First Quarter 2015 Investment Review

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1 First Quarter 2015 Investment Review The Financial Markets The continued drop in oil prices and jump in the U.S. dollar brought heightened volatility to stock prices and dampened the outlook for company earnings during the first quarter of For the quarter, the S&P 500 large cap index rose 1.0%. The S&P mid cap and small cap indices outpaced the large caps with quarterly returns of 5.3% and 4.0%, respectively. The Healthcare and Consumer Discretionary sectors provided the strongest returns for the quarter, while the weakest returns were in Utilities and Financials. International equities surged, yet currency weakness offset much of the gains for dollar-denominated investors. The MSCI All Country World ex-u.s. index had a quarterly return of 3.5%, while the MSCI Emerging Markets index rose 2.2%. After spiking early in January, precious metal prices fell following the cessation of quantitative easing in the U.S. For the quarter, gold was flat and silver rose modestly. The price of Brent Crude Oil continued its decline, falling from $55.27 at the end of 2014 to $53.69 at the end of the quarter. The strong U.S. dollar has pressured corporate profits. Since the end of 2012, the U.S. dollar index and the estimated S&P 500 Price Earnings ratio for the coming year have increased 23% and 25%, respectively. A corresponding slide in the Euro should provide a boost to exports and, hence, economic prospects for Europe. The yield on the 10-year Treasury note moved lower for the fifth consecutive quarter, decreasing to 1.92%, down 0.25% since year-end. The yield curve continued to flatten, led by a drop in long-term bond yields. Yields have turned negative on over $1.9 trillion of sovereign debt in Europe, just as the European Central Bank starts its quantitative easing program of purchasing government bonds. Foreign demand has pulled yields on U.S. Treasury debt lower and resulted in a stronger dollar. The Economy Real GDP increased 2.2% in the fourth quarter of 2014, compared to the 5.0% growth rate in the third quarter. The deceleration in real GDP growth primarily reflected an upturn in imports, a downturn in federal government spending, a deceleration in nonresidential fixed investment, and a larger decrease in private inventory investment. These were partially offset by accelerations in personal consumption expenditures and in state and local government spending. GDP growth is projected to slow further in the first quarter of 2015 due in large part to transitory factors, including the severe winter weather and port shutdowns. Corporate earnings have hit a soft spot. Consensus estimates are calling for 2015 first quarter S&P 500 operating EPS to fall 2.0% from a year earlier. The expected decline comes on the heels of a 5.2% decline in 4Q14. Additionally, earnings are estimated to fall an additional 0.5% in 2Q15, before rebounding in the second half of the year. The Arrington Building Bayberry Court Suite 400 FAX Richmond, Virginia

2 First Quarter 2015 Investment Review The Economy (continued) The U.S. Department of Labor reported that nonfarm payrolls increased 126,000 in March, the smallest gain since December The three-month average dropped to 197,000, below 200,000 for the first time in a year. The unemployment rate held steady at 5.5%. The participation rate has dropped to the bottom of its recent range, falling to 62.7% from 62.8% as fewer people look for work. Among the unemployed, there was a record drop in the number of new entrants; either these people have found jobs quickly, and/or there aren t as many people returning to the labor market. The S&P/Case-Shiller National Home Price Index rose 0.6% in January, its eighth straight gain, reaching its highest level since March The report noted that home prices are rising roughly twice as fast as wages, putting pressure on potential home buyers and heightening the risk that any uptick in interest rates could be a major setback. Data is mixed on the manufacturing front. The ISM Manufacturing Index fell 1.4 points in March to 51.5, a fifth straight decline and its lowest level since May Conversely, the Markit U.S. Manufacturing PMI rose 0.6 points to 55.7 in March, its highest level in five months, indicating an improvement in manufacturing conditions. The ISM Non- Manufacturing Index slipped 0.4 points to 56.5 in March, slightly below consensus estimate for an unchanged reading at Auto sales are booming. Total vehicle sales reached a seasonally adjusted annual rate of 17 million in March ahead of analysts expectations of 16.9 million. Several automakers posted record sales and European luxury brands largely outperformed expectations. Future Prospects and Portfolio Strategy Interest Rates: We anticipate that the Federal Reserve will begin to raise short term interest rates in the second half of At this stage of the economic cycle, bond yields would be expected to move higher across the curve, yet distortions from quantitative easing in Europe and Japan may inhibit a rise in U.S. bond yields. Macro-Economic: The U.S. economy has decelerated in recent months, similar to last year s first quarter. We are closely monitoring near-term economic reports for evidence of a return to the more moderate % growth currently expected. Improving conditions in Europe may help boost global economic growth in the second half of the year. Sentiment: The Investors Intelligence survey of Bulls and Bears shows a historically high number of Bulls within the ranks of investment newsletter authors. The percentage of Bears is also near historical lows. This combination usually precedes a correction but can last for long periods of time. The sentiment levels are flashing caution at current levels. Valuation: Depending on which measure of valuation one uses, domestic equity markets continue to be fully valued. The Cyclically Adjusted Price Earnings ratio, popularized by Yale professor Robert Shiller, suggests that U.S. stocks are overvalued at a current level of nearly 27X. The current Price Earnings ratio for the S&P 500 of just over 18X suggests modest returns are still possible for U.S. equities. Alternately, several international markets represent solid valuation discounts to the U.S. market, and potentially offer incremental opportunities to investors. As the global economy struggles to improve, central bankers are beginning to follow divergent courses to help their home economies. Thus, sound diversification across asset classes should enable portfolios to weather the inevitable bouts of volatility.

