Market Commentary Q1 2014
Content
Q1 2014 Market Commentary
2014 may be the year investors enter “the garden of forking paths”. By the end of 2013 we had come to an interesting place. Stocks had rallied, housing had rebounded, and the Fed had announced it would begin “tapering” its bond buying binge without much reaction from the equity markets. Additionally, parts of Europe showed signs of shaking off their credit woes, China reported a healthy pace of growth, and investors became comfortable with risk yet again. From 1,000 ft. it looked like a long, straight road leading to better times. In our opinion this has been far from a straight road. In fact, we feel we are at a junction of multiple roads, coming together only to split apart again, each with their own implications and destinations. Some are less wellpaved than others with potholes that we will have to maneuver around as best as possible. Others may be blocked completely, forcing us to re-calculate our route. The monetary policy tools used by Central Banks, the fiscal policies instituted by various governments, and the demand for goods and services by a widely disparate population of consumers will effect which road we find ourselves taking and what the ride will be like. At Northstar we see ourselves as the navigator for your financial plan. As such our goal is to assimilate all available data, now and as the year goes on, and match our investment decisions to your individual needs, desires and risk tolerances in order to steer your course as best we can. But we would like to caution that 2014 could be a bumpy ride. Between investor exuberance and the Federal Reserve’s economic stimulus program – Quantitative Easing (QE) – we unfortunately find ourselves in a spot where opposing assets classes are now correlated with regard to the risks they carry. While stocks and bonds have historically moved in a contrary manner (non-correlated), with one rising while the other falls, we currently find that both stocks and bonds hold similar levels of price risk. This leaves investors with few options for diversifying risk at exactly the point when many have again decided to take on much more of it. Stocks For The Long Haul Jeremy Siegel, Wharton Professor and uber-Bull, continues to be bullish on stocks for 2014 and his book by the name “Stocks For The Long Haul” espouses his beliefs. While we very much appreciate his outlook and agree with his stance on stocks over long periods of time, we do have concerns regarding the equity markets in the near term. Currently the S+P 500 is selling at roughly 17x trailing 12-month earnings and more than 15x forward-looking earnings for 2014. While still within historically normal ranges we are beginning to bump up against the upper levels. Our concern is twofold. One, current earnings have not necessarily been driven by an increase in demand for product and services, but by cost cutting, increases in productivity, corporate re-financing and stock buybacks. And two, with investors bidding up the multiples paid to be in riskier assets the expectation is that they will be
1100 East Hector Street, Suite 399, Conshohocken, PA, 19428 Tel: 800 220 2161 www.nstarfinco.com Registered Representative, Securities offerred through Cambridge Investment Research, Inc. a Broker/Dealer, member FINRA/SIPC Investment Advisor Representative,Northstar Financial Companies, Inc. a Registered Investment Advisor. Northstar Financial Companies Inc. and Cambridge are not affiliated.
rewarded by greater returns for that risk taken. But the higher the multiples, the more those expectations must be met or investors will take their money elsewhere. It has been our opinion for some time that either earnings must catch up to the multiples being paid, or it will not be worth the risk that investors are taking. But how do earnings go up more than marginally when demand remains weak, unemployment remains stubbornly elevated (globally) and the source of market enthusiasm, low interest rates and cheap monetary stimulus, is ending? For earnings to rise consumption must also rise, and economic growth will need to exceed the mediocre 2.5 % GDP increases we have been experiencing. Positive GDP growth requires a number of positive changes in different areas. The Fed must exit their QE program in a smooth and methodical manner, much like slowly letting the air out of a balloon, to create an orderly, systematic return to normalcy in liquidity. Unemployment must decrease not just by the “math” of a declining Participation Rate (retiring Baby Boomers and those that have given up finding a job) but by actual rehiring of many of those laid off after 2007. The economy must also absorb the large number of recent college graduates who have yet to enter the workforce. It may well take the long awaited corporate-tax reform which would hopefully entice many companies to repatriate monies squirreled away overseas. It could take an increase in minimum wage - if more consumers begin buying products and services companies will feel more confident increasing their capital-spending and the virtuous cycle can commence. It might require some delayed gratification with an understanding that for the price of a near-term decrease in profits (to fund reinvestment in manpower and capital equipment) the long-term benefits of a stronger global economy await. On the flip side, the risks aligned against a meaningful increase of stock prices include the economic cycle in general. We are about to enter our 5th year of expansion, post financial crisis. The average expansion in the US from 2001 to the financial crisis was roughly 73 months. We may not be at the end of the game but we are more likely in the latter stages of this cycle than the beginning. The Eurozone (except perhaps for Germany) needs increasing growth rates just to stay ahead of their debt. If their growth rates stall or worse, we are back to the