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Market Commentary - First Quarter 2016 & Outlook

April 19, 2016 – If you had gone to sleep on New Year’s Eve 2015 and emerged from your hibernation on April 1^st 2016, a cursory review of first quarter market performance would have likely left you scratching your head and wondering what all the fuss was about. Yet, the first quarter was a wild ride from start to finish with investors forced to deal with extreme levels of volatility and market pessimism. In the words of Mark Twain, “history never repeats itself but it rhymes.” As has played out many times in the past, the sharp market correction caused weaker hands to sell high quality assets indiscriminately and favored those with the ability to take a longer term perspective and act opportunistically.

In retrospect, the first day of trading in 2016 was an ominous sign of things to come. The Chinese stock market declined -6.9% as newly implemented circuit breakers, designed to reduce volatility and large market moves, appeared to have the opposite effect causing widespread panic selling among Chinese investors. Fears related to a slowing global economy continued to mount, with investors questioning the risk of a US recession in the face of weak manufacturing data due to lower global demand and the impact of a stronger dollar on US exports. Money continued to flow out of emerging market economies, causing currency depreciation and forcing a number of central banks to implement capital controls.  Oil remained a major destabilizing force with global stock market performance closely tracking the direction of oil prices which plunged in January and hit a 13 year low of $26.21 by early February. As oil prices continued to collapse, even the largest integrated oil companies were forced to make further budget cuts and in some cases cut dividends in order to preserve cash. Global banks were particularly hard hit during the market correction, as investors questioned future profitability and risks associated with low interest rates and energy loan exposure. Questions surrounding the safety of bank capital structures resulted in European bank shares declining -27% by early February with shares of Deutsche Bank declining -40%. Similarly, Japanese banks faced heavy losses as the Bank of Japan joined the European Central Bank in implementing negative interest rates in late January.

As fears mounted across global stock markets, bond yields on high quality US government debt continued to fall (often referred to as a “flight to safety”) driving the 10 Year US Treasury yield down to 1.64% which was the lowest level since 2012. At these levels, factoring in a core inflation rate of 2.3%, investors were willing to accept a real return (yield – inflation) of -0.66% for the perceived safety of owning US Treasuries. As is typically the case, global stock markets bottomed on February 11^th at the height of investor pessimism. From the start of the year, the S&P 500 had declined -10.5%, developed international markets had declined -12.8% and emerging markets had declined -13.3%. In a timely move, the CEO of JP Morgan announced a personal investment of $26.5M in company stock on February 12^th providing another signal of the oversold conditions across much of the banking sector. As oil prices stabilized and rose from the February lows, global stock markets rallied with the closely watched high yield bond market turning positive for the year by early March. Helping to calm market fears, the European Central Bank announced additional stimulus measures in March while the Federal Reserve put on hold further interest rate hikes.

Despite a bleak outlook only months earlier, the S&P 500 returned +1.35% for the quarter. Financial services and health care were among the worst performing sectors of the market, with communications (telecom) and utilities producing the highest returns. The health care sector was hurt by the turmoil at Valeant, as well as renewed political discussions surrounding drug pricing practices. Investor preference for quality defensive companies led to higher yield dividend paying stocks significantly outperforming the broader US market returning +4.14%. Small capitalization stocks lagged larger cap peers declining -1.52% in the quarter. In a reversal from previous quarters, value outperformed growth as many of the previous years “high flyers” experienced sharp declines during the early quarter correction.

Returns across developed international stock markets were disappointing, with the MSCI EAFE index -3.01% and European stocks declining -5%. The Eurozone has continued to struggle with weak economic growth and deflationary pressures, while negative interest rates designed to boost economic growth have had the unintended consequence of weakening financial institutions critical to future growth initiatives. European exporters were hurt by a stronger Euro and weaker global demand particularly from China, while major European drug companies declined due to similar politically-related pricing concerns faced by US competitors. After strong performance in 2015, Japanese markets reversed course in the first quarter declining -6.5% (-12.7% in local currency). Japan’s economy contracted for the fourth time in seven quarters, with the strengthening yen hurting Japanese exporters and recently implemented negative interest rates battering Japanese banks. Emerging markets were the bright spot for international investors rising +5.71% in the first quarter primarily driven by a rebound in energy and commodity prices, expectations that interest rates will remain lower for longer and stimulus actions by global central banks. Despite a rebound from market lows, China’s stock market declined -5%.

Driven by falling bond yields, the US bond market returned +3.03% in the quarter and outperformed developed stock markets. The US corporate and high yield bond market (referred to as the credit market) experienced losses during the market turmoil, though rebounded in the second half of the quarter with high yield bonds returning +3.25% and corporate bonds returning +4%. Expectations of further delays in Federal Reserve rate hikes as well as subdued inflation levels have helped to support bond prices in recent months. Yields on high quality US corporate debt and US government bonds remain attractive on a relative basis to international investors since much of the world is grappling with near zero or negative bond yields.

