Quarterly Report

The year started with uncertainty and heightened volatility across most asset classes.  For the quarter, the stock market volatility subsided a bit and returns remained mostly positive. Volatility did pick at the end of second quarter, which was punctuated by the “Brexit” vote, where the UK elected to leave the EU.  Polls were mixed throughout the quarter, generally leaning in the direction of the “remain” vote.  The decision to leave the EU was marked by skepticism about Europe-wide policy making and regulatory intervention, along with a surge in immigration and the resulting nationalism.  The UK Prime Minister, David Cameron favored continued membership in the EU, and quickly resigned when the vote went against his position. The resignation, along with the uncertainty created by the Brexit vote, created heightened volatility at the end of June.  The UK exit from the EU will likely be a long and uncertain process, but the impact on the US economy should be negligible.  The other factor that continues to contribute to uncertainty is the Federal Reserve’s timing around interest rate hikes.

In our last letter, we highlighted how we were cautiously optimistic about the markets, with our indicators leaning more bullish than bearish.  This contrarian view was and continues to be counter to most other advisors and asset managers, who are much more bearish and susceptible to being influenced by headline risk.  Although news and big developments are of concern, we try to stay above the noise and focus on the data and the prices of the assets we own and monitor.  Again, going into Q3 2016, we see a more bullish outlook than most.  We are continuing to use this volatility to add good stocks that exhibit the qualities we favor.

Stock Market Review.  For the quarter, the S&P 500 was up 2.5%, the Dow up 2.1%, and NASDAQ was down -0.2%.  We saw stocks, bonds and commodities led by gold and oil rally this quarter.  Energy was the best performing sector, up 11.6% for the quarter, followed by telecom up 7.1% and utilities up 6.8%.  Technology and consumer discretionary were the worst performing sectors, down -2.8% and -0.9%, respectively.  This defensive sector outperformance is not surprising given their sensitivity to interest rates.  Interest rates as measured by the 10 year Treasury fell from 1.94% to 1.46%, the lowest level on record.  This quarter saw funds flowing from higher growth assets like technology stocks to more stable defensive assets like Treasuries and defensive dividend paying stocks, which can be interpreted as somewhat ominous. For the quarter, capital flowed from risk assets to safer assets, including gold.

For the S&P 500, valuations remain somewhat elevated, yet within long term averages.  The forward 12 month P/E ratio remains at 16.6x, which is just above the 25 year average of 15.9x.  Quarterly earnings are for the S&P 500 are projected to growth from $23.97/share in Q1 2016 to over $31/share by Q4 2016, suggesting more room for upside.  One of my favorite valuation measures, price/free cash flow is at 23x vs. its long term average of 28.1x.  For the first half of 2016, the S&P 500 gained 3.8%, while the NASDAQ lost -0.2%.

Bonds & Interest Rates.  Interest rates as measured by the bellwether 10 year Treasury remained range bound for most of the quarter up to the Brexit vote.  After the vote, yields tumbled in the US, with interest rates for the 10 year Treasury hitting all-time lows at just below 1.5%.  Uncertainty around the Brexit vote combined with overly accommodative monetary policies has had the flight to quality effect, pushing yields down.  This volatility is likely to remain as long as uncertainty prevails.  With interest rates on foreign bonds so low and in some cases negative, the rest of the world is seeking anything with a positive yield, further driving up prices and pushing yields down.  Interest rate spreads as measured by the 2 year Treasury and the 10 year Treasury are tightening as the yield curve falls and flattens.  This is something to watch closely as this tightening spread and falling yield curve suggests economic malaise could be around the corner.  For the first half of 2016, bonds have been one of the best performing asset classes, with 30 year Treasuries among the best performing at 16.38% YTD.

All this uncertainty has made it increasingly difficult for the Federal Reserve to raise rates again this year.  Some recent softness in the economy, along with below trend inflation suggests the Fed does not see inflation as an imminent threat to the economy.  This could warrant keeping interest rates at historic lows.  The Fed meets monthly to determine interest policy with each meeting keeping the market on pins and needles.  There is no question the Fed would like to raise rates again, but they are being especially cautious given all the uncertainty around the globe and here in the US.  Another rate hike is likely to occur within the next year to 18 months, which could lead to more uncertainty and volatility across asset classes.  As long as the economy is on sound footing, with a solid growth trajectory, the rate hike will likely be a positive.  If rates are hiked into a weak recovery like we have now, we could see the Fed inducing a recession.  In my opinion, if the Fed were to raise rates before more robust GDP growth, especially given our below trend inflation, they will send the economy into recession and I will start raising cash.

