marginal rate for qualified dividends increases from 15% to 44.6%.
• The tax on interest, rents, royalties, etc., increases from 35% to 44.6%.
• Long term capital gain tax increases form 15% to 25%.

These tax increases, with no commensurate proposal to reign in government spending, will have a detrimental impact on economic growth in the U.S. said Josh Brown, vice president of Fusion Analytics and author of The Reformed Broker blog.

A detailed summary of the tax implications of the Affordable Care Act can be found on the Association For Advanced Life Underwriting website.

Issues To Impact The Market In Second Half Of 2012

Investors and consumers will face a number of key issues in the second half of 2012 that are likely to impact their confidence level due to the influence these issues will have on the markets. One impact is potentially higher equity market volatility and this will not be a positive to investor confidence. Some of the issues and the respective dates investors need to keep an eye on are:

• September 2012: Debt Ceiling Debate: The market's response to the debt ceiling debate last year: it started a six week decline following S&P's downgrade of the credit rating for the U.S. President Obama has stated to Congress July 22 is the deadline for coming to an agreement to increase the debt ceiling by $2 trillion. The news flow resulting from this issue will likely have an impact on the market and influence investor confidence. The debt ceiling is expected to be reached in early September.

From The Blog of HORAN Capital Advisors

Source: The Big Picture

• November 2012, U.S. Elections: The political rhetoric will undoubtedly be raised to a heightened level as the November elections approach. Historically, the equity market is stronger in the second half of a presidential election year. Given the many issues that will need to be addressed in the balance of the year, it remains to be seen whether the market can move higher in the face of these hurdles. Also, the lame duck session of Congress could lead to market moving headlines.

From The Blog of HORAN Capital Advisors

Source: T. Rowe Price

• December 2012, Fiscal Cliff: The fiscal cliff is in reference to the expiration of the so-called Bush tax cuts, expiration of the payroll tax cut, the implementation of automatic spending cuts and the initiation of additional taxes to support the new healthcare law, all beginning in 2013. This fiscal cliff is as much as 3.9% of GDP and is likely to have a negative impact on economic growth in the U.S. The below table outlines various scenarios that could play out through 2015 and the resulting impact on GDP.

From The Blog of HORAN Capital Advisors

• December 2012, The End of Operation Twist: The Fed recently stated they will maintain Operation Twist through the end of this year. Although this liquidity program really artificially impacts the market, past Federal Reserve actions have tended to support higher equity market returns. Interestingly, each subsequent liquidity action by the Fed is having a smaller positive impact on equity market returns. The culmination of this program at the end of the year, along with the consequences of the fiscal cliff, will certainly weigh on investor sentiment. The end of prior Quantitative Easing (QE) programs have been met with a weakening equity market.

From The Blog of HORAN Capital Advisors

Source: Schwab

• Ongoing, Euro Zone Issues: The one issue that will not end any time soon is that of the EU. This European Debt Crisis link not only outlines the current actions taken by the European Union, but also is evidence of the many steps yet to be taken in an attempt to resolve the crisis in the EU. It is almost certain that every news headline on EU efforts to deal with their debt crisis will be market moving. Some will move the market higher and some will result in the equity market moving lower. The point is the EU issues will inject volatility into global markets.

Very near term, companies will begin reporting second quarter earnings. The bar is set pretty low for earnings with earnings estimated to increase only 3% in Q2. Since the beginning of Q2, earnings growth expectations have been reduced from 6.8%. According to Factset Research, analysts have reduced estimates for the third and fourth quarters as well. As of July 6th, the projected growth rate for Q3 2012 has fallen from 6.0% to 2.0%, while the projected growth rate for Q4 2012 has fallen from 16.1% to 13.9%.

The above are just some of the macro issues that will face investors in the balance of the year. The Conference Boards Consumer Confidence Index reported at the end of June showed a fourth straight monthly decline in confidence. The Board notes if this trend continues it is most likely to begin to negatively impact consumer spending.Maybe consumers and investors are taking note of these potential issues already.

Economic Decoupling Intrigue

With the hurdles facing many of the countries in the Euro zone, strategist have been tossing around the idea that the U.S. economy may in fact be decoupling from the rest of the economies around the globe. This is certainly an intriguing thought and would be supportive of better equity returns in the U.S. Better equity return doesn't necessarily mean positive returns though.

One recently cited data point is the strength of the U.S. PMI (Purchasing Managers Index) relative to other country PMIs. The PMI measures the health of the manufacturing sector of the economy. Readings greater than 50 indicate the manufacturing sector is expanding while readings under 50 indicate a contracting manufacturing sector. As displayed in the below chart, the U.S. has been a standout versus a number of the other countries and regions.