Allocations to high quality dividend stocks and mid-quarter rebalancing benefitted quarterly performance. We entered the first quarter with higher cash balances and a more defensive positioning across client accounts. Individual dividend-focused holdings added in 2015 across the telecom and utilities sectors were among the best performers, as investors rushed to add high yielding dividend stocks to portfolios in an attempt to reduce portfolio volatility. The same was true for client investments in value-oriented and equity-income focused mutual funds that tend to shine in difficult market environments. As the market decline continued into early February, we took advantage of depressed prices to rebalance client portfolios and add to existing positions, while also adding new investments in the financial services and media sectors. It can be difficult and oftentimes frustrating to buy when the market seems to move lower each day and media headlines scream the worst is yet to come. Yet, I have found that at those times where investing is the most painful and gut wrenching the greatest long term opportunities tend to emerge. As one noted value investor commented during the market selloff, “The stock market is the only place where when things go on sale no one wants to buy.” Efficient markets make sense in theory, but all too often we see fear and emotions driving short term market moves which provide excellent entry points for longer term investors.

Given the current market backdrop, what can we expect going forward? Many of the fears plaguing markets in the first quarter appear to have subsided, with oil prices rebounding, higher interest rates in the US failing to materialize, the US dollar weakening vs. foreign currencies and no immediate sign of an imminent collapse in the Chinese economy. With the Federal Reserve turning more cautious in recent months and recent policy actions from major international central banks, the current interest rate environment remains supportive of stock prices. Low interest rates drive investors into riskier assets seeking higher returns, which tend to drive stock prices higher and support higher market valuations. Low interest rates have also driven demand for dividend paying stocks, an area we continue to focus on with an emphasis not on the highest dividend yields but rather companies with attractive dividend payment policies and sound balance sheets, strong cash flow generation, good growth potential and reasonable valuations. Market valuations across US and developed international markets are in-line with historical averages, albeit more attractive on a relative basis vs. the low returns expected from bonds. While the S&P 500’s consolidated earnings have surpassed levels reached prior to the Great Recession, earnings remain depressed relative to historical levels across the MSCI EAFE index suggesting greater future return potential in developed international markets. That being said, US companies are expected to benefit from easier comparisons in the second half of 2016 as the prior year challenges related to a strong dollar and collapsing oil prices become less of a headwind.

Though markets have stabilized for now, a number of risks remain on the horizon warranting caution. The role of central banks across the globe has changed dramatically as countries prioritize monetary policy over fiscal policy to boost growth and inflation. The long term negative consequences of the current global experiment with negative interest rate policies remain unknown, and leave central banks with limited options in the future should the world face another major economic downturn. With upcoming presidential elections in the US, a scheduled UK referendum in June related to European Union membership and impeachment proceedings underway in Brazil, it would be naïve to think that we have seen the last of market volatility this year. Despite these risks, we remain optimistic that investment opportunities will continue to emerge and confident in the investment strategies implemented across client portfolios.

Market Commentary - Fourth Quarter 2015 & Outlook

January 19, 2016 – The fourth quarter rally across global stock markets left diversified investment portfolios with a modest loss for the year, a notable improvement over the position investors had found themselves in only a few months earlier. US markets once again outperformed in dollar terms both international developed and emerging markets, while bonds posted a modest loss in the face of rising interest rates and widening credit spreads. Oil prices fell another -18% during the final three months of the year, as global supply continued to outpace demand with little signs of slowing.

The S&P 500 Index returned +7.04% in the fourth quarter, ahead of the +3.6% return of mid and small capitalization stocks. Mega mergers and acquisitions continued to dominate headlines, with Dell's acquisition of EMC, Pfizer's acquisition of Allergen and the announced merger of DuPont and Dow Chemical. Healthcare and technology sectors were among the best performers in the quarter. With the price of oil and other commodity prices continuing to fall, stocks with exposure to energy and metals were among the worst performers. Traditional brick-and-mortar retailers were also hard hit, as high levels of inventories, warmer weather and a continued shift to online shopping led to aggressive price discounting in the all-important holiday shopping season. From an investment style perspective, growth continued to outperform value in the fourth quarter and for the full year 2015.
 

Outside the US, international developed markets returned +4.71% in the fourth quarter. European markets rose during the first two months of the quarter in anticipation of further actions by the European Central Bank to stimulate growth. The Euro continued to weaken vs. the dollar, providing a boost to European exports while depressing returns in dollar terms for US investors. Despite lowering its outlook for growth and inflation, the Japanese stock market rose +9.3% in the fourth quarter on the strength of automobile companies and healthcare. Emerging markets rose +0.66% in the quarter, capping off a difficult year driven by a host of challenges including slowing growth in China, concerns over rising default rates across heavily indebted EM countries and lower commodity prices. Chinese markets moved +5.0% higher during the quarter, as the government continued to take actions to stimulate growth despite diminishing marginal returns.

