Market Review and Outlook Cedar Hill Associates, LLC January 2016 www.cedhill.com 6111 North River Road, Suite 1100, Rosemont, Illinois 60018 Phone: 312/445-2900 An affiliate of MB Financial Bank
Table of Contents Tab I: 2015 Investment Highlights Tab II: Investment Strategy Review Tab III: Other Charts 2
Tab I 2015 Investment Highlights 3
2015 Major Investment Themes Equity Market Volatility Re-Emerged: Investors stomached a white-knuckle ride through most of 2015. While the S&P 500 posted its fourth consecutive year of positive results, the paltry 1.4% return was entirely due to dividends. International equity markets disappointed with the developed international markets down (MSCI EAFE Index) 0.8% and emerging markets (MSCI Emerging Market Index) down 14.9%. Fixed Income Confounds Experts: Despite nearly non-stop discussions about the timing and magnitude of the Federal Reserve s first rate hike since 2006, rates only increased once, by 0.25%, in December. Interest rates finished nearly where they started, with the 10-Year Treasury moving from 2.2% to 2.3% by yearend. As a result, the Barclays Intermediate Taxable Bond Index was only up 1.2%. for the period 12/31/14-12/31/15 Source: Bloomberg Global Monetary Policies Diverge: While the Federal Reserve raised rates, Europe and Japan continued their easing efforts. The dollar climbed about 9% against a broad basket of major currencies as investors sought higher yielding dollar investments. Continued Economic Growth: The economy continued its sustained path of expansion, albeit at a slower than desired 2% - 2.5% GDP growth rate. Energy Prices Continued to Fall: Even though companies cut back on oil and natural gas drilling, better productivity resulted in a widening gap between supply and demand. 4
2015 Outlook Scorecard 2015 Outlook Outcome What It Meant for CHA Clients Equities: Economic conditions, monetary policy and valuation all continue to be favorable for further equity market increases in 2015. equity markets should continue their climb higher, but at a much more modest pace and in line with corporate earnings growth. International Equities: Quantitative easing measures announced by the European Central Bank should push markets higher in 2015. While emerging markets remain out of favor, valuation levels are attractive. Equity Income: Despite fears that higher interest rates will cause a sell-off in high dividend paying stocks, Equity Income securities remain attractive and pay a hefty premium above traditional fixed income. Partially Correct Incorrect Incorrect Equity results were modest and in line with stagnant corporate earnings growth. Earnings disappointed primarily due to profit erosion in the energy sector and a significant drag from the strengthening dollar. Developed international markets were relatively flat, but emerging markets suffered alongside declining commodity prices. Income-oriented securities declined in 2015 because of falling oil prices, but only limited dividend cuts means the strategy continues to pay a hefty premium above traditional fixed income. Fixed Income: Rates are unlikely to surge from year-end levels, but limited benefit can be achieved by pursuing additional risk. High quality, intermediate to long-term municipal bonds offer the most compelling risk/return. Correct Interest rates were range-bound in 2015, with most fixed income indices posting flat to slightly positive results. 5
Tab II Investment Strategy Review 6
Equity Markets 2015 Recap While the S&P 500 posted a modest 1.4% return in 2015, there was significant price volatility throughout the year, including a 6.4% decline in the third quarter and a 6.8% rally in the fourth quarter. Source: Bloomberg Industry Sector 2015 Total Return Utilities -4.8% Health Care 6.9% Information Technology 5.9% Financials -1.5% Consumer Staples 6.6% Consumer Discretionary 10.1% Industrials -2.5% Materials -8.4% Telecom Services 3.4% Energy -21.1% Source: S&P Dow Jones Indices, LLC With a dividend yield of just above 2%, the S&P 500 s total return was slightly less than its dividend. As is typical late in a market cycle, growth outperformed value as investors were willing to pay more for growing revenues and profits. This led to a narrow market rally: Facebook (+34%), Amazon (+118%), Netflix (+134%), and Google (+45%). After a strong start to the year, small cap stocks, as measured by the Russell 2000, finished the year down 4.4% because of fears of slower economic growth. The S&P 500 ended 2015 at a P/E of 17.3x, which is slightly higher than the historical average forward PE of 16.4x. The slight valuation premium appears warranted in a low interest rate environment. 7