From The Blog of HORAN Capital Advisors

Source: Charles Schwab

The above chart is showing data through May and the recently reported June U.S. PMI came in at 49.7. This was the first below 50 reading for the U.S. PMI since July 2009. With the June report, it appears decoupling may in fact not be occurring since the manufacturing segments of many economies are now contracting. It is not surprising the U.S. PMI is now below 50 given the interconnectedness of the world economies and the large percentage of revenue generated outside the U.S. by U.S. companies.

From an equity market return perspective, the equity returns in the U.S. still appear to be positively correlated with equity returns outside the U.S., as well, specifically, Europe and the emerging markets. In the two charts below there remains a positive correlation between the S&P 500 Index and both the STOXX 600 Index (Europe) and the MSCI Emerging Markets Index. Positive correlation numbers indicate the two indices move in the same direction. For the emerging market index and the S&P, the recent correlation coefficent equals .62. This means 38% (.62 squared) of the variation in return is related.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

In the end, I do not believe we will see a complete decoupling of the U.S. markets and economy with the other markets and economies around the world. I do believe the U.S. is in slightly better shape than many of the Euro zone economies as well as some emerging markets. Therefore, on a relative basis, the U.S. could continue to outperform a number of its foreign counterparts, with one example being the recent performance of the S&P 500 Index relative to the performance of the emerging markets index detailed below.

From The Blog of HORAN Capital Advisors

After the emerging markets outperformance from 2000 through 2010, maybe the S&P is poised for stronger relative returns in the coming decade for a whole host of reasons. Market returns do not move higher in a straight line and market volatility is likely a continuing theme. Additionally, there are near term potential headwinds: an upcoming debt ceiling debate, the fiscal cliff, the U.S elections in November, just to name a few. For a more detailed review of factors to consider, Charles Schwab's Chief Investment Strategist, Liz Ann Sonders' recently released the July Market Snapshot video and it is a worthwhile video to view.

Dividend Payments and Buybacks Decline In First Quarter

Both aggregate dividend payments and buybacks for companies in the S&P 500 Index declined in the first quarter of 2012. The decline in dividend payments is not unusual as first quarter payment amounts have been lower in Q1 versus the prior Q4 in ten out of the eleven first quarter periods since 2001. The pattern for buybacks is more mixed as aggregate buybacks have declined in six of the eleven first quarter reports since 2001. On a year over year basis, dividends are up 14.2% while buybacks actually declined 6.2%. S&P notes this decline in YOY buybacks is the first decline since the fourth quarter of 2009.

From The Blog of HORAN Capital Advisors

In a report from S&P on Tuesday, they note net dividend payments in the second quarter where higher by $12 billion, which S&P believes is a record dividend payout in aggregate dollars terms for U.S. domestic equities. Howard Silverblatt, Senior Index Analyst at S&P notes,

"Payout rates, which historically average 52%, remained near their lows at 31%. At this point, we expect to see double-digit growth in actual dividend payments for the remainder of 2012, which would equate to a 16% gain over 2011."

Complicating dividend payment trends beyond this year is the impact expiring tax legislation will have on dividends at the end of 2012 that could increase the tax rate on dividends to over 43% versus the current 15% rate.

Will Individual Investors Continue To Get The Market Direction Right?

One thing investors experienced and seemed to have learned was their mistake of piling into the stock market at the top of the technology bubble in 2000. As the below graph indicates, investors allocated significant dollars to equities, based on monthly mutual fund flows, just prior to the technology bubble bursting in early 2000. However, since that time, investors seem to be timing their market moves correctly. At the bottom of the tech bubble in 2002, investors began investing funds into equity mutual funds fairly steadily up until 2008. At the top of the market in 2008, just prior to the financial crisis that impacted the market in 2008-2009, investors began pulling funds from equities and subsequently reinvesting in stocks at the end of the recession.

From The Blog of HORAN Capital Advisors

However, since mid-2010 the S&P 500 Index is up nearly 35% and investor flows into equity mutual funds have actually been negative. They seem to sense a better opportunity in bonds. Not that bonds haven't delivered reasonable returns, but bond returns have trailed returns for the broader equity market over the most recent 2-year time period.

From The Blog of HORAN Capital Advisors

As the above two charts indicate, investors have not warmed up to equities over the last two years. There are many reasons why, volatility, euro zone issues, issues in Washington, DC, etc., but, will they be proven correct this time? The equity markets do seem to be climbing that proverbial wall of worry and maybe pessimism about the markets is overdone to the downside vis-à-vis fundamentals.