Bond markets faced a number of headwinds during the fourth quarter, as interest rates rose modestly and the yield on the 10 Year Treasury increased to 2.27% leading to a decline of -0.57% in the Barclays US Aggregate Bond Index. High yield bonds continued to see a widening in yield spreads (difference between interest rates paid on low quality bonds vs. comparable Treasuries) as the risk of rising defaults across the energy and materials sectors increased. Rising yield spreads are typically an indicator of market stress and have been closely watched by both stock and bond market investors in recent months. 

Breadth of market leadership remains in focus. Much has been said during the past year of the narrow breadth of market leadership, which can be summed up as the low number of underlying companies with positive returns within widely followed indices like the S&P 500. Whereas the S&P 500 Index returned +1.38% for 2015, the ten largest companies by market capitalization within the S&P 500 Index produced a return of +17%, with the remaining 490 stocks averaging a decline of -5.0%. For this reason, the headline return figure for the S&P 500 in 2015 was a poor indicator of actual returns experienced by most US investors with broadly diversified portfolios. In 2015, investors with outsized exposure to high growth/high valuation momentum names such as Amazon and Netflix benefitted to the detriment of more valuation-sensitive investment strategies. Despite the willingness of investors to “pay up for growth” in today’s slow growth environment, I continue to focus my attention on investment strategies that emphasize high quality companies trading at attractive valuations with the capacity to pay and grow dividends. In investing, one of the largest determinants of future returns is the price you pay to acquire an asset. Momentum companies trading at high valuations must continue to grow rapidly and spend heavily to maintain their premium valuations and stock prices. And when the growth rates eventually slow or disappoint, the valuations investors are willing to pay for these companies shrink along with the share price (sometimes with dramatic consequences).

The collapse in oil prices continues to dominate investor focus. Commodities continued to fall sharply in the fourth quarter with the Bloomberg Commodity Index declining -10.5% and losing -24.6% for the full year 2015. Oil prices, having fallen -18% in the fourth quarter, have now declined from $61 per barrel in late 2014 to below $34 per barrel as of the end of 2015 (-44.0%). Though I believe the decline in oil prices is likely to benefit global consumers and businesses by lowering the cost of fuel and related inputs, it has been devastating for oil exploration and production companies, oil services companies, pipeline operators (MLPs) and governments that are heavily reliant on oil production and sales to fund budgets. OPEC (Saudi Arabia) has demonstrated its willingness to tolerate lower oil prices, despite significant dissension among its ranks, with oil production continuing to surge as oil-producing countries pump greater volumes to offset price declines. Despite projections for modest increases in oil demand, the market has remained significantly oversupplied which has pushed oil prices lower. Many US shale producers, saddled with high debt levels, are now facing a rising tide of loan defaults which has raised concern about energy exposure across US bank balance sheets. As sanctions on Iran are lifted, additional new oil supply is expected to be added to the market which will further depress oil prices. A prolonged downturn in oil prices will result in more pain for companies exposed to the energy sector and have a destabilizing effect among many global economies that have relied on oil production to fund public budgets, meet debt obligations and support growth initiatives.

The US economy continues to be a tale of two stories. Economic data emerging from the US during the fourth quarter was mixed, as manufacturing (12% of US GDP) continued to contract and exports declined due to a stronger dollar making US goods less competitive, weaker demand from overseas and declining capital spending across the global energy and materials sectors. Inflation has remained stubbornly low and below the Federal Reserve’s longer term target of 2%, while retail sales figures were mixed during the 2015 holiday season despite surveys showing a relatively upbeat US consumer. Notwithstanding these challenges, data emerging from the services sector of the US economy (largest component of US GDP) has remained relatively upbeat. The US labor market has continued to improve with the unemployment rate falling to 5% and modest increases in wage growth. Recent softness aside, the US housing market has continued to be an important catalyst of US economic growth which has been further supported by the current low interest rate environment keeping mortgage rates low. In December, the Federal Reserve took its first steps to move away from its zero interest rate policy (ZIRP) by raising the Federal Funds Rate to 0.25%. Despite much hoopla surrounding the Federal Reserve’s first rate hike and the consensus Wall Street view that we are moving into an age of global monetary divergence, the Federal Reserve remains highly accommodative and I believe it is unlikely we will see interest rates move significantly higher from here in the US as long as the rest of the world remains stuck in a low interest rate environment.

An Overview of 2016 Risks & Opportunities. As we enter 2016, we are faced with a number of key risks that warrant our attention. The US economy faces headwinds including the strong dollar, corporate margin sustainability, troubles in the US energy and materials sectors, and the increased susceptibility to market shocks due to the current slow growth environment. Looking abroad, Europe is forced to content with a surging immigrant crisis, persistently low inflation levels, high unemployment levels and falling export demand from China. Elsewhere, Japan has failed to establish a sustainable path to economic growth and remains highly reliant on the Bank of Japan and its government to fight deflation, boost exports and implement needed structural changes. Some of the largest emerging market nations are struggling in an environment where access to capital is becoming increasingly difficult, and where public budgets are being cut in the face of falling commodity prices. From Russia to Brazil to China, previous emerging market leaders now face uncertain times that are likely to get worse before they get better.