threat of defaults, potential bank runs and dissection of the Eurozone as an economic entity. The ECB, along with Central Banks across the globe, have very few bullets left should their intervention become required again. Emerging Markets and Japan would quickly feel the effects of stagnation in Europe as their exports would decrease and their own domestic demand remains fragile. And China, the one catalyst for global expansion still running strong, is faced with slower expansion as it struggles with the effects of relentless growth on both its population and its environment. There is also the very real possibility that unwinding the Fed’s QE sets off a spike in interest rates, which would be detrimental to not only an increase in current growth rates, but to positive growth in any amount. As the Federal Reserve suppressed interest rates with massive bond purchases, they pushed yield hungry investors down the risk spectrum into high yield bonds, junk bonds – and equities. Some of those investors will look to return to the relative safety of bonds, should stocks stumble in reaction to rising interest rates. Safe Haven? The irony is that bonds prices, while off their highs, remain elevated. As the buyer of choice for many years, the Federal Reserve accomplished much of what they sought to do, pushing up the prices of 10 year Treasury bonds
1100 East Hector Street, Suite 399, Conshohocken, PA, 19428 Tel: 800 220 2161 www.nstarfinco.com Registered Representative, Securities offerred through Cambridge Investment Research, Inc. a Broker/Dealer, member FINRA/SIPC Investment Advisor Representative,Northstar Financial Companies, Inc. a Registered Investment Advisor. Northstar Financial Companies Inc. and Cambridge are not affiliated.
to decrease mortgage rates and support housing. They also succeeded in creating an overbought bond market. As bond investors fanned out across various maturities, credit ratings and types of issuers to maintain a modest interest income, these respective bond markets become equally over-priced, pushing those yields down as well. Even in the best case, the unwinding of QE will translate into a big player for the bond market becoming increasingly dormant, creating a vacuum in which prices must necessarily come down. This pricing risk is most acute for Treasury bonds as well as funds that are tied to Treasuries (or mortgages). But most traditionally invested bond mutual funds, without limitations on redemptions, will feel the impact as investors have little incentive not to flee when prices start to fall, regardless of the types of bonds the fund might hold. The bonds themselves, whether held within a fund or by individual investors, are slightly “stickier” as falling prices have a negligible effect on interest earned. But the risker bonds could succumb to selling pressure, as conservative income investors rotate back into “safer” new issues and out of high yield corporates or junk bonds. Also, in the event that the Fed exits QE poorly and we have an interest rate spike, it could cause more rapid price declines than hoped for, similar to the sell-off in May after Bernanke’s infamous “Taper” speech. We remain committed to fixed income as an asset component to client portfolios as bonds still have some value in their yield and their long term portfolio balancing. We will continue to shorten the duration of bond portfolios which limits sensitivity to interest rate increases. We also continue to increase allocations to bonds from countries and economies in better shape than ours, and diversify US bonds with non-traditionally invested funds that have an open investment style that allows them to seek opportunity wherever it can find it and adds the ability to short bond sectors as well. Where appropriate we also continue to build out ladders of individual bond issues, in order to manage the metrics of what is owned and decrease dependence on the day to day price movement or the influence of other shareholders. It is our opinion that it will be difficult for the Fed to exit QE as smoothly as they would like. There remain unemployment and inflation mandates that could call for a pause to further tapering, or an acceleration of it. They may yet stop it and begin funding QE again if the economy weakens, and as such the probability of a slow and steady glide path out of the program seems improbable. So as we move through 2014 and into 2015, we anticipate that there will be periods of uncertainty which will cause portfolio volatility. Likewise, there may be buying opportunities as price inefficiencies arise. Opportunities As in any cycle, market reactions can cause sectors or themes to be improperly priced, offering us the opportunity to take advantage when pricing becomes too low. Currently we are tracking numerous preferred stocks issued at the nadir of interest rates, which will fall in price as rates rise, allowing us to enter at lower than par costs with very good yields that are to be paid for decades to come. If we find we indeed have unexpected interest rate spikes, there may be opportunities to buy higher quality individual bonds which, during that short but intense decline, get priced cheaply. As in the bond market, short term volatility can also create situations where pricing becomes attractive, perhaps quickly and temporarily, for either stock indexes or for specific companies. And finally as rates begin to rise so does the earnings on cash and fixed accounts which have been much maligned for their low yields but can offer
1100 East Hector Street, Suite 399, Conshohocken, PA, 19428 Tel: 800 220 2161 www.nstarfinco.com Registered Representative, Securities offerred through Cambridge Investment Research, Inc. a Broker/Dealer, member FINRA/SIPC Investment Advisor Representative,Northstar Financial Companies, Inc. a Registered Investment Advisor. Northstar Financial Companies Inc. and Cambridge are not affiliated.
