• UNITED STATES – Fundamentals are Improving
• EUROPE – Exiting Recession
• JAPAN – Growing for the First Time in Recent Memory

The overall year-to-date performance for equity indices around the globe has been excellent: the MSCI All Country World Index is up 19% through October. The U.S. stock market has fared even better with the S&P 500 and Russell 3000 indices both up better than 25%. Interestingly, when we look at year-to-date performance numbers, the S&P 500 has been in positive territory everyday this year; furthermore, on November 16th, the S&P 500 celebrated one year since the last closing price below its 200-day moving average (the daily average closing price over the last 200 days). Fixed income returns have been lackluster: global and U.S. bonds in aggregate are down 1% on the year.

While this year showed a remarkable divergence between equity and fixed income returns, we do not expect another 25% equity performance in 2014. We are preparing for another tough year in fixed income despite a positive macroeconomic outlook.

Let’s take a moment to review the economic trends in key geographic regions that frame our portfolio asset allocation decisions:

The leading economic indicators we follow suggest economic momentum is accelerating and the recent strong equity market gains are an anticipatory force of an improving economy, and not a bubble as a number of Wall Street commentators seem to believe. This may be a longer-than-average business cycle expansion, considering still high unemployment, low inflation, and a Federal Reserve that continues to support the business cycle instead of suppressing it. It is extremely rare to enter a recession when we do not have direct monetary tightening: out of 19 recessions since the inception of the Fed Reserve Bank, there has been only one (1945, due to fiscal WWII demobilization) that was not associated with direct monetary tightening.

While not necessarily clear sailing due to recent choppy economic data and deflation fears, the region is slowly emerging from its 18-month recession with newfound help from the European Central Bank in the form of increased monetary accommodation.

The economic plan prescribed by Prime Minister Abe and the Bank of Japan—aggressive monetary stimulus, increased public infrastructure spending, and currency devaluation to make exports more attractive—should continue to be a powerful tonic for increasing the GDP rate up from 0% to 3% and combating debilitating deflation.

All major developed economies are moving in the right economic direction for the first time in a long while, and this will benefit emerging markets: developed countries buy commodities, industrial manufacturing products, and other raw materials from emerging market countries. China, the biggest emerging market by far, averted a hard landing during the recent global slowdown and now appears to be free of a major financial crisis despite recent fears associated with ongoing economic reforms.

Our asset allocation positioning remains overweight equities, which are now fairly valued relative to our forward growth projections in an improving global macroeconomic scenario but still inexpensive vs. fixed income. The flow of funds data that track mutual fund and ETF aggregate dollar movements has supported this position this year through the third quarter: $13 bln out of fixed income assets and $106 bln into equities. We expect this “rotation” to continue in 2014.

Though we see a continued improvement in our macroeconomic themes, both domestic and international developed equities have now anticipated and reacted to the developing upswing in their respective business cycles. Most valuations, measured by price-to-earnings (P/E) multiples, have expanded since the beginning of the year and are now fairly valued compared to historical averages. As an example, the P/E multiple for the S&P 500 index at the start of the year was around 12.7x (the price of the S&P 500 on December 31st was 1,426.19 and the expected 2013 aggregate earnings per share for all 500 companies at the time was $112.17); today the P/E multiple on expected 2014 earnings of $120.91 is 14.7x.

Similarly, international developed equity valuations have increased but not as much as domestic valuations. One area of the international equity sector that appears particularly attractive from a valuation perspective is emerging markets.

An improving economy, over time, leads to an increased level of employment; more jobs = more wages = more spending on goods and services = more inflation. The perceived outcome of this relationship will cause interest rates to go up, not down. In order to protect our fixed income portfolio in this environment, we continue to lower portfolio duration and increase exposure to tax-exempt/municipal bonds and opportunistic areas such as floating rate, high yield, and convertible bonds.

We remain committed to “alternative” assets (real estate, commodities, and MLPs) that have lower correlation to equity and fixed income. Alternative investments increase portfolio diversification, may reduce risk, and help protect against inflation. We believe, however, explicit inflation is not an immediate risk at this time. We continue to explore future opportunities in the diversified commodities area.

As always, we very much appreciate the trust and confidence you place in our firm. We value that trust every day and will continuously strive to retain it. Please do not hesitate to contact your advisor for any questions or service needs.