Four years after hitting bottom, housing is finally showing signs of a broadening recovery.

In the three years ended December 2008, housing starts fell by 72% and employment in housing-related industries contracted by 1.4 million. Sales of new and previously owned homes also fell sharply (-70% and -41%, respectively), and house prices plummeted 24%. In the gross domestic product (GDP) accounts, residential construction imposed a one-percentage-point drag on annual growth from 2006 through 2008.

Housing activity stabilized in 2009, but the recovery unfolded very slowly, reflecting lingering structural adjustments. As the broad job market began to improve in 2010, household formations began to rise: people who had doubled-up or moved in with relatives during the recession began to strike out on their own, raising the demand for places to live. Builders responded, but mostly in the multifamily sector, reflecting the ongoing aversion to homeownership.

Indeed, the entire 20% rise in housing starts for the two years ended 2011 came in the rental-oriented multifamily sector. Moreover, even as building activity stabilized, the drive to restore profitability continued: Housing-related industries shed an additional 800,000 jobs in 2009–2010.

The recovery began to broaden in 2011 and gained strength last year. Housing starts jumped 25% in 2011 and another 32% last year, actually contributing modestly to real GDP growth. At the same time, housing-related industries began a new hiring cycle, adding 55,000 positions in 2011 and 101,000 last year.

Finally, home sales began rising in mid-2011, spurring a recovery in single-family construction and supporting a rise in house prices that helped significantly reduce the number of mortgages in negative equity.

Gathering Momentum

These trends should continue to gather momentum this year, underpinning prospects for sustained growth in the broader economy despite the drag from recent tax hikes and the sequestration of federal spending.

Housing starts are still roughly 25% below the pace required to keep up with population growth over time. We expect this gap to close over the next two years, with residential construction making a one-half-percentage-point contribution to real GDP growth this year. The expansion of housing-related production should spur the creation of about 300,000 jobs in housing-related industries this year.

The income paid to these workers in construction, real estate services, mortgage banking, and housing-related manufacturing—spent on the broad array of goods and services—will be an important secondary channel by which the housing sector contributes to broader economic recovery.

The nascent recovery in home prices—including a 7% rise last year—is another welcome contributor to sustainable growth, though its influence is likely to be modest in the near term. That’s because the inflation-adjusted house price—a widely accepted valuation metric—is still 6% below its long-term, pre-bubble trend. As a result, relatively few homeowners have experienced the rise in home value that they may have expected when the house was purchased.

In all, however, the emergence of the full suite of cyclical dynamics in the housing recovery—new construction, demand, employment, and price appreciation—is a milestone in the private sector’s deleveraging and rebalancing.

With this healing in an advanced stage, recovery in the U.S. economy should continue to gain momentum this year and into 2014, even as the recent double dose of fiscal tightening—tax increases and subsequent spending sequestration—works its way through the system.  

Retirement-date funds—which offer a diversified, risk-sensitive approach to building retirement savings—have grown dramatically in popularity with investors since introduced a decade ago.

T. Rowe Price Retirement Funds are made up of as many as 18 different stock and bond funds. The mix of these funds is managed along a “glide path” that shifts investors’ asset allocations away from stocks into bonds as they approach their target date, or approximate age of retirement, and beyond.

However, many investors in these funds may not know that—in an effort to enhance returns or reduce volatility—the asset mix within these portfolios also is incrementally shifted from time to time to take tactical advantage of market conditions.

“We are not timing the market,” says Jerome Clark, manager of the Retirement Funds, “but we are searching for overvalued and undervalued sectors and then positioning portfolios to best capitalize on potential opportunities in the coming 12 to 18 months.”

While important, such tactical shifts tend to be incremental—small movements over time, not big, sudden shifts.

For example, the “neutral weight” for equities in the Retirement 2025 Fund at the end of the first quarter of this year was 76.0%, based on the glide path. However, at that time, the fund had 78.5% in stocks, or tactically 2.5 percentage points more.

That overweighting of stocks was based on senior investment managers’ view that stock valuations were reasonable relative to the higher valuations of bonds.

The range of these tactical adjustments is limited to no more than five percentage points for such broad asset classes as stocks and bonds. That is, if a fund’s neutral weight is 60% stocks, then the tactical adjustment could shift that weight within a range of 55% to 65%. The underlying stock fund investments are adjusted proportionately.

While the biggest contributor to the Retirement Funds’ performance over time tends to be the performance of their underlying funds, as much as 25% of their long-term performance relative to their benchmarks may stem from such tactical positions, Mr. Clark says.

The Committee

The process behind these tactical allocations was developed in 1990 with the T. Rowe Price Spectrum Funds, another series of asset allocation funds, and has evolved over time.

Driving the tactical shifts is the T. Rowe Price Asset Allocation Committee, composed of 12 of the firm’s senior investment managers.

Starting with bottom-up sector views, the group meets monthly to review stock and bond valuations, trends, and metrics to assess relative values. The committee weighs tactical positions along nine different asset class continuums, such as, most broadly, stocks versus bonds or, relatively narrowly, U.S. investment-grade debt versus foreign bonds.

“Tactical shifts give us another tool to potentially enhance return by taking advantage of changing market conditions,” Mr. Clark says. “It enables us at certain times to position the funds slightly more defensively, or more aggressively, or in between.”

The principal value of the Retirement Funds is not guaranteed at any time, including at or after the target date, which is the approximate date when investors turn age 65. The funds invest in a broad range of underlying mutual funds that include stocks, bonds, and short-term investments and are subject to the risks of different areas of the market. The funds emphasize potential capital appreciation during the early phases of retirement asset accumulation, balance the need for appreciation with the need for income as retirement approaches, and focus more on income and principal stability during retirement. The funds maintain a substantial allocation to equities both prior to and after the target date, which can result in greater volatility.

Diversification cannot assure a profit or protect against loss in a declining market.

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With taxes having been raised this year for the most affluent and surveys frequently showing that many expect to pay higher taxes in the future, tax-efficient investing may become more important for investors.

Of course, many investors already take advantage of such tax-advantaged accounts as individual retirement accounts (IRAs), Roth IRAs, 401(k) programs, and other workplace savings plans.

But those investing in taxable accounts—accounting for about half of all mutual fund assets nationally, according to the Lipper research firm—potentially face annual tax bills from distributions of funds’ short- and long-term capital gains and dividends.

The good news is that the latest comprehensive study by Lipper of mutual fund taxes shows that the tax drag on investors’ annual returns in the average equity fund trended downward during the 2001–2010 period.

Lipper attributes this to the Bush-era tax cuts and to many mutual funds’ having carried forward tax losses from selling during that decade’s two deep bear markets—losses that were used to offset the funds’ later capital gains.

The bad news is that, during the 2006–2010 period, investors in taxable equity mutual fund accounts still saw the average fund return trimmed 0.93 percentage points by taxes, the Lipper study noted.

Such tax expenses would be directly or indirectly funded—from fund redemptions or transfers from other accounts. (This annual tax drag may be somewhat mitigated when investors sell fund shares, as prior capital gain distributions reduce capital gains on sales.)

The trend of a falling tax burden may be temporary as the bear markets’ buildup of tax losses are rapidly being used up by many funds to offset gains realized during the recent rise in equity markets.

And then there are the recently increased tax rates on earned income and investment income for relatively wealthy investors.

In the booming equity markets of the late 1990s and the poor equity markets of the 2000s, investors may not have given much consideration to their mutual fund tax burden, says Don Peters, manager of the Tax-Efficient Equity Fund.

But with higher tax rates and the resurgence in equity performance, Mr. Peters says the differences between pretax and post-tax returns could widen in the future, and many investors may become more tax conscious.

“One of the most common mistakes that investors make is misunderstanding the potential losses associated with taxes,” he says. “If you compound a percentage point or two of difference between pretax and post-tax returns over a long period, that can be a significant difference in compounded wealth.”

Asset Location

To achieve greater tax efficiency, the place to start is with the question of asset location: Which assets should investors put in their tax-deferred accounts and which in their taxable accounts?

T. Rowe Price financial planners say that investors first should employ an overall investment strategy of linking the time horizons of their financial goals and their risk tolerances to appropriate asset allocations and to account types.

