Review and Outlook

Summer 2015

Investor's Update

Closing Prices 06/30/2015
DJIA.................................................
17,619.51
S&P 500 INDEX.................................................
2063.11
US TREASURY BOND
Current Yield - 10 year bond.................................................
2.35%
Current Yield - 30 year bond.................................................
3.12%
Past performance is no guarantee of future results and investing involves risk, including the possible loss of principle.

The tight, range bound action continued in historic fashion for the domestic equity markets, but fixed income and international headlines were anything but calm. The transition from unprecedented stimulative measures by the Federal Reserve towards a more normal policy positioning caused rotational action out of high yielding, low valuation, and generally safe industries and into those sectors that benefit from a rising interest rate environment. Although the major averages did touch new all-time highs, participation was lackluster as the average stock is technically in a corrective condition. Fewer and fewer companies are keeping the major stock indices afloat. The largest dividend payers in the S&P 500 were the worst performing decile, while the best performing deciles are those that pay no dividends. Extended valuation metrics proved to be no match for growth investors as many companies with no earnings history ramped to new highs. Historically, this scenario does not end without a significant correction.

The Greek default led to a 17.3% drop in the Greek stock market during mid-June, though the Athens Stock Exchange General Index closed the quarter slightly positive. This turmoil extended to the rest of Europe and emerging markets. However, most major European countries and the emerging markets show positive year to date gains, outpacing the United States for the first time in a few years. The US Dollar Index finally reversed its ascent with a pullback of 2.9% during the quarter. Treasuries responded to the Federal Reserve’s intent to raise Fed Fund rates this year as the 5, 10 and 30 year yields spiked by 25, 40 and 56 basis points to yield 1.63%, 2.35% and 3.12%, respectively. Yield shifts of this magnitude led to substantial principal losses in the fixed income market, primarily on the long end. The Barclays Capital Intermediate Government/Credit Index and the Barclays Capital Aggregate Bond Index dropped 0.62% and 1.68%, respectively.

The Russell 2000, whose constituents are typically more levered to the domestic economy and have lower dividend yields, outpaced their larger brethren with the index advancing 0.42% compared to the S&P, including dividends, returning 0.28%. The equal weight S&P 500 dropped 1.56%. The DJIA also declined 0.29% while the NASDAQ rose 2.05% during the quarter. Ireland, China and Japan were noted performers in the S&P Dow Jones Global Index performance gainers for the quarter, advancing 16.1%, 12.7% and 12.7%, in US dollar terms, respectively.

Digging deeper into sector performance, Healthcare, Consumer Cyclicals and Financials led the way with 2.43%, 1.56% and 1.23% price returns. Utilities and Industrials were laggards with losses of 6.26% and 2.77%. Growth stocks posted one of their largest quarterly gains ever relative to value stocks as investors reached for beta and shunned dividends. Oil prices rebounded 24.9% to $59 per barrel as the previous drop from $107 caused a massive amount of future production to be shut down. With future supply being withdrawn from the market, oil prices can get back to more appropriate levels. Gold continued its consolidative, range-bound action, ending the quarter at $1,172.42, down nearly 1%.

Economic Outlook

Manufacturing and industrial economic reports continued to point towards a significant slowdown in our economy, likely due to the West Coast port shutdown and nasty winter weather. The strong dollar ultimately creates headwinds for our multinational conglomerates and their ability to compete on price. Valuation metrics are near all-time highs not seen since the Dot-Com bubble of 2000. There has not been a 10% correction in the S&P 500 since late 2011, which is the third longest stretch since 1929. Stocks have been able to advance via financial engineering for quite some time. Rising interest rates could put a crimp on companies’ ability to continue their rapid rate of debt issuance in order to complete their share repurchase programs. Dividends and buybacks outpaced actual earnings last quarter, a trend that cannot continue and is usually seen at market tops. Operating earnings are expected to be down in every quarter of this year but reported earnings should show some growth due to the lower share count.

