Client Update

Performance Review - 2nd Quarter 2015

Performance Overview

Overall portfolio performance for the second quarter of 2015 was slightly negative. Our portfolios slightly under-performed (-0.79%) compared to the benchmark (0.34%).Similar to the 1stquarter, part of our underperformance can be attributable to our underweighted international position, which was again the best performing asset class for the quarter along with our increasing cash position. For the quarter 19.9% of all clients had positive returns and 9.0% of all accounts beat the benchmark.

U.S. stocks (as measured by the S&P 500 Index) generated total returns of just 0.3% in the second quarter of 2015.Combined with a weak first quarter, returns for the first six months of 2015 stood at a very modest 1.2%. For most of 2015, stocks have traded in a fairly narrow range. Most major U.S. stock market indices, including the S&P 500, Dow Jones Industrial Average, Russell 2000, and Nasdaq Composite, set new all-time highs in the second quarter. However, late in the quarter, stocks declined on worries concerning a Greek debt default, extreme volatility in China and concerns of rising rates in the US. However, most indices finished the quarter just a few percentage points below their highs.

The table below shows the performance of major equity indices for various time periods thru June 30, 2015:

 

Index	Market Sector	2ndQuarter 2015	Year-To Date		Annualized
				1-Year	3-Year	5-Year	10-Year
S&P 500	Large US Companies	0.3%	1.2%	7.4%	17.3%	17.3%	7.9%
Russell 2000	Small US Companies	0.4%	4.8%	6.5%	17.8%	17.1%	8.4%
MSCI EAFE	Developed Intl Markets	1.0%	3.8%	-6.6%	9.0%	6.5%	2.3%
MSCI EM	Emerging Intl Markets	-0.2%	1.7%	-7.5%	1.2%	1.2%	5.6%

Despite a lot of scary headlines, the overall theme of the second quarter was sideways market movement. If you had gone on vacation and ignored the market from the end of Q1 (March 31) to the end of Q2 (June 30), you never would have known there was one potential crisis in the news after another that pulled markets up and down, since the DJIA only moved down -156.61 points, or -0.3% for the quarter overall.

Most of the second quarter’s small drop in the DJIA occurred on June 29, when it became obvious that Greece would default on its large debt payment to the IMF. When the market experiences extreme positive or negative volatility at the end of a quarter like this, it can change investors’ overall mood, but the reality is that the quarter didn’t change that much from start to finish.

In an overvalued market, any news, even things like the Greek default that do not directly affect U.S. investors, can create higher-than-usual market movements up or down. There are four major areas that will continue to spark market volatility in Q3:

1. Greece: We’ve already seen investor panic over an economy the size of Detroit move domestic markets to the downside. The Greek situation is unlikely to change the positive economic trajectory of Europe and the U.S. overall, but it may continue to rattle the market.
2. China: Normally stock markets and economies rise or fall together, but China’s market ballooned far beyond the rate its economy was expanding. Finally that bubble popped, with the Shanghai Composite tumbling over 30% since mid-June. This is very serious for Chinese investors, but we have little to no exposure (in fact, neither do most American investors). The larger concern is China’s slow economic growth—it’s still growing, but at the lowest level since 2009. When a giant economy contracts, it slows down the wheel of international commerce, which in turn can impact our own economy and scare investors.
3. Weak domestic economic numbers: U.S. real GDP decreased 0.2% in Q1 after rising 2.2% in Q4 of 2014. This short-term drop isn’t reason to panic, and we are still on track to increase GDP by approximately 2% for 2015. But GDP corresponds to corporate growth, so if low GDP numbers continue, it will indicate that corporate growth is slowing too. This could trigger a correction if the market is overvalued. Think of it this way: why would you pay a premium for stock in a company that isn’t growing fast enough to justify a higher price?
4. Pending rate move from the Fed: Everyone knows the Fed Funds rate will rise sometime this year. Though anticipation creates volatility in markets, the important thing to watch is the rate of increase, not the date of the increase. Because of issues in China and Greece (and by extension, the E.U.) it’s very likely the rate of increase may be slower than initially expected. This is a positive for markets because the low rate of borrowing will continue.