In most cases, that means using tax-deferred and tax-free accounts (such as Roth accounts) for retirement savings and using taxable accounts for shorter-term goals, emergency cash, and retirement savings beyond the limits of contributions to tax-advantaged accounts.

But after that level of planning, tax-conscious investors may want to consider putting investments that tend to spin off more dividends, such as bonds and fixed income and real estate funds, in their tax-advantaged accounts.

That generally would leave growth–oriented equity funds, money market funds, municipal bond funds, individual securities, and lower-turnover equity funds, such as tax-efficient funds and index funds, for investors’ taxable accounts.

Of course, this overall asset-location strategy mainly applies to those with assets in both taxable and tax-advantaged accounts.

Those with the bulk of their investments in tax-advantaged accounts may want to give greater weight to equity funds in these accounts, depending on their time horizons, because over the long term stocks have tended to outperform bonds.

However, investors should keep in mind that gains from equity funds in tax-deferred accounts would be taxed at a possibly higher ordinary income tax rate than the capital gains rate.

And of course, tax efficiency itself does not ensure higher returns, and there are many equity funds with low turnover rates that are relatively tax-efficient—without being branded as such.

For tax-conscious investors, however, tax-efficient investing “may make more sense than ever,” says Christine Fahlund, a T. Rowe Price senior financial planner.

“In today’s fast-moving markets, investors should be looking for ways to invest for the long term without having to make constant adjustments to their portfolios based on tax code changes that Congress may be making, and investing in a tax-efficient manner could be a big step toward that.”

Buy and Hold

Since its inception in 2000, the Tax-Efficient Equity Fund has been almost 100% tax-efficient.

The Tax-Efficient Equity Fund has passed on some of its dividends to shareholders—although, as a growth fund, it tends to have a relatively low dividend yield ratio.

But the fund has had no capital gain distributions since its inception because Mr. Peters has kept the fund’s turnover relatively low (about 26.4% for the 12 months ended March 31, 2013) and offset realized capital gains with losses harvested from tactical selling.

At the same time, he stresses, the Tax-Efficient Equity Fund is not managed purely with the goal of tax mitigation.

Rather, he follows a philosophy of steadily buying a broad range of high-quality mid- and large-cap companies at reasonable valuations and holding them for the long term.

“In order to minimize taxable capital gain distributions and maximize after-tax returns,” Mr. Peters says, “we plan to own our companies for the long haul, focusing on those with strong, sustainable market positions and high returns on capital. We prefer to let our winners run, rather than realize gains, unless the companies’ long-term outlooks have deteriorated.

“We believe market timing is virtually impossible. Attempts to sell at the peak and buy at the bottom require an investor to make the right timing decisions not once, but twice—complicating an already challenging task under any market conditions,” he says.

“So, although we may make new purchases opportunistically, we don’t trade opportunistically or rotate from one sector to another in an attempt to capture short-term outperformance.”

Such an approach requires patience both for the fund manager and fund investors, he says, as over the short term the fund’s performance may deviate positively or negatively from that of funds more focused on pretax returns.

For Mr. Peters, it also requires discipline to stick with stocks of high-quality companies with durable franchises that may be temporarily subjected to declines from short-term problems.

Such is the case with Boeing, the world’s leading aerospace company and one of the larger, long-term holdings in the fund.

Boeing’s share of a firmly entrenched global duopoly in the commercial aircraft business (along with Airbus) and its continuing strong financial conditions enabled Mr. Peters to see beyond the battery problems with the new 787 Dreamliner that cropped up at the beginning of the year. So he added to the fund’s holding of the stock.

“As a longer-term investor, it is inevitable that every company we own will go through periods of adversity,” he says. “We believe our advantages in evaluating such issues are twofold: T. Rowe Price’s global research platform and this particular fund’s longer time horizon for investing relative to others.”

Shares of the Boeing Company made up 1.4% of the Tax-Efficient Equity Fund as of March 31, 2013. European Aeronautic Defence and Space Co., parent of Airbus, was not held by the fund.  

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Fund holdings are subject to market risk, and share prices may be more volatile than those of a fund focusing on slower-growing or cyclical companies.

Every investor’s dream is to get in on the ground floor of the next Apple or Google well before such companies become huge success stories and their stocks soar in value.

While the rewards can be great, the odds of success are usually low. “IPOs [initial public offerings] are a very risky segment of the market,” says Brian Berghuis, manager of the Mid-Cap Growth Fund. “For every success there are dozens of companies that meander through their corporate lives or outright fail. So it’s important to ferret out the rare company that may have at least the potential for major success.”

A recent T. Rowe Price study shows how difficult that can be. It tracked some 4,500 companies that went public from 1995 through 2007 and measured their progress through the end of last year.

Of those with less than $100 million in revenue at the time of their IPO, representing about three-quarters of the total, about 40% had reached $100 million through last year, and only one in 20 had reached $1 billion in revenue, marking a major milestone.

Of the roughly two-thirds of more seasoned companies that went public with more than $100 million in revenue over this period, only a third had reached the $1 billion mark in revenues through 2012. (The study did not account for companies that were bought out sometime after the IPO.)

And while many investors might expect to find these diamonds in the rough in such high-profile industries as technology and health care, some of the best success rates were found in relatively less dynamic sectors, such as energy, industrials, and consumer.

Based on his own analysis of IPOs over the past decade or so, Henry Ellenbogen, manager of the small-cap New Horizons Fund, says: “Only a few outliers actually get to $1 billion of sales. Just 3% have what it takes to become large-cap companies, and about half of them become road kill.”

T. Rowe Price invests mainly in companies with established track records, but the firm has participated in the IPO market for decades and is one of the largest investors in that arena. Equity analysts examine virtually every IPO that comes down the pike—many even before the IPO while the companies were still private.

On average, the firm participated in about 40% of all IPO issues over the past four years. In fact, about 25% of all U.S.-listed stocks that T. Rowe Price owned as of December 31, 2012 (excluding those in index funds) were originally invested in as IPOs over the past 20 years, although some were not owned continuously since the company went public.

Even picking “winners” that soar in early trading, however, has negligible impact on fund performance initially because of the relatively small position a fund may take in the stock. But, over time, as managers’ confidence and investment in these unproven companies increase, some have become significant contributors to shareholder returns.

Indeed, the firm typically views IPO investments as potential long-term holdings rather than an opportunity to turn a quick profit by “flipping” these stocks. Several dating back to the 1990s remain in portfolios today.

IPO Importance

“IPOs are a very important part of the investment process here,” says Preston Athey, manager of the Small-Cap Value Fund. “First of all, you don’t want to miss the next potential big winner. Also, you learn about possible threats to your other companies.”

Hugh Evans, an IPO specialist and equity analyst for the firm who has examined more than 1,000 IPOs over the past 18 years, adds: “It’s crucial to focus on the next generation of potential breakout companies. Over time they could potentially account for such a large portion of a portfolio’s return.”

For example, Mr. Evans cites another T. Rowe Price study showing how relatively few stocks can drive performance over time. From 1985 through 2012, the Russell 2000 Index of small-cap stocks had an annualized return of 12.6%. If the top 10% of performers in the index were excluded, the return would have been just 2.6%.

Another key reason the firm spends a lot of time studying new companies is to gain insight into possible threats to existing holdings.

“When you have a new company with a potentially disruptive business model, you’d better be familiar with it if you own one of their competitors,” says Dan Martino, manager of the Media & Telecommunications Fund.

Tom Watson, a computer software analyst, adds: “That perspective is especially important in software where the rate of change now is the highest it’s been since we switched from mainframes to client servers in the 1980s.”

Keys to Success

While the criteria for evaluating newer companies can vary from one industry to another, there are certain characteristics managers consider crucial. Having a solid business model and an innovative product or service with expansive market potential is important, but the quality of the firm’s management comes above all else.

“Most of these small companies will live and breathe to the rhythm of an entrepreneur with a vision,” Mr. Evans says.

Jack Laporte, former manager of the New Horizons Fund for 23 years, adds: “I’ve seen good managements make mediocre businesses very good stocks and bad managements turn good businesses into disasters.”

