2015 First Quarter

Kreitler Financial:

Blizzards, Central Banks, and Other Forces Beyond our Control

This installment of our newsletter was written in the middle of the 'blizzard' of January 2015. Forecasters gave the blizzard a "100-percent chance" of hitting the Connecticut area with dangerous force. Newscasters piled on, naming the storm despite a request not to from the National Weather Service. Bloomberg TV even joked that Sally's Pizza would be the epicenter of the storm. Storm predictions ranging from 20" to 30" and higher shut down the roads and caused officials to make grave pronouncements about the 'historic' storm. People across the region cancelled meetings and rearranged their schedules. We dutifully worked from home. The storm fizzled, a non-event.

This storm was another reminder that assuming a prediction has 100% certainty can lead to poor decision making.

Economic commentators, market participants, and even the central bankers of the world today have adopted concepts as "truths" with 100% certainty. This newsletter will discuss some of these and our concerns on other possible outcomes. Six years into a major bull market, we believe stocks carry more risk than they did in the recent past. We will address some of the major themes of 2014 such as the fall in oil prices and the rise in the dollar, continued geopolitical uncertainty, the significant divergences between global economies, and the massive distortions that global monetary policy continues to cause. Finally, we'll discuss what investors should do to adapt to these economic and financial forces that are out of their control and for which the outcomes are not certain.

Update on Kreitler Financial

Kreitler Financial continues to grow and improve. A couple years ago, we embarked on an ambitious but deliberate path for our wealth management practice to deliver even better service to our clients. This involved significant investments in our people, our technology, and our facilities. The change of the calendar to 2015 gives us a moment to reflect on some of the improvements we made last year.

We culminated an effort to elevate every one of our team's job responsibilities. In addition to advancing skills and shifting functions between positions, this included new titles to reflect the growing responsibilities of our team members.

  • Kim DiRaffaele became our Chief Operating Officer. In her new role, Kim has taken over most of the firm's day to day management responsibilities from Charlie and Bob.
  • Kersti Melchiore and Jake Ness are now Relationship Managers, better reflecting the critical roles they play in every client's experience with us.
  • Amy Alfano is the Office Concierge, which more accurately captures the many facets of her responsibility in keeping the firm running smoothly.
  • Charlie has assumed the title of President as he picks up overall firm management responsibility. This is an incremental step in our leadership continuity strategy.
  • Bob remains the Founding Partner of the firm. His role is working with clients, worrying about investment strategies in this fast changing world, and participating in the firm's management. He has also expanded his work in outside activities in charitable work and supporting education reform in New Haven.

We are expanding our team with additional talent. We're very pleased to announce that Bernadette Huang joined us as our newest associate. Bernadette brings extensive experience in finance, including work as an equity portfolio manager for the Government of Singapore, and as an institutional equity sales person at HSBC and Citigroup. Bernadette will be an additional planning resource for all of our clients and will serve as a member of Kreitler Financial's Investment Committee. We encourage you to introduce yourself to Bernadette when you have the opportunity.

We opened our new offices at 265 Church Street on February 2. While we enjoyed our prior offices for 16 years, the change will allow us to continue to grow and invest in even better service for our clients. We think you'll be pleased with the result. We will be hosting an open house in late March, and we hope that you will be able to join us to celebrate our new home. Watch for a forthcoming announcement.

Our enhanced facilities, technology improvements, and investments in our people represent improvements in our practice for the purpose of improving our clients' personal experience and financial outcomes. We hope that you're enjoying the benefits of this.

Raymond James has recently recognized our commitment to improvement. They selected us as one of four practices that will be highlighted at its National Conference. They will be filming a video to show how we continue to evolve and to improve the quality of what we do for our clients. The video will be shown to 3,000 Raymond James advisers and associates. We find this very humbling, but we are also very proud of the achievements of our entire team over the past several years. We hope to have a version that we can share toward the middle of the year.

Update on the World and Markets

In our January 2014 newsletter, we argued that growth could continue to accelerate, and that stocks could continue to do well in that environment. Global stocks had a positive year in 2014, up 4.2% as measured by the MSCI All Country World Index. Dire media predictions for bonds did not materialize and bonds generally made respectable returns with municipal being the standout. Real estate was the biggest positive surprise.

This very general overview downplays striking variations in different economies. The consensus opinion is that US growth has returned. Recent GDP numbers of 3.0% are encouraging, although perhaps not sustainable. This recovery in the US has been a very long time coming, but it finally seems to be getting some traction. The primary risks to this view are from outside the US, because other parts of the globe aren't faring as well. European economic growth has been slowing or gone negative. China, although growing, continues to see the pace of its growth moderate. We are also observing huge variation in the performance of developing economies.

In this environment, US large company indices generally outperformed, with the Dow Jones Industrial Average up 10.0% and the S&P 500 up 13.7%. Small company stocks in the Russell 2000 returned less at 4.9%. Foreign stocks, whose returns had to overcome a strong and rising US dollar, generally saw losses. Diversified portfolios fared in the middle.

