Market Update - January 14, 2016

It has been an unusually weak start to 2016, challenging analyst and investor views of where we are headed in terms of the economy, earnings, and the markets.

Here are the reasons why everyone is increasingly nervous about the investing environment:

• Third quarter GDP missed expectations at 2% growth and forecasts for fourth quarter GDP are now under 1%.
• Third quarter S&P 500 operating earnings were the fourth consecutive quarter of falling earnings and there are concerns that the fourth quarter forecasts will not be achieved.
• Base case expectations for 2.5% GDP growth in 2016 and for 17% growth in earnings are coming under increasing scrutiny; earnings and economic reporting season over the next few weeks will likely be volatile as expectations may be reset for the year.
• The turmoil in the energy industry has not ended and bullish expectations for an economic boost from lower energy prices have not materialized. Equity markets seem to be trading in lockstep with crude oil, so many are beginning to think that if there is another step down in crude oil prices that equity markets might be affected.
• China's economy and markets have been viewed as a bellwether for the global economy, and they are faltering; there are both economic and technical concerns based on this ongoing situation.
• Terrorism is on the rise globally, and there are concerns that these events could start to reduce confidence in the global economy and the markets.
• The Federal Reserve has started a tightening cycle to normalize interest rates at a time when many feel that such a change in policy is not warranted by our economic situation.
• High frequency trading is causing sharp volatility in securities, which makes it difficult if not impossible to understand price action relative to fundamentals.
• Net net, equity markets have been range bound for nearly two years in a wide 300 point range for the S&P 500.

It is important to note, however, that there are typically a broad range of economic, earnings, and market forecasts, so many, in retrospect, turn out to have missed the mark. Today in the news makes this point; Goldman Sachs says that the recent drop in the market was an "emotional response" and that fair value of the markets is 11% higher while RBC has made a historic call to exit the markets based on their forecast of a "cataclysmic year". Clearly, both of these forecasts cannot be right at the same time. This is exactly why we have developed our disciplined trading methodology that is based on tactical asset allocation and relative strength technology. We manage our portfolios based on what is actually happening in the market, not based on forecasts that may or may not be realized.

At the index level, the S&P 500 has been trading in a wide range since April 2014, from the 1820 area to the downside to the 2130 area to the upside. We suspect this pattern will hold in this current period of volatility, which would suggest that there may be a risk/reward ratio of about -4% downside risk relative to a +12% upside opportunity. Based on our models, we have raised approximately 50% cash in most portfolio components to reflect risk; however, should the market turn, as it did back in October, we will reinvest based on our view of the current risk/reward that we see in the markets.

It is also important to understand that we do not make individual investment decisions based on index-level performance. Even in the most challenging markets there are typically sectors and stocks that are exhibiting relative strength compared to their peers and are rising when the overall markets are falling. While we have recently raised cash, we have been studying the sectors and stocks that have had relatively strong performance and have had gains over the past 30-60 days, and will be making investment decisions about these sectors and stocks over the coming days. While we typically look for relative strength over longer periods of time, in these volatile markets we will be shortening our review periods in order to try to capture the emerging market leadership.

There are alternative strategies for managing your own personal assessment of risk and reward in the markets. We offer a number of portfolio components that have experienced very low volatility and have offered reasonable returns. If you feel you would like to reduce your portfolio volatility, you should contact us to discuss the alternatives.

Periods of extreme bearishness and fear about the markets often mark the bottoms of market cycles - it is always darkest before the dawn. This is the essence of using a disciplined investment process - a structured process takes the emotion out of investing and ensures that risk is managed appropriately and participation is forthcoming when markets recover.

Given the increasingly negative view of fourth quarter fundamentals, it is entirely possible that the equity markets have already priced in that outcome. It is also possible that we will see more volatility as the economic and earnings reporting season unfolds. Either way, we will continue to follow our process. While we have no idea where we are headed over the short-term, it would be typical to see a market bottom over the next month or so that could set us up for a multi-month rally into the Spring.

^{**Past performance is no guarantee of future returns. Performance does reflect the reinvestment of dividends and other account earnings. Performance returns are net of advisory fees and brokerage expenses associated with management of a client's account. The investment returns and principal value of strategies recommended by our firm will fluctuate and may be worth more or less than their original cost when sold. A client may experience a loss when implementing an investment strategy.}