Mr. Ellenbogen says he focuses on two key attributes in evaluating smaller companies. “One is a fundamentally better business model and the company continues to innovate,” he says. “The second is: Do they have an Act II that goes beyond the initial business model.”

T. Rowe Price managers have uncovered many interesting opportunities to invest in newer companies throughout the economy, including some that have already evolved into industry leaders and others that are forging new breakthroughs.

Here is a glimpse of a handful of IPOs the firm has participated in over the years and more recently in various sectors.

Consumer:

One of the firm’s longest-held companies bought on its IPO is Whole Foods Market, the natural food supermarket chain that went public in 1992. As a young analyst then, Mr. Berghuis believed in the company’s future even though Wall Street viewed it “as a really narrow niche, almost a fringe, hippie concept,” he says.

In a memo to the firm that year, Mr. Berghuis wrote: “I do not view natural foods retailing as a fad. It appeals to the baby boomers’ interest in health and wellness. As consumer concern about nutrition grows, several natural foods retailers, including Whole Foods, are moving into the cultural mainstream.”

In addition to the company’s potential market growth, Mr. Berghuis was intrigued with its chief executive, John Mackey.

“John Mackey ranks up there with the top CEOs I’ve ever known in terms of thought leadership, innovation, openness to new ideas, and his ability to manage people and create a culture that was highly differentiated,” Mr. Berghuis says. “So we had a company led by a passionate entrepreneur with a truly unique outlook and strategy. Whole Foods represented a huge innovation in what had been a fairly stodgy supermarket industry.” Today, T. Rowe Price remains among the company’s largest shareholders.

Other consumer-oriented companies that found new ways to innovate that the firm has participated in from the start include longtime holdings Panera Bread and Starbucks and such recent investments as Angie’s List; OpenTable, the leading electronic restaurant reservation platform; Allegiant Travel, a discount airline focusing on smaller, less competitive markets; and Youku.com, the leading online video site in China.

Social Media:

The firm invested in Facebook even before it went public. That has not been as rewarding as expected, but the firm’s due diligence on that company bolstered its confidence to invest in LinkedIn, a professional social networking company, when it went public two years ago. In contrast to Facebook, LinkedIn has exceeded expectations.

“People felt Facebook would create significant pressure on LinkedIn’s business model,” Mr. Martino says. “Our work on Facebook made us realize that this was not the case.

“LinkedIn is more of a business services model. Most of its revenue comes from recruiting services for HR [human resource] professionals. They are really disrupting the traditional HR recruiting model. This company has basically invented a new industry.”

As part of its research, T. Rowe Price convened a panel of HR professionals from various companies familiar with LinkedIn’s services. “It was clear from that discussion,” Mr. Martino says, “that they thought this service was incredibly good and that it enabled them to do something they couldn’t do before—hire the most attractive candidates more efficiently, including those who were only passively looking for jobs.”

Computer Software:

The software industry has been a fertile area for IPOs recently. Mr. Watson says 18 of the 34 companies he now covers were invested in at the IPO stage in recent years.

Although most have done well, “I know that not all 18 of our current software IPOs will make it to mid-cap or large-cap land, but if one or two do that’s a big success,” he says.

One of Mr. Watson’s five “sources of durability” for software companies is, simply, to “do something that’s really hard.” Among the more promising companies in this category is Workday, which has become the HR software system of record for businesses, helping manage employee profiles and performance and benefit programs.

“What Workday does requires so much complexity that it creates a barrier to entry that we think will improve its chances of becoming a larger business over time,” Mr. Watson says.

Other newer software companies that meet Mr. Watson’s criteria for durability include Concur Technologies, which serves the credit card industry and travel ecosystem; Sourcefire, a security software firm with a strong distribution network; Cornerstone OnDemand, providing employee performance and management learning services; and two companies that dominate small markets: RealPage, specializing in commercial real estate software, and Guidewire Software, which replaces old back-end systems for the insurance industry.

In this fast-changing industry, Mr. Watson says the most successful IPOs generally “have been those with some sustainable advantage besides the pure technology itself. Sometimes you find a software company that is gaining market share because it can perform a process slightly faster than the last generation. I’m more cautious on those because if there is no differentiation, in a few years there will be an even faster alternative.

Health Care:

This industry has generally been a minefield for IPOs in recent years, but the firm has invested in some new companies with unique products or services that are doing well. One is Pacira, which went public in 2011.

This company produces a long-lasting anesthetic that can provide post-surgery relief for up to 72 hours compared with six hours for existing drugs. This helps reduce recovery days in the hospital and provides an alternative to such powerful medications like morphine, which is often used for postoperative care and can have damaging side effects.

Athenahealth and Pharmasset are two other stocks the firm invested in on their public offering six years ago. Athenahealth provides information technology services for physicians that help reduce administrative overhead and increase efficiency. Pharmasset developed a hepatitis C medication and was subsequently acquired by Gilead Sciences, adding a significant new growth opportunity for that company.

Energy:

The revolution in hydraulic fracturing and horizontal drilling is creating a boom in shale oil and gas production and new opportunities for both established leaders and newcomers with attractive assets.

“Not many people realize that the U.S. is now the third-largest producer of oil and natural gas liquids in the world,” says Shawn Driscoll, an energy analyst. “In terms of just oil, we’ll pass Saudi Arabia within two years, and a year or two after that we’ll pass Russia to be the largest. So we own a lot of companies levered to this.”

One is Oasis Petroleum, a shale oil producer that went public two years ago. “Oasis is a classic situation of how we get interested in IPOs,” Mr. Driscoll says. “We had spent a lot of time in the Bakken field and we knew the economics of their wells, which is what drives these companies. So when the IPO was announced, we already knew the company and its assets very well.”

In searching for such potential investments, Mr. Driscoll says: “We spend most of our time on the oil and gas basins themselves, sifting through well information to figure out who has the best rock. And then we focus on the people because you can have very smart people, but if they don’t have good geology it won’t be a good stock.

“You just can’t make bad rock look good, but there are plenty of people who have made good rock look bad. That’s why we try to focus on both, and even then we’re probably only successful about half the time.”

Media:

T. Rowe Price initially invested in Google on the public offering in 2004, recognizing its substantial growth potential in U.S.- and international-sponsored Internet search. It currently represents the firm’s largest holding, accounting for $7.5 billion in assets alone. The bulk of this position, of course, was acquired in subsequent years after the IPO.

T. Rowe Price remains enthusiastic about Google’s future prospects. “Over time they have proven to be very innovative and ambitious,” says Paul Greene, an analyst who now follows the company.“They do not rest on their laurels. They are always pushing the needle.They are the leader in so many of tomorrow’s technologies and are well positioned in major growth areas. Their management team and willingness to think long term, aside from having a strong core business, leads us to believe that they will have continued success.”

What Can Go Wrong

By being very selective and cautious, taking a long-term approach, and always doing its homework, T. Rowe Price overall has had its share of success in IPO investing. But for various reasons, not all of these companies fulfill their promise.

“Sometimes our judgment is faulty, sometimes the concept is worthwhile but the execution is faulty, and sometimes it’s just bad timing,” Mr. Berghuis says. “A lot of factors can intervene between the best laid plans and success.”

In that regard, the jury may still be out on Groupon, but it represents one of the firm’s biggest disappointments and misjudgments to date. T. Rowe Price invested in the Internet-based commerce company even before it went public in late 2011. It was one of the hottest tech IPOs, valued at $16.5 billion. Since then the company’s stock has plummeted, its chief executive fired, and its market value fallen below $3 billion.

“When investing in companies with grand visions within entirely new industries and strong early success, it is inevitable that we will sometimes be wrong, as we were with Groupon,” Mr. Martino candidly wrote in a recent report to shareholders.

He adds: “The management execution certainly hasn’t been good, but the market opportunity probably was not as big as we thought. The product proved more faddish and trendy than a mainstream marketing channel….Consumers kind of got fatigued with it.”

Despite such inevitable setbacks, and a substantial decline in the number of IPO opportunities since the financial crisis, T. Rowe Price remains committed to this strategy.

“It may be more challenging,” Mr. Berghuis says, “and we may have more misses than big successes, but it absolutely remains an important part of our investment process. New companies are the lifeblood of public markets, so we have to stay focused on them.”

