Market Commentary The Pelican Bay Group

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1 Market Commentary The Pelican Bay Group 2Q 2016 You Know How I Like to Buy Things on Sale and with Coupons Richard DiMarzo, CPM The Pelican Bay Group at Morgan Stanley 1250 Pittsford Victor Rd. Building 200, Suite 350 Pittsford, NY West 52nd Street, 23rd Floor New York, NY Market Street Suite 600 Denver, CO Visit our website: pelicanbaygroup Contact us please call: (800) Portfolio Management Team The Pelican Bay Group assists high net worth individuals and institutional clients in meeting their financial objectives by offering customized portfolio management strategies. The Pelican Bay Group, a team of Morgan Stanley Financial Advisors, has four experienced portfolio managers covering an array of disciplines and offering a variety of strategies designed to optimize risk to help meet their clients investment objectives. These investment styles are offered as fully discretionary strategies with a comprehensive fee based on the asset value being managed. The team currently manages over $2 billion in client assets. During one of the downturns in the market this year one of our clients called to ask, Richard, is it time to buy? You know how I like to buy things on sale and with coupons! This is a rational thought for most buyers of any good or service. We go to the grocery or clothing store looking for items on sale, some of us scurry through the Sunday paper for coupons. And many of us go on Kayak or Trivago looking for the cheapest travel deals. It s no shock that most of us like to pay less for something that we perceive is worth more than we are bring charged. Yet most of us run for cover when stocks or bonds become cheap, whether as a result of a market correction, an oversold sector, or the specific stock is out of favor! Why do we react so differently when it comes to a market, a sector, or a stock or bond? The answer to that question is locked up in the way we humans think. Psychologically, we have a tendency to make decisions or take actions in an irrational way. Psychologists refer to these as biases. These biases, which can lead to systematic deviations from a standard of rationality or good judgment, are often studied in psychology and behavioral economics. What we think of as rational buying, purchasing a grocery item on sale, purchasing a hotel room at a deep discount, or simply applying a coupon to an item on sale is actually quite irrational behavior. Our actions are affected by a cognitive bias called the anchoring effect. It is a bias that influences you to rely too heavily on the first piece of information you receive. Stores use it all the time to convince you to buy a certain product. Most items on sale have been discounted from a marked-up price. Consider a dress that cost to the retailer of $ If the retailer marks it up 60 percent to $ and then discounts it by 20 percent to $100.00, the retailer has doubled its gross profit, but did you get a bargain? Most of us would say, yes. Yet when it comes to a sell-off in the stock market, a sector, or a specific stock or bond, our thinking is quite the opposite. Frankly, we are overcome with fear and our thinking becomes quite irrational. At play here, in my opinion, are three biases: fear bias, recency bias, and herd mentality. 1. Fear bias increases people s perception of risk, regardless of what caused them to feel afraid. Three studies were conducted to test and expand upon on this finding. Specifically, it was found the fear bias predicts that cognitive dissonance may be at least partially responsible for an increase in risk perception when people are afraid. (Source: Thomas Ramsey, Cain Rutgers University) 2. Recency bias is defined as the belief that what s happened recently will continue to happen. (Source: US News, May 26, 2015 contributor Kate Slater)

2 3. Herd mentality is defined as a bias that takes hold when a person doesn t want to be left out of a trend or a movement. These are the investors who buy when the market is high and sell when the market is down. This bias occurs when individuals are influenced by their peers to follow trends, purchase items and adopt certain behaviors, even if it is not in their best interest. (Source: Trent Porter as quoted in US News, May 26, 2015 contributor Kate Slater) You can quickly see how fear, recent events, and the herd mentality can irrationally influence a person s decisions. Well at least most peoples. But not our client who wants to buy all things on sale and with coupons! To overcome these biases we need to look for ways to introduce objectivity and discipline into our decision making and allow time to let to let other people s objective viewpoints into the process. As portfolio managers at the Pelican Bay Group at Morgan Stanley, to overcome our biases, we employ strict buy and sell disciplines to our money management strategies because, like you, we re human and don t want to let our biases get in the way! Thinking about selling your business? Shelley Ford Many CEOs and small business owners invest the majority of their time and wealth in their businesses in the hope that one day they will sell it. Yet, statistically speaking, over half of the deals don t close. 