January 2018 Market Update

In 2017, investors relished in solid economic growth, combined with abnormally high market returns, low unemployment and low market volatility. For the year, the S&P 500 increased 21.8% and the FTSE All World Ex-Us Index was up 24.40%. Investors watched as the Trump administration completed its first year in office, hurricanes ravaged parts of the country, and a tax reform bill was passed. In 2018, we expect GDP growth to accelerate, unemployment to decrease, interest rates to rise and inflation to increase slightly as the Tax Cuts and Jobs Act of 2017 takes effect.


Capital Markets Review

January 1, 2017 – December 31, 2017 index returns[1]:


S&P 500 (U.S. Large Cap): 21.8%

Russell 2000 (U.S. Small Cap): 14.6%

MSCI EAFE (Developed International Markets): 25.6%

MSCI EME (Emerging Markets): 37.8%

Barclays Capital Aggregate (U.S. Fixed Income): 3.5%

Barclays Global High Yield Index: 10.4%

Bloomberg Commodity Index: 1.7%


U.S. Economy

The U.S. economy has been steadily expanding for 9 years.  In the third quarter of 2017, real GDP increased at an annual rate of 3.1%. Total nonfarm payroll employment increased by 148,000 in December, and the unemployment rate was unchanged at 4.1%. In December, the ISM Manufacturing Index rose to 59.7, from 58.2, leaving it close to a 13-year high. We believe the Federal Reserve, with new Fed Chair Jerome Powell, will likely raise rates a few times in 2018 as the global economy continues to improve. The Fed estimates about 2.5% growth in 2018, which we believe is conservative.

In 2017, most major currencies appreciated against the U.S. dollar, which has a positive impact for investors with international investments. The yield on the 10-year Treasury is 2.5%, and we expect this to rise, however at a slower rate than short term interest rates. As a result, the yield curve will likely flatten.

Right before Christmas, President Trump passed the Tax Cut and Jobs Act of 2017, which gives various tax cuts to individuals and corporations in addition to other tax related changes. For a comprehensive review of the changes, and implications for the economy, portfolios, please see the Callan Capital Guide: Tax Cuts and Jobs Act of 2017.


Global Economy

Globally, growth and manufacturing is strong. In the eurozone, GDP growth and earnings are solid. Both reflation and rejecting the populist movement have been instrumental in sustaining the recovery that is ongoing. We see this as a tailwind to eurozone financial markets and international returns. We are keeping an eye on Brexit negotiations and the elections in Italy in the first quarter of 2018. As mentioned in prior communications, we increased international exposure in 2015, and our portfolios have benefited.

The Asia Pacific region had a good year, with solid growth and Chinese demand. We see a need to be cautious with China, as they are dealing with high debt levels. Hopefully, they will be able to de-lever by gradually tightening credit. However, China has a goal of doubling GDP per capita, and moving towards a consumption led economy, which will benefit many countries in the region[2].


What to Expect in 2018

We expect the U.S. economy in 2018 to benefit from the Tax Cuts and Jobs Act of 2017, but the benefits could be short term. Eventually, we feel that the increases in our federal deficit resulting from the tax cuts and increased spending will hinder growth in future years.

In 2018, we see unemployment decreasing to below 4% for the first time in 50 years and a boost in profits and earnings for corporations around the globe. It will be interesting to see how companies deal with tax cut savings, and where they allocate their funds.

This economic backdrop bodes well for stocks and is typically a headwind for fixed income given higher interest rates.  We feel much of this story is priced into the stock market and expect more muted returns and higher volatility as we move into the later stages of our U.S. recovery.  We are more optimistic about the opportunities overseas given the relative valuations.

Market performance in 2017 reminds investors that it is important to align with an investment philosophy based on discipline and diversification, rather than timing and prediction. To be able to predict the market, investors would have to both accurately forecast events and how markets will react to those events.  We believe that this is risky, and not possible on a consistent basis.

We continue to monitor the global economy and seek opportunities to invest in certain sectors and geographic regions given the current market environment. In our view, a long-term investment horizon, asset allocation, diversification and discipline remain crucial to portfolio success. If you are a client and would like further detail on these topics or anything else, please call or email us. If you are not a client, but would like more information on Callan Capital’s wealth management services, please contact us at (858) 551-3800 or www.callancapital.com.


[1] JP Morgan, Guide to the Markets, December 31, 2017, www.jpmorgan.com

[2] 2018 Global Market Outlook, Russell Investments. January 2018.


Important Index Descriptions and Disclaimers



The following descriptions, while believed to be accurate, are in some cases abbreviated versions of more detailed or comprehensive definitions available from the sponsors or originators of the respective indices. Anyone interested in such further details is free to consult each such sponsor’s or originator’s website.

The past performance of an index is not a guarantee of future results. Each index reflects an unmanaged universe of securities without any deduction for advisory fees or other expenses that would reduce actual returns, as well as the reinvestment of all income and dividends. An actual investment in the securities included in the index would require an investor to incur transaction costs, which would lower the performance results. Indices are not actively managed and investors cannot invest directly in the indices.

S&P 500®: Standard & Poor’s (S&P) 500® Index. The S&P 500® Index is an unmanaged, capitalization – weighted index designed to measure the performance of the broad US economy through changes in the aggregate market value of 500 stocks representing all major industries.

Russell 2000 Index: An index measuring the performance approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States.

EAFE Index: An index created by Morgan Stanley Capital International (MSCI) that serves as a benchmark of the performance in international index has been in existence for more than 30 years.

