APRIL 1, 2013

New Highs


n a seemingly odd juxtaposition of events, the Dow Jones Industrial Average reached a new all-time high on March 5, just five days after Congress allowed the much-anticipated deadline for the fiscal “sequester” to pass without taking action. A similar rally followed the weak legislative response to the “fiscal cliff” on January 1. After years of reacting to Washington’s repeated attempts to deal with the aftermath of the financial crisis, perhaps the markets are becoming hardened to the lack of a “grand bargain” and instead are focusing on the strong fundamentals of Corporate America. The resilience of American capitalism is remarkable. It was only a few years ago that the economy was deep in recession, leading banks and industrial companies had to be rescued from potential insolvency, and confidence had hit rock-bottom. Today, TARP money has been largely repaid, confidence is being restored—and the stock market is up more than 125%.

For reasons that we’ll explain shortly, we remain optimistic about the long-term outlook for equities. Still, it’s interesting that they have performed as well as they have in the face of continued financial challenges that remain largely unaddressed. It seems to us that company-by-company fundamentals, together with a massive monetary expansion, are overcoming the longterm risks that have colored investors’ thinking: • Total U.S. debt owed to creditors is now over $16 trillion, up from about $9 trillion in late 2007, before the financial crisis took hold. To put these staggering figures into perspective, just the increase in this debt works

out to an average of nearly $25,000 per citizen. Between spending “cuts” and the increase in taxes on the wealthy, the Administration claims to have come close to its goal of reducing the deficit by $4 trillion over the next 10 WILLIAM L. PATERNOTTE, CFA Senior Advisor years, but what this figure really means is that the cumulative deficit will be $4 trillion less than it would otherwise have been, assuming that no further changes are made over the 10 years. As long as we have annual deficits (the Congressional Budget Office [CBO] estimates this year’s to be $845 billion) our national debt will continue to rise. The CBO projects that U.S. debt held by the public will reach 77% of GDP by 2023, compared to a 40-year average of 39%—well below Greece and Italy’s levels but still ominously close to a tipping point from which it would be extremely difficult to recover. Not included in the national debt figure but nonetheless representing huge future obligations are entitlement programs, primarily Medicare and Social Security, which represent about two-thirds of federal spending. As these programs continue to rise faster than inflation because of an aging population, they will make it increasingly difficult to balance the budget. In effect, we will be forced to borrow money to fund deficits caused by the rapid growth of these programs.




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The cost of funding our debt is artificially low, masking the magnitude of the debt problem. In an effort to stimulate the economy, the Federal Reserve’s Quantitative Easing (QE) program has kept short-term interest rates near zero. At the same time, the government has shortened maturities to take advantage of the low rates. Despite the 80% increase in total federal debt outstanding over the last five years, the interest associated with it has hardly changed. When rates ultimately rise, they will cause a burdensome increase in interest expense, which is not fully factored into most deficit projections. Moreover, because of continued current deficits and short maturities, the government needs to tap the capital markets to the tune of about $4 trillion a year according to U.S. Treasury data, a precarious position to be in if the markets were to have any qualms about the quality of our credit.

While Congress and the Administration dithered over finding a solution to the deficit problem, the Fed intervened in 2008 with its aggressive QE approach to monetary policy, designed to stimulate the economy and help us grow our way back to fiscal health. Its strategy differs from conventional monetary policy by directly expanding the money supply rather than manipulating interest rates to achieve results indirectly. Further, purchases of bonds by the Fed are not “sterilized” by offsetting sales. Under the most recent phase, “QE3,” announced last September, the Fed is buying about $85 billion a month in a combination of Treasury and mortgage-backed securities. By focusing part of the program on longer-dated maturities, the Fed is attempting to lower long-term rates as well as keeping short rates close to zero. It intends to keep the program in place until unemployment declines materially. The ambitious scope of Quantitative Easing has caused the Fed’s balance sheet to balloon up to more than $3 trillion in assets, compared to about $900 billion five years ago. Since many of the asset purchases have been directly from banks, the financial health of the banking system has improved dramatically. Bank lending has picked up as a result, but the process has been painfully slow as companies already have lots of cash and have been reluctant to take on financial risk by borrowing heavily to finance their growth. At some point, probably two or three years down the road, such huge purchases under QE will have to end, given the practical limitations of the Fed’s balance sheet and the risks of renewed inflation and a weaker dollar. Interest rates will float up, but the process needs to be gradual. We believe that the economic expansion is still fragile and at risk of reverting to recession. In addition, a sudden surge in rates would add materially to the deficit since interest expense is a big factor.

into the capital markets. Initially, funds flowed primarily into Treasuries and other quality bonds, but soon investors began putting money into credit spread instruments with higher yields in their quest for income. Only recently has money flowed out of bonds and into stocks, and the result has been a new high for the Dow. With regard to the future direction of stock prices, we remain reasonably optimistic even after the first quarter’s rally, although it’s useful to bear in mind that the market never goes straight up. For perspective, let’s compare the current period with that of October 2007 (the previous peak) in terms of a cross-section of economic and financial indicators. Figure 1 contains a representative list. Taken at face value, the data would seem to suggest a market in decline today, in contrast to its last peak in 2007, just months before the financial crisis. Economic growth is slower, unemployment is substantially higher, and the country’s debt load is much greater. What the exhibit misses, however, is the change in direction that events took during the interim. A simple snapshot of late 2007 overlooks the increasing appetite for financial leverage and speculation that was ultimately followed by a steep decline in asset prices and an attendant recession. Today, it can be argued that the reverse is true. Confidence is still low in absolute terms, but the trend is up. Overcapacity in the business sector and the labor force in particular is keeping inflation at bay, and low interest rates reflect the economic slack, but again the trend seems to be positive.

