Fourth Quarter and 2015 Portfolio Review January 6, 2015

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1 Larry Hanslits, CFP Brenna Baucum, CFP Mary Way, CFP, CPA Ron Kelemen, CFP Katherine Suchan, CFP Fourth Quarter and 2015 Portfolio Review January 6, 2015 Happy New Year! We are pleased to share our thoughts with you about the past year and our outlook for We closed our 2014 review on a guardedly optimistic note, citing lower energy prices boosting consumer spending power and corporate balance sheets. While the fourth quarter ended well, the year as a whole did not. 12% 10% One Quarter Performance Ending 12/31/15 (Exchange-traded fund data used as a proxy for index performance. Source: Yahoo! Finance.) U.S. Bonds U.S. Stocks Foreign Stocks 8% 6% 4% 2% 0% -2% -4% 9/30/15 10/7/15 10/14/15 10/21/15 10/28/15 11/4/15 11/11/15 11/18/15 11/25/15 12/2/15 12/9/15 12/16/15 12/23/15 12/30/15 15% One Year Performance Ending 12/31/15 (Exchange-traded fund data used as a proxy for index performance. Source: Yahoo! Finance.) U.S. Bonds U.S. Stocks Foreign Stocks 10% 5% 0% -5% -10% 12/31/14 1/31/15 2/28/15 3/31/15 4/30/15 5/31/15 6/30/15 7/31/15 8/31/15 9/30/15 10/31/15 11/30/15 12/31/15 As it turned out, lower energy and commodity prices were a mixed blessing by helping consumers and energy-dependent industries at the expense of companies and regions of the world that produce them. The long-awaited interest rate increase by the Federal Reserve (the Fed ) finally happened, and it wasn t the end of the financial world. In fact, the stock market had a brief rally for a few days afterward perhaps in relief that the uncertainty was finally over. 500 Liberty Street SE, Suite #310 Salem, OR TheHGroup-Salem.com

2 This past year was a good example that we live in a global financial system and the economies of other countries can affect our stock market. As you can see by the red line in the charts above, international stocks led the charge during the first half of the year, but August brought about a 43% drop in Chinese equities. That killed the prospect for another strong year for many U.S. stocks. (In spite of the late summer drop, the Shanghai Composite Index still closed up 9.4% for the year.) Meanwhile consumer confidence is high as evidenced by year-end retail and auto sales along with crowded restaurants. That s the overview; let s drill down further. As is our tradition for this time of year, we want to share with you our detailed analysis of the major asset classes, our thinking and our portfolio management actions. Whether you are a long-time client or a recent addition to our client family, we hope you will find this information helpful. Over the course of 2015, we made several adjustments to our clients portfolios. Most of these were due to valuation changes in the fixed income (bond) asset classes. Others were manager changes or for year-end tax strategies. We will explain those changes in the context of each asset class. Asset Class Analysis and Portfolio Actions Fixed Income This was a year of uncertainty and volatility in the fixed income markets, both foreign and domestic. Demand for the U.S. dollar was strong, foreign central banks lowered interest rates, the Fed finally raised interest rates and investors started moving out of certain types of high yield bonds. In short, it was difficult to make money in bonds, and it probably will be so again in From the standpoint of diversification, however, the bonds in our portfolios still play a vital role, cushioning from higher risk of the more volatile asset classes of stocks, real estate and commodities. U.S. Bonds In spite of all of this uncertainty and the long-awaited increase of short term interest rates by the Fed, government bond returns were slightly positive. They outperformed total returns for corporate bonds, especially those associated with energy and material companies that were affected by falling prices of oil and other commodities. In May, we made changes to the fixed income portion of our portfolios. We shifted away from two shorter-duration mortgage strategies towards more conventional and liquid government agency mortgage-backed securities. This provides higher income than treasuries and more bond-like characteristics for our portfolios. We also reduced our overweighting of high yield bonds. This overweight has worked very well for our clients since 2009, but during this year, we saw less attractive valuation opportunities in corporate bonds when compared to government bonds. 2