Global Diversification and Its Impact on Portfolios

2014 was a challenging year for investors who have diversified portfolios but focus on the performance of US large company stock markets such as the Dow Jones and the S&P 500. For US investors who view returns in dollars, the US blue chip market for a second year provided very good returns versus other investments; therefore, the returns of most diversified portfolio underperformed the returns of blue chip stocks.

After a year of strong US market performance, some investors question the benefits of diversifying their portfolios. The answer lies in the unpredictability of returns and uncertainty of the future. US market leadership could quickly reverse. Markets are priced based on known information, and since no one can know when those basic facts will change, market 'surprises' are by their nature unpredictable. Yet market surprises occur quite frequently—it is only the nature of the new information that is unknown until after the fact. While some market moving events can be positive, investors need to protect themselves from permanent loss of capital. We are very much concerned with major market moves coming from non-predicted events, or "black swans". Here we discuss four surprises that moved the markets in 2014.

Surprise #1—Rapidly declining oil prices

The energy revolution in the United States has been underway for a number of years. As we have discussed over the past several years, two technologies created a new supply of oil and natural gas in the United States. Three dimensional seismic imaging allowed us to find shale oil and gas with great precision. Horizontal hydraulic fracturing ("fracking") permitted us to extract it. This increase supply was bound to put downward pressure on energy prices. Oil in the US (WTI) fell almost 60% from its June 2014 peak. We have been anticipating this for some time, but the magnitude and speed of the change surprised even us.

Oil's price drop has big winners and losers. The losers include energy producers (including alternative energy) and anyone with significant stockpiles of oil. The winners are the US consumer and other energy consumers. The decline in gasoline prices alone is the equivalent of $150 billion in savings for American families. Our belief is that putting more discretionary income in the hands of the consumer will overwhelm the negative affect on capital spending and employment in the important but relatively small energy sector here in the country. Oil exporting nations, however, are not so fortunate, and countries such as Russia, Venezuela, and others are struggling. The combination of reduced oil revenue, falling exchange rates, and debts denominated in foreign currency may prove highly destabilizing. This is an area of geopolitical and economic concern.

On the balance, we believe that the fall in oil prices will be a net positive for the economy. Those who were too heavily invested in energy—including some very savvy investors— suffered significant losses, illustrating the need to diversify across multiple market sectors.

Surprise #2—A fast rising US dollar

The US dollar experienced a big uptick in 2014, with the US Dollar Index (DXY) rising 12.8% versus other major currencies. Two primary drivers were the change in the balance of trade and instability abroad.

As discussed above, oil was a major mover of the markets, including currencies. Oil has been a large component of the US negative trade deficit. As domestic energy sources replace imports, the trade deficit declines and the dollar rises. Additionally, manufacturing activity and growth were picking up in the United States. This similarly reduced imports, boosting the dollar.

The dollar's appeal as a safe haven also drove it higher last year. As Europe's economic rebound faltered, the relative strength of the US became even greater. Foreigners sought the safety of US Treasuries and other investments. The trend accelerated as investors feared further declines in their own currencies.

For US investors, the rising dollar hurt investments denominated in other currencies. Even foreign stock markets with gains had their returns diminished on converting to US dollars. US corporations are feeling the pinch as well—40% of the S&P 100's earnings come from overseas. We have tactically tilted our equity portfolios toward the US for the past year. In the coming months, we may take advantage of dollar strength to buy relatively cheaper foreign stocks. Eventually if other currencies regain ground, then foreign equities will have a tailwind.

Surprise #3—Treasury Bond Volatility

Our expectation for volatility in stock markets is high right now. We got a taste of volatility in September and again in December. The financial press hyped the equity market swings. Although unpleasant, they never reached a 10% decline, and they bounced back swiftly. Even larger declines in stocks should be viewed as completely normal.

Not well reported by the press, on October 15 Treasury bonds opened with a yield of 2.20% and then immediately saw yields plummet to 1.86%. This may sound small, but this was the largest movement in Treasury yields in over 25 years! Yields rose over the next 30 minutes to 2.13%. Wall Street firms are carrying about one-tenth the bond inventory they did prior to 2008, and this affects the liquidity of the markets. Adding to the huge market swing, it is our understanding that when the market started moving quickly, the traders disconnected their computers when they realized their models couldn't account for the massive price moves. The implication is clear—if conservative US government bond markets can move like this, so can all the others.

Surprise #4—Swiss Devaluation

Another major movement in global markets was the January 15 announcement by the Swiss National Bank to drop their peg to the Euro. Within minutes, the Swiss franc dropped 29% versus the Euro. Investors who had been betting on the stability and predictability of central bank policy were completely wiped out, and several foreign currency trading houses failed.