As of March 31, 2013, the stocks mentioned in this story and charts accounted for 4.2% of assets of the Mid-Cap Growth Fund, 22.2% of the Media & Telecommunications Fund, 1.1% of the Small-Cap Value Fund, and 10.0% of the New Horizons Fund. Please note that the funds did not acquire their entire ownership of these securities at the time of the IPO. As of March 31, 2013, none of these funds owned Groupon or Pharmasset. For a complete list of portfolio holdings for all of the T. Rowe Price funds, go to www.troweprice.com.

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Past performance cannot guarantee future results.  All charts are shown for illustrative purposes only and do not represent the performance of any specific security.  

 They weren’t comfortable with the Japanese market or in the larger emerging markets of China and Brazil, both enduring economic slowdowns.

 But in July, when European Central Bank President Mario Draghi sent a strong signal that the bank would do “whatever it takes” to prevent a eurozone collapse, the positive impact on European equities, and on international equities overall, was dramatic.

Indeed, from late 2011, international markets saw three rallies of almost 20%, each the result of such unconventional central bank actions.

So as uncertainties in Europe subsided over the year, that region emerged as one of the leaders internationally, with the MSCI Europe Index returning 19.9%—outperforming the Japanese and emerging markets overall.

Bob Smith, manager of the International Stock Fund, notes that the European rallies over the last two years have been relatively “riskless,” meaning that defensive stocks outperformed economically sensitive cyclical stocks.

International markets for most of 2012 were led by defensive sectors, though, as in the United States, financials led all sectors.

For 2013, however, Mr. Smith foresees a reversal in the performance pattern of international markets.

He forecasts a much more difficult time for Europe, because of falling growth expectations. Moreover, he says, European defensive stocks that provide downside earnings protection with some growth potential have gotten pricey.

By contrast, he says, emerging markets may lead in 2013, noting the economic downturns in China and Brazil appear to be “bottoming out,” and “sentiment about these bigger markets should improve.”

Also, emerging market stock valuations are relatively favorable.”The market hasn’t begun moving money from relatively safe equities to riskier equities, but I think that will slowly begin to happen over the next 12 to 24 months,” Mr. Smith says. “That’s where the opportunity will be, but it will slowly develop.”

Emerging Growth

 Emerging markets are in transition, too.

 Gonzalo Pángaro, manager of the Emerging Markets Stock Fund, believes that these markets are shifting after a decade of phenomenal performance driven by the rapid industrialization of China and the resulting commodities boom.

 Now, however, growth in China— even short of a hard economic landing—appears to be ratcheting down from more than 10% a year to about 7%, and emerging markets’ growth overall is being driven more and more by rising middle class consumption.

 However, Mr. Pángaro adds, “While the consumer story is alive and well, it also is well known and, in many cases, already reflected in stocks’ prices.”

So some consumer staples stocks have become expensive, he says, but many are still offering the prospect of fairly high growth rates for many years.

He notes that certain emerging markets stocks that had high valuations five or 10 years ago, as measured by their price-to-earnings (P/E) ratios, still delivered good returns. “When there’s robust earnings growth,” he says, “high-quality stocks can grow into their high valuations.”

In 2013, the other likely rotation in emerging markets, Mr. Pángaro says, is better performance by companies in the BRICs, the larger emerging nations of Brazil, Russia, India, and China. (In 2012, such smaller peripheral emerging markets as Thailand, the Philippines, and Peru—less connected to the global economy, China, and commodities— generally outperformed.)

Like Mr. Smith, Mr. Pángaro sees the Chinese and Brazilian economies bottoming as a result of more accommodative fiscal policies, at a time when emerging markets valuations appear favorable.

“This loosening of financial conditions should help spur growth,” he says, “which bodes well for the cyclical outlook in emerging markets.”

But in 2013 and beyond, he concludes, “you’re going to need to be much more selective within emerging markets on the company level, the sector level, and the country level.”

European Morass

 Meanwhile, there has been more progress in Europe, but the crisis is far from solved.

Ken Orchard, an analyst/manager following the crisis for T. Rowe Price, says, “It’s a triple crisis,” made up of competitive imbalances between the eurozone’s north and south, unsustainable fiscal deficits, and excessive public and private sector debt burdens.

So solving Europe’s problems will be a lengthy exercise. The liquidity infusions of the last few years in Europe have bought time and reduced financial stress but are not the solution, Mr. Orchard says.

The eurozone’s peripheral countries need to undertake competitiveness and fiscal adjustments while reducing their debt, he says. “There’s going to have to be greater integration of nations.”

Mr. Orchard says that, rather than a eurozone breakup, the two most likely outcomes for Europe are turning into something akin to Italy or the United States.

Under the first scenario, which he dubs “Greater Italy,” the eurozone ends up with a relatively prosperous, competitive north and a poor, less competitive south sustained by financial transfers from north to south. The north would not like that, he says, but is likely to accept it.

The second scenario, which he calls “Federal Europe,” involves deficit limits on nations and greater borrowing at the eurozone level with strict fiscal and structural reforms to make the peripheral nations more competitive. The problem, he says, is this would be very difficult for the peripheral nations.

In any case, the needed adjustments are without precedent, Mr. Orchard says. “This is an economic, social, and political experiment.”

In 2013, Rays Mills, manager of the Overseas Stock Fund, which has about two-thirds of its assets invested in Europe, says investment, consumption, and growth will be suppressed in Europe—posing “risks to companies’ toplines.”

As a result, Mr. Mills entered 2013 still in a somewhat defensive posture, having added to an emphasis on health-care stocks over the past year and a half and continuing to look for selective opportunities in consumer staples, though many of those stocks have gotten expensive.

“It’s not as though we think we’re through the worst of it in Europe,” he says. “We’re not running out and buying a bunch of cyclical sectors. “But there’re a lot of good companies in Europe that have gotten stronger during the financial crisis in order to survive. They’ve buttressed their balance sheets and gotten more profitable.”

At the same time, however, he also is looking to emerging markets for growth, like Mr. Smith.

While about 7% of the Overseas Stock Fund is invested directly in emerging markets, a substantial share of the revenues of the portfolio’s companies, a third or more in some cases, derives from the emerging market operations of multinationals based in developed markets. And, he says, the percentage of the portfolio’s earnings growth attributed to emerging markets is even higher.

International investing is subject to market risk and risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad. Emerging markets investments are subject to the risk of abrupt and severe price declines.

 Charts are for illustrative purposes only and not intended to represent the returns of any specific security. Past performance cannot guarantee future results.

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 On one hand, the 2012 total return of the S&P 500 Index of large-cap U.S. stocks was notably healthy, 16%, with returns of the leading sectors—financials and consumer discretionary—topping that. Small-cap U.S. stocks also performed well, with a total return of 16.35% for the year as measured by the Russell 2000 Index.

 On the other hand, investors did not have to look very hard for bad news—from tepid U.S. growth to high domestic unemployment, from the European crisis to a slowdown in China. Moreover, corporate earnings growth is decelerating—casting a pall over stock prospects.

 “Every time I read the paper, it’s always another negative piece of news,” says John Linehan, T. Rowe Price’s director of U.S. equity. “There’s been this huge dichotomy between market performance and sentiment.

“The market climbed a very steep wall of worry last year, but it is well poised to climb it again this year.”

For 2013, Mr. Linehan sees a continuation of this “tug of war between the market’s significant headwinds and its significant tailwinds.”

Among the tailwinds: the extraordinarily accommodative stance by central banks around the world, green shoots of recovery in the U.S. labor and housing markets, deleveraged consumer and corporate balance sheets, improved corporate fundamentals, and the potential end to (and ultimate reversal of) the massive cash outflows from stocks to bonds.

Among the headwinds: a muted outlook for U.S. economic and corporate earnings growth; U.S. fiscal problems, policy uncertainties, and regulatory burdens; and the risks of a eurozone recession and of a “hard landing” for China’s economy.

Despite this continuing struggle between the micro positives and the macro negatives, Mr. Linehan sees the positives prevailing for U.S. stock prices—primarily because of reasonable valuations.

The S&P 500’s dividend yield at year-end was above the 10-year U.S. Treasury yield for only the third time in 60 years. And then there’s the further anomaly of the S&P 500 earnings yield (based on expected earnings) far exceeding the U.S. Treasury yield.