safe havens when and if the markets get rough. Earning higher interest on cash or cash equivalents can make it more palatable to move assets out of the way when things look too rich. In 2014 we will continue to explore ways of protecting portfolios and counterbalancing positions against the volatility we expect to see. For bonds, this includes managing the duration and credit quality of the bonds owned as well as the choice of issuer. For fixed income generally, diversifying into less interest-rate sensitive holdings such as senior loans, individual bonds, and the previously mentioned bond funds that can short their respective market. We have also begun looking for price inefficiencies in closed-end income funds, which can be bought below actual net asset value, and taking bond mutual fund yields in cash, instead of reinvesting, so we are prepared exit quickly if necessary. In equities we have paid particular attention to our chosen stock fund managers’ quality and flexibility, investing in those that show particular resilience to volatility. For certain clients, we will consider an exit of certain capitalization sizes if they become overpriced relative to their earnings, even if the market is still appreciating. For others, individual stock holdings allow us to more selectively buy companies we feel are not correctly priced, or invest in sectors that are experiencing non-cyclical expansion (such as US energy or global infrastructure). For both stocks and ETF positions, we may utilize stop-loss and limit orders, to manage pricing for the purchase and sale of those positions. Going forward we will look to find buying opportunities is less popular assets classes, such as the previously mentioned preferred stocks, and track alternative assets that have recently been beaten down, such as commodities and real estate, for positive entry/re-entry points. Additionally, we will begin to utilize funds that can quickly move capital between cash and investments. These funds operate on tight technical parameters and can be long or short the market, providing a hedge to potential volatility yet keeping funds invested. Conclusion It may well take us looking in the rear view mirror at the end of the year to see what the ride will have been like in 2014. We remain confident that the road is in much better shape than in 2008 and we remain focused on what is in front of us, steering around obstacles we see as best as possible. But as we have discussed on multiple occasions the depth of the financial crisis in 2008 is not something that is quickly or easily worked out. While we avoided the worst, and things “feel” better, we must be aware that the various mechanisms used to heal the global economy have potential side-affects that themselves can be detrimental, one of which is a short memory. Having performed financial planning and asset management for over 20 years, at Northstar our memory is long. And as such we remain diligent in our analysis and outlook and how it pertains to all clients’ personal planning. In every case, as with our strategies for the long-term, our strategies for mitigating the effects of market volatility will be tailored to match your unique situation, but if you have a question about a particular strategy mentioned in this Commentary, please feel free to call us at 800.220.2161. Steven B. Girard, President
The opinions expressed are those of Northstar Financial Companies, Inc. and are based on information believed to be from reliable sources. However, the information’s accuracy and completeness cannot be guaranteed. Past performance is no guarantee of future results.
1100 East Hector Street, Suite 399, Conshohocken, PA, 19428 Tel: 800 220 2161 www.nstarfinco.com Registered Representative, Securities offerred through Cambridge Investment Research, Inc. a Broker/Dealer, member FINRA/SIPC Investment Advisor Representative,Northstar Financial Companies, Inc. a Registered Investment Advisor. Northstar Financial Companies Inc. and Cambridge are not affiliated.