EME Index: An index created by Morgan Stanley Capital International (MSCI) that serves as a benchmark of the performance in global emerging markets. It is a float-adjusted market capitalization index that consists of indices in 21 emerging economies.

Barclays Capital Aggregate Bond Index: An index maintained by Barclays Capital, which took over the index business of the now defunct Lehman Brothers, and is often used to represent investment grade bonds being traded in United States. It is an unmanaged index considered representative of fixed-rate, noninvestment-grade debt of companies in the US, developed markets and emerging markets.

Barclays Global High Yield Index: An index maintained by Barclays Capital.

Bloomberg Commodity Index: A broadly diversifiedcommodity price index distributed by Bloomberg Indexes.  It tracks prices of futures contracts on physical commodities on the commodity markets. The index is designed to minimize concentration in any one commodity or sector. It currently has 22 commodity futures in seven sectors.


Nothing contained herein is intended constitutes accounting, legal, tax advice or investment recommendations, or the recommendation of or an offer to sell, or the solicitation of an offer to buy or invest in any investment product, vehicle, service or instrument.  Callan Capital does not provide individual tax or legal advice. Clients should review planned financial transactions and wealth transfer strategies with their own tax and legal advisors. For more information, please refer to our most recent Form ADV Part 2A which may be found at adviserinfo.sec.gov.

Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. All information presented herein is considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to any error or omission is accepted.  This information should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein.  In addition the Investor should make an independent assessment of the legal, regulatory, tax, credit and accounting and determine, together with their own professional advisers, if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance. The information presented herein is for the strict use of the recipient and it is not for dissemination to any other third parties without the explicit consent of Callan Capital LLC.

Second Quarter Economic and Market Update


The start to 2015 was characterized by modest returns and increased volatility across most capital markets. Headlines focused on low oil prices, a rising dollar, quantitative easing abroad, the humanitarian crises in the Middle East and Africa, and renewed fears of a Chinese slowdown.

Undoubtedly, low oil prices have not only hit the energy sector, but they have depressed corporate earnings in the U.S. and hurt emerging market economies dependent on commodities. The unexpectedly sharp increase in the dollar was a drag on corporate earnings and U.S. economic growth. However, these are short-term reactions and likely will correct themselves over the longer term: low energy prices benefit the global economy more than they hurt it and a strong dollar helps U.S. consumers and foreign nations dependent on exports, such as the Eurozone. Despite this short-term volatility, a well-diversified portfolio posted gains in the first quarter.

Capital Markets Review

1st Quarter Index Returns[fusion_builder_container hundred_percent=”yes” overflow=”visible”][fusion_builder_row][fusion_builder_column type=”1_1″ background_position=”left top” background_color=”” border_size=”” border_color=”” border_style=”solid” spacing=”yes” background_image=”” background_repeat=”no-repeat” padding=”” margin_top=”0px” margin_bottom=”0px” class=”” id=”” animation_type=”” animation_speed=”0.3″ animation_direction=”left” hide_on_mobile=”no” center_content=”no” min_height=”none”][1]:

  • MSCI EAFE (Developed Foreign Markets): 5.0%
  • Russell 2000 (U.S. Small Cap): 4.3%
  • MSCI EME (Emerging Markets): 2.3%
  • Barclays Aggregate (U.S. Fixed Income): 1.6%
  • S&P 500 (U.S. Large Cap): 1.0%
  • Barclays High Yield (U.S. High Yield Fixed Income): 0.6%
  • Dow Jones-UBS Commodities Index: -5.9%

Most of the major indices posted positive returns for the first quarter, with foreign markets leading the way – a turnaround from disappointing returns in 2014. The S&P 500 went from leader to laggard, with small caps beating large. In general, small cap stocks have less multinational exposure, and therefore were not as impacted by a strengthening dollar and other global headwinds, such as muted demand[2]. Surprisingly, Treasuries also outperformed the S&P 500, likely due to continued demand for U.S. bonds over lower-yielding foreign sovereign debt. Commodities continued to be dragged down by low oil prices, low inflation, over-production and decreasing global demand.

The U.S. Dollar

The dollar has been slowly moving upward over the past 4 years after a steady decline following the tech bubble, but jumped about 20% in the past 8 months[3] on an aggregate basis against foreign currencies.

USD Picture for the Q2 Market Update
Value of USD

The forces of supply and demand fundamentally determine the value of the dollar. The supply of the dollar is no longer increasing as the Fed’s easy money policy, known as quantitative easing (QE), has ended, and the demand for U.S. dollars has gone up for a number of reasons. First, the U.S. has been one of the strongest economies in the world and is attracting lots of foreign capital. Second, increased oil production here means we are importing less oil and fewer U.S. dollars are flowing abroad. Finally, domestic fiscal policies to reduce government spending and increase tax revenue have improved federal finances, and QE initiatives abroad have reduced the yields on foreign sovereign debt; investors seeking safety are flocking to the U.S. Treasury market, which increases the value of the dollar[4]. 

Continue reading

Is This the Beginning of the Next Bear Market?

Many investors fear another bear market is looming with the most recent pullback off the stock market highs in September. A bear market is typically defined as a market decline of 20% or more. There are many factors that could signal the start of a bear market – but bear markets typically happen in and around recessions, rather than in the middle of economic recoveries, such as the one that we believe we’re in now. We feel current market activity is more indicative of a classic correction within an ongoing bull market, rather than the start of a new bear market. Corrections are different from bear markets in that they start sharply (think triple-digit daily declines in the market), are usually based on sentiment-based fears rather than fundamentals, and are short in duration. Bear markets tend to start more slowly and are usually a result of deteriorating economic fundamentals, which is not the environment we are in right now.