Corporate Earnings Domestic corporate earnings growth was relatively stagnant in 2015, primarily because of profit erosion in the energy sector (-59%) and a significant drag from the strengthening dollar. Absent a global or domestic recession (both of which we view as unlikely), corporate earnings in 2016 should return to the long-term trend of mid to high singledigit growth. 2015 Forecast 2016 Forecast 8
Investor Sentiment: Cautious With the bull market approaching its seven-year anniversary, investor sentiment has become increasingly cautious. For the period 1/1/90-12/31/15 Source: Bloomberg The ISM Manufacturing Index is a closely observed leading economic indicator. While manufacturing activity is under pressure because of the decline in commodity-related activity and the strong dollar s negative impact on export demand, manufacturing now represents just 12% of the economy. More importantly, the services side of the economy (accounting for the majority of activity) remains healthy, as the ISM Non-Manufacturing Index is still depicting solid expansion. For the period 1/1/97-12/31/15 Source: Bloomberg Shaded areas of charts indicate recessions. 9
Equity Markets 2250 2000 1750 1500 1250 1000 750 500 250 0 S&P 500 Stock Price Index 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Shaded areas above indicate re ces s ions. 3/24/00 10/9/07 12/31/15 Forward P/E 26.5x 16.5x 17.3x Yield 1.2% 1.8% 2.1% Federal Funds Rate 6.0% 4.8% 0.5% 10 Year Treasury Yield 6.2% 4.6% 2.3% For the period 1/1/90 12/31/15 Sources: Federal Reserve Bank of St. Louis, Bloomberg 2016 Outlook We expect equity returns in 2016 to closely track the trajectory of corporate earnings growth and finish the year up modestly. We do not foresee an impending recession and/or rapidly rising interest rates, which have historically been the two most common factors that cause a bear market. An aging business cycle, tighter (though still accommodative) Fed monetary policy, variability in the commodity markets, and escalating geopolitical risks will likely keep volatility at elevated levels. That said, we still believe solid fundamentals are in place for the market to overcome these concerns as the year progresses. While acknowledging that we are now firmly in the second half of this economic cycle, the unusually slow recovery following such a deep recession means the duration of this expansion could continue to extend well beyond the typical recovery period (five years). That potential, together with a likely rebound in corporate profit growth, creates a strong opportunity for stocks to outperform other asset classes. Slightly elevated valuation levels are not overly concerning given the low rate environment. P/E multiples have shown no ability to forecast short-term pullbacks, but instead more accurately forecast whether longer-term results will be above or below average. Technology and Health Care remain favored sectors, as much for their valuations as for their operational outlook. 10
International Equity Markets 2015 Recap Market Performance Index Name 2015 Results S&P 500 1.4% MSCI EAFE -0.8% MSCI Europe -2.8% Nikkei 225 (Japan) 11.0% MSCI Emerging Markets -14.9% MSCI BRIC -13.5% MSCI Emerging Asia -9.8% MSCI Latin America -31.0% Source: Bloomberg Concerns of slow economic growth, particularly in emerging markets, led to subpar results for international equities. European and Japanese equities earned decent gains in local currency: the MSCI Europe and Nikkei 225 gained 4.9% and 9.1%, respectively. Gains in European markets, however, were only realized if currency exposure was fully hedged as the dollar climbed about 9% against a broad basket of major currencies. Emerging markets continue to underperform because of concerns over a slowing global economy, declines in most commodity prices and very weak currencies. China took center stage as a strong equity rally during the first part of the year quickly dissipated during the summer because of growth concerns and a series of ineffective policy responses. Market Valuations Index Name P/E Ratio S&P 500 17.3x MSCI EAFE 15.5x MSCI Emerging Markets 12.5x Source: Bloomberg as of 12/31/15 2016 Outlook Developed international economies should continue to see a rebound in economic growth, but markets will likely be weighed down by its sub-par pace. Notwithstanding economic growth, currency and commodity challenges, strong balance sheets, better demographics and more attractive valuation levels make emerging markets attractive relative to other equity markets. 11
