April 21, 2015

Dear Client:

A strong dollar and falling oil prices resulted in global volatility, so we increased cash in our portfolios.

Economic releases gave bulls and bears a chance to stir the pot. US stocks had a strong February sandwiched between two down months. The S&P 500[1] went a month-and-a-half without two consecutive positive days, the longest stretch in 50 years. The Dow[2] and S&P hit record highs in March, yet the Dow closed Q1 down slightly while the S&P just closed positive. The Russell 2000[3], a small company index, posted the best performance at +4%. Sector returns were mixed: health care and consumer discretionary posted solid gains while utilities, energy and financials all lost ground. International equities posted gains with developed markets +4% and emerging markets +2%. Fixed income was generally positive, while commodities were big losers with crude -10.6%, natural gas -8.6% and copper -2.8%. Gold was basically flat for the quarter.

What happened? Four factors helped decide Q1 winners and losers. A surging dollar and plunging oil prices hurt US exporters and firms working in or around the energy industry. The strike at West Coast ports, which handle roughly 50% of US imports, hurt retail sales which fell for three consecutive months, the first time since 2012. You can’t sell from an empty wagon. All of the above, plus harsh winter weather, impacted trucking, railroads, airlines… Analysts rushed to reduce earnings estimates, which enabled 75% of companies to beat earnings and 58% to beat revenue estimates. Even so, corporate profits posted the first annual decline since the middle of the recession. Yet we see positives: sub-2% inflation and unemployment falling to 5.5%. New car sales are on pace to top 17 million for an unprecedented sixth straight annual increase for the first time in 50 years. Also, new home sales surprised with the highest annual sales pace in seven years and prices were up 3.4%. Overall, we feel seasonal factors masked a strong economy.

In DC, international diplomacy got the headlines as the administration negotiated a nuclear deal with Iran and started to reverse US policy on Cuba. Despite partisan opposition to the policies, there are early signs of bipartisan action. Members of both parties voted for the XL pipeline, but the presidential veto held. Still, we see signs both parties want to reach across the aisle to do their jobs. Closer to investors’ hearts, QE ended and the Federal Reserve removed “patient” from their guidance. Now, the big question is when will be the Fed’s first interest rate increase. Overall, DC was a positive.

Europe was a mirror image of the United States. Mario Draghi announced QE and the Euro had its largest quarterly fall on record. This helped exporters as Germany, Italy and Spain signaled accelerating growth. Despite Greek fireworks, Eurozone PMI hit a 10-month high buoyed by rising German industrial orders, Spanish housing prices and French retail sales. Japan was much the same as exports climbed sharply due to their QE and cheap currency. Russia’s economy stabilized as a February Ukrainian ceasefire was put in place. Emerging markets were a different story. China’s growth rate was the slowest in 24 years.  They maintained their currency peg with the dollar, but cut interest rates to offset deflation and a property market slowdown. This slower growth has impacted commodity-based emerging economies, which seem to be stabilizing. Middle East issues have been exacerbated by falling oil prices. Saudi Arabia, with a new king, has started to assert itself as a stabilizing influence and a counterweight to Iran. We don’t see a resolution soon, but feel the overall international picture is improving.

Going forward – We use one of our basic rules of investing – rising or falling market usually go further than you think and do not correct on your timeline. We call this “investment lags”. Thus, corporate managers have been conservative since the recession, and profits increased despite slow top-line growth – why capital spending has lagged. The end of QE and the Fed’s zero-interest-rate policy should accelerate corporate investment via mergers, acquisitions and capital spending. We think the deleveraging process is nearly complete as consumer delinquencies are the lowest since 2008 and total debt payments as a percentage of disposable income are the lowest since the early 80s. Consumers now have the capacity to take on debt. Our research indicates the employment cycle has turned and the improving jobs picture is sustainable. The combination of modest inflation and rising consumer confidence should drive household formations, consumer spending and ultimately housing. We also feel a stabilizing dollar will help companies with large international operations. The economy is stronger than people think.

In Washington the shift is on. It is the third year of the presidential cycle, so the bipartisan spirit will result in Congress doing its job. This means government emphasis will be on fiscal policy as the Fed moves away from zero interest rates and becomes less of a factor in the economy. Overall, positive for the US economy.

With 24 central banks providing liquidity, we expect continued improvement. Greece will be resolved and European growth will continue. The struggle will be entitlement and fiscal reform. We hope the Ukrainian cease fire holds and Russia will not be a negative for European growth. We also see commodities stabilizing which will help economies like Brazil and Russia. The Middle East is extremely complex and we can only hope the world can reach agreement with Iran on their nuclear efforts. We are firm believers that trade, which has raised billions out of global poverty, can start to help the Middle East conundrum. Only time will tell.

Our Bottom Line – Clearly, a strong US dollar, low oil prices and uncertainty of when the Fed will begin to hike interest rates will weigh on US equities. We see the bull market in large cap stocks getting a second wind as real growth is reflected in higher revenues. Even so, valuations are higher for US equities than international equities. So we will continue to increase the international equity allocations. We also think interest rates are not an attractive risk/reward proposition and will continue to underweight fixed income.

As always, we appreciate your trust. This letter provides our outlook of the most probable events, but at best is a summary. If you have any questions, please call us. Better yet, we would enjoy meeting with you to discuss our outlook and your current situation.

Yours Truly,

George Bernard, President

Doug Woods, Director of Research

[1] S&P 500 is an unmanaged index of the common stock prices of 500 widely held stocks and does not include reinvestment of dividends.

[2] Dow Jones Industrial Average is an unmanaged index of the common stock prices of 30 widely held stocks, not including reinvestment of dividends.

[3] Russell 2000 is an unmanaged index generally representing the US market for small capitalization stocks and does not include reinvestment of dividends.