The U.S. Economy

The U.S. economy rebounded nicely in the second quarter after a disappointing first quarter decline, posting 4.6% annualized GDP growth. As we’ve mentioned in prior communications, the decline in the first quarter was largely attributed to the severe winter weather on the East Coast and as a result, did not cause a lot of market volatility. Though the third quarter GDP numbers won’t be available for a few weeks, economic analysts believe the economy will grow at approximately 3% (annualized) over the next few years.[fusion_builder_container hundred_percent=”yes” overflow=”visible”][fusion_builder_row][fusion_builder_column type=”1_1″ background_position=”left top” background_color=”” border_size=”” border_color=”” border_style=”solid” spacing=”yes” background_image=”” background_repeat=”no-repeat” padding=”” margin_top=”0px” margin_bottom=”0px” class=”” id=”” animation_type=”” animation_speed=”0.3″ animation_direction=”left” hide_on_mobile=”no” center_content=”no” min_height=”none”][1]

Importantly, all of the leading economic indicators point to a continued recovery. For example, auto sales are well above average at 17.5 million units per year, and pent-up demand in housing will likely drive housing starts above the current 950,000 homes per year. Capital goods orders continue to climb as companies deploy more of the cash that’s been piling up on their balance sheets, and there will likely be no additional austerity measures put in place by the government.

The U.S. Bureau of Labor Statistics’ latest jobs report shows that 248,000 jobs were added during September and the unemployment rate decreased again, to 5.9% – both were better than expected.  We’re now close to the Fed’s target for full employment: 5.4% unemployment. Many Americans don’t realize we are now below the historical unemployment rate of 6.1% and we’ve added 10.3 million jobs in the past 5½ years – more than the 8.8 million jobs that were lost during the recession. The percentage of part-time workers (of the total labor force) has declined from 6% in 2010 to 4.7% today, and average hourly earnings are up 2.5% year-over-year. However, labor force participation has declined from 67% of the population in 2000 to 63% of the population today and will likely not recover for many years. This is attributable to a shift in demographics, as Baby Boomers exit the workforce and the overall population ages.


Job Growth (total non-farm employees)

Job Growth Chart
Source: http://research.stlouisfed.org/fred2/series/PAYEMS/ (as of 10/03/2014)


As we approach full employment, inflation risks increase. This is a classic result of supply and demand forces at work: as the supply of available and desired labor decreases, workers demand greater compensation. Higher wage growth is one of the factors that leads to increasing prices, which leads to inflation. The Fed will have a difficult balancing act in the coming years of increasing interest rates fast enough to mitigate inflation, but not too fast to detract from economic growth.

Continue reading

Preparing For More Tempered Returns as the Federal Reserve Ends the Quantitative Easing Program

As we enter the second half of 2014, we have a more tempered outlook on our market return assumptions. We feel volatility will increase as the Federal Reserve transitions from a provider of liquidity to a retractor of liquidity by ending their quantitative easing program and ultimately raising interest rates in 2015. While this may sound counterintuitive, we believe the economy will continue to improve. Although volatility and the risks of corrections have increased, we feel a highly diversified portfolio will continue to significantly outperform cash over the next several years.

In 2014, U.S economic growth faced an uneven start. The weakness was attributed to one of the worst winters in decades, low capital spending by corporations, reduced government outlays and depressed consumer activity. Fortunately, as we anticipated earlier this year, each of these trends has begun to improve, which should benefit economic growth for the remainder of the year.

Domestic Economy Shows Signs of Strength

Corporations are reaching higher levels of capacity utilization and employment, both of which should increase investment spending. As a result, we have seen a dramatic uptick in merger and acquisition activity.

Thanks to a boom in domestic energy production, our country has become more energy independent and imported goods have slowed. This reduction in imported goods should help lift domestic economic output.

With the federal budget deal in place, another fiscal cliff or similar Washington slowdown appears unlikely. In 2013, falling government spending was a significant drag on our economy, but this challenge is largely behind us in 2014.

Unemployment Falls and Consumer Spending Increases; Housing Market Temporarily Slows

In more good news, the unemployment rate has fallen faster than the Federal Reserve anticipated and is now within one percent of their long-run target for full employment. Part of this fall can be attributed to decreasing labor force participation, but job creation has been the main driver. Approximately 8.8 million jobs were lost in the 2008 downturn, while 9.4 million have been created in the recovery. These jobs will continue to help drive the economy through consumer spending.

On the subject of consumer spending, U.S. consumers have reached new records of household net worth which provides fuel for consumption. In addition, low interest rates have provided an opportune time to lock in fixed rate financing—another key that could help propel spending for years to come.

The June housing starts report showed a 9.3 percent drop month-over-month to 893,000, while building permits fell to 963,000. Although this was a disappointment, we predict the trend will reverse itself thanks to low home inventories and mortgage rates. In addition, home construction and purchases that were delayed due to weather in the first quarter will likely occur later in the year.

Quantitative Easing (QE) Program Nears End

The Federal Reserve has stated they will stop their controversial quantitative easing (QE) program by ending the bond purchase program later this year. This should put upward pressure on interest rates, but the trend could be slower than most anticipate as the Fed continues to reinvest their current portfolio while bonds mature. The Fed has indicated that they will begin to increase the overnight lending rate approximately six months after the end of the QE program, which would be sometime between the first and second quarter of 2015.

