Q1 2016 Client Letter

April 26, 2016


“If you don’t like the weather… just wait a few minutes.” -- Mark Twain


Hello All:


Living in the midwest, as in some other parts of the country, we are prone to dramatic swings in the weather. This time of year, it’s very possible you may have to wear a coat as you leave for work in the morning, and by later afternoon, you need to turn on the air conditioner. It’s almost as if the weather in this part of the country is somewhat bipolar.


Manic-depressive behavior is also a great way to describe the capital market environment so far this year. The first quarter of this year presented our portfolio strategies with a real-world stress-test scenario. It began with the worst start to a year in Wall Street history, as global equity markets dropped dramatically, oil prices plunged, and fears of a global recession grew.


Then beginning around mid-February, everything changed. Oil prices spiked higher, stock markets rallied, and the U.S. dollar declined (serving as a tailwind for foreign equity returns). In a welcome change for our portfolios versus recent years, emerging-markets stocks and bonds were among the highest-returning asset classes. Core bonds, which had rallied strongly in the first half of the quarter, fell and the 10-year Treasury yield moved higher.

This sort of extreme market turmoil vividly illustrates why we construct diversified investment portfolios for our clients. It also points out the unpredictability of short-term market movements. As you know, our approach is to carefully analyze long-term risk and return potential and build portfolios that balance these considerations and are resilient across a variety of market scenarios.

During the first half of the quarter, our defensive positions in core bonds and diversifying allocations to high-dividend alternative strategies such as real estate investment trusts helped offset the dramatic equity market declines.

As the market rebounded, our allocations to emerging-markets and U.S. stocks boosted performance as each asset class ended in positive territory for the quarter (5.9% and 1.3%, respectively). Developed international stocks also rebounded dramatically off their mid-quarter lows, but trailed for the quarter, down just under 2%. When the dust cleared, our portfolios managed to post a gain for the quarter.


It’s Raining Bulls and Bears

We believe that part of successful investing involves riding out these nervous markets in which prices are driven by short-term news and investor cycles of emotion, staying focused on long-term fundamentals, and remaining committed to our disciplined risk-management process. The quarter’s market volatility seemed to reflect a recognition by investors of some of the macroeconomic concerns we have expressed over the last few years, including the uncertainty created by unprecedented monetary policies (which have resulted in ultra-low and even negative interest rates) and the potential effects of an economic slowdown in China on global markets. Our assessment of these risks has not materially changed, and we have factored them into our asset allocation decisions.

Based on our analysis (and supported by a variety of commonly used valuation metrics), the U.S. stock market is fairly-valued to slightly overvalued and company earnings have declined from peak levels. U.S. market returns over the next five years are likely to be low not only in absolute terms, but also relative to the outsized gains we’ve seen in the post-2008 period. This assessment has been key in supporting our relatively conservative allocation to U.S. stocks in our portfolios.

On the other hand, the attractiveness of foreign markets is almost the exact opposite of the U.S. market. We see the potential for faster earnings growth from current below-normal levels and valuation levels we believe will expand somewhat as earnings improve. To the valuation point, foreign stocks have seen very steep declines of up to 35% from their April 2015 highs, bringing prices to recession-like levels even though it isn’t at all clear that we are either in or at imminent risk of a recession. In other words, foreign stocks, having discounted a lot of negative news, are set up for a potential rebound should markets realize things aren’t as bad as prices suggest. Our tilt toward foreign stocks has so far been a headwind for our portfolios. However, the performance of emerging-markets stocks versus U.S. stocks since the quarter’s turnaround may be hinting at a possible turn in the cycle that, if realized, could result in further gains for our equity holdings.

Our diversified bond allocations reflect our assessment that in the current ultra-low rate environment, allocating to fixed-income calls for greater ingenuity than in a more normal environment. And while our core bond positions provide useful risk-management qualities—as illustrated during the downturn early this year—their longer-term upside potential is limited. We continue to think of our bond portfolios as “dry powder” - something to sell when equity markets are weak so we can buy stocks on the cheap. This proved to be valuable to our portfolios in late January and early February.


Forecast: Partly sunny with a chance of volatility

Markets are cyclical, and for the past couple of years our portfolios have been facing some meaningful cyclical performance headwinds given our long-term, valuation-driven investment approach. While the sharp reversal in the markets beginning in the middle of the first quarter may indicate the pendulum is starting to swing in our favor, we realize it is impossible to time these short-term shifts and reversals.


Capital market returns are not linear in nature. As always, patience, discipline, and fortitude remain key to achieving one’s long-term investment goals and avoiding being swept away by the market’s unceasing swings.


Just like the weather in the midwest, the markets can be stormy one minute and sunny the next. Our portfolios are structured so we always have a both an umbrella and sun block ready and available.

As always, we appreciate your continued trust and confidence.

Best regards,


Ron Sanders



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