Despite these challenges, I believe opportunities continue to emerge for the patient long term investor. Since the start of 2016, global stock markets have declined more than -9.0% driven by 1) falling oil prices 2) clumsy attempts by Chinese officials to support local stock markets in the face of weaker economic data 3) growing fears of a US economic recession. As long term investors, we are presented with a growing list of attractive US companies that have strong economic moats, healthy balance sheets and attractive dividend yields that have fallen in price -20.0% or more in the past year. If you believe like I do that the US isn’t headed into an imminent recession, now may be an opportune time to add to existing and new high quality companies and mutual fund strategies. Falling unemployment and energy prices will benefit US consumer spending, with low interest rates continuing to support housing. Highly accommodative monetary policies throughout the world should continue to be positive for US and international developed markets. As of December 2015, the Euro area reported one of the healthiest readings in its manufacturing sector since April 2014. I remain less optimistic about the emerging markets and see more trouble ahead. I continue to maintain minimal direct exposure to emerging market investments within client portfolios given what I view as serious structural issues which will likely plague many of these countries for the foreseeable future.
 

Some Final Thoughts. Famed investor Joel Greenblatt once advised “Invest in a strategy that makes sense, and stick with it.” Those words couldn’t be more prescient in today’s market environment dominated by high frequency trading and constant media hype focused on timing day-to-day moves in the market. As investors, we make a conscious decision to trade the insecurity associated with investing in a volatile market today in exchange for longer term financial security. While market pundits debate daily whether we are in a bear or bull market, or whether the next 10% move will be higher or lower in the markets, I would prefer to focus my time on more productive pursuits. We cannot know with certainty where the market will be in a day, week or month from now. But when we look back in ten years from now on the current bout of market volatility, will we be pleased that we stuck to our plan and continued to implement our existing investment strategy? I believe we will.

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Market Commentary - Third Quarter 2015

October 5, 2015 – A relatively quiet start to the third quarter gave way to growing levels of fear and anxiety by the beginning of August. Higher valuations left markets more susceptible to a selloff as investors sold US and international holdings in the face of a variety of market challenges including ongoing confusion about Federal Reserve policy, a steady stream of negative news headlines out of China and the continued collapse in commodity prices. For the quarter, the S&P 500 Index declined -6.44% after falling nearly -10% from its peak in late July. Mid and small size US companies fared worst, declining -8% and -11.9% respectively. Outside the US, international developed markets fell -10.2% with the emerging markets experiencing sharp declines of -17.9% in the third quarter. Short and intermediate term high quality bonds were the loan bright spot in the quarter, returning +0.31% and +1.23% respectively. High yield bonds, an area of strong outperformance for the first half of 2015, declined -4.9% in the quarter as investors feared rising default rates across commodity-exposed companies. In summary, the third quarter was a challenging environment for global investors. Though it is never pleasant to see the values of portfolios decline, it is important to recognize that this is a normal occurrence in market cycles and can provide unique buying opportunities for patient investors. 

Putting the third quarter into perspective, there were a number of interrelated themes driving market pessimism. Slowing growth in the Chinese economy raised concerns about the strength and resilience of the global economy. Over the past decade, the Chinese government has boosted both domestic and global growth through massive amounts of industrial spending providing a tailwind to commodity-exporting emerging market nations and many industrial and commodity companies. Rising commodity prices and strong demand for exports led many commodity producers and emerging market countries to aggressively expand production and take on debt assuming the good times would last forever. As the Chinese economy slowed and began its transition away from an infrastructure and manufacturing based economy, global demand for commodities waned leaving a long list of heavily indebted companies and countries in its wake. Today, many multinational companies doing business in China and other emerging markets are forced to contend with depreciating currencies (hurting overseas profits) and weak demand for products and services. Emerging market economies that had borrowed heavily in good times, often financing projects and budgets with debt issued in US dollars and Euros, are now forced to contend with falling revenues from slumping commodity sales, weaker currencies making it more expensive to service debt in foreign currencies and widening budget deficits at a time where stimulus is required to boost economic growth. In the face of these worries, more than $1 Trillion of foreign investment has left the emerging markets over the past 13 months.

In the midst of these global worries, the Federal Reserve has continued to send mixed messages about the timing of the first interest rate hike, with greater emphasis now being placed on foreign market developments. Expanding beyond previous targets tied to the labor market and inflation levels, Federal Reserve Chair Janet Yellen highlighted “heightened uncertainties abroad” in the September FOMC press conference as a factor in the decision to delay interest rate actions. The stronger dollar and weaker demand for US exports has hurt US manufacturers in recent months while increasing the US economy’s reliance on the consumer to drive GDP growth. Investors have taken a pessimistic view of US market valuations in recent months as profitability and earnings projections for the third quarter and the year have declined driven by weakness across the energy sector, slowing global growth and the negative impact of a low interest rate environment on banking profitability. Though the risks behind many of these market worries have not been fully resolved, I do take heart in knowing that they are now widely known and ideally priced into asset values given the recent market correction. 