Critics have suggested that the Fed’s QE program has fueled the market rally over the past several years. We agree that some of our recovery was due to increased liquidity, but perhaps more significantly, strong earnings have been the most important factor. Even during the first quarter of 2014, which had one of the worst economic growth rates since the recovery began, profits rose six percent year-over-year. With the second quarter earnings season under way, 76 percent of those companies that have posted results have beat their analysts’ forecasts for earnings and 67 percent have exceeded their sales forecasts, according to data compiled by Bloomberg.

Valuations Invite Tempered Expectations

Although the U.S. economy seems likely to slowly improve in 2014, it is difficult to get excited about valuations of marketable securities. Whether you use the price earnings multiple or any other valuation metric, the markets in general are clearly not as cheap as they once were. That said, they do not appear to be particularly expensive either. Given current valuations, investors should temper their expectations for meaningful returns in the U.S markets over the next 12 to 24 months.

Global Economic Health Warrants Cautious Optimism

Looking overseas, emerging markets remain attractive long-term investment opportunities, but there are some short-term concerns. Long-term growth is driven by growth in the labor market and increased efficiency. With a young workforce, high levels of investment, and lower debt loads, the emerging markets remain attractive in each of these areas. In addition, valuations of emerging market stocks are more favorable than in the majority of the developed world.

European equities look very attractive relative to the Unites States. Europe had a double-dip recession and, as a result, has had a much slower recovery. The unemployment rate in Europe recently peaked at 12 percent, which is a lagging indicator of economic growth. Earnings in the United States are 18 percent higher than the peak of 2007, while European earnings are 25 percent lower. The eurozone is in the early innings of economic expansion relative to the United States. As a result, the equities have greater potential to outperform. Therefore, we have reduced our United States equity exposure in favor of Europe.

Conclusion: Economic Fundamentals are Slowly Improving, Return Expectations are Moderating

The probability of a bear market still seems remote, barring an economic shock from a geopolitical or other unexpected event. Bear markets typically emerge from tight liquidity, deteriorating fundamentals and investors’ extreme euphoria, none of which are present today.  Although we are entering into an era in which the Fed will be reversing course and could potentially raise rates in 2015, there are no signs of significant tightening of liquidity. Instead, there are now signs that private sector credit growth could start to replace the Fed as a supplier of liquidity. Economic fundamentals seem to be slowly improving and we do not see signs of extreme euphoria in the investment community as many people remain nervous.

Still, market volatility is likely to increase and total returns are likely to fall as equity valuations rise and the Fed adopts less-accommodative policies. On average, market corrections of 10 percent happen every year and we have not experienced a decline of this magnitude since 2012. Investors should stay focused on long-term market fundamentals and broadly diversifying their portfolios.


First Quarter U.S. Stock Returns and Ongoing Fed Policy Changes Point To Continued Importance of Diversification

By: Tim Callan

In this year’s first quarter, growth in the stock market slowed significantly. The S&P 500 rose just 1.8 percent over the past three months, following a year in which the S&P 500 rose more than 32 percent. Recently, the most common question we hear from investors is, “Is the stock market overvalued?”
A decent-sized pullback would not be a surprise, given the past four years of upward momentum. After tremendous growth in equities, valuations by virtually every measure are back to long-term averages. The forward price-to-earnings multiple is 15.2 times forward earnings, while the 15-year average is at 16. We can no longer make the case that stocks are cheap on their own; however, when compared to competing asset classes like bonds, they remain attractive in the long term. When interest rates are low, stocks tend to have higher-than-average valuations because bonds are not paying investors enough yield. On a positive note, there is $10 trillion in cash sitting on the sidelines, which should help fuel further equity growth. Still, our expectation for stock market returns over the next three to five years is in the mid single digit range, below the historical average of 11 percent.

Though the overall economy continues to grow at a very slow pace, we are approaching five years of economic growth, which makes this the fifth longest economic expansion since the Civil War. There is very little evidence of economic growth being derailed in the near term. Overall household net worth has never been higher, which continues to drive consumer spending. Meanwhile, with the sequestration subsiding, government spending is expected to increase as well. However, we expect first quarter GDP growth to be around 1 percent, well below our 3 percent expectation for the year primarily due to weather-related effects.

Unemployment continues to trend lower, confirmed by the March report of an additional 192,000 jobs and an unemployment rate of 6.7 percent. We have now made up all of the 8.8 million jobs lost during the recession, an important milestone. Full employment is considered 5.4 percent so we still have a little ways to go. Our expectation is that we will reach a level of full employment by 2016 and that, until then, the Fed will keep the short-term federal funds rate extremely accommodative.

The Fed has already reduced the bond-buying program known as Quantitative Easing to $55 billion per month and we expect the program to end this year, putting additional downward pressure on bond prices and causing long-term interest rates to increase. We remain defensive in our bond portfolios and think this trend will continue for several years. Diversification outside the United States in fixed income securities is important to help protect against higher domestic interest rates.

Emerging markets remain attractive long-term investment opportunities, but there are some short-term concerns. Long-term growth is driven by growth in capital stock, growth in the labor market, and increased efficiency. With a young workforce, high levels of investment, and lower debt loads, the emerging markets remain attractive in each of these areas. In addition, valuations of emerging market stocks are the cheapest they have been in a decade. There is good reason for cheap valuations: China has been increasing its debt at about twice the rate that its economy is growing and has an overvalued housing market. However, valuations will eventually revert back to the mean, which will equate to a significant rally in emerging market stocks.

