2015 Year End Newsletter & Outlook

If MCS clients’ investments were treated as one large portfolio including their cash, clients gained 1.64% after fees. The range of individual client returns was -2.48% to 6.65%. For comparison purposes, the S&P 500 Total Return Stock index earned 1.38%, and the Barclays Aggregate Bond Index was up 0.55% for the year. Clients with the lowest returns were negatively impacted by more concentrated stock exposure and higher exposure to oil related securities. The client with the highest return benefited from an 18% position in an inherited real estate security with very cost low basis.
Auxier portfolios, on average, lost 3.08 %. The Auxier results are included in the total client results above. After reviewing over 3.5 years of performance data, I have decided to discontinue using Jeff Auxier’s services. It was not an easy decision. Statistically speaking, 3.5 years of data is not enough to draw a conclusion about a manager’s performance – it takes about 20 years – but no one can wait that long. Please see comments below.
2015 will go down as an investment year in which breakeven was a good result. Broad diversification actually hurt returns. The pain of diversification resulted from the best performing assets making little or no money, while many foreign and commodity related assets did very poorly. In a diversified portfolio, if the best investments make 1-3%, but the worst investments lose 15-30%, the overall portfolio results are going to be ugly.

Annual Return Vs. Annual Income

Assuming that you made only 1% or less last year, does that mean that you’re spending principal if you spent 4% of your portfolio value? Answer – It’s not that simple. In a year of low returns, some investors may become needlessly worried that they are not making enough to live on when their investment income may be more than sufficient.
An annual portfolio return is the change in value of all securities plus the investment income. Annual investment income is the distribution of interest or dividends.
If you buy a security paying 4% (as interest or dividends) and one year later the security has declined in value by 2%, the annual return is 2% (4% income less 2% decline in price). Alternatively, if the security price increased 2%, your annual return would be 2% price gain plus 4% income gain for a 6% overall gain. In either situation, if the dividend or interest payment has not changed, your original investment still paid you income equal to 4% of its purchase price.
Prices of stocks or bonds do not go up every year: having portfolio income and cash available to meet your needs enables you to bear the risk of fluctuating annual returns in pursuit of price gains over a multi-year period.

The US Economy Is OK and Making Progress

Nationally, US unemployment has dropped from a peak of nearly 10% in December 2009 to 5% today. Housing prices have continued to increase (see Figure 1, below). The US remains the best economic story in the world, despite a recession in the manufacturing part of the economy which comprises 12% of total US economic output.

Figure 1
Housing Prices Recover

Housing Prices Recover - MCS
Source: Federal Housing Finance Agency US House Price Index, Bloomberg
The expected December increase in the Fed Fund interest rate did not result in an increase in long term rates – something that legions of market pundits and advisors have continuously warned and fretted about for the past 3 years.
My 2015 third quarter newsletter outlook was upheld, when I wrote:

“Given the global risks, it isn’t clear that a December increase in the Fed Funds interest rate (overnight rate between banks) would have much impact on long term rates.”

Since the Fed interest rate increase on December 15th, ten year Treasury bond yields rates have declined from 2.27% to 2.05% as money flows out of risky investments like stocks into Treasury bonds.

A Tough Environment

I am uneasy about the recent stock and bond market developments; stocks are falling while bonds are increasing in price. One of my concerns is overhead costs.
Overhead costs are building in some US business sectors due to wage pressures as momentum (appropriate in my view) for higher minimum wages continues. If this occurs, stock prices could fall further: squeezed by an ugly combination of higher than expected US interest rates and stagnating earnings growth. The inflationary impact of increasing labor costs would be modest, but it may be enough to upset the market’s current view that the Fed will be forced to slow the pace of interest rate increases due to a slowing global economy. Figure 2 below shows the Fed’s guidance about interest rates vs. the market’s expectations. Clearly, the market and Fed have different expectations, so expect more volatility ahead.

Figure 2
Fed and Market Expectations Diverge

Fed and Market Expectations Diverge - MCS
Source: BCA Research 2016
* Median midpoint target from the Fed’s summary of economic projections (Sept. 2015)
** As discounted in the OIS curve as of Dec. 2 2015
The global economy is in rougher shape. China, now the second largest economy, has been stumbling toward a hoped for transition from an export / capital projects led economy to a domestic consumer economy – no quick or easy task. On the flip side, should the Chinese economy stabilize this year, any hint of a prospective recovery could send global rates higher. Commodities, Chinese and emerging market stocks would rebound. While this would be positive for the US economy, the financial markets could suffer as prices dropped to account for higher interest rates.