FIGURE 1: Then and Now: A Comparison
Regular Gas, Price per Gallon GDP Growth (trailing 12 months) Americans Unemployed* Americans On Food Stamps Size of Fed’s Balance Sheet U.S. Debt as a Percentage of GDP U.S. Deficit (LTM) Total U.S. Debt Outstanding U.S. Household Debt Labor Force Participation Rate Consumer Confidence S&P Rating of U.S. debt 10-Year Treasury Yield Gold (per ounce) NYSE Average Daily Volume $2.75 +2.5% 6.7 million 26.9 million $0.89 trillion 38% $97 billion $9.0 trillion $13.5 trillion 65.8% 99.5 AAA 4.64% $748 1.3 billion shs

MARCH 2013
$3.73 1.6% 13.2 million 47.7 million $3.01 trillion 74% $976 billion $16.4 trillion $12.9 trillion 63.6% 69.6 AA+ 1.89% $1583 545 million shs

So for now, the money supply continues to expand at a rapid rate, and much of the additional liquidity is finding its way

Used with permission of The Associated Press Copyright ©2013. All rights reserved. *Counted as part of labor force (i.e., looking for work)




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Importantly, Figure 1 says nothing about stock valuations and the direction of earnings, the two most critical drivers of the equity markets. In late 2007, the Standard & Poor’s 500 Index was selling at about 18 times trailing 12-months earnings—not excessive compared to 28 times in early 2000, but still above its long-term average of 15-16. In calendar 2007, S&P 500 earnings per share were $84.63, but they declined 29% in the recession the next year before rising again and reaching a record $100.75 in 2012. Based on the latter figure, the S&P 500 now carries a P/E ratio of about 15, just slightly below average. Skeptics will point out that profit margins are now at peak levels, making further earnings progress challenging unless the economy picks up steam. Indeed, we are not forecasting substantial growth over the next couple of years, but we also don’t envision a collapse in profits since they have not been inflated by a powerful cyclical recovery. In making these comparisons, it’s essential to take into account the level of interest rates, and as shown in Figure 1, rates have declined dramatically since 2007. Lower rates generally support higher stock valuations since they result in a higher discounted present value of future corporate earnings and, further, when interest rates are low, bonds offer meager return potential compared to stocks. So, based on the rudimentary valuation data above, we don’t believe that stocks in general are over-valued even though they have reached new highs. In considering where we go from here, it’s useful to gauge investor psychology, which tends to run to extremes in either direction over the course of a typical cycle. In this sense too, it appears that stocks may have some distance to run before hitting the wall. Psychology is always tough to measure, but it’s safe to say that markets peak when investors no longer see much risk in investing in an asset class, and they trough when investors perceive that risks are high. As we talk with a wide range of people, we continue to hear them express concern about the economy, mounting budget deficits, rising federal debt, loss of business and consumer confidence, and increased costs associated with regulation and health care—many of the same issues outlined earlier in this letter. By being so clearly identified and discussed, these risks are well known and thus have been factored into investor psychology. In short, these imponderables have already been pondered. It’s the unknown risks about which we worry most. In a sense, then, investors have been buying stocks, not because they necessarily want to, but because they have few other good choices. Money is flowing freely into the financial markets, thanks to QE, and it has to go somewhere. Most investors already have ample exposure to fixed income, and the yields on quality bonds have been driven down to levels that offer sparse returns. Buying a 10-year Treasury security yielding 2%, for example, almost guarantees a negative inflation-adjusted return over the life of the bond since inflation has averaged over 2% for many years. Unless an investor is prepared to give up liquidity by participating in alternative investments (and for many qualified investors, that can make sense up to a point),

stocks are becoming the default asset class because there aren’t many other places to put money profitably. If we thought that speculation was rampant, we would be worried, but that doesn’t appear to be the case. Within equities, of course, there are many choices, and we devote a great deal of time and energy to thinking about how clients can best be positioned. In previous letters, we’ve talked about our preference for small-cap stocks over large caps, and we continue to think that they represent good value—that is, we are inclined to overweight small-caps in balanced portfolios. In an environment of sluggish economic expansion, smaller companies are generally able to grow by focusing on market niches or gaining share in fragmented markets. They also tend to be more dependent on local demand, and since the U.S. economy is growing faster than other developed markets, this means that small companies have the wind (or at least a gentle breeze) at their backs compared to large enterprises with international exposure that must overcome the resistance of a recession or flat economy.

