April 19, 2016

Dear Client:

Due to early volatility we stayed in US large caps but sold international positions to raise cash and conserve capital.

The first quarter saw early pessimism then relief creating a roller coaster ride. The S&P 500[1] plummeted a historic 11%+ in the first three weeks, then double-bottomed and finished up 0.8%. The Dow[2] had a similar pattern finishing +1.5%, while the tech-heavy NASDAQ[3] couldn’t complete the climb and fell 2.8%. The Emerging Markets[4] had the best recovery ending +5.4% while the EAFE[5] index (developed international markets) closed -3.8%. Fixed income was positive with only convertible bonds negative. Commodities were generally positive, highlighted by gold +16%, oil +3% and copper +2% while natural gas was -16%.

What happened? Investors started 2016 looking at a towering wall of worry. Key issues were a possible Chinese hard landing, falling oil prices, rising rates and a strong US dollar. Q4 2015 corporate results didn’t help with earnings down year-over-year for a third straight quarter. Then the economic picture started to improve. Employment was the star averaging 210,000 net new jobs per month and unemployment holding at 5%. The participation rate increased and income were up, meaning more people are working and making more money. As we stated in our last letter, Americans have become rational consumers. They are in the best financial shape ever, saving more and cautious in their consumption. Thus big ticket spending, particularly on autos and home purchases, outpaced general merchandise sales. The rate of durable goods growth was more than twice that of non-durables. We view the economy as following the pattern of a slow first quarter.

Government policies have been a drag. The Fed’s measures have been less effective than anticipated. They boosted financial asset prices and lowered the cost of capital, but have not stimulated growth. The focus on borrowers has ignored the negative impacts of lower interest rates, which stimulate savings not spending, and definitely not growth. Our elected officials aren’t helping with federal policies having a decidedly non-business-friendly tone. When rules can be changed without the normal legislative process, it hinders corporate decisions on capital expenditures and location. Maybe the reason fifty Fortune 500 companies have moved their headquarters to foreign nations in the last decade. The current political campaign slogans against international trade and specific corporations only makes matters worse. Time to change policy.

Fears of China’s (world’s second-largest economy) issues were a factor for Q1’s tumult and recovery. The implementation of needed reforms to rebalance their economy resulted in slower growth. There is no quick fix and there have been spill-over effects. The World Bank posits reduced China demand resulted in 42 of the 46 commodities they follow traded at the lowest levels in 36 years. China also impacted profits in the West as European companies generated 10%+ of their revenues from the Asia-Pacific region. The Eurozone also dealt with terrorists and a potential British exit (Brexit) from the European Union. Central bankers used coordinated monetary policy to stabilize international economies. Though we frown on continued QE and negative interest rates, these policies have helped European growth and calmed the international situation.

Going forward – Our advice, avoid headlines and look at leading indicators. ISM indexes are leading indicators, and March Manufacturing rose to growth levels for the first time since August. New orders, a predictor of future earnings growth, jumped during the quarter. The Service index, consistently positive, jumped in March, indicating growing labor market strength. Our favorite indicator, new unemployment claims, has been below 300,000 for 58 weeks, the longest streak since 1973. The leading indicators have not taken out their 2006 highs, which suggests no slowdown is upon us. We feel this means housing and autos will remain strong. Also, there has never been a better time to be a consumer as their financial position has never been stronger. Our rational consumer can shop from a mobile device at any time of the day and will wait to find just the right item at just the right price. All of this suggests profits are bottoming and should strengthen with the economy throughout the year. Almost, but not quite, goldilocks.

We expect government to continue to disappoint. The Fed will lead from behind as they follow interest rates higher. We expect two increases this year, the first in June. As the end of the primaries draw near, the silly season will come into full bloom. Expect plenty of sound and fury with no meaningful progress on key issues like corporate tax reform, and reducing the 32 million, or 27.1%, of households, on at least one means-tested poverty program. Instead of compromise, we expect partisan rhetoric and positioning through November.

We call the Chinese scenario “Red Ink Rising!” Their year-end private debt reached 200% of GDP, well above the US level prior to the financial crisis. Their use of bank lending to stimulate capital investment resulted in a lopsided economy. Capacity utilization is 50%+/- vs. 77% in the US with investment at 46% of GDP vs. 17%. Expect China to use this tactic during any 2016 slowdown. Sooner or later they must reduce this debt, a tricky process that could be painful – and not just for China. Away from this we see improvement. The PMIs for nine major countries and regions are showing a clear rebound. More broadly, PMIs in over thirty countries are at the highest levels since 2009. Lending has been rising in the Eurozone and coordinated central bank policies should increase this activity, a precursor to economic growth. Emerging markets seems to be in a growth pattern, except for Brazil and Russia. We feel the international picture is improving, but there are issues such as Brexit and the usual suspects of the Middle East, North Korea and Greek debt.

Our Bottom Line – We think US stocks continue to experience bouts of volatility, but a growing economy and healthy US consumer will help equities move higher. Coordinated central bank activity will support a rebound in global equities. This suggests increasing global diversification. Interest rates seem ready to move higher so fixed income allocations should be in short and intermediate durations.

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] 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.

[5] The MSCI EAFE Index is comprised of 21 MSCI country indexes, representing the developed markets outside of North America: Europe, Australasia and the Far East and does not include the reinvestment of dividends.