Continued government stimulus played a meaningful role in boosting third quarter returns as the European Central Bank took action to reduce some nations' borrowing cost and the U.S. Federal Reserve announced a new round of monetary stimulus measures on September 13, 2012. However, the Fed's efforts to keep asset prices moving higher may not be enough to overcome risks on the horizon. Eventually, investors must contend with weak economic growth (both domestic and global), decelerating corporate earnings growth, and major political uncertainty including the "fiscal cliff" looming at year-end when key economic stimulus measures are set to expire. Individual investors remain the largest skeptics as dollars continued to flow out of U.S. stock mutual funds and into bond funds.
Third Quarter Results
During the quarter, economically sensitive stocks once again took the lead following an investor preference for defensive-oriented sectors in the second quarter. The energy (+10%), telecommunications (+8%), consumer discretionary (+8%), technology (+7%), and financials (+7%) sectors were the best performers during the third quarter after lagging in the second quarter. Only the utilities sector, the classic defensive sector, declined during the quarter.
Overall economic growth continues to be weak with the exception of a stabilizing U.S. housing market. There are also signs of a deceleration in corporate earnings growth. In the most recent round of earnings reports, 67% of companies beat analysts' expectations; however, 59% missed revenue growth expectations. If revenue growth starts to slip, it may be more difficult to maintain profit margins, which are near their highs.
As a whole, our portfolios continue to be disproportionately weighted toward higher quality companies; however, we are beginning to see more attractive valuations in lower quality companies. The risk of moving down the quality spectrum is in how well lower quality companies can withstand a period of weak earnings and how much of that risk is reflected in current prices. In general, we have more confidence in large, diversified companies' ability to withstand a decline in earnings than in smaller companies with less diversified earnings. We are carefully evaluating the risk/reward of moving down the quality spectrum in search of more attractive valuations. Our belief that the current level of fiscal and monetary support is unsustainable argues in favor of holding positions in higher quality companies, but individual stock valuations are a key piece of the equation. If/when the stimulus is removed, the impact on earnings could be significant.
Our long-term economic view has not changed. Economies around the world continue to demonstrate very modest rates of overall growth; however, most key developed markets and a few important emerging countries like China have recently experienced a clear slowing in activity levels. U.S. and European economies continue to diverge along with the level of fiscal and monetary stimulus. In the U.S., employment remains stable, while the overall housing market appears to be improving with the activity levels picking up and values now rising in most markets. Meanwhile, Europe looks to be mired in a recessionary environment as its peripheral countries struggle with the difficult combination of elevated debt costs and fiscal restraint while having no monetary flexibility. Consumer discretionary spending is benefitting from various government initiatives, offsetting the effects of sluggish employment levels combined with continued household deleveraging. We continue to believe that the U.S. economy will be challenged for many years by financial deleveraging and the ultimate withdrawal of fiscal and monetary stimulus. From current levels, we believe the equity market could achieve a 5% to 7% total return, annualized, over the next five years. This is modestly below historical averages and down from our expectation just one year ago of a 10% annualized return over five years, primarily due to the increase in stock prices over the past twelve months.
The views expressed are those of the portfolio managers as of September 30, 2012 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Portfolio holdings are subject to change and will be made available at least monthly for download at www.diamond-hill.com, typically on the seventh (7th) business day following the most recent month ending date.