Equity Income Index Name 2015 Results Alerian MLP Index -32.6% FTSE mreit Index -8.9% S&P BDC Index -3.7% S&P 500 Index 1.4% Barclays Agg Bond Index 0.6% Source: Bloomberg for the period 1/1/07 12/31/15 Source: Bloomberg for the period 1/1/07 12/31/15 Source: Bloomberg 2015 Recap Equity Income underperformed our expectations primarily because of the decline in Master Limited Partnerships, which, despite growth of more than 10% in their distributions, saw their stock prices severely affected by falling oil prices. Although most MLP revenues being tied to the volume of oil and gas running through pipelines, when energy price moves are extreme, MLP prices may temporarily decline alongside them. During 2015, crude oil prices declined 30% and the Alerian MLP index declined 33%. Mortgage REITs posted a 9% loss, as their strong dividend yield was offset by rising interest rate fears. Business Development Companies (BDCs) declined alongside wider credit spreads for high yield bonds as fears of an economic recession heightened. 2016 Outlook Key benefits of the strategy remain: significant current income (8%+), additional appreciation potential as prices converge with the security s higher intrinsic value, and limited correlation to stocks and bonds. Notwithstanding fears that higher interest rates will cause a sell-off in high dividend paying stocks, Equity Income securities remain attractive and pay a hefty yield premium above traditional fixed income. Overweight MLPs, as the strategy appears to be set up to deliver strong returns in 2016. The timing and magnitude of this rebound will likely depend upon technical selling subsiding, oil price stabilization, and management teams reconfirming current distribution and growth potential. 12
Fixed Income Interest Rates Bond Index 12/31/2014 12/31/2015 1-Year Treasury 0.3% 0.7% 5-Year Treasury 1.7% 1.8% 10-Year Treasury 2.2% 2.3% 30-Year Treasury 2.8% 3.0% Barclays Int'l Taxable Bond Index 2.0% 2.3% Barclays 5-Year Muni Bond Index 1.4% 1.5% Barclays Corporate Index 2.1% 3.6% Merrill Lynch High Yield Master II 6.7% 8.8% Source: Bloomberg 2015 Returns Bond Index 2015 10-Year Treasury 0.90% Barclays Int'l Taxable Bond Index 1.21% Barclays 5-Year Muni Bond Index 2.43% Barclays Corporate Index -0.68% Merrill Lynch High Yield Master II -4.61% Source: Bloomberg, Zephyr, and JP Morgan 2015 Recap While much speculation surrounded the timing and magnitude of the Federal Reserve s first rate hike since 2006, only one 0.25% rate hike occurred in December. The 10-year Treasury finished the year yielding 2.17%, only 0.13% higher than the start of the year. Concerns about the pace of economic growth and the absence of inflation have many questioning how quickly the Fed will raise rates in 2016, particularly in light of the precipitous drop in energy prices. The Barclays Intermediate Taxable Bond index finished the year up just 1.2%, slightly less than its yield at the start of the year. Corporate bond credit spreads moved wider. The yield on high yield bonds widened from 5.8% to 8.8% over the past 18-months as investors demand additional yield for incremental credit risk. Municipal bonds enjoyed a strong rally, outperforming nearly all equity indices and taxable bonds. Better municipal finances, stronger demand and limited new supply all contributed to the rally. European sovereign bonds performed well as investors remain concerned about economic growth prospects. The German 10-year bond finished the year yielding a paltry 0.62%. 13