3 Foreign Bonds Our portfolios contain a mix of bonds from developed countries, such as the U.K., Japan, Canada, and Europe, as well as those from less-developed countries. The developed market indexes lost ground due to the strong dollar and lowering interest rates. Fortunately the emerging country bonds especially those with shorter maturities and with their currency pegged to the U.S. dollar did better. Equities Last August and September we experienced our first correction (a decline of 10%) since Why did this happen when the U.S. economy is strengthening? We believe there are several reasons. These include interest rate jitters, the Chinese stock market, a strong dollar, concerns about the energy sector, lowered earnings expectations and an overall global economic slowdown. As far as other asset classes go, we see large cap stocks as fully valued. While valuations aren t as attractive as they were in recent years, this doesn t necessarily indicate a risk bubble, as long as earnings continue to grow in this low interest rate environment. There were some big winners and losers in 2015 canceling each other out in the overall indexes. Whereas in the past few years, money could be made by investing in an index of large cap stocks, now this class needs to be viewed on a company-by-company level. In our portfolios, returns were generally in line with the broader index, with stronger results from holdings focused on technology, consumer stocks and health care. While mid-cap indexes suffered in 2015 with negative returns, our portfolio strategies focused on active stock selection and higher-quality assets, thus surpassing index results and ending the year positive. Small-cap stock index returns also suffered during the year, in part due to weakness in oil exploration and production stocks as well as lackluster results in other areas, such as specialty consumer companies. In August, after a good run, we moved our micro-cap (the smallest of the small caps) holdings to a manager that handles larger small caps. The micro-cap area had become overvalued. While there may be more opportunity in the small cap area, we re still underweighting this class because these stocks look more expensive than do larger companies. Our positions in foreign stocks payed off handsomely in the first half of the year, helping most of our portfolios outperform the domestic indexes. This was a good reminder about the importance of international diversification. Unfortunately, as the Chinese economy slowed, uncertainty about Europe and Japan s prospects grew. Couple this with a stalling U.S. market and we saw the foreign stock asset class drop. Also, emerging market holdings started feeling the effects of low commodity prices. Alternative Asset Classes Real estate investment trusts (REITS) provided equity-like returns in 2015, with U.S. REITs outperforming foreign holdings. Underlying fundamentals continued to show strength in several key urban centers. While domestic REITS outperformed broader equities during the year, a smaller portion of this category which held foreign REITs detracted from this well-performing asset class. 3

4 If there was any one asset class that underperformed it was commodities, the stuff we use every day. Fortunately, it is a very small portion of most portfolios, ranging from 0-5%. While we are all enjoying lower gasoline and diesel prices, we are paying for it with the impact they are having on other sectors of the domestic and global economy. The stronger U.S. dollar doesn t help, either. Fortunately, our portfolios had lower energy weightings than the more popular commodity funds. For our taxable accounts we executed a short-term tax swap in November and December by temporarily selling a commodity portfolio position to allow clients to capture a potentially useful tax loss, with the intention of returning to the original position after the wash sale period expired. Now that it has, we are buying back our original positions. Asset Class Weightings The portfolio themes remained relatively consistent in 2015 as valuations among asset classes did not dramatically change, despite bouts of typical volatility through the year. In fact, as you may have heard us say in your update meeting, this is the first time in more than a decade that our allocations are very close to normal weightings in most categories. Our Outlook 4 We think you will find the colorful chart on the last page very interesting. We call it a periodical table (from chemistry class) or a Skittles chart (named after a candy). It illustrates how returns can vary from one asset class to the next year by year. It also makes a good case for diversification. As always, our objective is to seek higher returns, but with prudent risks. We overweight undervalued asset classes and underweight overvalued ones. This is contrarian in nature and can take patience waiting for undervalued assets to outperform. Looking ahead, we see valuation opportunities in high yield bonds and emerging market equities. Overall, foreign equities look less expensive relative to U.S. equities. There is also the possibility that commodities could be oversold and poised for a rebound. However, as we undergo another round of valuation studies, we may reshuffle sub-asset classes in From the 30,000 foot view, equities continue to look more attractive than bonds, which offer historically low yields and potential downside as interest rates rise. However, we realize that valuations cannot be considered in a vacuum. We see some negatives on the horizon that could temporarily cause market volatility. In addition to deterioration in worldwide commodity prices, there is political instability in the Middle East, China, and Europe.

5 Don t forget that this is an election year. Candidates need to make a case for how bad things are to justify electing them instead of others. We ask that you put that into perspective as you wait to get a table at a restaurant, stand in line for a movie, get on a crowded airplane, buy a new gadget, or read about the huge holiday shopping season we just survived. The Fed raised rates because the economy is improving. While the economy is improving, we understand that subpar returns can be rattling when considering your long term security. One year of good or not-so-good investment results don t have a major impact on long term goals. We encourage you to stay the course, and reach out to us when that feels challenging. Some of the most valuable advice we re able to give is during times of worry. In 2016, we don t expect above average returns in most of the asset classes. We need time to digest the out-sized gains of the past few years and to absorb the changes that challenge the global economy. While no one knows what will happen in 2016, we are cautiously optimistic for modest returns based on the facts before us and our strategy of diversification and not chasing or timing the market. We wish you all the best for 2016! Other Items Your performance reports will be mailed on or before January 15. Tax information from Fidelity or TD Ameritrade will be sent in February. We will be closed next Monday, January 11 for an all-day team retreat. Even if you haven t made reservations, please join us on January 14 to celebrate Brenna s CFP certification and to meet our newest team member, Katherine Suchan, CLU, CFP. We ll still have plenty of food, beverages, music, and opportunities to visit. 5

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