So what have these market developments meant for the composition and performance of client portfolios? The core mutual fund and ETF holdings across client portfolios remain relatively unchanged, with the expectation that some of my favorite value-oriented strategies which have lagged the broader market this year will begin to outperform when the market begins to prioritize company fundamentals and valuations over high growth companies with excessive valuations and flashy stories. The past quarter has provided some unique opportunities to add individual stock positions in high quality companies at discounted prices while reducing risk levels where appropriate. Timely individual stock picks in the beaten-down airline, utility, telecom and business development company sectors boosted performance given their attractive yields and low valuations. With many high quality companies now trading down more than 20% from recent highs, my shopping list of potential investments has grown as I methodically work through assessing the risk/return potential for new additions to client portfolios.

During the quarter, I sold our small remaining stakes in emerging markets and international small company investments to free up cash for new investment ideas.  As markets moved deeper into correction territory, I added a new position in an undervalued global retailer while increasing client holdings in a high quality diversified international stock fund. Healthcare, a top performer over the past five years, experienced a sharp decline in the quarter due to heavy liquidations across hedge funds and some panic selling in the face of industry pricing concerns (particularly related to high profile orphan drug increases) which were magnified by comments made by presidential hopeful Hillary Clinton. I continue to maintain a small targeted position in healthcare in the range of 2%-5% for clients given the longer term potential for the sector, with many leading pharmaceutical and biotech companies now trading at attractive price levels.
 

In light of the recent market correction, it is time to refocus on the facts. The US economy has remained relatively resilient despite troubles abroad. Labor markets continue to recover with unemployment falling and rising wages. Improving consumer spending and consumer confidence has been apparent across key metrics including auto sales, retail sales, growing consumer credit and falling savings rates. US inflation remains subdued driven by lower energy prices and lower import prices, meaning more money in the consumer’s pocket. The US housing market continues to exhibit healthy growth across existing home sales and new construction. Though future economic growth will be impacted by a continued slump in the energy sector and weaker manufacturing levels driven by falling export demand, I remain relatively upbeat about the outlook for the US economy over the next 12 months.
 

Europe’s struggles with Greece have subsided for now with PM Tsipras returning to power and working to meet the new demands for the latest bailout package. GDP growth across the Eurozone grew a stronger than anticipated (albeit anemic) +0.4% in the 2Q15, though unemployment levels still remain high and inflation remains well below target levels. A weaker Euro has been a boost to major European exporters over the past year, though weaker global demand will hurt some of the biggest industrial exporters including Germany which is also dealing with the fallout surrounding Volkswagen’s emissions scandal. The European economy remains fragile and susceptible to shocks, and further monetary policy actions from the European Central Bank are likely needed to boost growth and inflation levels. Across Europe today, stocks continue to be a more appealing option vs. bonds given the low level of interest rates and the positive impact stimulus actions should have on stock valuations. Beyond Europe, Japan’s struggles continue to be evident with the economy contracting -1.2% in the 2Q15 driven by falling auto and equipment exports and weaker consumer spending levels. Despite supportive actions by the Bank of Japan, inflation levels have turned negative again and it is likely that the Japanese government and central bank will be required to implement additional fiscal and monetary stimulus measures to once again boost growth. The long term outcome and effectiveness of these measures remains largely unknown.
 

I believe the most likely scenario for China remains a prolonged period of slower growth. Recent Chinese stock market declines have highlighted risks facing investors in the Chinese capital markets (something largely ignored and never discussed in many of my discussions with Wall Street strategists and money managers). The deceleration in Chinese growth will impact the rest of the world by varying degrees. Germany and Japan are among the most exposed of the developed nations to a slower Chinese economy, along with many of China’s major trade partners across the emerging markets. I see a difficult road ahead for many emerging market economies driven by subdued commodity demand, eventual higher interest rates in the US, high debt levels and the lack of action related to economic reforms when times were better. This is not to say all emerging markets will face the same challenges, but at this time I prefer to obtain emerging market exposure via multinational companies based in developed countries with geographically diversified revenue streams.
 

The environment for bond investors remains challenging with unclear Federal Reserve policy continuing to make portfolio positioning difficult. With a healthy US economy, I have favored credit risk with higher comparative yields given default levels have remained subdued and the limited protection the highest quality bonds offer investors in a rising interest rate environment. The past quarter’s performance across lower credit quality bonds has highlighted the growing risk of defaults driven by the collapse across the energy and materials sectors, and I have taken steps to reduce risk within client bond portfolios. I do continue to expect interest rates will rise but likely at a much slower pace than originally anticipated given the current global environment.
 

