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Q4 Update / 2016 Outlook

| December 10, 2015
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Q4 Commentary / 2016 Outlook – December 8, 2015

Hard to believe that yet another year has flown by. While certainly not lacking drama, 2015 brought investment results that were somewhat boring, yet very frustrating. “Boring” in the sense that, generally speaking, both bonds and stocks domestically sit not far from where they started. Not that either lacked volatility along the way – in fact far from it. Add some exposure to emerging markets and commodities – to which 2015 was not kind – and many investors experienced negative investment returns for the year.

These results are not surprising to us, having started the year with what we believed to be muted return expectations for most asset classes. Yet the environment remains “frustrating” for virtually the same reason it was “boring” – the fact that nothing much has changed. Earnings for stocks have not “grown into” their valuations. If anything, the opposite is true as corporate earnings have generally fallen during the course of the year. Interest rates remain near historical lows, and it still remains to be seen how the never-before-attempted monetary policies of the past several years (both here and now abroad) will ultimately play out.

As anyone who has listened to our ranting knows, we do not make short-term investment predictions. We view such predictions as dangerous to the extent that any investor believes that they or any other “expert” can ever accurately make them on a consistent basis…..trying is a recipe for disaster. So – instead of predictions – we present our readers with Round Hill Wealth Management’s “Major Themes for 2016”. Described herein is NOT what we predict to happen (which is impossible to know) in the coming year, but rather major themes that we believe will ultimately determine the direction of financial markets in 2016. Without delay, and in order of perceived importance…..

#1 – The Federal Reserve, Their Resolve and the Effect of Their Decisions on Asset Prices

One week from the writing of this letter, the Federal Reserve will announce whether or not they have decided to raise interest rates for the first time in a long while – it is now widely believed that they will in fact finally take the plunge. However, we believe that the Fed will raise rates less out of conviction and more because they find themselves facing a Washington and Wall Street crowd that increasingly wants them to do so. In the past 20+ years, it is far from outlandish to note that the Fed has been at least cognizant of the political landscape – including the Wall Street money that helps get the politicians elected. To be fair, the Fed may have reacted to an increasingly dysfunctional political landscape, realizing that they are the last line of defense for the health of the overall economy. In either case, current sentiment allows the Fed to raise rates with at least some “cover” from Wall Street, Washington and the general public.

We view the Federal Reserve and their decisions as the greatest potential determinant of investment returns for 2016 - mainly because we perceive the Fed to have been the main determinant of asset prices going back some 20+ years. At minimum, they most certainly contributed to the boom and eventual bust cycles in asset values over that time – particularly considering the role of leverage (debt) in the creation of asset “bubbles”. Has monetary policy since the financial crisis ultimately led to yet another “bubble” in asset prices? Only time will tell of course, but it remains the primary reason we believe protection to be paramount.

#2 – “It’s the Economy, Stupid.”

Stating that the economy and corporate earnings matter to asset prices is hardly a revelation, but here is what we will be watching most closely:

- The effects of rising interest rates, assuming they occur. In other words, can we maintain or grow the current economy in the face of a reversal in Fed policy? Or, has the unprecedented monetary policies of the past several years provided a “false sense” of economic growth in the U.S.?

- Does the dollar continue to strengthen against other world currencies, and what effect does that have on corporate profits – particularly for large, multi-national firms? The rate at which the Fed decides to tighten rates could have a lot to do with answering that question in 2016.

- The unemployment rate vs. the “real unemployment rate”. A declining unemployment rate as reported by the government would lend itself to greater disposable income and a growing economy as a result. However, if the jobs being created are less valuable than the ones lost – or, if the numbers truly do not represent the number of people actually looking for work – the opposite could be true under the radar.

- “Financial engineering”. Companies have been able to use the ultra-low interest rate environment to finance buying back their own stock by taking on additional debt. While this can certainly have an effect on earnings “growth”, it is not a true representation of the “health” or “growth” of a company or economy. It is worth watching the effects of potentially rising rates on such practices.

#3 – Geopolitical Unrest & “The War on Terror”

We hesitate to even discuss, as there are some things in life that are much more important than one’s investment returns for the year – and war is certainly one of them. That said, it would be irresponsible to not consider the ramifications. And it has become increasingly clear in the past several weeks and months that the risk of “terrorist attacks” around the globe is unfortunately increasing.

We need not look any further than 9/11 to understand the effects of a major terrorist attack in this country on economic activity and financial markets. Furthermore, the current environment lends itself to the risk of another prolonged military engagement, with the list of participants on both sides seemingly growing on a daily basis. Of course, a global resolution of sorts - or prevailing feeling of security in our country and abroad - could lend itself favorably to the overall economic sentiment and outlook. Either way, 2016 seems to be setting up as a year where geopolitical unrest will dominate headlines, and create some level of uncertainty for financial markets.

#4 – The Presidential Election: More of the Same - or a “Bold, New World”?

Acknowledging the taboo nature of the topic, there is no question that politics and the economy / financial markets are inter-twined – even more so during presidential election cycles. While we do not subscribe to the “election years are always good (or bad) for stocks” theories, we do believe in the “markets hate uncertainty” theory.

We remain unconvinced that it will play out in the end, but the 2016 election cycle has a different feel to it - based on the public’s apparent zest for an “outsider”, at least on one side of the aisle. If it does come down to a battle between two establishment politicians, the 2016 election will probably amount to the same old, same old in terms of its effect (or lack thereof) on financial markets. However, the introduction of an “outsider” as a viable candidate could bring additional uncertainty – and potential volatility – to a period already ripe with both.