1i There are many theories about why this is so, but one main reason, is lack of preparation. Here are three things to do that will help you when considering selling your business: 1. Hire an excellent team. You will find that the more collaborative your team, the more successful your transaction will be. Make sure to hire a team that has experience in the M&A world. This often means re-examining the current relationships you and your company have. Don t be surprised to find that you will need several experts in each field including an M&A attorney and another attorney who can handle your personal estate issues after the transaction is completed. Your investment banker and personal financial advisor should have access to your CPA and your attorneys to help make sure that the deal stays on track. I have found that some of the most successful deals happen when the advisory team and management team meet on a monthly basis to make sure that all the details are handled. 2. Plan your time wisely. Many business owners are not aware of the planning and time required to sell a business. In fact, experts recommend that CEOs and business owners begin preparing for the transaction at least two years in advance. ii This will not only help to insure a better price for your business, it also allows you to prepare employees and make sure the culture of the business stays in- tact after the sale. Additionally, it will give you, the owner, time to prepare your personal estate, which, if done properly, can potentially save you money in terms of the sale s personal tax consequences. 3. Be realistic in the valuation of your business. While there is nothing wrong with being confident when selling your business, make sure to be open to suggestions from your advisory team when it comes to the valuation of the business. M&A transactions can be complicated and time consuming, but, if done properly, they are the ticket to success for many of the wealthiest people in our nation

3 Next Generation Gifting Considerations Paul Hanrahan As you consider your gifting options, ask yourself how you would like financial gifts made to your children, grandchildren, or other family members spent. Giving financial gifts to children or grandchildren can help reduce your estate taxes; however, if you are concerned about the recipients wasteful spending, there are several options that allow you to exercise some control over how the is money used. Tax-free Annual Gifts: Federal law permits unlimited tax-free annual exclusion gifts of up to $14,000 per recipient ($28,000 if you are married), without the donor having to file a federal gift tax return. If you make a gift to any person in excess of the annual exclusion amount, you will be required to file a federal gift tax return (Form 709), and the excess amount will reduce your lifetime gift and estate tax exemption currently $5.45 million per individual ($10.9 million per married couple, but you will not have to pay a gift tax. The gift will simply reduce the amount of your lifetime exemption. Your generosity and good fortune potentially places a significant amount of money into the hands of children and grandchildren adult as well as minors who may be unprepared to manage a windfall. Here are some suggestions that may allay your concerns. Lead by Example When making gifts to adult children, discuss your feelings with them before making the gift. Suggest that they put the money to good use; for example paying down debt, starting a college fund for their own children, investing a portion, or donating some or all of it to a charity of their choice. Avoid handing a check to an adult child you believe may squander the money. Instead, offer to contribute to big-ticket items, such as a new car or a mortgage down payment, or require them to attend a financial education course to learn about budgeting, savings, credit scores, and other topics that could help them become fiscally responsible adults. Custodial Accounts, Trusts and 529 Plans If the gift recipient is a young child, Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) custodial accounts may be appropriate choices. With UTMA/UGMAs accounts, the minor owns the funds, but the donor may serve as custodian and has complete control of the account until the minor reaches the age of majority (generally 18 or 21depending on the state), at which point the custodian is required under the law to turn the assets over to the former minor. l For those desiring some lasting control over the gifted money, a trust may be the better choice. Unlike custodial accounts, money held in a trust does not have to be transferred to the beneficiary at a specific age. You choose the timing and distribution schedule, for example a lump sum at age 21, or periodic payments over a set number of years. If you prefer that the money be used to fund longer-term financial goals, offer to fund an individual retirement account or open a 529 college savings plan.under the special five-year election rule, you can make a lump-sum contribution of $70,000 (or $140,000 per married couple) to a 529 plan in the first year of a five-year period. Keep in mind that if you choose that option, you won t be able to give the recipient any additional annual exclusion gifts for the remainder of the five-year period. These are just a few suggestions for making thoughtful, satisfying gifts to children. Contact me for help assessing your overall estate planning and exploring additional gifting and financial education options. Sources/Disclosures: 1 Kiplinger, Ways to Give Money to Children, updated January The Wall Street Journal, Financial Gifts to Adult Children: Strings or No Strings? January 2, 2015.

