DURSO WEALTH MANAGEMENT GROUP AT MORGAN STANLEY May 31, 2016 ECONOMIC LANDSCAPE

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1 ECONOMIC LANDSCAPE Noise, very low levels of optimism, heightened levels of pessimism, and even more noise have flooded the headlines in the month of May. Here are some of the topics I am sure you have been bombarded with recently: Sell in May & Go Away? The Fed is Going to Raise Rates (Possibly Hurting US Stocks & Bonds) The Fed is NOT Going to Raise Rates (Possibly Helping US Stocks & Bonds) The US Dollar is Going to Strengthen (Possibly Hurting US Stocks) The US Dollar is going to Weaken (Possibly Helping US Stocks) Stock Prices are Too High No, Bonds Prices are Too High Everything is Overvalued Cash is King Shockingly, even with all this noise, volatility in the equity markets has remained relatively low compared to historical standards. Please refer to the chart below as the blue line displays the recent price movements in the CBOE Volatility Index (VIX) over the last 6 months (as of Wednesday, May 25 th ). As mentioned in previous insight letters, the VIX measures implied (expected) volatility of the S&P 500 Index over the next 30-day period. 1 Much more simply said, the blue line depicts how much risk is expected in the market in the near term. If the blue line is higher, risk is expected to be higher. If the blue line is lower, risk is expected to be lower. We find it very supportive that amongst all the noise we have been exposed to, expected risk in the market remains low in the near term. 1 Thomson Reuters DataStream Chart: Chicago Board Options Exchange, May P a g e

2 We find it imperative for all of our clients to understand that market tops are generally characterized by extraordinary levels of optimism. Due to the current low levels of investor zeal, these extraordinary levels of optimism should be the least of our concerns regarding the markets. Historically speaking, it is important to recognize that we have regularly experienced extended periods of uncertainty surrounding economic output, upcoming elections, potential Fed rate hikes and even geopolitical risks. These potential headwinds are not new. Can anyone really tell me the last time they felt 100% confident when investing for the future? Moving on. The topic that continues to garner most of the attention in the markets is the inevitable timing of the next Fed rate hike. We do believe the Fed will raise rates this year, maybe even multiple times. Please refer to the table below. I put this table into our insight letter back in December of 2015; however I thought it would be appropriate to update and review once more given the current environment. Let s face it, in June we may potentially see the second Fed rate hike in the last 12 months. The team and I thought it would be beneficial for you to understand where interest rates stood prior to previous bear market transitions. These bear markets are described as declines of at least 20% or more in the S&P 500 Index. As you can see, typical bear markets and recessions begin to take place as interest rate yield curves begin to flatten or invert. This occurs as short term interest rates (Fed Funds) inch closer to or even surpass longer term rates (10YR T-Note). In this example, we examine the ratio between the Fed Funds Target Rate relative to the 10YR Government Bond Rate immediately before the past bear markets started. The average ratio of these two rates preceding the last five bear markets was 101%. The current ratio is hovering between 26% and 29% as you read this letter. 2 This is currently well below historical levels of concern. Why is the current level of this ratio a positive sign? Numerical data is a much better predictor of future price movements when compared to the talking heads (News Anchors). Why does this ratio really matter? Well, it explains buying momentum of one of the safest investments in the world, the US Government Bond. This table demonstrates to you that yield curves flatten or even invert prior to recessions. An inverted yield curve is bad because it portrays that the demand for long-term bonds is increasing at a faster pace than for short term bonds. This signifies that investors believe the economy will slow down, eventually driving interest rates even lower in the future. Inverted yield curves are rare and they are considered to be a good forecaster of an economic recession. 3 We are not there. 2 First Trust Portfolios L.P., Bespoke Investment Group, Bloomberg, as of May 11, Morgan Stanley Investment Management, Global Investment Committee, May P a g e

3 PORTFOLIO MANAGEMENT UPDATE Target % s As of PORTFOLIO FOCUS BALANCED GROWTH GLOBAL GROWTH HIGH YIELD INCOME EQUITY TARGET 45% 70% 90% 30% US LARGE CAP 27% 42% 54% 17.5% US MID CAP 2.5% 4% 5% 4% US SMALL CAP 1.5% 2% 3% 0% INTL EQUITY 14% 22% 28% 8.5% FIXED INCOME TARGET 45% 20% 0% 63% ALTERNATIVES TARGET 10% 10% 10% 7% Out with new and in with the old? Could we really be shifting back into an investing phase where stock fundamentals and valuations actually matter? Will current stock valuations relative to current and future earnings play a larger role? Will market participants finally start moving capital into businesses that have current positive cash flow? A very direct way to measure the many possible responses to these questions is to monitor the relationship between growth and value stocks. What s the difference? Think 3D printing versus heavy industrial equipment. If the responses to the questions outlined above are yes, then value stocks should routinely outperform. This has certainly been the case for 2016; however our team feels that this trend may continue in the near future. The overall economy seems to be entering the late-cycle business environment which is typically characterized by tightening labor markets, rising commodity prices, tightening monetary policy, rising inflation expectations, increasing long-term interest rates and increasing investor optimism. 4 These characteristics of economic activity should bode well for value oriented investment opportunities. As interest rates increase and credit markets constrict, companies with the strongest balance sheets and barriers to entry should perform well. These companies will maintain more advantageous borrowing contracts due to their well- 4 Richard Bernstein Advisors LLC, May P a g e

4 established relationships with their creditors. Their products are also more recognizable and understood by the mass public. 5 We would like to highlight one recent change in the equity allocation in our Global Growth, Growth and Balanced Investment Portfolios. In anticipation of this long-term shift, our team has continued with the ongoing shift of capital out of large cap growth stocks into large cap value stocks. We feel this reallocation is warranted due to the economic reasons (outlined above), as well as the recent price movements of the two equity styles (depicted below). The chart below shows the ratio of price movements between the Russell 1000 Growth Stocks and Value Stocks over the last two years (as of May 26 th, 2016). As the teal line moves up, growth stocks outperform. As the teal line moves down, value stocks outperform. Do not get caught up in the day to day changes. Focus on the white and red lines as they signify the 50-Day and 200-Day Moving Averages of this relationship. Moving averages help smooth out the noise and represent a much better picture of longer-term trend shifts. In this specific example, it is a very positive sign for value stocks when the 50-Day Moving Average (White Line) falls below the 200-Day Moving Average (Red Line). 6 The last time this shift took place was between 8/15/2012 and 10/2/2013, lasting almost 14 months. Value stocks, as measured by the S&P 500 Value Index, returned 26.13%. Growth stocks, as measure by the S&P 500 Growth Index, returned 20.32% over the same time period. 7 Matthew David Sheridan, CFP CPM Portfolio Manager Financial Advisor Durso Wealth Management Group at Morgan Stanley 5 BlackRock Investment Management, Thomson Reuters DataStream, as of May 26 th, Bloomberg L.P., as of May 26 th, P a g e

5 Please contact your Financial Advisor for a complete listing of all transactions that occurred during the last twelve months. This material is intended only for clients and prospective clients of the Portfolio Management program. It has been prepared solely for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument, or to participate in any trading strategy. The individuals mentioned as the Portfolio Management Team are Financial Advisors with Morgan Stanley participating in the Morgan Stanley Portfolio Management program. The Portfolio Management program is an investment advisory program in which the client s Financial Advisor invests the client s assets on a discretionary basis in a range of securities. The Portfolio Management program is described in the applicable Morgan Stanley ADV Part 2, available at or from your Financial Advisor. 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