With regard to geographic weightings, we have felt for the last two years that the U.S. and emerging markets represent a better investment opportunity than other developed markets, specifically Europe and Japan. We arrive at this conclusion by first examining the underlying economic fundamentals of the regions and then looking at how the equity markets are valued relative to one another. In the emerging markets, sovereign debt and current deficits are not big issues for most of the investable countries, and their growth prospects are generally better than the developed world. We are focusing much of our attention on smaller-capitalization companies, which, like their U.S. counterparts, are more dependent on local economic trends and thus less susceptible to recession-depressed demand from the eurozone. We’ve also launched a new mutual fund, the Brown Advisory Emerging Markets Fund, subadvised by Somerset Capital Management in London, that focuses on emerging markets stocks with above-average dividend yields and prospects

FIGURE 2: Key Indicators Favor U.S.
Year/Year Growth, Dec. ‘12 vs. Dec. ’11
10 8 6 4 2 0 -2 -4 -6 -8

7.9%* 5.8% 4.4%* 3.6% 0.6%**


U.S. Eurozone
0.8% 1.7% 0.2%

-6.0% Bank Loans Money Supply (M2) Consumer Spending Disposable Income Productivity (5-year avg. growth)

Source: Federal Reserve, European Central Bank, Bureau of Economic Analysis, Bureau of Labor Statistics, Eurostat *Jan. ‘13 vs. Jan ‘12 **3Q’12 vs. 3Q’11




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for healthy dividend growth. The presence of significant current yields tends to dampen the volatility inherent in emerging markets stocks. In the developed world, there’s considerable debate about the respective merits of Europe vs. the U.S.—a kind of value vs. growth comparison. Following the overall financial crisis and the emergence of serial sovereign-debt problems in Greece, Spain, Ireland, Portugal and Italy, the eurozone finds itself mired in recession while the U.S. is gradually recovering and perhaps even accelerating. Digging deeper, the prospects for growth in Europe are dim. The average debt-to-GDP ratio of the five nations just mentioned is well above 100%, and all are running significant deficits. Since all are members of the European Union, they cannot devalue their individual currencies in order to alleviate their debt problems, so the cost of servicing their debt will continue to mount over time. Because of their already burdensome debt loads, these nations—and Europe generally—have embarked on austerity programs to go along with monetary expansion by the European Central Bank (ECB) as a means of dealing with their deficits. In contrast, the U.S. has relied more heavily on Quantitative Easing to promote recovery, with the objective of growing our way out of the debt problem over the long term. As a result, U.S. bank lending has expanded at a rate of about 6% year-over-year, while bank lending in the eurozone has declined by a similar amount. Employment in Europe has fallen slightly, while in the U.S. it has grown, albeit at a modest pace. Labor productivity has increased steadily in the U.S. over the past five years, contributing to improving profit margins, but in Europe productivity has stagnated. In light of these comparisons, one would assume that European stocks carry significantly lower valuations than U.S. equities, but that is not the case. The price/earnings ratio of the MSCI Europe Index is about a third higher than the S&P 500 Index’s, even though interest rates in Europe are well above those in the U.S. The main reason for this disparity is that corporate profits in Europe remain depressed while those in the U.S. are at record levels, reflecting the recovery, labor productivity and the decline in interest rates. In spite of these differences, European stocks have slightly outperformed the U.S. since last June. We believe that the main reason has to do with the ECB’s

demonstrated willingness to take extreme measures to prevent defaults by those nations in the greatest difficulty. The ECB has thereby eliminated what some observers term “tail risk” (in this case, the remote but still real possibility that a developed nation would default). Now that this risk appears largely removed, facilitating a rally, it’s hard for us to see why European stocks would outperform the U.S. over the next year or so. None of the foregoing is to say that we would avoid European equities altogether, any more than we would avoid owning bonds in a balanced portfolio. Diversification helps reduce overall portfolio risk and, as in the second half of last year, the sudden surge of an asset class or sector can surprise us. In summary, we continue to believe that equities offer the best combination of long-term capital appreciation and liquidity. In identifying the most compelling opportunities within this broad asset class at a particular point in time, we inevitably fall back on our fundamental investment philosophy—and the fundamentals argue in favor of the U.S. and emerging markets.

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The views expressed are those of the authors and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance. In addition, these views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients or other clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients and is for informational purposes only. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. The S&P 500 Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Criteria evaluated include market capitalization, financial viability, liquidity, public float, sector representation and corporate structure. An index constituent must also be considered a U.S. company. An investor cannot invest directly into an index. The MSCI Europe Index is a free-float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed markets in Europe. The MSCI Europe Index consists of the following 16 developed market country indices: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom. Brown Advisory is the marketing name for Brown Advisory, LLC, Brown Investment Advisory & Trust Company, Brown Advisory Securities, LLC, Brown Advisory, Ltd., and Brown Advisory Trust Company of Delaware, LLC.



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