January 15, 2016

Dear Client:

2015 frustrated both bulls and bears and provided little joy.  Our only changes to portfolios was to raise cash.

Despite a positive Q4, 2015 equity markets were flat to down.  The S&P 500[1] was -0.7%, the Dow[2] -2.2%, while only the tech-heavy NASDAQ[3]  posted a gain, +5.7%.  International markets fared no better.  The DJ Global ex-US Index[4] fell 6% and the MSCI Emerging Markets[5] were -17%.  Investment-grade corporate and government bonds were mixed, with high yield posting the biggest losses.  In 2015, the commodity slide continued: oil -30%, copper -24%, natural gas -19%, agricultural -15% and gold -10%.

What happened?  The US had plenty of negative and positive statistics.  S&P earnings were down 2.5%, yet 68% of companies beat expectations.  Ex the energy sector, earnings were up 4.1%.  The jobs picture was almost perfect.  Q4 added 851,000 jobs pushing unemployment down to 5%.  The participation rate edged up, part-time workers due to economic reasons fell and wages were up 2.5% vs. inflation of 0.5%.  Hiring across industries plus lower energy prices helped consumers celebrate the season.  MasterCard reported that holiday spending ex-autos and ex-gas was up a robust 7.9%.  Home sales and prices were up for the year, and the auto industry ended 2015 with a record 17.5 million vehicles sold.  Against this positive news, the rout in energy and commodity prices forced drastic actions: layoffs, dividend cuts, slashing capital budgets…leading to record M&A activity.  A strong dollar is the most-cited factor hurting foreign sales and commodity prices.  Despite the negatives, we feel US growth was stronger than the numbers indicate.

Efforts in our nation’s capital were a positive surprise.  Lawmakers passed a two-year budget deal which eliminates a potential government shutdown until March 2017.  They extended several tax credits and depreciation rules to incent corporate investment.  There was entitlement reform which strengthened social security by eliminating some filing strategies.  Middle and upper class families will pay for this via lower benefits.  The Fed finally raised rates on December 15.  Central banks set the tone for the economy and a firm message gets the best results.  The Fed’s delay and indecision did create market confusion.

China’s transition to a consumer economy started a paradigm shift.  Their decades-long drive to become the world’s factory drove global growth and created a commodity super-cycle.  Demand forced suppliers to expand capacity: mines, steel mills, cement plants, energy projects…  These are physical investments, so slowing demand took a tremendous toll.  Countries reliant on Chinese demand have experienced growth issues and deteriorating finances.  Resolving the supply/demand imbalance will take time and is a drag on global growth.  A positive, the Eurozone’s economic growth accelerated in 2015 as did job growth and business sentiment.  Japan also increased their QE which helped exports and growth.  Our view is the developed economies have replaced China and emerging markets as the international growth engine.

Going forward – We feel most of the damage from plunging commodity/energy prices and a strong dollar has been done.  This volatility should moderate and we expect US corporations to adjust and increase exports and profits.  Positive employment trends should continue, but the number of new jobs may slow as labor markets tighten and it is harder to find workers.  Expect accelerating wage gains.  Also, unions in major industries are negotiating rate hikes for the first time since the recession and many local governments are raising minimum wages.  Higher wages plus lower energy prices has lifted consumer confidence to an 11-year high.  No wonder household formations are at the decade’s high while new housing remain at recession-like levels.  Housing should drive growth.  The savings rate is now 5.6%, Americans are in the best financial shape ever and the potential for a smarter US consumer indicates solid, sustainable growth for the US.

Washington’s year-end budget boosts spending $80 billion through September 2017.  It’s silly season, March 1 is Super Tuesday.  We would like, but don’t expect, action on crushing regulations and taxes that are driving US companies to move abroad or restructure out of businesses.  The Fed’s rate hike is history and now focus is on what might be next.  The Fed must improve its communications.  Consensus is three rate hikes for 2016.

The Eurozone and Japan will supplant China to lead international growth.  They extended their quantitative easing programs which should support manufacturing and exports.  Improving Eurozone corporate earnings exceeded estimates by a wide margin.  We see the region bucking global trends as growth improves in 2016.  China guided their currency lower and used stimulus to stabilize their manufacturing and exports.  The IMF gave permission to add the yuan to the basket of currencies which make up Special Drawing Rights, which should boost offshore use of the yuan.  We see China stabilizing with lower growth rates as their demographic time bomb poses an impediment to growth.  This slower growth poses problems for countries that depend on China’s imports.  Countries with sound government policies during boom years (Peru, Chile, Indonesia) will fare better than those that did not (Brazil and South Africa).  We expect net global growth to be up slightly.

Our Bottom Line – The market’s main lesson from 2015 is timing the market is extremely difficult.  It also showed that panic selling is not an investment strategy.  We will not try to pick a bottom in commodities and energy.  It seems the rationalization of energy supply and demand will force investors to raise cash, expect volatility.  We continue to emphasize domestic large cap stocks which pay dividends.  We also like large cap technology and biotech.  We continue to see value in Europe despite political challenges to European unity and the migrant crisis.  We maintain an underweight in emerging markets.  We will continue to hold short and short-intermediate duration investment-grade US fixed income securities, while avoiding high yield and international bonds markets.

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                                                                      Doug Woods

President                                                                                 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] NASDAQ is a market-cap weighted index of more than 3,000 companies listed on the NASDAQ Stock Market and does not reflect reinvestment of dividends.

[4] DJ Global ex-US covers approximately 95% of the market cap of the 45 countries in the index and does not reflect reinvestment of dividends.

[5] The MSCI Emerging Markets index is designed to measure equity market performance in 25 global emerging market countries and does not reflect reinvestment of dividends.