3 (As many of Lowe, Brockenbrough and Company s clients are current participants in employer-sponsored retirement plans, we will periodically address some of the relevant issues impacting their retirement savings. This article represents a follow-up to the piece we wrote for our 2nd Quarter 2013 Newsletter, and specifically focuses on issues associated with the transition from employer-sponsored retirement plans to IRA rollovers.) Summary of White House Council of Economic Advisors Report In February 2015, the White House Council of Economic Advisors issued a report titled, The Effects of Conflicted Investment Advice on Retirement Savings. The report addressed the issues facing many individual investors today, with regard to the possible conflicted investment advice provided by their current investment professional. It sought to spell out the differences between Registered Investment Advisors (RIAs) and Broker Dealers (brokers). Lastly, the report shed light on the inconsistencies among advisors with respect to legal standards and compensation methods, and how those issues could negatively impact an individual s IRA savings account. Below is a summary of the current retirement savings landscape, along with a brief description of the issues facing IRA investors outlined in the Council of Economic Advisors report. The Shift to Defined Contribution Plans Today s Retirement Savings Landscape As we explored in our 2nd Quarter 2013 Newsletter (The Changing Employer-Sponsored Retirement Plan Landscape), there continues to be a shift from defined benefit (DB) pension plans to defined contribution (DC) plans. Over the past 30 years, defined contribution plans have shifted from a supplement to traditional pension plans to the primary or only retirement plan structure offered by many employers. As the chart below illustrates, the change has been dramatic.

4 Today s Retirement Savings Landscape Responsibility Shift While the transition from traditional DB plans has provided the intended reduction in long-term financial liability to the employer, it has materially increased the retirement savings burden and investment responsibility on individual employees. These greater responsibilities have created challenges for many individuals, who may lack the financial expertise to make such complex decisions. Growth of the IRA With the increase of defined contribution plans over the past 20 years, the number of rollovers to Individual Retirement Accounts (IRAs) has grown commensurately. When a defined contribution plan participant retires or terminates employment, there are two options on how to handle his/her DC plan account balance. The individual can leave the accumulated assets in the employer-sponsored retirement plan (as long as the balance is over $5,000), or he/she can choose to rollover the DC account balance to an IRA. According to the White House Council of Economic Advisors*, rollovers from DC plans to IRAs exceeded $300 billion in 2012 and are expected to increase steadily over the coming years. With the reduction in the number of individuals covered by traditional DB plans that provide guaranteed payments for life, many are searching for income-oriented rollover investment options not offered in their former employers DC plans. Other individuals are choosing to rollover their DC account balances into IRAs in search of better investment options or simply for account consolidation and convenience.

