Market Commentary Q2 2013

Steven B. Girard
It was the speech felt around the world. On June 19th, Fed Chairman Ben Bernanke let the markets know that the use of the Central Banks balance sheet to prop up the US economy would someday need to end. While this was not a surprise to many,the volatile reaction of the bond and stock market was. We had anticipated that the Fed would announce the intent to slowly taper their bond buying, in an effort to slowly increase bond yields and decrease bond prices over time as they let the proverbial air out of the balloon. We also anticipated that the markets would, in essence, wait and see if they actually followed through. Instead, the mere announcement of a potential end to this round of Quantitative Easing, or QE III, sent the markets into a tailspin and within a two week span of time the equity markets were nearing correctional territory and the yield on the 10 Year Treasury rose by more than 20 %. Mutual funds and individual investors alike were caught in the unexpected selling fervor across all asset classes with intermediate, higher grade bond funds taking the biggest hit. This prompted the Fed Chairman to publicly clarify that tapering might happen in the future, but the buying would continue for now. As such, the bond market has been stealing the headlines away from a US economy that continues to limp along in a slightly positive manner. With Q2 earnings season recently kicking off, equity investors continue to shrug off slowing revenue and earnings growth, instead buying into the lowered expectations and all eyes have turned to fixed income. Inventory of bonds, which have been hard to come by for many months, has suddenly become full of opportunity as many fixed income investors have moved away from the asset class after Mr. Bernankes speech, as if the asset class were tainted. For many quarters now we at Northstar have been making allocation changes to address the higher prices of bonds and the impending decrease or elimination of QE III. We have done so by allocating some assets to the bonds of countries with better balance sheets and pricing than the US, some to high yield bonds where spreads were more attractive (and are more attractive again since the sell-off occurred). In some cases, we have bought senior loan funds where we get some rising rate protection, as the interest rate charged on these loans are tied to LIBOR and as rates rise so does the income, some assets are invested in bond funds that can actually short particular bond sectors and in some accounts weve used individual bond laddering to control the metrics of what we own and to know, from the date of purchase, what we will earn on a particular bond either to its call date or to its maturity. But the bulk of work we have done has been to manage overall duration of the portfolio. Duration is in essence a mathematical weighting of how long it will take an investor to receive all of a financial instruments future cash flows. So the shorter the duration the faster an investor will receive all those cash flows. The longer the duration the greater the period of time an investor needs to hold the asset in order to reap the entire yield benefit and thus be more exposed to interest rate and default risk. This becomes important in a rising rate environment because the longer an investor must wait to receive future cash flows, the less reinvestment opportunity they have for rates above what they are currently earning. If an investor receives those yields faster they then have more capital to reinvest in new, higher yielding bonds.

So longer duration, lower yielding bonds will need to decline in price and rise in yield in order to become competitive when compared to higher yielding, newly issued bonds. Thus the longer a portfolios duration, in a rising rate environment, the more volatility and price decline is felt. While there are inefficiencies in bond pricing, like any other market, the bond market is far more mathematically driven than the equity markets, which tend to be more emotionally driven. As stated, at Northstar we have been striving for the last year to not only allocate away from higher priced bond sectors but to also draw down overall portfolio duration. Currently our average portfolio has duration of between 2-4 years. Given the recent volatility much of the excess in bond prices has been washed out and pricing in some areas has become more attractive, though we do anticipate a further increase in yield and decrease in prices over the course of the next year or more. That said bonds remain an integral part of client portfolios and we feel that, through allocation, active fund management, the use of bond ladders and the use of short or negative duration portfolios, we can mitigate further potential price declines. On the equity front, after a post-Taper speech correction of about 7 %, the S+P 500 has rebounded back towards it 52 week high. In the 1650 range the S+P is currently selling at roughly 15 times expected 2013 earnings per share. This, in our opinion, is fairly if not fully valued and will require an increase in second half 2013 earnings, leading into first half 2014 earnings growth, for index price expansion. Earnings growth is still a possibility, but headwinds persist, the biggest of which are the continued effects of the Sequestration cuts that occurred at the beginning of the year. We have an ongoing trend of declining top line revenues and bottom line earnings growth as the continued recession in developed Europe, slight slowing in China (and credit tightening in that country) and the decline in Emerging Market growth have added to the drag brought on by mandatory cuts from Sequester. As we head through this earnings season and get the outlook of corporate CEOs we will begin to be able to see if this trend is going to persist for some time. Our feeling is that slow US GDP growth, in the 2 to 2.5 % range will be with us through 2014. While that sounds good it is still stall speed and any unaccounted for risk that arises could push the US back into Recession while we keep working our way toward more normalized growth rates and unemployment under 6 %. In other words we have yet to achieve enough organic momentum to flywheel the economy forward on its own, and thus the Fed continues its $85 billion dollar a month asset buying strategy. Risk awareness and mitigation remains our strategy. While fixed income retains risk due to a potential rising rate environment and strategic changes in Fed policy, we feel comfortable with the strategies we put in place for bond allocation, duration management and the use of bond ladders. We do not feel there is a need to abandon the assets class in a baby with the bathwater exit. There is still yield to be made and opportunities to be found in bonds. In equities we will continue to keep positions moderate relative to risk tolerance, time frame and return requirements on a client by client basis. We are not convinced that we are in a period of risk on with relative security that economic growth will follow through as needed to provide that future earnings increase necessary to make the stock market bid up. We do feel better about the long term prospects for growth out into the 2015 and on range but in the near term, while growth could very well continue, the ride could be bumpy as numerous risks to that expansion could rise up and its ability to combat those risks is weak. As such we recommend that recent equity market returns be taken with a grain of salt. Long term stock returns, at their most fundamental level, are based upon an expectation that corporations will continue to increase their earnings, maintain tight fiscal controls and create expanding earnings per share for stock holders. It is that potential growth of various companies that we, as investors, are paying to participate in.