On the other end of the spectrum, consumer confidence and consumption have rebounded tremendously from the weather-induced slowdown in the first quarter. A strengthening consumer is necessary if the economy has any chance of expanding during a rising interest rate cycle. Job and wage growth continues to be steady. Personal income showed its biggest two month gain in over a year. Household net worth is handily above the pre-recession highs. The housing market is posting multi-year highs in sales. Median home prices are also at 10 year highs as millennials slowly shift from renting to owning. All signs point to no recession on the horizon. However, a correction would be welcome news as removing some of the excess in the market could help investors refocus their efforts towards high quality companies with actual earnings and stable dividend payouts.

The last update to 1st quarter GDP report showed a modest 0.2% weather-induced drop. We expect a more normalized trend going forward, likely in the 2.0% - 2.5% range with an upward bias if the currency market continues to normalize and Greek default issues subside. Interest rates should continue to extend the upper end of their range, assuming global markets do not have any unforeseen headwinds. Outside of the Energy market, actual earnings should reverse their short-term descent and rebound with the global economy.

Capital Market Analysis

The consolidative, range-bound action is likely to continue until there is further confirmation that the first quarter negative growth reports were, in fact, based on short-term issues. The market also has to readjust to higher interest rates, which is critical to the improving economy. Historically, leaders in a rising interest rate environment are quite different than at the beginning stages of an economic cycle. Financials are one sector that is finally showing signs of life after net interest margins dropped to historic lows when interest rates bottomed in the first quarter. Accommodative central banks on the international front should be able to assist corporate growth and spark reinvestment into their markets. A global economic rebound can be seen on the horizon absent geopolitical issues.

The Fed Fund futures market is now pricing an initial rate hike late in the second half of this year, but the timing, could certainly be altered. As we have noted, the pace, frequency and size of those rates hikes, not the absolute timing will be paramount. It is clear the Federal Reserve would like to normalize policy; however it is unlikely they will do this if economic data do not support their thesis. The recent spike in interest rates does not put us anywhere near historic norms, which keeps the cost of funding near significant lows. However, fixed income investors should expect to see principal losses in their portfolios as rates rise.

Summary

We continue to shift our portfolios to be more interest rate exposed, consumer oriented, and economically sensitive. A focus on global macroeconomic conditions should allow us to book profits in a more volatile investment environment going forward. A correction in the markets would likely be a more attractive opportunity to get more aggressive. We remain focused on high quality companies, which have clean balance sheets and stable dividends. Stock selection will remain paramount. Fixed income investors will continue to benefit from exposure to high quality securities with a neutral duration.

We appreciate your confidence and business. Please do not hesitate to call us if you have any questions or if we can be of assistance.

Barclays Capital Intermediate Government/Credit Index: An unmanaged index based on all publicly issued intermediate government and corporate debt securities with maturities of 1-10 years. This index represents asset types which are subject to risk, including loss of principal. Barclays Capital Intermediate Aggregate Index: An unmanaged index that consists of 1-10 year Governments, 1-10 year Corporates, all Mortgages, and all Asset-Backed securities within the Aggregate Index (i.e. the Aggregate Index less the Long Government/Corporate Index). Dow Jones Industrial Average: The most widely used indicator of the overall condition of the stock market, a price-weighted average of 30 actively traded blue chip stocks, primarily industrials NASDAQ Composite Index: Measures all NASDAQ domestic and international based common type stocks listed on The Nasdaq Stock Market. The NASDAQ Composite is calculated under a market capitalization weighted methodology index. Standard and Poor’s 500 Index: Capitalization-weighted index of 500 stocks, including the reinvestment of dividends and other distributions, designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Russell 2000®: The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000® is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set. Athens Stock Exchange General Index: The Athens Stock Exchange General Index is a capitalization-weighted index of Greek stocks listed on the Athens Stock Exchange. The index was developed with a base value of 100 as of December 31, 1980. Dow Jones Global Indices®: The Dow Jones Global Indices® (DJGI) family is a comprehensive global index series designed to provide a complete range of portfolio-management and benchmarking tools. The indices are designed to be broad yet investable, targeting 95% market capitalization coverage. The Dow Jones Global Indices® family currently includes 48 country indices.

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