Some Good News Regarding Cash

A positive outcome of the Fed rate increases is increasing yields on 1-2 year treasury bonds. For clients with large cash balances this is good news.

Discontinuing Auxier’s Services

As I mentioned above, I have discontinued the sub-advisory relationship with Auxier Asset Management. I appreciated Jeff’s efforts on our behalf. He was very flexible, allowing each my clients to identify stocks that they did not want him to purchase for them, such as tobacco stocks. Also, in the beginning of the relationship, he did not bill the accounts until he had them about 25% invested. Overall, we made money; his performance was in-line with many value stock managers. In fact, his US stock picks performed much better than the S&P 500. Unfortunately, losses in his foreign stock selection more than offset his US stock results. MCS divided and tracked his portfolios in two composites, domestic and foreign stocks to understand what was working and what wasn’t.

Figure 3
Auxier Asset Management Performance History Equities
From 02-22-12 to 11-30-15

Auxier Asset Management Performance History Equities - MCS
Source: Auxier Asset Management, LLC: equities only, cash and management fees not included
Jeff Auxier portfolio returns underperformed the S&P 500 for the entire period because he started with 100% cash, which was expected. The S&P 500 is always 100% invested in stocks. In an up market, a stock plus cash portfolio will have lower returns than a 100% stock portfolio.
When markets decline the opposite should occur; the fully invested portfolio should do worse. Auxier’s 2015 year to date third quarter results were a disappointment because the advantages of his 25% cash position during a market decline were offset by losses in foreign stocks.

Next Steps

I spent a few hours with Jeff going over each stock position he held to understand his investment rationale. I will be selling some stocks and retaining others. As I write this, we are transitioning the accounts he was managing. In my conversations with Jeff I emphasized that I would track the performance of these accounts and wished to leave the door open regarding future work together. Jeff invited me to call him any time if I had questions about the positions.

Investment Strategy

Unless I see something very compelling, my intuition is to hold off buying longer term bonds. I believe there is room for short and 10 year Treasury bond rates to rise .25% to .50% if wage pressures continue. Stocks are vulnerable because earning growth is slowing in many industries.

Bottom Line

The economic and financial markets are entering a new phase. The market volatility is evidence of the uncertainty that markets face in determining financial asset prices. MCS clients have enjoyed stability during this period. Nevertheless, this is the most difficult environment I’ve been faced with.
There was a time, not that long ago, when a 20% loss could be recovered in just less than 5 years simply by investing in five year, 5% CD. Today a 20% loss would take about 12 years to recover in 5 year, 2% CD’s. Most investors don’t fully appreciate the implications of a low return world; losses in riskier investments can take a very long time to recoup.
Given these risks, my strategy is to selectively sell stocks and bonds in order to raise cash in some client accounts. I’ll be looking for entry points to repurchase stock or bond exposure while keeping in mind that just because the price of a security has hit a recent low, it doesn’t mean you’re near the bottom.

MCS Family Wealth Advisors (MCS) consolidated client returns are dollar-weighted, net of investment management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all clients with fully discretionary accounts under management for at least one full month in 2015. Individual client returns represent client discretionary accounts under management for the entire period – starting on 12/31/2014 and ending on 12/31/2015. These accounts represent 100% of MCS’s discretionary assets under management as of 12/31/2015 and were invested primarily in US stocks and bonds (17% of client assets on 12/31/2015 were invested in tax-exempt municipal bonds). The Auxier sub-portfolio returns are dollar-weighted, net of investment management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all clients with fully discretionary accounts under management for at least one full month in 2015. These accounts represented 10% of MCS’s assets under management as of 12/31/2015 and were invested primarily in US and foreign stocks. The Stock Index values are based on the S&P 500 Total Return Index, which measures the large-capitalization US equity market. The Bond Index values are based on the Barclays Capital US Aggregate Bond Index, which measures the US investment-grade bond market. Index values are for comparison purposes only. The report is for information purposes only and does not consider the specific investment objective, financial situation, or particular needs of any recipient, nor is it to be construed as an offer to sell or solicit investment management or any other services. Past performance is not indicative of future results.