Economic Growth & GDP.  The economy continues to send mixed signals, yet plods along. GDP growth has seen several revisions, finally coming in at 0.9% for Q1 2016, on pace for real GDP growth of 2.3% for 2016.   For the second quarter of 2016, unemployment remains near all-time lows, coming in at an annualized rate of 4.8%.  Inflation remains low at around 1% and the Federal Reserve expects as gradual increase back to their 2% target.  Consumer spending, which makes up 69% of GDP, has been supported by job growth and should continue to do as so as the job market tightens and wage growth improves.   Housing continues gradual recovery, but first time buyers still face hurdles and are mostly staying away.  The US dollar’s ascent continues to slowly reverse course as the Fed rate hikes become less likely for the foreseeable future.  The global economic outlook remains relatively soft by historical standards, with a number of downside risks. The Brexit vote add to this uncertainty as the UK will spend the next 2 years negotiating its exit from the EU.

In my last letter, I highlighted the correlation between the the 10 year treasury yield and GDP growth.  I suggested the bond market is forecasting much less GDP growth than most economic forecasters, which has been true.  Now with yields falling even further, we could see more downside revisions to GDP for the next few years.  The change in real GDP for the next few years remains just above 2%.  This could be reduced given how much yields have declined.

In my last letter, I also highlighted that with this tepid growth and little, if any inflation, the Fed is likely to reduce the number of interest rate hikes this year.  This was my view prior to the Brexit vote and still remains my view today.  Forecasters were calling for 3-4 hikes this year, yet the data and the market seem to be suggesting far fewer. This has been true so far and given the recent increase in global uncertainty is not likely to change.  During recent testimony, Janet Yellen mentioned concern around Brexit, indicating that these events still pose risks to the U.S. economy.  The Federal Reserve recently stated that this is an economy that is not running hot.

Commodities: Oil & Gold.  During the quarter oil prices have nearly doubled to $50 per barrel from February’s low.  Similarly, gold prices also rallied during the quarter, moving from $1200 an ounce to nearly $1400 an ounce.  With the US dollar weakening during the quarter as the Federal Reserve is less likely to raise interest rates, commodities, led by oil and gold were able to benefit.  Commodity centric economies such as Canada and Brazil will likely continue to see headwinds as the commodity prices remain volatile.

Outlook for the Quarter.  As mentioned in my previous updates, uncertainty remains a worry, given the recent developments with the EU, combined with the timing of the US rate hike.  Internationally, there are many factors at play that could also increase uncertainty including the issues with the EU, a cooling Chinese economy and global deflation to name a few.   Our outlook for 2016 remains cautiously optimistic and we continue to look for great stocks to add. We continue to look for opportunities in healthcare and information technology, which are positioned to benefit from an aging population and growing middle class.  Bearish sentiment and short interest remains quite high, which could lead to more upside surprises for the market.  The technical condition of the market remains mixed to slightly positive.  Earnings season for the second quarter improved and this improvement is projected to continue through the remainder of this year.  Monitoring data releases will be crucial as the second half of 2016 progresses and we enter the US Presidential elections.  Monetary policy continues to loom large, as every month the market awaits the Federal Reserve’s decision on interest rates.  We will continue to monitor the markets closely and adjust our portfolios accordingly.

The year 2016 started with uncertainty and heightened volatility across most asset classes.  After a strong sell off in January and February, the stock market bounced back in March. For March 2016, the S&P 500 was up 6.6%, the Dow up 7.1%, and NASDAQ was up 6.8%. For the first quarter of 2016, the indices were mixed, with the S&P 500 up slightly at 0.7%, the Dow up 1.5%, and the NASDAQ still down for the  year at -2.8%. The first quarter also marked estimated earnings declines of -8.5% for Q1 2016, marking the first time the S&P 500 has seen four consecutive quarters since the Q4 2008 through Q3 2009. The biggest drag was the energy sector. The bright spot remains consumer discretionary. For the S&P 500, valuations still remain somewhat elevated with the forward 12 month P/E ratio at 16.6, which is above the 5 year average of 14.4 and the 10 year average of 14.2. I believe there are still good values in the market and we will continue adding names  that exhibit good valuations  and solid  growth potential, even in the face of many risks.

