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Market Commentary — 1st Quarter 2016

Equity markets began 2016 with what looked like the start of a major bear market. Collapsing commodity prices, weakness in China, and the fear that the Federal Reserve was on the cusp of a major change in monetary policy all came together in a perfect storm to send equity valuations into a tailspin. Equity markets declined over 6% in the first week, a record decline to begin a new year, and by mid-February U.S. Markets were down more than 10%. Forecasts for further deterioration and recession became the norm amongst pundits on most media outlets.

Beginning in February, however, everything changed. Commentary from the Federal Reserve assuaged investors as they essentially reversed course on future rate hikes and reduced the forecasted number of increases in 2016 from four hikes to two. This change in stance was welcomed, and equity markets began to rally. Headwinds earlier in the quarter became tailwinds later as fears of a bear market quickly dissipated. The second half was almost a mirror image of the first half, as the S&P raced up 13% in the final six weeks. In the end, the S&P 500 actually ended the quarter slightly in the green with an increase of 1.4%. The Dow Jones Industrials finished the quarter with a slightly better gain of 2.2%, while the Russell 2000, an index made up of smaller companies, lagged behind with a loss of 1.5%.

The latest of these tools is the shift from a zero interest rate policy (ZIRP) to a negative interest rate policy (NIRP). For the first time in history, Japan and Europe are issuing bonds that carry a negative interest rate. In theory, this is supposed to stimulate demand as consumers and investors have no incentive to save because the negative rates act as a tax on savings. In many cases, however, the actual outcome in practice can be significantly different from what the theory predicts. We believe this is the case with NIRP, which, in our opinion, will likely have negative consequences for overall economic growth. While borrowers may in fact be more willing to borrow in this environment, lenders are likely to further tighten standards and be much less willing to lend. Without both lenders and borrowers acting as willing participants in a market, the net effect will be a drain in liquidity, and this will only exacerbate the deflationary spiral currently dragging down the economies of Japan, emerging markets, and parts of Europe.

In what seems like a recurring theme in our quarterly writings, acute volatility in the markets has not actually generated any noticeable market trend. Essentially, the S&P 500 has traded within a 15% range for the better part of two years. Volatility in the first quarter was especially menacing, as we experienced both the high and the low of the range in the short span of three months. We do not expect to see a market trend arise until we break out of these levels either on the downside or the upside. In our view, the likely path will be a move higher as continued accommodative monetary policy and low interest rates create a limited number of investment opportunities outside the equity markets.

First quarter earnings reports are likely to be a significant factor driving equity valuations. As of this writing, we are in the early stages of earnings releases, but we have seen expectations decline since the beginning of the quarter. This is due to several factors. Firstly, improved employment numbers as well as gradually increasing wages likely signaled a peak in profit margins, which have been increasing for several years. The strong dollar as well as weak economic growth around the world has also been a deterrent to revenue growth. This was further exacerbated by several economic releases during the quarter that pointed toward lower overall economic growth in the first quarter, well below the anticipated 2% rate that was forecast at the beginning of the year. In general, we expect companies to meet these reduced expectations and to forecast moderate growth in earnings as we move into the summer. While this forecast may appear to be fairly sub-optimal, we expect it to be enough to drive prices higher given the historically low interest rate environment.

International markets continue to be a major drag on economic growth. China, despite several devaluations of its currency, has yet to get out of the quagmire of mid-single digit growth, and many believe that it will slow further before a recovery takes hold. Similarly, most of Europe and Japan are languishing in the throes of a recession at worst or zero growth at best. All of this is occurring in the face of central banks around the world employing every tool available to stimulate economic growth.

The latest of these tools is the shift from a zero interest rate policy (ZIRP) to a negative interest rate policy (NIRP). For the first time in history, Japan and Europe are issuing bonds that carry a negative interest rate. In theory, this is supposed to stimulate demand as consumers and investors have no incentive to save because the negative rates act as a tax on savings. In many cases, however, the actual outcome in practice can be significantly different from what the theory predicts. We believe this is the case with NIRP, which, in our opinion, will likely have negative consequences for overall economic growth. While borrowers may in fact be more willing to borrow in this environment, lenders are likely to further tighten standards and be much less willing to lend. Without both lenders and borrowers acting as willing participants in a market, the net effect will be a drain in liquidity, and this will only exacerbate the deflationary spiral currently dragging down the economies of Japan, emerging markets, and parts of Europe.

Growth continues to be elusive, yet we remain of the belief that the equity market will continue to outperform other assets. Interest rate levels support current equity valuations. In addition, oil prices, which have recently become a leading indicator for the direction of the stock market, have moved from the mid $20s in February to the low $40s currently. We believe production declines in North America will support a gradual increase in prices as we move into the summer. Lastly, with the Federal Reserve on hold for now, strength in the US Dollar should subside, creating a tailwind for exports and corporate profits.

Unfortunately, we expect market volatility to remain elevated as investors continue to weigh the reality of a slow growth environment countered by monetary policy that is extremely conducive to equity valuations. The issue with high levels of volatility is that it tends to trigger responses based on emotion, which, for an investor, often leads to inferior investment decisions. It is our goal to remain strident in our convictions regardless of market conditions. We are hopeful, however, that the first quarter marked an extreme in terms of volatility.

Market Commentary 1st Quarter 2016

Market Commentary 4th Quarter 2015

Market Commentary 3rd Quarter 2015

Market Commentary 2nd Quarter 2015