5 Today s Retirement Savings Landscape Rollover Complexities and the Increasing Role of Advisors The increase in rollovers from DC plans to IRAs has led to significant growth in the number of trading platforms and investment options available to individual investors. With greater complexity and more investment options to choose from, many individuals are turning to investment advisors for guidance with the management of their IRA rollovers. While enlisting the services of an investment advisor can be extremely beneficial, the advice landscape can be confusing and create the potential for conflict. Understanding the advice platforms and the differences between Registered Investment Advisors (RIAs) and Broker Dealers (brokers) is important, both from a legal standard and a compensation standpoint. Advisor Description Legal Standard Registered Investment Advisors (RIAs) Broker Dealers (brokers) Receives compensation in exchange for giving investment advice. May also manage a portfolio for clients. Makes trades for a fee or commission. A broker makes trades for a client's account, while a dealer makes trades for his or her own account. Source: White House Council of Economic Advisors Report, February 2015 Sources of Investment Advice Fiduciary duty to client, including a duty of loyalty and a duty of care. Must serve the best interest of the client. Recommendations must be suitable for a client's investment profile taking into account factors such as age, income, net worth, and investment goals. Though the differences between an RIA and a broker may appear insignificant, the distinction in fiduciary responsibility is important. According to the SEC, an RIA is a fiduciary whose duty is to serve the best interest of its clients. The SEC definition of fiduciary standard also imposes on RIAs the duties of loyalty and care. The fiduciary standard was established with the Investment Advisors Act of 1940, and outlines, in clear terms, the requirement to put client interests above that of the RIA. While many of the functions of a broker are the same as an RIA, the SEC makes certain distinctions. Brokers are not held to a fiduciary standard, but instead are held to a suitability standard. The suitability standard tasks brokers with the responsibility of determining whether a recommendation is suitable for their client. The suitability standard does not require that brokers place the client s interest above their own. The Department of Labor (DOL) and the White House intend to increase transparency and reduce the confusion for individual investors by developing a more uniform standard for both RIAs and brokers, Requiring brokers to follow the higher fiduciary standard when making recommendations should improve the likelihood that any recommendations are made in the sole interest of the client. In addition to the legal standards associated with fiduciary responsibility, compensation and the potential conflicts related to compensation models are also important distinctions between the RIA and the broker. In general, an RIA is compensated based on a percentage of assets under management or in a fee for service arrangement. In contrast, most brokers are compensated by commissions that are generated through the sale of an investment offering. As is shown in the chart on the next page, there are a number of ways commissions can be paid. However, most are not particularly transparent to the individual investor.

6 Today s Retirement Savings Landscape Select Types of Payments Generating Conflicts of Interest Type of Payment Description of Advisor's Monetary Interest Potential Consequences Ongoing revenue-sharing arrangements, including 12b-1 fees Front-end sales load, back-end sales load Sales targets, payouts Variable commissions Mutual funds may make ongoing annual payments to advisors based on the advisors' clients' investments, often specified as a percentage of assets. Known by the SEC rule that created them, 12b-1 fees are one example of ongoing revenue-sharing payments. Mutual funds may charge investors a fee when an investor buys shares (a front-end load) or sells shares (a back-end load). Most or all of this charge is generally passed on to the advisors selling the product. Advisors may receive payouts when they achieve certain sales targets. The payout can vary by asset class and product. In some cases, proprietary products receive higher payouts. Advisors may receive compensation through commissions for selling individual stocks, insurance products, and other financial products. The amount of the commission can vary across products and asset classes. Creates a financial incentive to direct clients to funds with higher revenuesharing payments. Creates a financial incentive to steer investors into funds with higher loads and that pass on a larger portion of that load to advisors. Loads also encourage excessive trading as more trades increase load payments. Creates a financial incentive to recommend trading and selling specific products over others based on the schedule of payouts. Creates a financial incentive to recommend products that generate higher commissions and can encourage excessive trading. Source: White House Council of Economic Advisors Report, February 2015 The Department of Labor suggests that current rules and regulations with regard to investment advice may not be in the client s best interest since many brokers do not abide by the fiduciary standard. For instance, under the fiduciary standard, an RIA is strictly prohibited from purchasing an investment for a client if the RIA would only be earning a higher fee by doing so. Under the Broker Dealer suitability standard, as long as the investment offering is suitable for the client, earning a higher fee for recommending one investment product over another may not always be prohibited. This could present a conflict of interest for a broker receiving commissions. While RIAs and brokers perform many of the same services and roles for their clients, it is very important that clients understand the distinction with regard to legal standards and methods of compensation. Proposed Regulatory Changes On April 14th of this year, the Employee Benefit Security Administration (EBSA) and the DOL released a proposal to redefine ERISA s fiduciary standards. According to the DOL, the proposal seeks to update retirement protections and lessen conflicts of interest. The proposal states that since 2011, both the DOL and White House have engaged extensively with industry experts, advocates and academics to determine the best way to craft a rule that adequately protects consumers while minimizing compliance burdens. The goal of the new proposal is to remove conflicts of interest and clearly define the legal standard for giving individuals investment advice. The intended outcome would be a more transparent investment environment, with investment recommendations offered in the best interest of the client.

7 Lowe, Brockenbrough & Company s Position Today s Retirement Savings Landscape Since our firm was founded in 1970, we have operated on the premise of full transparency and positioning our clients interests first. As an independent, employee-owned RIA, we are held to the highest standard as a fiduciary and are in a position to provide our clients with conflict-free advice. These core principles allow us to provide our clients with sound advice in every decision and recommendation. In our role as advisor and fiduciary, as we continue to broaden our involvement with both individuals facing retirement and plan sponsors, we will work to keep our clients abreast of the constantly evolving regulatory landscape, and how any changes may impact their retirement savings.

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