In our opinion, along with the Federal Reserve’s monetary policy, one of the main factors contributing to market uncertainty has been Central Bank guidance from China. It is only recently (February 2016) that the governor of China’s Central Bank, Zhou Xioachuan has offered information about China’s  intentions  in  the  global  markets,  particularly  around  their currency. After mounting pressure from the US, EU and other more transparent nations, China has finally started offering information via press conferences about their policy intentions. They finally calmed markets over the last month by stating in a press conference that they will no longer weaken their currency and the global markets have responded favorably. This is something we are watching very closely, as any deviation from this stance and a return to non- transparency about their intentions or any further weakening of their currency could rattle the markets again. It is a positive development that the Central Bank in China is now offering some

information and guidance about their intentions.  As the 2nd largest economy and a major global

player, it is incumbent upon them to provide more transparent communications. As Ben Bernanke once stated, the role of the Central bank is 98% communications and 2% policy implementation. We are hopeful this will continue and for now, things are looking much better. This is something we are monitoring very closely.

Additionally, in March, the European Central Bank (ECB) announced more stimulus for Europe. The ECB cut interest rates and expanded its bond buyback program. The ECB, along with the Bank of Japan (BOJ) have ushered in an era of negative interest rates in an effort to have banks lend and to spur investment.  Negative interest rates are a new policy tool and it remains to be seen if it will be effective in stimulating these economies. Furthermore, the Fed announced that they would keep interest rates unchanged and the market has been strong since these policy decisions. Interest rates in the US continue to come down, be it for technical reasons or fundamental reasons. In my opinion, there are a few things going on here.  First off,  the 10 year treasury yield and GDP growth tend to be correlated, so it seems that the bond market is forecasting much less GDP growth than most economic forecasters. In fact, when reading the last Fed minutes from a few weeks ago, it is clear that they are bring down GDP growth expectations and the bond market seems to be corroborating this view.  Here are the Fed’s recent economic projections:

Second, with tepid growth and little, if any inflation, the Fed is likely to reduce the number of interest rate hikes this year. Forecasters where calling for 3-4 hikes this year, yet the data and the market seem to be suggesting fewer. Maybe one or two hikes at most, if any. Given the state of the yield curve (flattening and falling), any rate increases will likely increase the likelihood of a flatter and flatter yield curve, suggesting an inducement of recession down the road. Coincidentally, the meetings of the Fed’s board of governors, which determine short term interest rates happen to correspond with significant political events such as the Democratic and Republican National conventions and the upcoming Presidential elections. Interest rates for the 10 year treasury remain near historic lows of around 1.7%. On March 29, 2016, Janet Yellen delivered a dovish  speech to the Economic Club of New York, indicating that the global economy still poses risks to the U.S. economy, and thus a more gradual path of interest-rate increases should be pursued. The market rallied as her dovish comments seemed to also reduce the probability of significant rate hikes this year.

Oil continued its rise from its February low of $26 per barrel to a recent high of nearly $42 per barrel in late March. Much of the rise in oil was driven by speculation of a deal being struck at the OPEC and non-OPEC meeting in Qatar to discuss a production freeze. Moreover, The USD has been weakening of late, given the likelihood that rates here in the US do not move much higher. This has been good for emerging markets, oil and commodities such as gold as a weakening dollar helps these asset classes. This could continue given the Fed will likely not raise rates much this year, thus leaving the USD dollar vulnerable to more downside pressure. The key will be watching the BOJ and the ECB and whether they look to more stimulus, which seems highly likely. This would then put pressure on the Yen and Euro, causing the USD to rebound. So it seems the USD will likely trade range bound given these counter forces. Commodities, oil, gold and emerging markets will remain volatile.

As mentioned in my previous updates, uncertainty remains a worry, given the problems in China and their opaque policy and communication. Hopefully, this continues to improve. Geopolitically, there are many factors at play that could also increase uncertainty. Our outlook for 2016 remains cautious. Bearish sentiment and short interest remains quite high, which could lead to more upside surprises for the market. The technical condition of the market remains mixed to slightly positive. Earnings season for the second quarter will begin and it will be important to see how companies report earnings and guidance. Monitoring data releases will be crucial as the second quarter of 2016 progresses. Monetary policy continues to loom large, including ECB and Fed rate decisions in April. We will continue to monitor the markets closely and adjust our portfolios accordingly. Please let me know if you would like to schedule a call to review any of these details together.