European equities look very attractive relative to the Unites States. Europe had a double-dip recession and, as a result, has had a much slower recovery. The unemployment rate in Europe is at 12 percent, which is a lagging indicator of economic growth. Earnings in the United States are 18 percent higher than the peak of 2007, while European earnings are 25 percent lower. The euro zone is in the early innings of economic expansion relative the United States. As a result, the equities have greater potential to outperform. Therefore, we have reduced our United States equity exposure in favor of Europe.

Growing Global Economy and U.S. Market Corrections Create Opportunity for Investors

By: Trevor Callan
Last week was another down week for Wall Street which led the U.S. stock market to its largest monthly loss in more than a year. After five straight years of stock market gains, many observers question whether the climb can continue in 2014. With the 2008 credit crisis still fresh in investors’ minds, skepticism has been further fueled by concerns over China and other emerging markets. We predict, however, that market corrections and the growth of the global economy will create opportunities for investors during 2014.

While no market is without areas of concern, we remain optimistic about U.S. economic prospects for the upcoming year, though rises may be less dramatic when compared with the record gains of the past year. After the recent run in prices, a correction in the equities markets is healthy and should be viewed as an opportunity to rebalance portfolios. We expect the major trends during 2014 to be very similar to those of 2013, with one exception: lower returns. Analysis of current market dynamics suggests that 2014 will be a year of continued global growth, higher stock prices, and generally lower bond prices as interest rates slowly rise. Global economic growth is expected to accelerate in the coming year, driven by accommodative central bank policies abroad and a reduction in the pace of austerity both at home and in markets throughout the world.

In the U.S., several indicators point to faster economic growth in 2014. Sales of housing and cars are climbing, and companies are increasing capital expenditures and hiring workers to meet increased demand. The average net worth per capita broke records in 2013, and housing affordability is at historic lows, which fuels spending. Given these positive signals, we believe 2014 will be very similar to 2013, favoring equities at the detriment of fixed income securities. Interest rates should slowly drift higher, and we will most likely experience higher corporate profits. Inflation should remain relatively low, though higher than in 2013. During the past year, valuation expansion drove abnormally high returns in riskier asset classes, including stocks and lower quality bonds, at the expense of high quality bonds and cash reserves. Over the next five years, we believe the days of valuation expansion are largely behind us, and equity returns will be driven by earnings growth resulting in much lower returns, likely less than 10 percent. Of the 251 S&P 500 companies that have reported fourth quarter results, 74 percent have beaten earnings expectations and 67 percent have beaten revenue expectations. After the weaker-than-expected December jobs report, the Federal Reserve cited “growing underlying strength in the broader economy.” Then, as expected, the central bank announced another $10 billion per month cut in its asset purchase program. We believe the Federal Reserve will continue to taper and ultimately end the controversial quantitative easing program, which will result in higher yields placing pressure on high-quality bonds. As a result, we will continue our strategy of holding short-maturity, high-quality bonds with some exposure to below-investment-grade bonds.

There is also good news for European and emerging markets. Experts predict that Europe, which is showing signs of a recovery, will emerge into a growth cycle for the first time since 2011. Equity valuations are still attractive and look similar to U.S. equities one year ago. The manufacturing index has shown Europe emerging from a recession, and their recovery is only just beginning. The European Central Bank will most likely continue to provide liquidity as the Federal Reserve in the U.S. slowly withdraws liquidity from the system. As confidence builds in Europe’s recovery, we expect to see valuations rise, making European equities attractive over the next three to five years. As a result, we are increasing our exposure to international equities and more specifically, European equities, in 2014.

In Japan, the world’s third largest economy, Prime Minister Shinzō Abe has long campaigned to end deflation and revive the country. The prime minister’s policies have led to a falling yen, rising earnings, and rising asset prices. These trends should continue over the short term but longer term risks remain over their enormous accumulated deficit.

Emerging markets should continue to grow as well, albeit at a slower pace than in 2013. Emerging markets are expected to shake off their 2013 slowdown and grow by 5.3 percent per year over the next two years. In the short term, emerging market equities will likely struggle due to weak governance and volatility associated with the U.S. continuing to taper, but they offer reasonable valuations for investors with a longer-term outlook. Chinese GDP growth slowed to 7.7 percent in the fourth quarter of 2013. Meanwhile, purchasing managers’ indexes for the country indicated that the fourth quarter slowdown may have extended into 2014, as Chinese manufacturing activity contracted during January. Risks remain as emerging markets are vulnerable to a major dollar upswing and falling commodity prices.

In general, we favor the same asset classes that showed strength in 2013: equities; high yield bonds; and real estate. Equities should benefit from faster global economic growth, low inflation, accommodative central banks, and low but rising interest rates across the globe. We expect this year’s correction to provide an opportunity for investors to rebalance their portfolios into the asset classes that performed well in 2013. Although we expect the economic trends of 2013 to continue in 2014, we expect much lower average returns, as the valuations have increased dramatically. Overall, a growing global economy and healthy market corrections will create an opportunity, not an obstacle, for investors this year.

Economic Update and the Political Standoff in Washington

The S&P 500 had a great 3rd quarter—up 5.2% and 19.8% for the year—as the economy continued to show signs of improvement. As a result of the growth in stocks and real estate, along with the reduction of interest rates, overall household net worth hit a new record of $76 trillion, surpassing the high set in 2007 by $8 trillion. With the tremendous growth in equities, many investors question their valuation.