At this time and based on price/earnings ratios, many consider the S&P 500 to be fully valued, or perhaps even overvalued in some areas. Morningstar stated in its quarterly update, the “market as a whole still looks fairly valued to slightly overvalued. The median stock in Morningstar’s coverage universe trades right around our fair value estimate. On a price/earnings basis, the S&P 500's valuation remains rich by historical standards. The index was around 2,120 in late June. That implies price/earnings ratios of 19.2 (using trailing-12-month operating earnings), 27.3 (using a 10-year average of inflation-adjusted earnings--the Shiller P/E), or 18.5 (using trailing peak operating earnings). Those measures have been lower 65%, 76%, and 78% of the time since 1989, respectively. Such high valuation levels could be justified--assuming interest rates stay low and profit margins stay high--but we don't see much room for error in today's stock market.

As I have expressed in previous communications for much of the past year, I am of the belief that U.S. stocks are relatively expensive, and therefore, have held a cautious view of U.S. equity markets. The S&P 500 has gone almost four years without a 10% correction. On average, 10% corrections occur about once per year, so it might seem that we are overdue for one. While some might interpret these comments to mean that I view equities are unattractive long-term investments, this is not the case. While I have some concerns that stocks are slightly overvalued, I still regard equities as attractive for long-term investors when compared to other asset classes, such as fixed income (bonds) and cash.

Stocks are extremely difficult to value, primarily because there are so many variables to consider and the future events that impact businesses and the economy are challenging to predict. One of the most common metric used to value stocks is the price-to-earnings (P/E) ratio. This ratio is calculated by taking a stock price and dividing it by its earnings-per-share. This ratio indicates how much investors are willing to pay for every dollar of earnings. The ratio can be used to value individual stocks and the overall market.

Since the beginning of 1988, the S&P 500 has traded at an average P/E of 17.5 times its previous 12-month earnings. The annualized return for this time frame was 10.7%. The average one-year return for quarters which had a below-average P/E was a stellar 13.9%. For quarters when the P/E was above the 17.5 average, the one-year return was 7.4%.

While past performance is no guarantee of future results, you can draw two important observations from this information:1)The stock market is significantly more attractive when its P/E is below its historical average, and 2)even when the market has an above-average P/E, as is the current situation, its average returns have been good (7.4% annualized) and have exceeded those of other asset classes.

The real concern will come if the market's P/E moves to an extremely high level. For example, in the quarters when the market P/E exceeded 20, the next one-year returns averaged just 3.5%. For the quarters when the market P/E was above 25, the following one-year returns were negative.

It makes sense that stocks are more attractive when P/E ratios are low. Stocks, and the stock market collectively, increase in value when P/E ratios expand - when investors are willing to pay more for each dollar of earnings. Obviously, there is more potential for P/E ratios to increase when they are low, than when they are high. When P/E ratios are high, an increase in earnings is necessary to push stock prices higher. Since S&P 500 earnings are estimated to grow just 2.2% in 2015, it is unlikely that stocks will get a lift from earnings in the near term.

With the market currently trading at a P/E ratio about 10% above its long-term average, one could describe the market as slightly expensive, but not significantly overvalued. The overall long-term outlook remains positive, but my near-term return expectations are tempered. If earnings growth picks up steam going into 2016, stocks should begin to look more attractively valued.

Another major concern relates to the potentially negative impact of rising interest rates. Higher rates will increase borrowing costs for companies and consumers which could cause economic growth to slow. The Federal Reserve will likely begin its long anticipated move to increase interest rates soon. The stock market has reacted positively to Fed statements which indicate that the Fed will move rates higher at a gradual pace, in a manner that will continue to support economic growth. While that feat is easier said than done, it is the story that the market currently wants to hear.