Some final thoughts as we enter the fourth quarter. The recent market decline has been unnerving for many investors, and that’s natural. We are six years into the current economic cycle which began after the Great Recession, and this is longer than what we might typically expect. However, data today does not suggest that a recession is near which would be the typical precursor to a bear market. Client portfolios remain broadly diversified and in-line with longer term asset allocation targets. As I have noted in the past, the key to long term investment success is sticking with our investment strategy and ignoring the short term gyrations in the market. Whereas institutional money managers are often forced to emphasize near term quarterly results, as individual investors we have the benefit of time and patience to buy attractively priced assets and wait for the market to realize their worth. It is this mentality and process which is employed by the actively managed mutual fund strategies within client portfolios, and the same approach I take when selecting individual stocks and investments for client portfolios.

Market Commentary - Second Quarter 2015

July 21, 2015 – Investment returns were mostly flat across major US and International stock markets in the second quarter. As discussed in previous client letters, three major themes – CHINA, GREECE & FEDERAL RESERVE POLICY – appeared to dominate and drive investor actions during the quarter. China’s stock market entered correction territory in June declining more than 20% despite repeated efforts by the government to stabilize the stock market and stimulate the economy via emergency measures. A rising Chinese stock market has benefited heavily indebted companies (many state-run) enabling them to issue shares and reduce outstanding debt, while serving as a de facto casino for local retail investors. Unfortunately, the driving force behind rising Chinese markets has been small investors speculating on daily price changes and borrowing heavily to finance stock purchases (not typically a healthy sign for a market). Heavy margin borrowing exacerbated the Chinese market selloff in June, while fears over a further slowdown in the Chinese economy caused declines across major commodity and stock markets. 

Adding to investor worries, the Greek debt crisis reached a crescendo as negotiations between the Greek government and Eurozone creditors fell apart. Greece defaulted on its $1.7B loan to the International Monetary Fund in June, while Greek Prime Minister Tsipras’s ill-fated decision to call for a referendum to accept creditor proposed austerity measures led to a resounding “No” vote by the Greek people. By the end of the quarter, Greece had effectively been cut off from receiving additional financial assistance leading the country to impose capital controls including closing banks, stock markets and limiting ATM withdrawals. As the Greek crisis escalated, European and US stock markets fell giving back gains from earlier in the quarter. Though the S&P 500 managed a positive return of +0.28%, the DJIA declined -0.29% while mid-size US company stocks fell -1.92%. European markets experienced a broad selloff from May-June with France, Germany and Spain all declining more than -4.5%. These losses were partially offset by rebounds across previously hard hit emerging markets including Russia and Brazil, as well as continued strength in the Japanese stock market.   

Signs of a second quarter rebound in the US economy including improvements in the US labor market, rising home prices, improving retail sales and rising consumer confidence increased the likelihood that the Federal Reserve would begin raising short term interest rates as early as June. Despite much speculation, the Federal Reserve kept its interest rate policy unchanged in June with investors now anticipating the first interest rate hike will occur by September. With rising interest rates potentially months away, interest rate sensitive areas of the market including bonds and high yielding stocks declined in value. The yield on the 10 Year US Treasury moved rapidly higher from 1.93% in March to 2.34% in June, while the US Aggregate Bond Index declined -1.68%. European bond markets were particularly hard hit, as uncertainty across the Eurozone in the face of the Greek crisis led to rising yields and falling bond prices that wiped out European bond returns earned in the first quarter. In the US, utility stocks and Real Estate Investment Trusts (REIT) declined as investors feared that rising bond yields would make high-yielding dividend stocks less attractive. REITs were among the hardest hit sectors declining -10.7%. It is my personal belief that the selloff across higher yielding dividend stocks has been somewhat indiscriminate and fails to consider some key points including the likely gradual pace of interest rate increases and individual company fundamentals. Too often we see group-think permeate Wall Street and when consensus opinion becomes viewed as fact the opposite tends to occur.

After the strong gains we have experienced across stock and bond markets in recent years, the investment results of the second quarter are likely to be viewed as rather unexceptional despite the exciting headlines which dominated the news on a daily basis. If anything can be taken away from the quarter, it is a reminder that global markets can often become disconnected from underlying company fundamentals with short term returns driven by fear and panic. Though there were no major strategy shifts during the quarter, I did adjust client portfolios to further reduce exposure to Emerging Markets while taking additional profits on our healthcare-focused investments. I continue to favor investment strategies focused on value investing and dividend-growth companies. Allocations to cash within client portfolios as a result of portfolio rebalancing in June enabled us to make some new investments as the US market declined. In particular, attractive opportunities emerged among utilities, telecommunication services, airlines, business development companies (BDCs) as well as companies undergoing shorter term restructuring efforts. Allocations to new stock holdings across client accounts were driven by individual risk tolerances and portfolio size constraints. Though the core of client portfolios are expected to remain invested in a diversified mix of low cost actively managed mutual funds and exchange traded funds (ETFs), I believe opportunities will continue to emerge to selectively add individual stocks that can serve to reduce portfolio volatility, lower costs and increase client returns over the longer term.