Fixed Income 2016 Outlook Source: Bloomberg Though we do not expect rates to be materially different at the end of the year, rates will move within a fairly wide range and the yield curve may flatten further as the Fed raises short-term rates. Given the low yields on foreign bonds, it is difficult to see how rates could rise significantly, though extending duration offers limited additional benefit. Corporate Bonds: Investment grade and high yield appear attractively priced, but oil prices will likely need to stabilize before spreads begin to tighten. Municipal Bonds: Limited new issuance (supply) provide positive backdrop for decent returns relative to government bonds. While the Fed is expected to raise rates throughout 2016, rate increases will be slow and a lower for longer scenario is likely. Additional labor market tightening will be a lead indicator of inflation and higher interest rates. 14
2016 Outlook Summary Equities: We expect equity returns in 2016 to track the trajectory of corporate earnings growth closely and finish the year up modestly, while volatility levels will remain elevated. Equities: While acknowledging that we are now firmly in the second half of this economic cycle, the unusually slow recovery following such a deep recession means the duration of this expansion could continue to extend well beyond the typical recovery period (five years). International Equities: Developed international economies should continue to see a rebound in economic growth, but stronger balance sheets, better demographics and lower valuation levels make emerging markets more attractive after sentiment improves. Equity Income: Despite fears that higher interest rates will cause a sell-off in high dividend paying stocks, Equity Income investments, and MLPs in particular, remain attractive and pay a hefty premium above traditional fixed income. Fixed Income: Though rates are unlikely to surge or drop significantly from today s levels, extending bond duration offers limited additional benefit. High quality, intermediate to longer-term municipal bonds offer the most compelling risk/return. At current yield, investment grade corporate bonds offer compelling value relative to treasury securities. 15
Tab III Other Charts 16
A Narrow Market Rally While the S&P 500 increased 1.2% in 2015, the average stock price fell 4.1%. Update Past performance is not necessarily indicative of future investment results. 17 for the period 9/30/11-12/31/15
Performance by Investment Style 2015 was a difficult environment for fundament value investing. Source: Evercore ISI for the period 1/1/15 12/31/15 Past performance is not necessarily indicative of future investment results. 18
Standard & Poor s Composite In August 2015, the S&P 500 suffered its first 10% correction since June 2012 and the largest correction since October 2011. for the period 3/6/09-12/31/15 Past performance is not necessarily indicative of future investment results. 19
10-Year Treasury Rates Interest rates continued their more than 30-year descent. for the period 12/31/41-12/31/15 Past performance is not necessarily indicative of future investment results. 20
Treasury Yields The 10-year Treasury finished the year yielding a paltry 2.27%. Past performance is not necessarily indicative of future investment results. 21 for the period 12/31/09-12/31/15
Yield Curve The yield curve shifted out in 2015. for the period 12/31/14-12/31/15 Past performance is not necessarily indicative of future investment results. 22
High Yield vs. 10-Year Treasury Rates High yield bond spreads to the 10-year Treasuries widened in 2015; lower quality credits were especially hard hit. This spread widening has made high yield more attractive. for the period 12/31/10-12/31/15 for the period 12/31/10-12/31/15 Past performance is not necessarily indicative of future investment results. 23
Oil As the price of West Texas Intermediate (WTI) has declined, so have the number of rigs drilling for oil. for the period 12/28/07-12/31/15 Past performance is not necessarily indicative of future investment results. 24
Dollar After a strong rally early in the year, the Dollar has range traded since March 2015. for the period 5/4/11 12/31/15 Past performance is not necessarily indicative of future investment results. 25