Despite the Fed holding its benchmark rate below 0.25%, longer-term interest rates moved higher during the second quarter of 2015. The yield on the 10-year Treasury bond increased from 1.93% to 2.34% during the quarter. The increase in interest rates contributed to losses for most intermediate and long-term bond indices for the quarter. The U.S. bond market suffered a 1.7% loss for the second quarter. With long-term rates likely to rise further, as I have been saying for some time, longer-term fixed income investments as relatively unattractive. Consequently, the fixed income portion of our portfolios is primarily invested in short duration securities.

A critical part of my investment philosophy is predicated on dividends. Dividend income is an important element of total return. But there’s a subtle difference between investing in high-yield stocks and in dividend-growth stocks.

High-yield stocks typically have dividends that pay out in the 5%-8% range. They are perceived as being at risk in a rising rate environment. As interest rates are moving higher, equity investors could be drawn to the relative safety of bonds over high yield stocks. Further, a yield in the 7%-10% range could signal a dividend is at risk, particularly in the Energy sector.

How can we maintain our portfolio of income oriented investments and not sustain capital losses as interest rates rise? One strategy to avoid the impact of higher rates on dividend oriented investments is to focus on dividend growth over dividend yield at this stage of the economic and market cycles. Specifically, I aim to focus on persistent dividend growers – companies that have boosted their dividend for many years consecutively – and companies that have an above-average rate of dividend growth. To avoid losses due to interest rate increases, I am favoring dividend growth in sectors outside the traditional equity-income areas of utilities, REITs and MLPs while focusing on measures of dividend safety; a favorite being cash-flow coverage or free-cash-flow coverage of dividends.

What happens to stocks when interest rates rise? A 50-year chart of the 10-year yield shows two great tendencies. Long rates broadly rose from 3% in 1953 to 15% in 1980; and rates broadly declined from the 1980 high to the low of 1.6% reached in spring 2013 and again in early 2015.

Within those broad trends are multi-year periods in which rates clearly rise or fall. Argus Research has demonstrated that the stock market can maintain its long-term uptrend during extended periods of rising rates. For example, interest rates rose across 1995-96 and again from 1998 to early 2000 without disrupting the great 1990s bull market. The long-bond yield was also in a clearly rising trend from 2003 through 2006, or for most of the 2003-07 bull market. Reaching further back in time, the stock market rose 14% during 1986 in a rising-rate environment and the S&P 500 rose 25% in 1980 even as rates were approaching their double digit peak. In 2013, the stock market delivered its best total return of the post-2008 bull market even though the long yield nearly doubled during the year.

We have already explained the risks of high-yield investing in a dynamic rate environment. Why then go anywhere near income stocks at such a time? One reason is that we need income. Moreover, Argus Research has found that dividend-growth stocks tend to hold their value better in periods of rising rates and deliver solid total returns in all markets.

Dividend growth is a superior strategy in relation to chasing high yield for long-term returns across the entire market cycle. Dividend growth is not an ironclad defense against a down market. But for investors requiring income, dividend growth has outperformed in a rising-rate environment.

As markets have dipped in July, I have used that period to selectively begin putting our large cash position to work. I remain underweight bonds, where valuations are unattractive, and have been increasing our allocations to international investments.

I remain focused on appropriately managing risk based upon each client’s specific needs. Thank you for your confidence and support. Should you wish to discuss any of the above in greater detail, please do not hesitate to contact me.