So What Should We Expect Going Forward? The recovery in the US economy since 2009 has driven company sales higher, while low levels of inflation across goods and services has increased company profit margins (arguably at the expense of employee wages). Higher margins have led to rising company earnings, while historically low interest rates have driven investment valuations on stocks higher. All of these factors have led to strong stock market returns with market valuations continuing to rise and now sitting above historical levels. Valuation tools are a necessary part of every investor’s toolkit, and useful in gauging how much investors in the marketplace are willing to pay for a company’s future earnings. In theory, companies with proven growth potential and those with strong business fundamentals should command higher valuations. As of today, the S&P 500 trades at 17.5x 2015 estimated earnings (per FactSet) vs. the 25 year average of 15.7x forward earnings. Though elevated US market valuations are defensible given high profit margins and current interest rates, it is difficult to see how much further valuations can expand as interest rates begin to normalize and earnings growth rates moderate. The more likely scenario is that future market returns will be driven primarily by company earnings growth rates leading me to believe that future returns will be lower than historical levels. However, this does not mean that valuations can’t become more inflated should investor demand continue to drive multiple expansions. 
Currently, stock market valuations outside the US appear to be more attractive relative to historical levels particularly given economies across Europe and Japan remain further behind the US in their phase of economic recovery. Weaker currencies and economic stimulus from foreign central banks should keep interest rates low outside the US while helping to boost exports and stimulate demand for domestic goods and services. Though recent economic data including GDP growth, inflation and manufacturing indicate improvements are continuing across parts of Europe and Japan, risks still remain to the Eurozone related to Greece and the slowdown in China. For bond investors, rising interest rates pose a unique risk given the low absolute level of interest rates today. As noted previously, interest rates and bond prices tend to move in opposite directions with interest rate increases having a more profound negative effect on longer term bonds and when rates are at very low levels. Though no single bond strategy can completely shield bond investors from rising interest rates, I have continued to favor a targeted mix of investment grade, variable rate and high yield bond strategies emphasizing bonds with shorter maturities that have historically performed better during periods of rising interest rates.            

Putting all of this into perspective, projected long term returns across major asset classes (stocks, bonds and cash) are likely to be lower going forward. Long term projected asset class returns are a function of assessing current valuations within the context of historical valuations and returns, risk free rates and asset-class premiums (the additional return expected for taking on more risk). Though stock market returns are expected to be lower than historical levels, I believe projected stock returns still remain attractive relative to projected returns for bonds and cash. Additional information related to these projections will be provided in your annual Investment Policy Statement update and are available upon request. 

On a personal note, I would like to extend a special thanks to all of my clients for continuing to help drive the growth and success of Timmons Wealth Management. In the July 2015 issue of Financial Advisor magazine, Timmons Wealth Management was ranked #22 on FA’s 2015 Annual RIA Ranking as one of the 50 Fastest Growing Firms. Thank you for your continued trust in Timmons Wealth Management!

Timmons Wealth Management Ranked Among 50 Fastest Growing RIA Firms

Market Commentary - First Quarter 2015

April 16, 2015 – With oil prices declining so significantly over the past six months, many hoped the extra money in consumer pockets would translate into a rebound in US consumer spending in the 1Q 2015. This was not to be, as weaker retail sales data emerged throughout the quarter as well as a mixed picture of overall economic activity. Weather has been largely cited as the culprit for the slowdown early in the year, though US company earnings have been hurt by other factors including a stronger dollar depressing overseas profits and a rapid decline in capital investment and revenues across the energy industry. In the face of this uncertainty, the S&P 500 (our preferred measure of the US market) produced a small positive return of +0.95%. Small companies in the US market continued to rebound +4.32% due to growing investor preference for domestically-focused companies less exposed to currency fluctuations.

In a sharp reversal from the 4Q 2014, international stocks were the big winners this quarter. The FTSE Global AC ex-US index (how we benchmark international stock markets) earned +3.74%. The European Central Bank embarked on its long-awaited quantitative easing program (QE) driving shares of European companies higher as the Euro plunged -11% vs. the US Dollar. Though still weak, economic news emerging from the Eurozone has been gradually improving in terms of manufacturing and inflation data as well as upward revisions to GDP estimates. Japan’s stock market soared in the first quarter +10.2% as the Japanese economy continued to benefit from lower oil prices, a weaker Yen that has boosted exports and continued monetary and government stimulus programs. Emerging Markets, led by rebounding stock markets across places like China, Russia and India rose +2.24%. The stock market rally in China reached a frenzied pitch in the 1Q 2015, despite a slowing economy and a government attempting to stimulate growth while pushing through reforms aimed at reducing debt and overcapacity. We remain leery of the recent Chinese market rally and believe much of it has been driven by the expectation of a never-ending fountain of government stimulus and the lack of viable investment alternatives for retail investors.