“One of the reasons that valuations are attractive is that markets are very effective at discounting bad news, and right now current valuations reflect a great deal of bad news in the future,” Mr. Linehan says. “If we don’t get that bad news, it then will be very positive for equities.”

Durable Growth

Still, no matter what happens in the near term, the U.S. and world economies likely are going to grow slowly over the next couple years, notes Joe Milano, manager of the New America Growth Fund, which focuses on U.S. large- and mid-cap growth stocks.

As a result, Mr. Milano says he is looking for “secular growth” stocks instead of cyclical growth stocks— companies with high levels of stable or recurring revenues and that have the potential to grow even in a slowing earnings growth environment, because of innovation, better management, or the ability to take market share.

“My vision is to buy great companies that can grow in any environment,” he says, citing two examples, Fastenal and Stericycle, both of which are growing off of solid bases by serving clients in new ways.

Fastenal sells industrial nuts and bolts, as well as supplies for nonresidential construction sites, such as welding supplies, safety glasses, and gloves. It has pioneered on-site vending machines that distribute and track such supplies to each worker, which pays off in greater productivity and less loss. “Within 10 years its vending machine business could be bigger than the entire company is now,” Mr. Milano says.

Stericyle is a big player in the medical waste business, a company that picks up those red bags of hazardous waste from medical facilities. While the firm has steady recurring revenue from its long-term client relationships, it has branched out into new services such as managing medical offices’ patient communications. “Now they’re up-selling,” Mr. Milano says.

Neither stock is cheap, he says, “But when the economy gets tougher, investors shouldn’t buy lower-quality stocks—buy the best.” Sudhir Nanda agrees. Mr. Nanda, the firm’s director of quantitative equity research and manager of the Diversified Small-Cap Growth Fund, sees a “muted, steady-Eddie environment” without big valuation disparities among stocks.

That tells him that “high quality” stocks—stocks with the metrics showing high recurring revenues, high free cash flows, and high returns on equity—should do well, and in late 2012 these sorts of stocks already began to evidence that, he says. “There’s not going to be a sharp upshift in the economy this year, so it’s likely going to be an environment in which the quality companies will rise relative to others—a stock picker’s environment,” Mr. Nanda says.

Opportunities

 Overall, managers of T. Rowe Price’s asset allocation portfolios entered 2013 with a strong tilt toward large-cap stocks over small-caps and a less pronounced tilt toward growth stocks over value plays.

Within that, Mr. Linehan sees a wide range of opportunities among the following investment themes:

• U.S.- and international-based companies with exposure to the explosive growth in emerging market consumers.
• Derivative plays on the housing recovery, such as regional banks.
• Companies with growing dividend payments (versus high-dividend-yield stocks, whose valuations have become expensive).
• Providers of new treatments in healthcare.
• Companies with exposure to mobile and cloud computing.
• Compelling “sum of the parts” valuations in energy, in which certain firms are trading significantly below their breakup values.

Not particularly prominent within that list are companies within 2012’s top S&P 500 sector—financials.

Financials did well in 2012 because, first, they started the year with very cheap valuations, says Eric Veiel, manager of the Financial Services Fund. The sector had singularly underperformed the market for each of the prior five consecutive years. Second, he says, “While there are still a lot of problems in financials, a lot of things stopped getting worse for the sector last year. So these companies started bottoming and the market reacted positively.”

For 2013, Mr. Veiel believes that the sector’s returns may keep up with or exceed that of the overall market but not notably so, unless the low interest rate environment significantly improves. Low rates have muted returns for banks and other financial institutions.

As for small-cap stocks, Greg McCrickard, manager of the Small-Cap Stock Fund, notes that the asset class has typically done best coming out of recessions, when economic growth has been negative. That will not likely be the case in 2013’s muted-but-positive growth environment, he says.

Moreover, he says, while small-cap valuations relative to large-caps have fallen some, they’re still higher than large-caps—when the long-term trend is for them to be even with or at a small discount to large-caps.

“Even if we solve our other problems, we’re still looking at a fairly slow economic recovery,” Mr. McCrickard says, “and that implies relatively middling performance for small-caps. Until we get valuations at a discount to large-caps, it’s going to be a challenge to outperform the S&P 500.”

The stocks mentioned by Mr. Milano accounted for 3.4% of the New America Growth Fund as of December 31, 2012.

All funds are subject to market risk, including possible loss of principal. Small companies tend to have less experienced management, unpredictable earnings growth, and limited product lines, which can cause their share prices to fluctuate more than those of larger firms.

Charts are for illustrative purposes only and not intended to represent the returns of any specific security. Past performance cannot guarantee future results.

Download a prospectus

In this discussion, these managers reflect on some of the more significant market developments and insights gained over the past two decades. The managers are Brian Berghuis (Mid-Cap Growth Fund), Larry Puglia (Blue Chip Growth Fund), Preston Athey (Small-Cap Value Fund), and Greg McCrickard (Small-Cap Stock Fund). (In addition, Brian Rogers has managed the Equity Income Fund since its inception in 1985.)

Market Developments

Mr. Puglia:

One of the most striking changes over the past 20 years has been globalization, which has presented both opportunities and challenges. In the average large-cap portfolio, about 45% of the operating earnings now come from outside the U.S. That, of course, provides access to faster-growing markets and more diversification. But with the greater synchronization of the global economy, portfolios are more subject to changes overseas, and we’re seeing that now with concerns about growth in China.

Another striking development was the bursting of the tech bubble in 2000, which caused distrust of large technology companies for quite a long time. Its unwinding was certainly very palpable, but, ironically, from the ashes you saw the ascension of some very dramatic growth leaders, like Amazon and Google.

It’s interesting that 20 years ago technology ranked as the ninth-largest sector in the S&P 500 Index, accounting for just 6% of its market capitalization. Now it’s the largest sector, accounting for a fifth of the assets. That’s consistent with the spending on technology in the economy and the importance of the Internet. It also reflects the thirst for real-time information and the rise of e-commerce and social networking and the increasing dominance of hand-held devices such as smartphones or tablets.

 Mr. Berghuis:

 Of course, the global economic and political landscapes were vastly different 20 years ago. The Internet was still mainly the province of academics; mobile phones were a cumbersome luxury; and the world’s most powerful computer, by one calculation, was roughly as powerful as today’s iPad.

Today, there is far more debt in the financial system, particularly at the government level, and the prospects for growth in the developed world are much more modest than in the 1980s, 1990s, and through most of the 2000s. The current period seems more like the 1970s, with many individual investors shunning stocks following years of poor returns.

The rise of hedge funds and high-frequency traders, which now account for most of the trading volume, also has been significant. The time horizon of investors has become very, very short. Many are focused solely on the next data point, and price momentum and earnings revisions have become the metrics of choice rather than a company’s prospects over two or three years. That can provide a tremendous advantage for patient investors who focus instead on a company’s fundamentals and long-term prospects. Some of our best investments have been lower-profile, moderately growing companies that are able to compound earnings over a long period of time.

Mr. McCrickard:

In the small company arena, I would say the sector gets more attention now than it did in the early 1990s in the sense that there are more market participants, though the rise of hedge funds has probably brought increased volatility. But there’s a lot more liquidity than there was 20 years ago. The increased interest in the sector has changed the definition of small-cap stocks. It used to be a company with a market capitalization of $500 million or less. Now the Russell 2000 Index is revised at $3 billion.

Mr. Athey:

Twenty years ago, small-cap investing was synonymous with emerging growth—rapidly growing high technology- or medical products-type companies. Today, small-cap value is a distinct asset class. There is a whole subset in the small-cap market that are not the most rapidly growing, sexiest stories but where one can invest in solid companies and do well.

But small-cap companies are much less followed on Wall Street than they were 20 years ago, partly because new rules have severely reduced commissions in these stocks. So it’s less costly to trade in these stocks, but investors have to rely more on their own research.

In addition, the hurdle to become a public company is much higher today. The companies going public tend to be more substantial, with higher revenues and profits, so the quality of the initial public offering market has improved. We’re also seeing greater variety in the types of companies going public, so the market’s more diversified. There are opportunities in the small-cap world in every sector you can name. And, generally, fewer small companies are going public. Many are staying private longer, or in some cases they sell out to larger companies rather than go public.