The more participation due to actual follow through of that mandate, the higher the prices go. But revenue and earnings growth will take more than the Fed, the European Central Bank, the Bank of Japan and the Chinese Central Bank pouring liquidity into their respective economies through every avenue they can. It will require greater amounts of consumption, and consumption goes hand in hand with global growth. Growth, that as of yet, is not happening without Central Bank assistance that cannot go on forever without great risk. As such, we continue to beat the drum of individual financial planning and prudent asset management. Successful achievement of ones financial goals does not come all at once. Instead it is achieved through the long term systematic process of identifying goals and creating and maintaining your personal savings and investment plan. It comes over time and never ends. To use a baseball analogy, financial planning is a lifelong endeavor that is best achieved through hitting many singles over and over, rather than trying to hit home runs. I raise this idea as fixed income has quickly become the asset non-grata in the last few weeks. While the bull market in bonds may have come to an end that in no way means that it is a worthless asset class. We do not have to go that far in the past to find that fixed income was the saving grace in diversified portfolios as stocks were declining due to the fiscal crisis. Each of these asset classes has a place in portfolios as each serves an individual purpose at various points in time. The same can be said for alternatives like commodities and for stocks in emerging markets, each of which has struggled in the last quarter. The strategy is to own each asset in relation to your own financial planning and to realize that capturing less of a downturn is more important than trying to capture all of an upside. Long term average performance with reasonable deviation is what we are seeking as your asset managers. That, in our opinion, increases the probability of meeting and sustaining your goals. For the second half of this year we will be keeping an eye on the rhetoric of corporate CEOs and their outlook for the rest of 2013 and into 2014 looking for signs that either they continue to feel recovery is happening or that we are sliding back into recession. We will be watching for further proof that the Fed is actually moving forward with their tapering strategy and much of that will be dependent upon where unemployment goes. We will be monitoring actual corporate earnings and expected earnings announcements to make sure that we are not moving into overbought territory in the stock markets. And finally we will be watching the budget negotiations that will begin to occur in the near future as appropriations will need to be agreed upon by the end of September for fiscal year 2014. This debate will most likely include an examination and review of the sequester cuts already in place. As we have said in past Commentaries, we are pleased with the fact that the economy is still showing signs of improvement but we are concerned about the depth of assistance the Fed is providing to support this improvement and that the recovery remains at risk without it. As well we are concerned by the growing size of the Feds balance sheet as it keeps its buying spree going, and we are disappointed that an exit strategy for the bond buying program as well as any plan to divest of the assets they currently hold has not been made clear. It is our contention that the Fed may very well retain those assets on their books for years to come, allowing it to naturally mature. As such, we do not feel that increasing overall portfolio risk is prudent until such a time that a clear path to long-term, sustainable growth is seen. This is not to mean that we are not participating in the positive performance it simply means we are hedging our bets that it continues without serious pause.

Should you have any questions or comments regarding this Commentary please feel free to email me or Julia Randall at steve@nstarfinco.com and julia@nstarfinco.com respectively or call us at (800)220-2161. Steve Steven B Girard President
The opinions expressed are those of Northstar Financial Companies, Inc. and are based on information believed to be from reliable sources. However, the informations accuracy and completeness cannot be guaranteed. Past performance is no guarantee of future results.
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