2016 1st Quarter Outlook

Review of 2015

Last year was the most eventful year in the financial markets since 2011. The year started off slow and steady – stocks exhibited little volatility and modest returns for the first five months. In June, the Greek debt crisis began to impact markets around the globe. As that situation was resolved in August, concerns about the Chinese economy began to manifest. In one week in mid-August, Chinese stocks declined by 20%, with U.S. stocks declining by 9%. Over the rest of the year, Chinese stocks stabilized, and U.S. stocks have recovered much of that decline, but the volatility is something we hadn’t seen in the past four years.

Over the full year, large-cap U.S. stocks increased in value by 1%, but all of the other major sectors of the market fared worse. Small-cap U.S. stocks declined by 4%, developed international stocks fell by 1%, emerging market stocks dropped by 15%, and bonds were flat. One outcome of these data is that for 2015, diversification did not work – nearly all diversified portfolios under-performed the S&P 500.

A good question to consider is whether last year’s volatility was abnormally high -- the answer depends on your perspective. Stocks were 32% more volatile in 2015 than they were for the previous three years. However, that 2012 to 2014 time frame is noteworthy because of its stability. When we compare last year to the previous 30 years, stocks were actually 15% less

volatile.

Before leaving 2015, we want to point out one important lesson. On August 24, during the height of the Chinese market crisis, we cautioned investors about panicking and selling out of their stock market positions. Fortunately, nearly all of our clients heeded our advice, and their values recovered over the next few months.

U.S. Economy

Below is a table showing key economic and market indicators (as of December 31)*:

**Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, JP Morgan, Federal Reserve Board

The economic news is moderate to good. Unemployment has continued to decline, and while economic growth has been far from spectacular, it’s been steady over the past six years. Inflation remains at a lower level than any time since the Vietnam War. And while interest rates have been slowly rising and are likely to increase some in the future, they are still relatively low. The only chink in this economic data is our relatively strong economy has led to a higher value of the U.S. dollar, which might lead to lower earnings in 2016.

U.S. Stock Market Outlook

Our belief is that 2016 will be more volatile than the past few years for several reasons:

• As we said earlier, stocks over the past few years have had abnormally low volatility – such stability is unlikely to last over the long-term

• While we believe the recent declines in the U.S. market may be an overreaction to concerns about China, the uncertainty about China’s economic health will have continual impacts on the U.S. market

• After a decline of almost 70% in the past 18 months, oil prices may have reached the point in which future declines will hurt U.S. growth (we’ll address this further in a blog post next month)

• There is much debate about the efficacy of the stated Fed policy of increasing interest rates – such debate adds to the uncertainty about stock price movements

All of this volatility doesn’t mean you should get out of equities, or even avoid investing new money into stocks. Current valuations of stocks, compared to forward looking earnings, seem to be appropriate. And as we noted earlier, the economic conditions in the U.S., and in most of the developed world, are solid. Note that one factor we haven’t mentioned is the upcoming presidential election. We’ll post a commentary later this month on the election, but for now we’ll tell you that elections have little impact on the U.S. stock market..

Bond Market

The much-anticipated decision by the Federal Reserve to increase rates finally happened last month, but there’s still uncertainty plaguing the bond market as to how much interest rates will rise in 2016. Over the past two years, the Fed has actually spoken loudly but carried a small stick –in early 2014 and 2015, they projected 1% interest rate increases by year- end, but during the year increased rates by 0% and 0.25%, respectively. So it’s not surprising that most analysts are forecasting interest rates to be higher, but by an amount less than the 1% projected by the Fed.

International Stocks

The return payoff to diversifying in international stocks that we’ve seen over the past 20 years has not occurred recently. But we are still believers in a modest amount of international investing, specifically in emerging markets. One reason in particular is the relative cheapness of stock markets overseas. Even with the volatility emanating from China, we recommend selective diversification into international stocks.

Summary

The capital market highway throughout time is littered with the carcasses of various investing fads. However, one universal tenant that has held over any long period of time is that broad diversification – across securities, across asset classes, and across fund providers – reduces risk and in some cases increases long-term returns. Hence, our recommendations are to remain broadly diversified, and focus on long-term goals.

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