2014 may be the year investors enter “the garden of forking paths”. By the end of 2013 we had come to an interesting place. Stocks had rallied, housing had rebounded, and the Fed had announced it would begin “tapering” its bond buying binge without much reaction from the equity markets. Additionally, parts of Europe showed signs of shaking off their credit woes, China reported a healthy pace of growth, and investors became comfortable with risk yet again. From 1,000 ft. it looked like a long, straight road leading to better times. In our opinion this has been far from a straight road. In fact, we feel we are at a junction of multiple roads, coming together only to split apart again, each with their own implications and destinations. Some are less wellpaved than others with potholes that we will have to maneuver around as best as possible. Others may be blocked completely, forcing us to re-calculate our route. The monetary policy tools used by Central Banks, the fiscal policies instituted by various governments, and the demand for goods and services by a widely disparate population of consumers will effect which road we find ourselves taking and what the ride will be like. At Northstar we see ourselves as the navigator for your financial plan. As such our goal is to assimilate all available data, now and as the year goes on, and match our investment decisions to your individual needs, desires and risk tolerances in order to steer your course as best we can. But we would like to caution that 2014 could be a bumpy ride. Between investor exuberance and the Federal Reserve’s economic stimulus program – Quantitative Easing (QE) – we unfortunately find ourselves in a spot where opposing assets classes are now correlated with regard to the risks they carry. While stocks and bonds have historically moved in a contrary manner (non-correlated), with one rising while the other falls, we currently find that both stocks and bonds hold similar levels of price risk. This leaves investors with few options for diversifying risk at exactly the point when many have again decided to take on much more of it. Stocks For The Long Haul Jeremy Siegel, Wharton Professor and uber-Bull, continues to be bullish on stocks for 2014 and his book by the name “Stocks For The Long Haul” espouses his beliefs. While we very much appreciate his outlook and agree with his stance on stocks over long periods of time, we do have concerns regarding the equity markets in the near term. Currently the S+P 500 is selling at roughly 17x trailing 12-month earnings and more than 15x forward-looking earnings for 2014. While still within historically normal ranges we are beginning to bump up against the upper levels. Our concern is twofold. One, current earnings have not necessarily been driven by an increase in demand for product and services, but by cost cutting, increases in productivity, corporate re-financing and stock buybacks. And two, with investors bidding up the multiples paid to be in riskier assets the expectation is that they will be
1100 East Hector Street, Suite 399, Conshohocken, PA, 19428 Tel: 800 220 2161 www.nstarfinco.com Registered Representative, Securities offerred through Cambridge Investment Research, Inc. a Broker/Dealer, member FINRA/SIPC Investment Advisor Representative,Northstar Financial Companies, Inc. a Registered Investment Advisor. Northstar Financial Companies Inc. and Cambridge are not affiliated.
rewarded by greater returns for that risk taken. But the higher the multiples, the more those expectations must be met or investors will take their money elsewhere. It has been our opinion for some time that either earnings must catch up to the multiples being paid, or it will not be worth the risk that investors are taking. But how do earnings go up more than marginally when demand remains weak, unemployment remains stubbornly elevated (globally) and the source of market enthusiasm, low interest rates and cheap monetary stimulus, is ending? For earnings to rise consumption must also rise, and economic growth will need to exceed the mediocre 2.5 % GDP increases we have been experiencing. Positive GDP growth requires a number of positive changes in different areas. The Fed must exit their QE program in a smooth and methodical manner, much like slowly letting the air out of a balloon, to create an orderly, systematic return to normalcy in liquidity. Unemployment must decrease not just by the “math” of a declining Participation Rate (retiring Baby Boomers and those that have given up finding a job) but by actual rehiring of many of those laid off after 2007. The economy must also absorb the large number of recent college graduates who have yet to enter the workforce. It may well take the long awaited corporate-tax reform which would hopefully entice many companies to repatriate monies squirreled away overseas. It could take an increase in minimum wage - if more consumers begin buying products and services companies will feel more confident increasing their capital-spending and the virtuous cycle can commence. It might require some delayed gratification with an understanding that for the price of a near-term decrease in profits (to fund reinvestment in manpower and capital equipment) the long-term benefits of a stronger global economy await. On the flip side, the risks aligned against a meaningful increase of stock prices include the economic cycle in general. We are about to enter our 5th year of expansion, post financial crisis. The average expansion in the US from 2001 to the financial crisis was roughly 73 months. We may not be at the end of the game but we are more likely in the latter stages of this cycle than the beginning. The Eurozone (except perhaps for Germany) needs increasing growth rates just to stay ahead of their debt. If their growth rates stall or worse, we are back to the threat of defaults, potential