Investment Review and Outlook

Performance for 2nd Quarter 2015

Below is the analysis of all accounts that I managed with full discretion for the Second quarter of 2015. Summary results of portfolio performance for the Second Quarter of 2015 appear as follows:

Asset Class	Benchmark Return	Actual Allocation	Actual Benchmark Return	Suggested Allocation	Suggested Benchmark Return
US Stocks	0.31	70.22	0.22	63.42	0.20
Foreign	1.00	15.31	0.15	30.37	0.30
Bonds	-1.65	2.11	-0.03	6.19	-0.10
Cash	0.00	12.36	0.00	0.02	0.00
Totals:		100.00	0.34	100.00	0.40

 

Asset Class	Benchmark Return	Actual Allocation	Actual Benchmark Return	Suggested Allocation	Suggested Benchmark Return
US Stocks	1.11	72.23	0.80	63.38	0.70
Foreign	5.35	16.71	0.89	30.32	1.62
Bonds	1.61	2.40	0.04	6.28	0.10
Cash	0.00	8.65	0.00	0.03	0.00
Totals:		100.00	1.73	100.00	2.43

 

 

Performance Metric	2nd Qtr-15 Weighted Result	2nd Qtr-15 Average Result
Actual Portfolio Return	1.30 %	1.41 %
Actual Benchmark Return	1.74 %	1.75 %
Performance vs. the Benchmark	-0.44 %	-0.34 %
Out / Under Performance %	-25.4 %	-19.6 %
Suggested Benchmark Return	2.31 %	2.31 %
Allocation Effect	-0.56 %	-0.56 %
Allocation Effect %	-24.4 %	-24.2 %

 

Category	Total	# With Positive Returns	% With Positive Returns	# That Beat the Market	% That Beat the Market
Accounts – 2ndQtr-2015	211	42	19.9	42	9.0
Accounts – 1stQtr-2015	186	163	87.6	65	34.9
Accounts – 4thQtr-2014	201	186	92.5	83	41.3
Accounts – 3rdQtr-2014	200	12	6.0	8	4.0
Clients – 2ndQtr-2015	118	18	15.3	8	6.8
Clients – 1stQtr-2015	118	111	94.1	34	28.8
Clients – 4thQtr-2014	123	120	97.6	45	36.6
Clients – 3rdQtr-2014	126	6	4.8	2	1.6

 

Category	Best Return	Worst Return	Top Quartile	Bottom Quartile
2ndQuarter, 2015	3.61	-3.69	-0.15	-1.04
1stQuarter, 2015	6.33	-2.40	2.07	0.64
4thQuarter, 2014	14.02	-5.36	3.36	1.80
3rdQuarter, 2014	2.26	-6.70	-1.61	-3.17

 

Exclusion Reason	#	$
Single Non-Discretionary Stock	0	0.00
New Account – Less than full quarter	5	209,568.50
Non-Discretionary – Moved to All Cash	2	45,577.23
Non-Active Accounts	0	0.00
New Accounts – All Cash	0	0.00
Cash Only Distribution Account	2	17,037.80
Exclusion Totals:	9	272,183.53
Exclusion $ Total Percent of Portfolio:		1.31%

 

2nd Quarter - 2015 Performance Highlights:

