Q4 Client Letter

January  2016

2015 started out with great promise.  Analysts were universally upbeat about the market’s outlook expecting S&P 500 revenues to grow 2.6% and earnings to grow 8.1% over 2014.  2015 was also the third year of the presidential election cycle where historians can show that since 1940 the Dow had risen an average of 22.3% in the third year of a presidential term.  The U.S. economy was well into its fifth year of expansion and economists predicted continuing job growth.

Despite its promise, 2015 turned out to be a disappointment in terms of returns by nearly all accounts. We are reminded once again that asking a stock analyst if the market will go up is akin to asking a barber if you need a haircut.  The answer is often more predictable than accurate.

2015 global markets finished as what can best be described as weak.  We experienced our first correction in the U.S. equity market since 2011 and our first interest rate hike by the Federal Reserve since 2006. The S&P 500 was up 1.4%, U.S. small cap stocks were down -4.4%, and the Barclays U.S. Aggregate Bond Index was up 0.6% on the year.  Developed international equities mirrored the U.S. market down -0.8% while the  emerging markets had another disappointing year declining -14.9%.

Looking forward to 2016, many of the key themes and challenges of last year remain in place: the questionable trajectory of China’s growth, the strength of a rising U.S. Dollar, the seemingly bottomless  price of oil, and the pace of rising rates due to the tightening policy of the Federal Reserve.  Adding to the risks the market faces in the year ahead, geopolitical relations remain tense between Saudi Arabia and Iran, while North Korea would like the world to believe it possesses a hydrogen bomb, and uncertainty remains as to who will be the leader of the free world following the U.S. presidential election.

Meanwhile, analysts expect sturdy corporate fundamentals in 2016.  Analysts project 2016 S&P 500 revenue growth of 4.3% and earnings growth of 7.1%.  Housing, auto sales, and employment are relatively strong while energy, manufacturing, and industrial production are relatively weak.  Earnings season is just getting underway and market expectations have already been ratcheted down.  We will be watching to see if companies can beat the reduced expectations.  In light of continuing concerns about growth in China and the Federal Reserve tightening policy, this earnings season is shaping up to be more important than most.

All of these issues are weighing on the minds of investors and we have seen a meaningful uptick in volatility to start the new year.  Thus far, the new year has been considerably more volatile than 2015.

In times like these it is important to step back and take a longer term strategic perspective.  The recent uptick in volatility may be disturbing but from a historical perspective it is probably more of a return to normal.  The current level of the stock market volatility the last few weeks is more in keeping with the historical norm.  Over the last two years the market has been lulled into sensing less risk.  Going forward, we would expect episodes of volatility to be more frequent and pronounced, or, in other words, more common than in recent history.

We have two core strategies to cope with volatile markets: Immunize and Equitize (I&E), and where appropriate, diversification into private, nontraditional investments. The I&E strategy builds on our financial planning capabilities to estimate near-term cash flow needs and immunize (protect from market risk) a portion of the portfolio against market volatility.  In other words, an investor would raise cash for known expenditures when the market is up.  Cash flow needs are then protected from the volatility in the market.   Research suggests this strategy can dramatically protect the value of a portfolio in turbulent times.

The nontraditional investment strategy builds on our long-term belief in the return potential and diversifying power achieved by the inclusion of private real estate, private debt, private equity, and absolute return strategies.  Private investments, by their very nature, tend to be less efficiently priced than traditional marketable securities.  These investments often involve limited liquidity so they are not appropriate for everyone.  For suitable investors, however, these investments offer the potential for non-correlated sources of investment return. A well-diversified portfolio of nontraditional investment strategies can help to dampen volatility, provide income, and has the potential to achieve superior risk adjusted returns over a complete market cycle.

Markets have always been and will continue to be volatile and unpredictable.  In light of this uncertainty, our focus will remain on the long-term strategic thinking that has served our client families well over the years.  This involves carefully planning for cash flow requirements, maintaining a globally diversified portfolio of investments, being vigilant about taxes, periodically rebalancing out of assets that have become more expensive in favor of assets that have become relatively cheap, and where appropriate, pursuing more favorable opportunities in the more independent and less efficient private markets.

As always, we welcome your thoughts, and appreciate the confidence you have placed in our firm.  We remain grateful for the opportunity to work with you and your family.

Nicholas Hoffman & Co.