bank runs and dissection of the Eurozone as an economic entity. The ECB, along with Central Banks across the globe, have very few bullets left should their intervention become required again. Emerging Markets and Japan would quickly feel the effects of stagnation in Europe as their exports would decrease and their own domestic demand remains fragile. And China, the one catalyst for global expansion still running strong, is faced with slower expansion as it struggles with the effects of relentless growth on both its population and its environment. There is also the very real possibility that unwinding the Fed’s QE sets off a spike in interest rates, which would be detrimental to not only an increase in current growth rates, but to positive growth in any amount. As the Federal Reserve suppressed interest rates with massive bond purchases, they pushed yield hungry investors down the risk spectrum into high yield bonds, junk bonds – and equities. Some of those investors will look to return to the relative safety of bonds, should stocks stumble in reaction to rising interest rates. Safe Haven? The irony is that bonds prices, while off their highs, remain elevated. As the buyer of choice for many years, the Federal Reserve accomplished much of what they sought to do, pushing up the prices of 10 year Treasury bonds
1100 East Hector Street, Suite 399, Conshohocken, PA, 19428 Tel: 800 220 2161 www.nstarfinco.com Registered Representative, Securities offerred through Cambridge Investment Research, Inc. a Broker/Dealer, member FINRA/SIPC Investment Advisor Representative,Northstar Financial Companies, Inc. a Registered Investment Advisor. Northstar Financial Companies Inc. and Cambridge are not affiliated.
to decrease mortgage rates and support housing. They also succeeded in creating an overbought bond market. As bond investors fanned out across various maturities, credit ratings and types of issuers to maintain a modest interest income, these respective bond markets become equally over-priced, pushing those yields down as well. Even in the best case, the unwinding of QE will translate into a big player for the bond market becoming increasingly dormant, creating a vacuum in which prices must necessarily come down. This pricing risk is most acute for Treasury bonds as well as funds that are tied to Treasuries (or mortgages). But most traditionally invested bond mutual funds, without limitations on redemptions, will feel the impact as investors have little incentive not to flee when prices start to fall, regardless of the types of bonds the fund might hold. The bonds themselves, whether held within a fund or by individual investors, are slightly “stickier” as falling prices have a negligible effect on interest earned. But the risker bonds could succumb to selling pressure, as conservative income investors rotate back into “safer” new issues and out of high yield corporates or junk bonds. Also, in the event that the Fed exits QE poorly and we have an interest rate spike, it could cause more rapid price declines than hoped for, similar to the sell-off in May after Bernanke’s infamous “Taper” speech. We remain committed to fixed income as an asset component to client portfolios as bonds still have some value in their yield and their long term portfolio balancing. We will continue to shorten the duration of bond portfolios which limits sensitivity to interest rate increases. We also continue to increase allocations to bonds from countries and economies in better shape than ours, and diversify US bonds with non-traditionally invested funds that have an open investment style that allows them to seek opportunity wherever it can find it and adds the ability to short bond sectors as well. Where appropriate we also continue to build out ladders of individual bond issues, in order to manage the metrics of what is owned and decrease dependence on the day to day price movement or the influence of other shareholders. It is our opinion that it will be difficult for the Fed to exit QE as smoothly as they would like. There remain unemployment and inflation mandates that could call for a pause to further tapering, or an acceleration of it. They may yet stop it and begin funding QE again if the economy weakens, and as such the probability of a slow and steady glide path out of the program seems improbable. So as we move through 2014 and into 2015, we anticipate that there will be periods of uncertainty which will cause portfolio volatility. Likewise, there may be buying opportunities as price inefficiencies arise. Opportunities As in any cycle, market reactions can cause sectors or themes to be improperly priced, offering us the opportunity to take advantage when pricing becomes too low. Currently we are tracking numerous preferred stocks issued at the nadir of interest rates, which will fall in price as rates rise, allowing us to enter at lower than par costs with very good yields that are to be paid for decades to come. If we find we indeed have unexpected interest rate spikes, there may be opportunities to buy higher quality individual bonds which, during that short but intense decline, get priced cheaply. As in the bond market, short term volatility can also create situations where pricing becomes attractive, perhaps quickly and temporarily, for either stock indexes or for specific companies. And finally as rates begin to rise so does the earnings on cash and fixed accounts which have been much maligned for their low yields but can offer
1100 East Hector Street, Suite 399, Conshohocken, PA, 19428 Tel: 800 220 2161 www.nstarfinco.com Registered Representative, Securities offerred through Cambridge Investment Research, Inc. a Broker/Dealer, member FINRA/SIPC Investment Advisor Representative,Northstar Financial Companies, Inc. a Registered Investment Advisor. Northstar Financial Companies Inc. and Cambridge are not affiliated.