Another big change that has affected investors generally is the huge increase in information and media coverage of the markets. Twenty years ago we didn’t have CNBC or smartphones and tablets giving us instant news all the time. So investors are better informed, but it’s often about minutiae rather than important things.

There’s more anxiety, and many people are traders rather than investors. They’re less willing to look long term and more likely to make irrational decisions based on emotion. Just because we have more information, are we better off? Yes, if we use it wisely; otherwise it’s just noise.

Market Leadership

(Note: Of the 10 largest companies in the S&P 500 Index in terms of market capitalization in 1992, five still retain that position (ExxonMobil, AT&T, IBM, General Electric, and Procter & Gamble). The other five have been replaced by Apple, Microsoft, Google, Chevron, and Johnson & Johnson.)

Mr. Puglia:

History will tell you that change occurs and the leadership of the market changes accordingly. It has been very difficult for companies to sustain dominant positions. But it’s much more difficult to sustain leadership in the technology area where companies are subject to shorter product life cycles.

I think it’s noteworthy that IBM has been able to maintain its leadership, and the reason is that it has been strong in services and software rather than being solely subject to product life cycles. It’s also a little easier for companies in staples, such as Procter & Gamble, to maintain leadership over time.

Mr. Berghuis:

I was surprised that five of the top 10 are still there. It shows that there is more stability and persistence in our economy and in corporate America than perhaps is commonly perceived. Our economy is evolving, but that’s not to say that if you invest in a blue chip company today it won’t still be a reasonably vibrant company a generation later if it is well managed.

 Insights and Lessons Learned

Mr. Berghuis:

 Twenty years has taught me that a consistent process is really important. While the environment and the fund’s holdings have changed over the past two decades, the characteristics we look for have not changed. We have always focused on the quality of a firm’s management, the long-term viability of its business model, the company’s balance sheet and cash flow, and its valuation. While we are willing to pay more for growth, we prefer to buy companies when their prospects are subject to doubt and tend to sell them when others seem overly confident about their prospects.

One of the mistakes I’ve seen investors make over the years is following the crowd because a certain sector or strategy is working at the time. There’s often a tremendous pressure to conform, and that’s almost always a mistake. It might feel good for a few weeks, months, or even a year, but it usually ends badly. Maintaining a balanced perspective and a consistent process is a good recipe for long-term success in investing, but it doesn’t always work over shorter periods.

Mr. Puglia:

 I agree that the key tools for evaluating stocks really haven’t changed. Stock prices ultimately follow earnings and cash flow. We have empirical data going back to 1954, for example, that show that free cash flow growth has been a good indicator of future stock returns.

 Another lesson is that even though we have had these major bear markets and dislocations in the economy, there are always opportunities, especially during crises.

 A third lesson comes from Warren Buffett, who said that when a good management meets a bad business the bad business wins every time. We don’t think we can compound wealth for clients investing in inferior business models. You really have to invest in companies that have a high return on invested capital or return on equity.

I also think that you always need to be looking out for what people are not worried about, and few are worried about inflation now and many assume bonds will continue to do well. With the policy measures that have been pursued, I think we’ll see a moderate increase in interest rates over time that will cause dislocation in longer-term bonds.

 Mr. McCrickard:

 I’ve also learned not to get too caught up in trends. I tend to lean a little bit against the wind from time to time. If you are willing to be a contrarian, the markets will give you opportunities to invest in good companies at very attractive prices.

Another lesson is what I call the pain trade. If some sector is doing particularly well and you are not participating in it, don’t chase it, because that’s often when your biggest mistakes will occur.

The consensus opinion often turns out to be wrong. So I also think you want to look at what people do not like. A lot of retail investors view the equity markets as stacked against them now. That negative sentiment can create tremendous opportunity for those willing to look out a few years.

 Mr. Athey:

We’ve had some pretty violent cycles in the past 20 years, especially the 1999–2000 tech bubble and the hangover from that and then the housing bubble that led to the financial crisis of 2008 and early 2009. Despite that, the equity markets have performed reasonably well over the past 20 years. But many investors have foresworn stocks for bonds because they can’t stand the pain.

 I think they will be disadvantaged long term because, from today’s levels, stocks are much more attractive than fixed income despite the problems in the U.S. and Europe and the question marks in China. History does tend to repeat itself in one way or another, so I feel very confident in saying this.

   The American economy is an amazingly resilient engine of growth, and not just over the last 20 years. So I’ve learned that panicking at the bottom of bear markets never works. Patience and a sense of history can see you through a lot of rough patches.

All funds are subject to market risk, including possible loss of principal. The chart above is for illustrative purposes only and not intended to represent the returns of any specific security. Past performance cannot guarantee future results.

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 *Morningstar FundInvestor, July 2012. The securities mentioned by Mr. Puglia represented 9.3% of the Blue Chip Growth Fund as of December 31, 2012.

 The Wilshire U.S. Real Estate Securities Index outperformed the S&P 500 Index by a wide margin over the 10 years ended December 31, 2012, and turned in a stellar 17.55% return through the turmoil and uncertainties of the past year. (See chart this page.) Global real estate did even better with the FTSE EPRA/NAREIT Developed Real Estate Index returning 28.65% in 2012.

“The main drivers of performance are the lack of construction in commercial real estate coupled with steady demand against the backdrop of limited supply,” says David Lee, manager of both the Real Estate and Global Real Estate Funds. With the yield on 10-year Treasury bonds below 2% through much of 2012, it’s not surprising that investors have gravitated to a segment of the market where yields have exceeded the average yield on the S&P 500 Index.

“We have been living in an environment of historically low interest rates, which has resulted in a hunger for income on the part of investors,” Mr. Lee says. “Real estate stocks pay relatively high dividends, and many of our companies increased their dividend payouts in 2012.”

Investors also have regarded real estate stocks as a hedge against inflation, along with gold and other natural resources. “So far, inflation has been subdued,” Mr. Lee says, “but it’s likely to accelerate once the economy gains more momentum.”

Global Values

While the Real Estate Fund focuses primarily on U.S. real estate investment trusts, or REITs, the Global Real Estate Fund invests in real estate securities worldwide, including Europe, Hong Kong, Japan, the Pacific Rim, and South America, as well as in the U.S.

In managing these funds, Mr. Lee keeps an eye on macroeconomic influences but primarily looks for value. Globally, he’s finding value in the United States and abroad—particularly in apartments, large retail malls, and local shopping venues. The U.S. accounted for 40% of fund assets as of December 31, 2012.

Mr. Lee believes that the fundamentals remain positive for real estate investors. Supply is likely to be limited for a while since it takes time to rebuild the pipeline following an economic slowdown. Lending for new projects is tight, although refinancing loans are more available.

At the same time, demand should continue to strengthen as job creation improves, which has been the case in the United States. Even if a stronger economy in 2013 leads to rising inflation, that should be beneficial for real estate investing.

High Valuations

“One caveat is that valuations for real estate stocks are near the upper limit of their historical range,” Mr. Lee says. “That could lead to some weakness in the event of a general stock market sell-off. Still, I would expect investors to be attracted to the recurring income stream generated by these stocks.”

The big headwinds confronting the sector—and the equities market in general—remain. The sovereign debt crisis in Europe has yet to be resolved. The United States is grappling with a deficit problem. And China’s economy has been slowing, although there is some evidence that it may be bottoming.

“Some variables have been removed from the equation,” Mr. Lee says. “China is transitioning to new leadership, which is likely to do whatever it can to spur growth. The uncertainties surrounding the U.S. election are behind us. And hopefully we will have more clarity on how the federal government plans to deal with its fiscal imbalances.”

Due to its concentration in the real estate industry, the Real Estate Fund’s share price could be more volatile than that of a fund with a broader investment mandate. Trends perceived to be unfavorable to real estate, such as changes in the tax laws or rising interest rates, could cause a decline in share price. Because the Global Real Estate Fund can invest substantially in foreign securities, it also will be subject to the risks inherent in non-U.S. issues.

Chart is for illustrative purposes only and not intended to represent the returns of any specific security. Past performance cannot guarantee future results.