4 Net Unrealized Appreciation (NUA) Teresa Bustamante Net Unrealized Appreciation (NUA) is the special tax treatment granted to appreciated employer stock in retirement plans. This special treatment is covered under IRS Section 402(e)(4). This special tax treatment may be appropriate for investors who are preparing to retire and who would like to implement a strategy to reduce taxes on employer stock in 401(k) plans. When considering this strategy an investor should consult with their tax advisor as the rules are many and can be complicated. This strategy is not for all and must be undertaken after thorough evaluation and consultation with your financial advisor and tax advisor. In general, this strategy allows investors to move employer stock in kind from a 401(k) plan to a non IRA account as part of a complete rollover. Non employer stock holdings can be rolled over to a regular IRA. This creates a taxable event for the employer stock withdrawn from the retirement plan. It is based on the cost basis of the stock, and will be deemed ordinary income for income tax purposes. The appreciation Net Unrealized Appreciation is not taxed at this time. When the stock is sold, immediately or at a later date, the NUA (market value less cost) is deemed to be a long term capital gain and taxed according to prevailing law. Long term tax rates are usually lower than ordinary tax rates and the strategy may provide considerable tax savings. The conditions for such a strategy include, but are not limited to, the following: The stock must be received as part of a lump sum distribution. The participant must have attained the age of 59 ½ years and separate from the employer. The appropriateness of the strategy depends on, but is not limited to, each investor s situation, tax status, cost of the stock vs. market value, future tax situation, the investor s desire to hold the stock, required minimum distributions and diversification. The decision to carry out the NUA strategy does not have to be all or none. It can be carried out for a portion of the employer stock. A word of caution: Investors may inadvertently forego the ability to utilize this strategy if their employer stock is sold and the proceeds are disbursed from the plan in cash. This benefit might also be lost if the stock is rolled over to an IRA or if the stock is paid in a non-lump-sum-distribution or if the process is not done within the allowable time after retirement. Finally, employees planning to use this strategy should be cautious about trading their employer stock in their 401(k) plans as frequent buying, selling, and repurchasing might have a negative impact on a participant s NUA. The Beginning of the End Stephen Stribling, CPM On June 23rd the United Kingdom held a referendum. This referendum was not a requirement but rather a political maneuver on the part of the prime minister to quell the dissent within the British Conservative party. The vote came to be known as Brexit. It was a vote on whether the United Kingdom should stay in the European Union. As we have discussed in prior issues the European Union (EU) was formed by the treaty of Rome in 1951 as a response to two world wars and millions of deaths. The premise was that countries that traded together and became dependent upon each other commercially would never have the incentive to attack their neighbors for economic gain. It is a trade union much like the AFL/CIO. Laws were passed to harmonize tariffs or taxes on goods sold within the Union thereby lowering the trade barriers. Further integration followed with the election of a European Parliament, the formation of a central bank (ECB), and the creation of a common currency, the EURO. It should be noted that not all members had to adopt the currency, which is regulated by the European Central Bank in Frankfurt Germany. The British for one kept the pound as they felt the new currency infringed upon their sovereignty.

5 Not only were trade barriers lowered and harmonized, but physical barriers were also removed so that individual citizens of the EU could travel throughout the Union on their passport without needing a visa. Internal border check points were also eliminated. More on this later. The EU Parliament was formed and located in Brussels, and laws and regulations were passed encompassing all members. Interestingly although there is an ECB (much like our Federal Reserve), each country has its own central bank which regulates that country's banks and issues its own national debt. Each country kept its own language, and local laws, and manages its own budget, defense, and so on. Any full member state can veto any proposed law or action. So while united economically, they are not united politically and they are not and have never been, as some pundits would like us to believe, the "United States of Europe." They are a trading block, period. Everything seemed to be progressing nicely. The Union expanded to 28 nations with the acceptance of Croatia in Then as Warren Buffett stated, "only when the tide goes out do you discover who has been swimming naked." In this case the tide was the financial crisis of 2008 and the first caught skinny dipping was Greece. I don't have the time nor do you have the patience to relive the Greek saga. Suffice it to say that Greece (as well as many other Southern European nations were over spending; borrowing at a rate subsidized by and large by those of their fellow EU members who used the Euro. In other words, Greece was allowed to borrow money at amounts and at rates that the fiscally responsible economic powerhouse Germany could. It was as if their balance sheet, income stream and spending restraint were the same as Germany s...they weren't. So the 2008 crisis found the Greeks with so much debt that they couldn't repay it. The EU came to the rescue with multiple restructurings, loans, and debt forgiveness. Greece promptly fell into a severe, multi-year recession that