Thankfully, Switzerland's economic size is relatively modest, but the de-pegging from the Euro was a vote of no confidence for what was European Central Bank's upcoming massive program of quantitative easing (QE). In the US, the Federal Reserve has stopped expanding its QE program, and it stated that it intends to begin raising interest rates later this year. How much credence can investors put into central banks, and what is the implication for portfolios?

The world's markets are truly in uncharted waters. One of the great truths that investors take at face value is that prices are open and set by a free market of buyers and sellers. However, the scale of central bank intervention in the markets means US and European governments' bonds always have a buyer right now—the central bank—and the buyer doesn't care what price it pays. Money is fluid, and this has influenced other asset classes, too. While we hope that policy makers navigate these challenges, we are aware the history books chronical a list of past mistakes and missed opportunities.

Implications for Investors in 2015

If an investors odds of forecasting the markets are as bad (or, more likely, worse) than our odds of forecasting a blizzard, what are they to do?

Today we find ourselves more cautious in the near-term (3-6 months) although we remain optimistic longer term. US stocks have now had a strong run. Not since 2011 has there been a correction of 10%. Traditional metrics for valuing stocks such as price to earnings ratios have stocks at the more expensive end of their historical range. Combined with low dividend yields, our expectation for stock returns is more modest than during earlier parts of this 6-year bull market. We continue to expect stocks to outperform bonds over the long-term, however. US 10-year Treasuries yielded 1.68% as of January 30; therefore, their 10-year return before inflation will also be 1.68%. Investors should plan for potentially lower returns and consider the implications of this on their personal financial decisions such as retirement distribution rates, savings rates, etc.

What to do? Market returns are out of investors' control, so we emphasize taking action on the things we can control.

First, in an environment with low predictability and high volatility, investors may need to lengthen their time horizons. Long-term, we're optimists. Short-term, we believe that predicting the markets movements is not possible. We think those able to handle short term risk will be rewarded over the longer term.

Second, we strive to control the risk in our portfolios. This is done by using the appropriate allocation to growth (or risk) assets relative to our ability to withstand losses and stomach market swings. We continue to use a heavy level of diversification, investing globally and just in the US because we never know if our own country will end up looking like the MSCI Russia (down –44.9% in 2014) or MSCI India (up +23.9% in 2014). We look for asset classes with different sources of returns to reduce the risk of everything falling together. Importantly, effective risk control via diversification allows investors to maximize the amount of growth (risk) assets they own in order to seek higher returns over long time horizons.

Providing long term returns to meet clients' objectives is a key tenant for the way we manage client money. Diversification, which reduces exposure to US blue chip stocks, historically has reduced volatility and enhanced returns over long periods. We expect this strategy will continue to do so into the future. In short periods of time, individual markets will do unusually well or poorly versus diversified portfolios. For example, in 2014 the blue chip averages beat diversified portfolios, yet in

January of 2015, most of our client's portfolios beat the returns of the US blue chip markets. We believe that investors who can filter out the noise of these short time periods will get superior returns.

Third, we proactively manage taxes and expenses. At Kreitler Financial, our investment management process is designed to minimize unnecessary costs, thereby maximizing investor capital. A partial list of recent examples of how we do this for our clients include:

  • When managing assets, we control asset allocation at the portfolio level in order to minimize tax exposure at the account level. Trading in tax-deferred accounts, selling the highest basis lots, and putting different types of assets into different accounts based on their tax treatment can add significant value. Studies from Vanguard and Morningstar suggest this approach adds about 1% to long-term after-tax return for investors.
  • We are proactively addressing future taxes through the tactical use of exchange traded funds in cases where our favorite stock managers are carrying forward large unrealized capital gains. We will continue to monitor these unrealized tax liabilities.
  • We reviewed every client account in December for opportunities to save taxes by proactively selling positions rather than receive mutual fund capital gain distributions. We typically find that this creates real tax savings for our clients.
  • We are completing an exercise to convert our mutual fund shares to the least expensive share classes possible. In the case of managers like American Funds or Vanguard, this typically means obtaining high quality active management at a similar cost to some passive index funds.

These activities are complex, but we believe they pay significant benefits for our clients. This list is also not comprehensive. While no single one makes a large difference, the cumulative effect of many small positives is significant. Our processes are built to maximize the number of these and other opportunities we can capitalize on for clients.

We begin 2015 with optimism and excitement. We look forward to serving our clients and helping them navigate the challenges and opportunities to come.

With warm regards,

Robert P. Kreitler, CFP®
Registered Principal
Charles F. Kreitler, CFP®
Financial Advisor

This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of Robert P. Kreitler, CFP and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Diversification and asset allocation do not ensure a profit or protect against a loss. Investing involves risk and investors may incur a profit or loss regardless of strategy selected. Inclusion of any index is for illustrative purposes only. Individuals cannot invest directly in any index. Past performance does not guarantee future results.

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