As investors, we continued to grapple with the tremendous divergence of monetary and interest rate policies across the globe. The US appears alone in its current quest to begin raising interest rates, as central banks and governments outside of the US engage in policies focused on devaluing currencies and driving down interest rates. Negative yields, a phenomenon once only discussed as an economic theory, have become a reality outside the US. Today, the interest rate on a 10 Year Swiss Government Bond is -0.25%. The interest rate on a 5 Year German Government Bond is -0.16%. Imagine taking out a loan and then being paid interest as the borrower! It is a small wonder why the US Treasury market with its juicy 10 Year yield of 1.89% continues to be viewed as an attractive investment for foreign investors. Despite widespread belief that US interest rates are headed higher later this year, bond prices continued to rise and the US bond market returned +1.61% during the first quarter.

During the quarter, portfolio investment performance benefitted from our positioning in several healthcare-focused investments. We continue to believe in the long term potential of our healthcare investment theme given ongoing global demographic changes, new developments in personalized medicine and a favorable regulatory environment for drug approvals. Client portfolio allocations to mid and small sized companies, investments in large growth companies, a small allocation to REITs and an increasing allocation to international stocks all benefitted performance. As part of our increasing stake in international stocks, we have added a new strategy that hedges against foreign currency movement given our opinion that the Euro will continue to fall vs. the US Dollar. Over the past quarter, our core bond strategy within client portfolios has remained relatively unchanged with minor adjustments to weightings. We continue to focus on higher quality short and intermediate term bonds, though have added small stakes to high yield bonds and bank loans. In accordance with past discussions, we have continued to avoid longer term bonds. At times, this positioning as resulted in giving up some potential return, but our risk/return analysis dictates the need to focus on reducing the interest rate sensitivity of client portfolios.

Given the strong market returns we have experienced over the past several years, it is not uncommon to hear clients ask “Is now time to take profits and get out?” We always begin our answer with the statement that we aren’t market timers, and attempting to time the market consistently is a near impossible feat. Too many studies highlight the risk of trying to call market tops and bottoms and conclude investors are better off maintaining a well-diversified portfolio and ignoring the “noise.” Having said this, it is understandable why clients would be concerned given the last financial crisis remains fresh in many minds. Despite hitting new highs, valuations across the US market are not as stretched as we have seen during past market peaks. As of March 31st, the S&P 500 traded at 16.9x the next 12 months earnings estimates, only modestly above the historical 25 year average of 15.7x. We rarely focus solely on the price levels of indices, but rather put the price levels of broad indices into context by comparing the growth of the underlying company earnings to the cost per share (Price/Earnings Ratio). To us, it is not a surprise to see elevated valuations for growing companies given the current interest rate environment. Low interest rates boost stock valuations and provide companies with a low cost of capital, while forcing investors seeking higher returns than those offered in banks and bonds into stocks. Other factors impacting US market valuations include downward revisions to earnings estimates across the energy industry, as well as a stronger dollar depressing overseas earnings for multinational companies. As we look overseas, valuations across many developed and emerging international markets are more appealing, particularly where central banks are in a much earlier stage of providing monetary stimulus.

So, what are the biggest risks we see going forward? One concern is the potential for future returns to be lower than historical averages. Bonds face an uphill struggle given the low level of current rates, while further stock price appreciation will rest heavily on earnings growth. Higher rates would eventually result in higher income for savers and retirees, though the road to higher rates would result in initial falling bond prices and principal losses. If anything is clear, it is that bond investors do not agree with the Federal Reserve. The Federal Reserve continues to see interest rates and inflation rising higher than is priced into the term structure of interest rates (the difference in interest rates across different bond maturities which can be used to gauge market opinion). We believe if the Federal Reserve does move forward with raising its benchmark rate in June we may see some market volatility as investor expectations reset. Beyond US markets, we believe issues surrounding Greece’s “cat and mouse” game with the European Central Bank will continue to dominate international headlines. We see minimal chance of Greece ever being able to repay its debts in their current format, leaving European officials with an unenviable set of options. Though we believe it is far more likely for the debt to be forgiven or adjusted in some format than for a Eurozone exit (referred to as “Grexit”), the risk certainly remains that events transpire differently raising concerns about other indebted members of the Euro. Finally, we believe risks associated with China’s continued economic slowdown remain elevated. The accuracy of economic data emerging from China is questionable at best, so when official reports continue to reflect disappointing figures there is always the potential that things are actually much worse. With burgeoning debt levels across the shadow-banking industry, government officials have attempted to reign in unauthorized lending while simultaneously boosting business lending. Enacting reforms to address overcapacity and competition are difficult at best, and when push comes to shove party officials have prioritized boosting growth (ie. keep people employed to prevent unhappy thoughts about revolt) over these reforms. China remains a critical trade partner for many commodity-exporting countries and a key source of demand for consumer and business products from the US and other developed markets. As we move forward, we remain largely upbeat for the remainder of 2015 but wary of some of the risks discussed here. 

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