continues today. Protests, demonstrations, numerous elections were called but the Union is preserved! In 2012 Cyprus was the next country to experience economic issues and a major run on the banks. To stem the tide the EU again agreed to restructure and loan the banks money, but this time the pain had to be shared with the bank's shareholders (wiped out), bond holders(wiped out), and large depositors (haircut). The rule was called the buy-in rule and stated that a bank's owners and lenders must pay the price by losing their investment if a bank fails. Then the ECB loaned them money to continue their operations. The central bank of the home country was forbidden to recapitalize the banks from its funds. The theory was that this would make the banks pursue more conservative practices and the other Euro member countries would not have to pay for Cyprus s poor judgment. Beware of the law of unintended consequences. As of this writing, The Italian Banks are in severe distress. Huge amounts of underperforming loans, slow growth, and falling deposits are the culprits. While Greece and Cyprus have very small economies, Italy is the fourth largest economy in Europe. The failure of its banking system would probably mean a failure of the entire EU and undoubtedly bring on a recession throughout the Union. So why doesn't the Union just restructure the banks and loan them money? Or better yet, allow the Italian government to recapitalize the banks? Ah don't forget the buy-in rule. Not only does the Union forbid the Italian Government from recapitalizing the failed banks like our FDIC would, it also requires that shareholders and bond holders be wiped out. Unlike Cyprus, large institutions are not the dominant owners of Italian Bank bonds; individual investors in search of positive interest rates own the bonds. Thus the buy-in program wipes out small Italian investors who are a powerful constituency at election time. While politics in Italy are always challenging, recent dissatisfaction with the EU has spawned a new party, the Five Star party, which is gaining in popularity. In fact, the Five Star Party recently won the Mayoral elections in Rome and Turin. One of the primary articles on its platform is to leave the EU. In the face of this, what should the ruling party do? Bankrupt many of its citizens and get thrown out of power or defy the EU and recapitalize the banks and perhaps hold a referendum? In 2011 we had the Arab Spring. Mass protests erupted throughout the Middle East toppling governments and leading to a civil war in Syria. Massive numbers of refugees migrated from their war torn homelands. If they could escape and make it to Greece overland or on a boat to Italy or perhaps sneak into and out of Turkey into Bulgaria, they could travel unrestricted throughout the EU and even apply for some of the generous benefits provided by the Union. Tens of thousands have made the trip. As a result, some member countries began closing their borders (despite the treaty) and began rebuilding their border checkpoints. Germany, the largest economy in the EU, implored the member states to accept an allotment of refugees regardless of the host country s ability to house, feed, or protect them. Rightly or wrongly the citizens of these countries fear the loss of their own jobs, cultures, and futures. They are demanding something be done.

6 Britain was first to take back control of their country through Brexit. France, the Netherlands, and Denmark have increasing numbers of people who want a referendum on whether to stay in the EU. The recent terrorist attacks in Paris and Munich feed the fear. Fringe political parties are gaining support on a "leave the EU" platform. If it continues, the parties currently in power will have to respond or they will find themselves marginalized and out of office. Britain leaving the Union may be the beginning of the end for the European Union as we know it today. More citizens are asking for safety, and a way to maintain their culture or their standard of living. They inherently know that they can always vote their local politician outcome the next election. But how can they control some bureaucrat in Brussels they don't know, and can't see, who may not even speak their language but has the power to make rules that affect their daily lives. The structure of the EU itself holds the seeds of its self-destruction. Without political union, no economic union can survive. Without some means of enforcement, how can it stop some country or elected politician from breaking the rules? Politicians will out of their own self-interest or that of their citizens continually break the rules in favor of their own country. Without political union and the force necessary to enforce the rules, economic union is only viable if it's in the best interest of each country's citizens and when it's not - it's not. Anthony M. Gallea Managing Director-Wealth Management Jennifer D. Hartmann, CIMA Executive Director-Wealth Management Stephen Stribling, CPM Executive Director-Wealth Management Teresa Bustamante Senior Vice President-Wealth Management Senior Investment Management Consultant Richard J. DiMarzo, CPM Senior Vice President-Wealth Management Paul M. Hanrahan, CRPS Senior Vice President-Wealth Management Professional Alliance Group Director Shelley Ford William VandenBrul Vice President-Wealth Management Wealth Advisor Please refer to the Pelican Bay Group s team website: for a description of the team s Portfolio Management strategies mentioned in this material which is located under the Strategies Tab on the website. The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. Please contact your for a complete listing of all transactions that occurred during the last twelve months. The individuals mentioned as the Portfolio Management Team are s with Morgan Stanley participating in the Morgan Stanley Portfolio Management program. 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