Stocks closed the quarter at a 14.3 times price to forward earnings multiple. That’s a slight discount to the average since 1985 of 14.9 times earnings. It’s rare that the market would peak at historical average valuations, as investor optimism generally pushes equities significantly higher before they fall. However, with earnings growth slowing and the equity markets approaching fair valuation, we do not anticipate the robust equity growth we’ve experienced in the last 3 years.

Bonds, particularly treasuries, remain expensive despite a selloff in the 3rd quarter. The yields on treasuries bottomed at 1.7% early in the year and have increased nearly a full point to 2.61%. This has caused the housing refinance market to slow considerably, as many homeowners locked in record-low long-term rates. However, there continues to be a housing shortage in the U.S.; the number of homes for sale is at 2.3 million, among the lowest in 30 years. In addition, housing starts are at 891,000, well below the average of 1.4 million. As a result, we continue to believe real estate will appreciate, albeit at a much slower pace as mortgage rates increase.

We expected the Federal Reserve to taper the quantitative easing program in September, which it did not do. The Fed continues to buy roughly $85 billion of bonds per month from banks in an attempt to keep rates low and keep the economy growing. We do have concerns long term about this program and its ability to increase inflation and deflate the value of the dollar. However, with core inflation at 1.8%, the risk will not likely present itself until the economy shows much higher growth.

The unemployment rate continues to decline as the economy adds roughly 180,000 jobs per month; it’s now at 7.3%, down from a peak of 10% in October 2009. In addition to added job growth, we’ve seen the overall labor force decline from 66% in 2007 to 63.2% today. Part of decline is disgruntled workers and young Americans staying in college, but the vast majority of the labor force decline is due to a demographic shift. The Baby Boomer generation is reaching retirement age, putting downward pressure on the labor force. We expect the labor force to increase in the coming years at a slow pace. If the addition of jobs continues, we should be at a 6.5% unemployment rate by mid-2014, the rate at which the Fed indicated it will likely end the quantitative easing program.

What’s Happening Now

There are significant risks to economic growth that have emerged in the last two weeks that can possibly derail the economy. House Republicans and Senate Democrats have not reached an agreement on the budget, causing non-vital areas of the government to shut down and the markets to sell off about 4% from the peak. This political gamesmanship has the potential to cause devastating economic effects, particularly if the debt ceiling is not raised by October 17. The news today is a proposal by House Republicans to extend the debt ceiling for another six weeks but keep the government shutdown in place. The White House insists that Republicans must also agree to end the government shutdown. Stocks rallied on the news, but this is far from a done deal.

The U.S. government has a projected borrowing amount of $642 billion for fiscal year 2013 or about 19% of its total spending budget of $3.5 trillion. If the government doesn’t raise the ceiling, it will have to immediately reduce spending to match the level of tax receipts—which will have potentially devastating consequences. In that scenario, the treasury will likely prioritize spending and continue to pay the interest on government debt to appease bondholders and maintain stability in the U.S. debt market. After all, interest payments to bondholders represent less than 10% of tax receipts. However, under this scenario, it will likely not have the funds to pay the full amount of Social Security obligations to seniors and veterans benefits on November 1. Given the fact that foreign countries own about half our government debt, the headlines would see that as favoring foreigners over seniors and veterans.

We feel some agreement will be reached close to or shortly after the October 17 deadline, perhaps to extend the implementation of parts of Affordable Care Act short term in exchange for funding the government and increasing the debt ceiling. However, the longer this plays out, the more damage it can cause. We feel risk assets such as stocks will have downward pressure until an agreement is reached, at which point they will rally.

We believe the best antidote for volatility and uncertainty is diversification, and ultimately, common sense will prevail. Unfortunately, the road toward a solution will be volatile and frustrating. We remain cautious short term in light of the current political pressure.

Opportunities, Risks and the Fiscal Cliff

This has been a great year for risk assets such as stocks and mediocre for low risk assets such as treasury bonds and cash.  The S&P 500 is up 16% through the third quarter while the Barclays aggregate bond index is up only 4%.  Since the bull market in stocks started in in March 2009, the S&P 500 is up over 112%.  Despite the market approaching previous highs set in 2007, most investors favor bonds over stocks.  Investors have added $1.2 trillion to bond funds and bond ETF?s since 2007 versus $200 billion into stock funds, despite the strong market performance.  The current yield on 10-year treasuries is a mere 1.65% through the third quarter and -0.27% real yield after inflation.  In addition, approximately $10 trillion sits in cash throughout the U.S. economy earning almost nothing.  So why aren?t investors adding to stocks over low risk assets like bonds and cash?

Economic uncertainty remains the primary driver behind investors? low aptitude for risk.  The economy is growing at a pace of about 1.3% as of the second quarter, which is well below the historical average of 2.5%.  In addition, the European debt crisis, high unemployment, the fiscal cliff, the presidential election, future tax rates, and other variables continue to create uncertainty.  What investors are ignoring, however, is the fact that even ?low-risk? assets present risk.

The 10-year Treasury bond, for example, has climbed under a 30 year bull market.  Yields peaked in 1981 at 15.81%!  Since then, bond prices have increased and yields have declined steadily to less than 2%, where they sit today.  While increases in interest rates don?t seem likely in the near future, they are inevitable long-term.  For every 1% increase in 10-year interest rates, investors can expect the value of their 10-year Treasury bond investments to decline by 9.1%.  We believe proper diversification in fixed income and short maturities will reduce but not eliminate this risk.