To be sure, that is not at all to say that additional uncertainty or volatility added by a “non-establishment” candidate is either good or bad…..simply an observation (intentionally and with difficulty withholding very strong views on the subject). What is certain is that the election cycle will be a major theme for financial markets in the coming year.

So, What Does It All Mean?

We most certainly have our own opinions on the above topics – as well as many others – in terms of how we view the different asset classes heading into the new year. However, we differentiate ourselves from other wealth managers to the extent that we are not arrogant (or stupid) enough to believe that our opinions are fact. As such, we don’t make radical, short-term investment decisions for clients based on our opinions, or “gut feelings”. We DO however make investment decisions based upon perceived risk / reward – and it is imperative to understand the difference.

If you forced us to make a “prediction” for stocks and bonds in the coming year, we would say that the Fed has very little resolve in terms of consistently raising rates in the short-term, for a multitude of reasons. As a result, it would be less than shocking to us for both stocks and bonds to have favorable outcomes in 2016 - mainly in reaction to the “free money” party still rocking. Yet, as you know, we continue to suggest a reduction (not removal) of equities from an investor’s target equity allocation. We also recommend shortening duration and adding credit quality to one’s fixed income portfolio. The strategies would seemingly contradict our feeling that stocks may rise while interest rates fall in 2016 – so what gives?

Quite simply, the risks outweigh the potential reward. For one – as mentioned – we could certainly be wrong in our belief that the Fed will be slow to act. If that were the case, it would change our thinking dramatically. Much more important – in fact most important – is that valuations of both stocks and bonds remain historically stretched using any number of metrics. Numbers are real and not assumed – fact rather than opinion. Yes, numbers can be interpreted differently depending on who is doing the interpreting. We acknowledge this, and that is why we never make (nor recommend) “all-in” or “all-out” changes to portfolios based on opinion, numbers, or who won last year’s Super Bowl. Instead, we believe tactical changes to allocations - derived specifically from investor goals, needs and tolerance for risk – considering our perceptions of both risk and opportunity within the current landscape, remains the most prudent strategy.

Finally, it is important to reiterate the importance of one’s overall financial profile in making both short and long-term investment decisions. A 25 year old client - investing through his 401k for retirement in 40 years – should pay minimal (if any) attention to short-term changes in the overall investment landscape. He has plenty of time to ride-out even significant pullbacks in asset prices, and will be using such pullbacks to add at lower prices. But many of our clients are already retired, or getting ready to do so - and their assets will be relied upon for living expenses for years to come. Rather than accumulating assets, those investors are instead withdrawing from their assets for living expenses. The effect of a significant drop in their portfolio value during their retirement years (particularly early on) can have devastating effects on their ability to achieve long-term goals. Importantly, so too can failing to achieve sufficient long-term returns. There are countless studies demonstrating both.

It is for those clients (and their advisors) that the current environment proves most frustrating. It is not difficult, nor is it rocket science, to reduce volatility in a portfolio by reducing the percentage of stocks held in it. What makes this environment so challenging, however, is the minimal return potential (including yield) on most bonds. Gone are the days where we can collect 5-6% income on the “safer” portion of our portfolios, while mitigating the risks of a declining stockmarket. Worse yet, because of the interest rate environment, bond prices themselves involve abnormally high downside risk – especially for longer dated bonds. If all of that wasn’t enough, add that it is nearly impossible to earn even 1% interest on cash holdings....

As is always the case, one can argue whether or not stocks are generally under, over or fairly valued. What cannot be argued is that stocks carry greater risk (volatility) than bonds or cash. Interest received on bond or cash holdings also cannot be argued – they are clearly stated in the morning paper or on your bank statement at the end of the month. These statements are not “predictions”, nor do they serve as an “outlook” for the coming year. Quite simply, this IS the investment landscape heading into 2016.

As such, we continue to perceive current valuations to where risks most often outweigh potential reward across most asset classes. We still favor reduction of risk (volatility) at the expense of potential for greater, short-term return. As the saying goes, “short-term pain” may very well be needed for the eventual “long-term gain”. Our goal remains to minimize such “pain” – while staying mindful of each client's objectives - and wait for long-term opportunities to once again present themselves.

We want to wish you and your family the very best for the holidays – and for an abundance of joy, prosperity and health in 2016.

To all of our clients, we can never thank you enough for the trust and confidence you have placed in Round Hill Wealth Management.

Sincerely,

Douglas Brymer                                                 David Swanson

President & Wealth Advisor                                              Principal & Wealth Advisor

 

The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Statements of forecast are for informational purposes and are not guaranteed to occur. Trends discussed are not guaranteed to continue in the future.

All performance referenced is historical and is no guarantee of future results. Investments mentioned may not be suitable for all investors.

Equity investing involves risk, including loss of principal. No strategy - including tactical allocation - assures success or protects against loss.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Duration is a measure of the sensitivity of price (the value of principal) of a fixed income investment to a change in interest rates. It is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. The bigger the duration number, the greater the interest rate risk or reward for bond prices.

Securities offered through LPL Financial. Member FINRA/SIPC. Investment advice offered through HighPoint Advisor Group, LLC, a registered investment advisor. HighPoint Advisor Group, LLC and Round Hill Wealth Management are separate entities from LPL Financial.

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