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1.  Economy likely to remain anemic through 2013

A gradual, shallow recovery is likely—a robust rebound is not. Current consensus economic forecasts for 2013 may be too pessimistic. A mild recovery beginning in the second quarter seems likely. Financial stress has plummeted since August, which should help confidence and be positive for growth. Although fiscal austerity will be a drag on the economy, it should not have the same pronounced impact as last year. The eurozone will continue to face headwinds to growth from fiscal consolidation, high private sector debt, and banking sector deleveraging. Just like Japan during its lost decades, the eurozone is likely to experience recurring periods of negative gross domestic product growth over the next few years. An acute phase has passed, but the crisis—and the impact on the economy—is not over.

2. The doctrine of fiscal austerity will weaken

There is evidence that the doctrine of fiscal austerity is weakening. The European Commission and European Central Bank seem to be realizing that an endless recession will undermine public support for the eurozone and, ultimately, make solving the crisis more difficult. New politicians, particularly President Hollande of France, are not as willing to sacrifice economic growth in pursuit of fiscal sustainability; and German leadership appears willing to slow the pace of fiscal consolidation to support the broader economy ahead of German elections in September. Fiscal policy will still tighten in 2013, but the easing of fiscal austerity targets will avoid an additional round of midyear fiscal tightening as occurred in mid-2012. This should give some breathing room to an incipient economic recovery.

3.  There will be few rating downgrades

Sovereign rating downgrades were abundant in 2011 and 2012. The (unweighted) average eurozone sovereign rating declined from “AA-” in December 2010 to “A+” in December 2011, and then to “A” in December 2012, based on ratings by the three major credit rating agencies.  We expect few sovereign rating downgrades in 2013. The reasons are twofold. First, we believe that the action taken by the ECB and eurozone governments has, at least temporarily, stabilized the sovereign creditworthiness from a macro-financial perspective. The prospect of a “death spiral” of rising yields and falling GDP growth leading to liquidity crises is now unlikely, in our view. Second, we think that most sovereigns are currently fairly rated based on their fundamentals. Unlike in the past, there are no major differences between T. Rowe Price’s internal credit research ratings and the rating agencies’ ratings. 

4.  Social unrest will return

The major driver of social unrest in the eurozone is likely to be rising unemployment. Even though the region is expected to exit recession this year, growth is unlikely to be strong enough in the periphery to create jobs. There are other potential causes of social unrest: labor market reforms that reduce protections for existing workers, pension and retirement reforms, higher taxes, and cuts to public services. All are necessary to solve the crisis long term yet all will also exacerbate social stress in the short term. The risks posed by social unrest should not be underestimated. Governments will need to be strong and determined to enact reforms in the face of widespread public opposition. If the reform process stalls, the eurozone could become trapped with high debt and no growth. A more serious risk is that governments try to ease the economic pain through unorthodox policies. Greece is most at risk of following this path in 2013.

5. Greece will not be solved

The common perception that Greece is “solved” is too sanguine. There is still much potential for the situation to deteriorate again in 2013. The high and rising unemployment rate, combined with the cuts to pensions and public sector employment passed in November, could lead to a resurgence of public protests in the spring and summer. The Greek government is fragile and divided—its majority in parliament is eroding and one of the coalition partners (Democratic Left) refused to support the International Monetary Fund-European Union package in November—and may not survive a concerted attack on its policies. Greece may once again rise up the market’s list of concerns.

6. There will be at least one more IMF-EU rescue program

The most obvious candidate for an IMF-EU rescue program is Cyprus. Although it has a small economy, the market probably does not fully appreciate the nature of its problems—large insolvent banks, high government debt levels, and a collapsing economy. Cypriot banks need to be recapitalized, but lending the government the money to do so would push its debt/GDP limit to 160%. A rescue program, funded wholly by the eurozone, seems the most likely outcome, with debt restructuring deferred for several years.

The second candidate for an IMF-EU rescue program is Spain. We believe that Spain will be forced to request a contingent credit line from the European Stability Mechanism, thereby allowing the ECB to activate outright monetary transactions, the ECB’s program to purchase government bonds of one- to three-year maturities subject to the requesting country meeting certain conditions. The fundamental situation in Spain continues to slowly deteriorate: The economy is mired in recession, the budget deficit and government debt are high, and the banking system and regions are under pressure. When another risk-off period rolls around, the market is likely to refocus on the fundamentals and push spreads higher again (although we do not expect it to be a traumatic event for financial markets). 

7. The ECB will continue to ease monetary conditions

The ECB is likely to take action to prevent a contraction of its balance sheet, following significant expansion in the past year, as it will want to avoid a tightening of liquidity conditions across the eurozone. Several options are available: 

a) Cut the repo rate to 0.50% or 0.25%. 

b) Reintroduce multiyear long-term refinancing operations, or LTROs, which provide low-cost financing to eurozone banks, including loans of six-month, 12-month, and 36-month maturities. The aim is to maintain liquidity for banks holding illiquid assets.

c) Use the outright monetary transactions to reduce sovereign spreads (although this would require at least Spain, Ireland, or Portugal to make a formal request). 

d) Buy financials sector assets, such as covered bonds, to try and keep the market for these instruments open to periphery banks. 

e) Move the deposit rate into negative territory to encourage banks to lend and invest more. This would have unintended consequences and is likely to be used only as a last resort.

8. The cycle of hope, disappointment, and crisis will continue

The eurozone has been characterized by a cycle of hope, disappointment, and crisis since the region’s sovereign debt problems began. We are currently in the “hope” phase. “Disappointment” and “crisis” are likely to return again at some point, even if they are less pronounced than in the past.

The crisis will not be solved without new institutions and greater integration. Changes to the eurozone’s structure are needed to minimize the collective action problem, transfer fiscal and financial risks from the national level to the eurozone level, and make the eurozone more like a federal state rather than a collection of individual states. These changes would make the eurozone more stable and more permanent, thereby significantly reducing the probability of a breakup and taking a major step toward solving the crisis. 

The problem with new institutions and integration, however, is that there will be winners and losers. The transfer of risk, resources, and decision-making powers will benefit some countries while hurting others. The politicians in the losing countries can only justify the changes when financial stress is high enough that the transfer leaves them better off on a net basis.

The link between market stress and progress toward institution building and greater integration is fundamental to the crisis itself. A lack of stress leads to procrastination, which leads to crisis, which later leads to progress on institutions and integration. Market stress is a symptom of the crisis but should also drive the solution to the crisis. Although we will not see the ultimate solution in 2013, we think it should be a little bit closer by this time next year.

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1/2013

First and foremost, will I even be able to afford to retire. And , if so, will it be comfortable enough and early enough to even be able to enjoy it In the first place? I think those are the main questions for the majority of us all….

A  from Stuart Ritter

 Bob, I think you’re right that these are some of the fundamental questions many people want the answers to – probably along with when they’ll be able to it.  As you might expect, it comes down to how much money you’ve saved by the time you leave the workforce.  Which means, to some extent, you control the answers by how much you’re saving and how long you work.  The more you save, the longer you save, the more likely you’ll be able to maintain your spendable income throughout your retirement.  You might want to start by checking out our Retirement Income Calculator (troweprice.com/ric).  It lets you put in your specific information on how much you’re saving and gives you a sense of how much you’ll be able to spend when you leave the workforce.  Then it lets you play “what if” to see what would happen if you saved more now, worked longer, etc.  Hope this helps give you a sense of when (not if!) you can retire.

 Q  from Vikas Gupta 

To maintain diversity in portfolio each year

A  from Stuart Ritter

Vikas, I’m glad you’re asking about one of the fundamental tenets of a properly constructed portfolio.  Just as there are some people who want to drive a manual transmission car and there are those who prefer an automatic, you have two ways to maintain diversity: do it yourself or choose a service/investment that does it for you.  If you want to do it yourself, we have some guidelines to give you a starting point for spreading out the money you have invested in stocks and the money you have invested in bonds – Investor Time Horizon Chart

 If you prefer the “automatic transmission” approach, we have an automatic rebalancing service we offer in our IRA accounts – or you can choose an asset allocation investment like our Retirement Funds, Spectrum Funds, or Personal Strategy funds that are designed to automatically maintain diversity for you.