Performance Category	Performance Review
Overall Portfolio 2nd Quarter Returns	Second quarter 2015 returns were slightly negative at -0.45% for the weighted average portfolio and -0.61% for the average portfolio. This is down from the 1stquarter wen returns were 1.30% and 1.41% respectively. Year-to-date returns have been 0.85% and 0.80 respectively.
Returns by Asset Class	Foreign stocks were again the best performing asset class for the quarter with a modest 1.00% return after a very strong 5.35% in the 1stquarter. US stocks were the 2ndbest asset class at a meager 0.31% after a similarly uninspiring 1.11% return in the 1stquarter. Cash with its 0% return was third and bonds finished with the worst return at -1.65% after a 1.61% return in the 1stquarter.
Performance versus the benchmark	We underperformed the benchmark this quarter. The weighted average return of -0.45% underperformed the benchmark(0.34%) by -0.79. The average return of -0.61% underperformed the benchmark return of 0.34% by -0.95. Given the low returns for the quarter the underperformance was slight. The under allocation to international equities and our large cash position were the biggest drags on our portfolios.
Beating the Benchmark	In terms of our accounts 9.0% of all accounts beat their benchmark. This is down significantly from 34.9% last quarter. A slightly lower 6.8% of all clients beat their benchmark, also down slightly from 28.8% last quarter.
Positive Returns	For the 2nd quarter 19.9% of all accounts and 15.3% of all clients had positive returns. These are also down considerably from last quarter when 87.6% of all accounts and 94.1% of all clients had positive returns.
Best & Worst Returns	The best return for the second quarter was +3.61% (compared to +6.33 for the 1st quarter) while the worst return was -3.69% (compared to -2.40% in the 1st quarter). The top quartile return was -0.15% (compared to 2.07% in the 1st quarter) and the bottom quartile return was -1.04% (compared to 0.64% in the 1st quarter). It’s easy to see that returns in the 2nd quarter were generally lower and within a narrower range than in the first quarter. This continues the same trend from the 1stquarter, further underpinning the low level of performance so far in 2015.
Allocation Effect	The allocation effect for the 2nd quarter was -0.04 (-10.9%) after a -0.56 (-24.4%) reading in the 1st quarter. This measures how much better or worse our portfolios did by not being totally aligned with the target allocations. Our tactical allocations away from the suggested allocations hurt us again in the second quarter. The largest contributor to the negative allocation effect was the lower allocation to the best performing asset class, foreign stocks, than suggested (15.31% vs. 30.37%), or an under allocation of 15.06 or 49.6%. Our returns were also slightly impacted by the larger than suggested over allocation to cash (12.36 vs. 0.02). We were helped slightly by our over allocation to US stocks, the second best asset class, with an over allocation of 70.22 versus the suggested allocation of 63.42 or an over allocation of 6.79 (10.7%). We were also helped by our under allocation to the worst performing asset class - bonds. Our 2.11 allocation to bonds was lower than the suggested allocation (6.19) by 4.08 (-66%).
Allocation Changes	Allocation changes were again significant during the second quarter.After a large increase in cash during the first quarter (+56.4%), we experienced a similarly large increase in cash during the second quarter by +3.70 or 42.9%. This was the biggest percentage change of the quarter. The large increases in cash reflect my more conservative stance this year as markets hit new highs with valuations appearing to get stretched. At the end of the quarter and into July and early August markets have been correcting, which has provided opportunities to put this large cash position to work at better prices. The second largest percentage change was a decrease of -0.29 or -12.1% in bonds. This continues my theme of lowering our allocations to fixed income with interest rate increases on the horizon. We also had a -1.40 (-8.4%) decrease in international stocks. This was due to the selling of a number of international investments that had fallen in my ranking system. I have subsequently started purchasing more international investments in better investment alternatives. Finally, we had a decrease of -2.01 or -2.8% in US Stocks for a similar reason, a couple of large holdings had fallen out of favor and I uncovered better alternatives that I began buying over the last couple of months. As I mentioned last month, most of the decreases in asset classes were intentional choices to either lower exposure to asset classes I believe will underperform (Bonds) or opportunities to upgrade positions while the market was high. Recent market declines have provided the opportunity to deploy the increased cash balances at favorable prices.
Excluded Assets	For the quarter $ 272,184 (1.31%) of investments were excluded from the performance analysis as outlined above.
Current Strategy	Returns in the 2nd quarter were slightly negative, and the market overall has not done much so far in 2015. I have been making some major shifts in our portfolios that I believe will have positive impacts in the coming quarters. I am upgrading our holdings while paying close attention to investment costs and dividend growth. Given the higher valuation of US stocks versus international, the majority of my recent purchases have been in international stocks. Asset class allocations should move closer to our suggested amounts for international stocks. Expect bond allocations to remain below the suggested allocations and to be focused on short-term bonds until interest rates rise. Overall I like our portfolios and in the long run I expect that they will provide good returns. I am continuing to upgrade, simplify and add as much value to our portfolios as possible.

• Morningstar Update – 2ndQuarter 2015
• Argus Research – Market Digest – August 6, 2015
• 2015 Q2 Market Review by: John D. Frankola July 9, 2015