Cash and CDs are asset classes of choice among the risk averse.  For every $100,000 invested in a 6-month CD, an investor is earning $440 for the year.  After inflation, cash loses purchasing power of nearly 2% per year.  Despite this lackluster return on investment, $10 trillion is sitting in cash money funds, including CDs, surpasses the total mortgage debt in the entire United States.

The Federal Reserve has been keeping both short and long-term interest rates at low levels in hopes of getting banks to lend and investors to start taking more risk.  This has yet to happen, and all the money sitting in cash and bond funds will be added fuel for future stock price appreciation.

Despite the bull market in stocks over the last 5 years, stocks remain at very attractive valuations.  The consensus earning estimate for the S&P 500 over the next 12 months is $111 per share, which represents a forward price to earnings ratio of 12.9 times.  This is a 20% discount to the historical average multiple of 16.2 times earnings.  In other words, stocks would have to increase by 20% to reach the average multiple on earnings.  While, we don?t expect the multiples to go back to the historical average short term, the current valuation discounts lend themselves to long-term stock price appreciation.  Historically, stocks trading at current valuations have never been negative 5 years later.  In fact, the average return after 5 years has been 13% annually.

The pending fiscal cliff remains the biggest short-term risk to economic growth and stock market returns.  If nothing is done by congress over the next two months, $400 billion in tax increases will go in effect with the expiration of the Bush tax cuts, payroll tax cuts, unemployment benefits and the 3.8% increase due to the Patient Protection and Affordable Care Act, commonly called Obamacare.  In addition, approximately $200 billion of spending cuts go into effect, mostly in the area of defense, which would hit our local economy particularly hard in San Diego.

All of the tax increases and spending cuts would target the current deficit, which is on track to hit $1.2 trillion in 2012 or 7.3% of gross domestic product.  The fiscal cliff would drive deficits down to 2% of GDP in 2 years.  While that would be great for deficit reduction, it would likely drive our economy back into another recession by reducing $600 billion of economic demand immediately.  Our national debt remains a concern long term, but it would be more advantageous short term to lower deficits gradually.  Both political parties recognize this dilemma, and a more gradual solution will likely prevail.  However, time is running out, and we will likely see Congress and the newly elected President scrambling down to the last minute.

At Callan Capital, we believe investors will be rewarded for taking more risk over the long term.  However, we still hold bonds and cash to help reduce potential declines short term.  In addition, we have been defensive in our bond holdings by being diversified, avoiding treasuries and keeping maturities short.

Callan Capital Q3 2012 Newsletter

Read Between the (Head)Lines

By: Trevor Callan

The elephant in the room right now is fiscal austerity, and not just for the U.S.  As U.S. policy makers grapple with impending tax hikes and budget cuts, European leaders are scrambling to save the Euro. Headline-driven investor behavior is nothing new, but cooler heads will look past the panic-laced headlines as they position their investment portfolios for the remainder of 2012 and 2013.

US Economy

As we anticipated in our prior updates, the U.S. economy has continued to experience tepid growth and has managed to avoid a recession in 2012.  Our nation?s economy marked its 12th consecutive quarter of growth but expanded at a slower pace.  Housing shows signs of improving, with the Case Shiller, FHFA Purchase Only and Average Existing Home indexes all moving higher.  As of June 30th we have added 4.3 million jobs since the great recession, but the growth in payrolls has been a disappointment and not strong enough to move unemployment down in a meaningful way.


As usual, plenty of risks need to be addressed in the design of our portfolios.  If no action is taken in Washington to extend current law (Bush era tax cuts), 2013 will begin with a $400 billion tax increase and a $100 billion per year spending cut, which could send us into another recession.  As we approach this well-anticipated fiscal cliff, the U.S. economy is growing slowly at 1.5%-2.0%.  Both sides of the political aisle are flexing their muscles as we head into the election, signaling gridlock.  We feel neither party will ultimately want to take responsibility for a fiscal cliff dive and that this will lead to a compromise, providing relief to investor fear and reduce some of the uncertainty in the financial markets.

Europe continues to fight to save their monetary union.  Greece is struggling to satisfy the troika on budget cuts and other reforms promised as part of their bailout arrangement.  The process of saving the Euro has proven to be and will continue to be slow and uneven.  Jose Manuel Barroso, the head of the European Commission, recently warned Antonis Samaras, the Greek prime minister, that Greece has only a couple of weeks to persuade its creditors that it can put economic reforms back on track.  Mario Monti, Italy?s prime minister, noted serious concerns about the possibility that Sicily would default.  In the face of this uncertainty, the Europeans have shifted their rhetoric towards creating a fiscal union in addition to their monetary union, which is what is needed to solve the crisis.  Mario Draghis, president of the European Central Bank, pledged last week to do whatever is necessary to save the euro, saying, ?And believe me, it will be enough.?  This statement is important because it speaks to the little known fact that despite the rhetoric and the messy political process, the ECB controls the printing press and theoretically has access to unlimited Euro Dollars.

Although the European region will continue to be a source of uncertainty and volatility, we favor the region?s equity markets for long term investors.  Our European equity position, which includes over 400 of the world?s largest companies, provides a dividend yield of more than 4% and is trading at deep discounts to historical averages.  Europe has been and will continue to be a case of three steps forward, two steps back, but the overall fear should slowly dissipate, reversing some of the pressure on the financial markets.