Q  from Emily Maurer 

I am already retired

A  from Stuart Ritter

 Emily, as you know, retirement planning doesn’t end with retirement!  Retirement is just a new beginning – of a phase that could last to age 95.  So good planning throughout retirement is key to making it what you want it to be.  I mentioned our Retirement Income Calculator to Bob; you might want to try it out also.  In addition, Advisory services are available for your consideration.

Q from Shan Mclendon

I have been a little slack in it I have only a few hundred in an IRA

A from Stuart Ritter

 Shan, the Tao Te Ching, attributed to Lao Tzu, says that “A far-reaching journey is begun from a small step.”  So congratulations on starting on that journey.  You are where you are.  How you arrived there (e.g., slacking or not) isn’t nearly as important as what you do from here on out.  The guideline we give people on how much to save is to put at least 15% of your household gross salary away for retirement each year.  And if you’re not there yet, put a plan in place to get there – maybe 10% this year, and increase that by two percentage points each year until you are.  (Note: The 15% includes your company match if you get one).  What you have is a good start, keep going.

Q from Janet Pearcy 

Just want to outlive my money

A from Stuart Ritter

 Janet, I really hope you meant that you want your money to outlive you (at least by a day!) so that you can maintain your lifestyle throughout your retirement.  To see whether you’re on track, try out the Retirement Income Calculator I mentioned.  It will give you a sense of how likely it is that your money will last longer than you.

Q from Eddie Galvan

 I’ve got a 401(k) to start with

A from Stuart Ritter

 Eddie, always a good place to start.  We recommend people save at least 15% for retirement.  Step one: Get whatever match your employer might be offering.  Next, consider using a Roth – either in your 401(k) if you employer gives you the option.  If not, consider a Roth IRA if you’re eligible, then go back to contributing to your 401(k) plan.  How much you save is the most powerful driver of your retirement success.  You’re starting in the right place; just make sure you’re completing the package.

The principal value of the Retirement Funds is not guaranteed at any time, including at or after the target date, which is the approximate date when investors turn age 65. The funds invest in a broad range of underlying mutual funds that include stocks, bonds, and short-term investments and are subject to the risks of different areas of the market. The funds emphasize potential capital appreciation during the early phases of retirement asset accumulation, balance the need for appreciation with the need for income as retirement approaches, and focus more on income and principal stability during retirement. The funds maintain a substantial allocation to equities both prior to and after the target date, which can result in greater volatility.

 Retirement Income Calculator results are presented as a snapshot of the first month in retirement. These estimates are displayed in today’s dollars and do not take any taxes into account that may be due upon withdrawal. The dollar amounts are assumed to increase by 3% each year throughout the retirement horizon. Any Social Security estimates are based on your current annual salary, current age, and age at retirement. The accuracy of the estimate depends on the pattern of your actual past and future earnings. The estimate may not be representative of your situation. Estimates for retirement ages prior to age 62 and some spousal estimates may also be included for illustrative purposes only. Visit socialsecurity.gov for more information.

 Monte Carlo Simulation

 Monte Carlo simulations model future uncertainty. In contrast to tools generating average outcomes, Monte Carlo analyses produce outcome ranges based on probability—thus incorporating future uncertainty.

 Material Assumptions Include:

 • Underlying long-term rates of return for the asset classes are not directly based on historical returns. Rather, they represent assumptions that take into account, among other things, historical returns. They also include our estimates for reinvested dividends and capital gains.

 • These assumptions, as well as an assumed degree of fluctuation of returns around these long-term rates, are used to generate random monthly returns for each asset class over specified time periods.

 • The monthly returns are then used to generate 1,000 scenarios, representing a spectrum of possible return outcomes for the modeled asset classes. Analysis results are directly based on these scenarios.

 • Required minimum distributions (RMDs) are included. In the simulations, if the RMD is greater than the planned withdrawal, the excess amount is reinvested in a taxable account.

 Material Limitations Include:

 • The analysis relies on return assumptions, combined with a return model that generates a wide range of possible return scenarios from these assumptions. Despite our best efforts, there is no certainty that the assumptions and the model will accurately predict asset class return ranges going forward. As a consequence, the results of the analysis should be viewed as approximations, and users should allow a margin for error and not place too much reliance on the apparent precision of the results. Users should also keep in mind that seemingly small changes in input parameters (the information the user provides to the tool, such as age or contribution amounts) may have a significant impact on results, and this (as well as mere passage of time) may lead to considerable variation in results for repeat users.

 • Extreme market movements may occur more often than in the model.

 • Some asset classes have relatively short histories. Actual long-term results for each asset class going forward may differ from our assumptions—with those for classes with limited histories potentially diverging more.

 • Market crises can cause asset classes to perform similarly, lowering the accuracy of our projected return assumptions, and diminishing the benefits of diversification (that is, of using many different asset classes) in ways not captured by the analysis. As a result, returns actually experienced by the investor may be more volatile than projected in our analysis.

 • The model assumes no month-to-month correlations among asset class returns (“correlation” is a measure of the degree in which returns are related or dependent upon each other). It does not reflect the average duration of “bull” and “bear” markets, which can be longer than those in the modeled scenarios.

 • Inflation is assumed to be constant, so variations are not reflected in our calculations.

 • The analysis assumes a diversified portfolio which is rebalanced on a monthly basis. Not all asset classes are represented and other asset classes may be similar or superior to those used.

 • Taxes on withdrawals are not taken into account, nor are early withdrawal penalties.

• The analysis models asset classes, not investment products. As a result, the actual experience of an investor in a given investment product (e.g., a mutual fund) may differ from the range of projections generated by the simulation, even if the broad asset allocation of the investment product is similar to the one being modeled. Possible reasons for divergence include, but are not limited to, active management by the manager of the investment product, or the costs, fees, and other expenses associated with the investment product. Active management for any particular investment product — the selection of a portfolio of individual securities that differs from the broad asset classes modeled in this analysis — can lead to the investment product having higher or lower returns than the range of projections in this analysis.

Modeling Assumptions:

 • The primary asset classes used for this analysis are stocks, bonds, and short-term bonds. An effectively diversified portfolio theoretically involves all investable asset classes including stocks, bonds, real estate, foreign investments, commodities, precious metals, currencies, and others. Since it is unlikely that investors will own all of these assets, we selected the ones we believed to be the most appropriate for long-term investors.

 • Results of the analysis are driven primarily by the assumed long-term, compound rates of return of each asset class in the scenarios. Our corresponding assumptions, all presented in excess of inflation, are as follows: for stocks, 4.90%, for bonds, 2.23% and for short-term bonds, 1.38%.

 • Investment expenses in the form of an expense ratio are subtracted from the return assumption as follows: for stocks 0.70%, for bonds, 0.60% and for short-term bonds, 0.55%. These expenses represent what we believe to be a reasonable approximation of investing in these asset classes through a professionally managed mutual fund or other pooled investment product.

Portfolio and Initial Withdrawal Amount:

 • The portfolio is either determined by the user or based on pre-constructed allocations that consider the user’s current age and shift throughout the retirement horizon (as displayed in the graphic “Why should I consider this?” in the Asset Allocation section).

 • The initial withdrawal amount is assumed to be distributed in 12 monthly payments at the beginning of each month for the year; in each subsequent year, the amount withdrawn is adjusted to reflect a 3% annual rate of inflation.

 • The modeled asset class scenarios and withdrawal amounts may be calculated at, or result in, a Simulation Success Rate. Simulation Success Rate is a probability measure and represents the number of times our outcomes succeed (i.e. has at least $1 remaining in the portfolio at the end of retirement).

IMPORTANT: The projections or other information generated by the T. Rowe Price Retirement Income Calculator regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The simulations are based on assumptions. There can be no assurance that the projected or simulated results will be achieved or sustained. The charts present only a range of possible outcomes. Actual results will vary with each use and over time, and such results may be better or worse than the simulated scenarios. Clients should be aware that the potential for loss (or gain) may be greater than demonstrated in the simulations.

The results are not predictions, but they should be viewed as reasonable estimates.

Source: T. Rowe Price Associates, Inc.Copyright 2013, T. Rowe Price Investment Services, Inc, Distributor. All rights reserved.

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