safe havens when and if the markets get rough. Earning higher interest on cash or cash equivalents can make it more palatable to move assets out of the way when things look too rich. In 2014 we will continue to explore ways of protecting portfolios and counterbalancing positions against the volatility we expect to see. For bonds, this includes managing the duration and credit quality of the bonds owned as well as the choice of issuer. For fixed income generally, diversifying into less interest-rate sensitive holdings such as senior loans, individual bonds, and the previously mentioned bond funds that can short their respective market. We have also begun looking for price inefficiencies in closed-end income funds, which can be bought below actual net asset value, and taking bond mutual fund yields in cash, instead of reinvesting, so we are prepared exit quickly if necessary. In equities we have paid particular attention to our chosen stock fund managers’ quality and flexibility, investing in those that show particular resilience to volatility. For certain clients, we will consider an exit of certain capitalization sizes if they become overpriced relative to their earnings, even if the market is still appreciating. For others, individual stock holdings allow us to more selectively buy companies we feel are not correctly priced, or invest in sectors that are experiencing non-cyclical expansion (such as US energy or global infrastructure). For both stocks and ETF positions, we may utilize stop-loss and limit orders, to manage pricing for the purchase and sale of those positions. Going forward we will look to find buying opportunities is less popular assets classes, such as the previously mentioned preferred stocks, and track alternative assets that have recently been beaten down, such as commodities and real estate, for positive entry/re-entry points. Additionally, we will begin to utilize funds that can quickly move capital between cash and investments. These funds operate on tight technical parameters and can be long or short the market, providing a hedge to potential volatility yet keeping funds invested. Conclusion It may well take us looking in the rear view mirror at the end of the year to see what the ride will have been like in 2014. We remain confident that the road is in much better shape than in 2008 and we remain focused on what is in front of us, steering around obstacles we see as best as possible. But as we have discussed on multiple occasions the depth of the financial crisis in 2008 is not something that is quickly or easily worked out. While we avoided the worst, and things “feel” better, we must be aware that the various mechanisms used to heal the global economy have potential side-affects that themselves can be detrimental, one of which is a short memory. Having performed financial planning and asset management for over 20 years, at Northstar our memory is long. And as such we remain diligent in our analysis and outlook and how it pertains to all clients’ personal planning. In every case, as with our strategies for the long-term, our strategies for mitigating the effects of market volatility will be tailored to match your unique situation, but if you have a question about a particular strategy mentioned in this Commentary, please feel free to call us at 800.220.2161. Steven B. Girard, President
The opinions expressed are those of Northstar Financial Companies, Inc. and are based on information believed to be from reliable sources. However, the information’s accuracy and completeness cannot be guaranteed. Past performance is no guarantee of future results.
1100 East Hector Street, Suite 399, Conshohocken, PA, 19428 Tel: 800 220 2161 www.nstarfinco.com Registered Representative, Securities offerred through Cambridge Investment Research, Inc. a Broker/Dealer, member FINRA/SIPC Investment Advisor Representative,Northstar Financial Companies, Inc. a Registered Investment Advisor. Northstar Financial Companies Inc. and Cambridge are not affiliated.