Portfolio Strategy

Stocks and bonds continue to trade at valuations that, in some cases, resemble those not seen since the 1950?s.  This is clearly reflected in the Price Earnings Multiple (a valuation measure for stocks) of the U.S. Stock Market, which is trading at a lower multiple than what has been typical in past recessions.  This is extraordinary given the fact that we have experienced 12 consecutive quarters of economic growth.  Investors are so fearful of the unknown that many are actually purchasing 10 year U.S. treasury bonds with a negative real yield (net of inflation).  If we use the earnings yield as a valuation measure (earnings divided by price), the stock market is cheaper today than the week following the Lehman Brothers bankruptcy, September 11th, the stock market crash in 1987 and the Cuban Missile Crisis.  This leads us to believe that the remainder of 2012 will be directed more by emotions and headlines and less on fundamentals.  This creates an enormous opportunity for investors with a longer term time horizon.  As an example, when Mario Draghi pledged to defend the euro this week, investors exhaled and stock markets around the world skyrocketed in euphoria.  This begs the question of how much bad news could be priced into the financial markets.  If the news is slightly less dire, we should see relief and a move toward more normal valuations, creating a headwind for bonds and support for stocks and residential real estate.

Our antidote during these uncertain times is to focus on diversification and dividends.  We continue to focus on yield across our fixed income and equity portfolio, which has proven to be a good strategy in 2012.  Standard and Poors expects dividends to set a record this year as companies distribute their record cash surpluses.  We expect to continue to see companies repurchase their stock, increase dividends and make acquisitions which provide support for equities.  We feel interest rates will eventually rise as central banks reverse their bond purchase programs and fear subsides, creating a headwind for fixed income.  With this in mind, we continue to position our fixed income portfolios defensively against interest rate exposure.

Callan Capital Q2 2012 Newsletter

By: Tim Callan 

We are off to a great start in 2012 with the S&P up over 10% in the first quarter giving back only about 2.5% during the month of April.  The S&P is up 108% (120% if you include dividends) since it bottomed in March 2009.


During this period, many investors have remained on the sidelines fearing volatility.  Currently, $9.9 trillion of investor funds sits in savings accounts, money market funds, certificates of deposits etc., earning near zero return.  To put that in perspective, total mortgage debt outstanding in America is $9.8 trillion.  We are now within 10% of the market highs set in 2007, and many investors fear that the current rally is over.  A pull back after such a significant gain would be normal.  However, fundamentals suggest the market still has room to grow long term.   Large U.S. companies have never been more profitable than they are now, and they have never hoarded so much cash either.  The forward price to earnings multiple is 13 times, which represents a 17% discount to the valuation at the peak of 2007 and a 50% discount to the valuation at the peak of 2000.

As companies continue to hoard cash, they experience increased pressure from investors to return it to the shareholders through either share buybacks or increasing dividends.  For the S&P 500, buybacks are up from $50 billion in 2009 to $120 billion in 2011 and dividends have increased from $80 billion in 2010 to over $140 billion in 2011.  We expect 2012 to set a new record for dividends and buybacks with growth of over 20%.

Economic Growth and Employment

The economy continues to grow, albeit slowly.  The fourth quarter gross domestic product increased 3% on an annualized basis and we expect between 2.5% – 3% growth for 2012.  We continue to see job growth around 200,000 jobs per month, (excluding March which came in at 120,000 jobs) and we stand at an 8.2% unemployment rate.  At the current rate of job growth, we likely won?t see full employment until 2016.

Unemployment varies drastically by education level.  The unemployment rate for those without a high school degree is 13%, while those with college degrees have an unemployment rate of 4.2%.  Many individuals start college and for various reasons, mainly financial, never finish.  There?s not a big difference between those with high school diplomas and some college experience versus those with high school degrees and no college experience, 7.3% versus 8.3% respectively.  As a result, it?s more important than ever that parents plan for continuing education for their children.


The 4th quarter of 2011 saw significant fears of another global recession stemming from the European debt crisis.  However, those fears have subsided.  The ECB injected over $2 trillion into the banking system in the 4th quarter preventing another Lehman style disaster in the region.  As a result, we expect the European recession to be milder that we previously thought for the major economies of France and Germany.  However, risks still remain especially in the peripheral countries of Greece, Italy, Spain and Portugal as they fight to keep their borrowing costs under control.

Other risks are still in play.  A tremendous amount of political pressure exists to cut the mounting U.S. deficits by a large amount in a short period of time.  If nothing is done by the end of the year, $500 billion in austerity measures will take effect in 2013 which, if legislation doesn?t change, would push the economy into recession.  For example, the Bush tax cuts are set to expire at the end of this year causing tax increases across the board.  In addition, part of the debt ceiling limit increase agreement reached in July 2011 creates $1.2 trillion in spending cuts over 10 years starting in 2013.  The best way to reduce the deficit is gradually rather than immediately.  Congress will likely come to an agreement to change this after the presidential election.

The other risks we see pertain to oil prices.  Oil is now trading at $104 per barrel up from $45 after the crash in 2008.  Oil currently represents a 3.2% drag to our GDP growth.  For every 30% increase in oil, it reduces our GDP growth by 1%.  We do see risks with Iran, which provides about 4.9% of the worlds oil supply.  The U.S. is increasing sanctions on Iran effectively cutting the supply of the market and putting upward pressure on prices.  The world economy can withstand a 4.9% cut and continue to grow.  However, Iran has threatened to shut down the Strait of Hormuz where 18% of the world?s oil travels.  They don?t have the military capabilities to do this for a long period of time but they can certainly cause havoc in the oil markets if they attempt to do so.

Despite the current market rally and risks, we continue to think that riskier assets, i.e. stocks, will outperform risk-free assets, i.e. treasury bonds and we continue to position our portfolios to reflect this.