Asset Class Returns Asset class performance is cyclical. 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source REITs 35.06% Emerging Markets 32.95% Int'l Equities 26.33% Small Cap 18.37% Large Cap 15.79% Hedge Funds 12.89% Cash 4.85% Bonds 4.33% Commodities 2.07% Emerging Markets 39.37% Commodities 16.23% Int'l Equities 11.18% Hedge Funds 9.96% Bonds 6.97% Large Cap 5.49% Cash 5.00% Small Cap -1.57% REITs -15.69% Bonds 5.24% Cash 2.06% Hedge Funds -19.03% Small Cap -33.79% Commodities -35.65% Large Cap -37.00% REITs -37.73% Int'l Equities -43.39% Emerging Markets -53.33% Emerging Markets 78.50% Int'l Equities 31.78% REITs 27.99% Small Cap 27.17% Large Cap 26.46% Hedge Funds 19.98% Commodities 18.91% Bonds 5.93% Cash 0.21% REITs 27.96% Small Cap 26.86% Emerging Markets 18.86% Commodities 16.83% Large Cap 15.06% Hedge Funds 10.25% Int'l Equities 7.74% Bonds 6.54% Cash 0.13% REITs 8.29% Bonds 7.84% Large Cap 2.11% Cash 0.10% Small Cap -4.18% Hedge Funds -5.25% Int'l Equities -12.13% Commodities -13.32% Emerging Markets -18.42% Emerging Markets 18.23% REITs 18.06% Int'l Equities 17.32% Small Cap 16.35% Large Cap 16.00% Hedge Funds 6.36% Bonds 4.21% Cash 0.11% Commodities -1.06% Small Cap 38.82% Large Cap 32.39% Int'l Equities 22.80% Hedge Funds 7.9% REITs 2.47% Cash 0.07% Bonds -2.02% Emerging Markets -2.63% Commodities -9.52% REITs 30.14% Large Cap 13.69% Bonds 5.97% Small Cap 4.89% Hedge Funds 2.98% Cash 0.04% Emerging Markets -2.19% Int'l Equities -4.91% Commodities -17.01% REITs 3.20% Large Cap 1.38% Hedge Funds 0.80% Bonds 0.55% Cash 0.05% Int'l Equities -0.82% Small Cap -4.41% Emerging Markets -14.92% Commodities -24.66% for the period 1/1/06-12/31/15 Large Cap Small Cap S&P 500 Index Russell 2000 Index Int'l Equities MSCI EAFE Index Emerging Markets Hedge Funds REITs Commodities Bonds Cash MSCI Emerging Markets Index HFRI Fund Weighted Index FTSE Nareit Equity Index Dow Jones UBS Commodity Index Barclays Aggregate Index BofA ML 3-month Treasury Index Past performance is not necessarily indicative of future investment results. Source: Zephyr and MSCI Barra 26
Disclosures This Market Review may include forward-looking statements. All statements other than statements of historical fact are forwardlooking statements (including words such as believe, estimate, anticipate, may, will, should, and expect). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements. Any information provided by Cedar Hill regarding historical market performance is for illustrative and educational purposes only. Clients or prospective clients should not assume that their performance will equal or exceed historical market results and/or averages. The performance results for Cedar Hill Core Equity are provided by Cedar Hill. Composite results include fee paying accounts that have been managed by Cedar Hill for at least six months, have an investment objective of 90% or more of the assets invested in Core Equity, and have a minimum value of $200,000. The composite includes the history of active and terminated accounts. Cedar Hill does not believe the inclusion of accounts with 10% or less invested in non-core Equity strategies has a material impact on the results of the composite. Cedar Hill does not believe the inclusion of accounts below the $1 million stated minimum account size has a material impact on the results of the composite. The performance results for Cedar Hill Equity Income are provided by Cedar Hill. Composite results include fee paying accounts that have been managed by Cedar Hill for at least three months and have an investment objective of 90% or more of the assets invested in Equity Income. The composite includes the history of active and terminated accounts. Cedar Hill does not believe the inclusion of accounts with 10% or less invested in non-equity Income strategies has a material impact on the results of the composite. Cedar Hill does not believe the inclusion of accounts below the $1 million stated minimum account size has a material impact on the results of the composite. Performance results include reinvestment of dividends, interest, and capital gains. Results include the deduction of commissions and other expenses incurred in the management of the account. Investment performance results do not reflect the deduction of advisory fees, which would reduce client returns. For example, if a $1 million account is charged a 1% annual advisory fee and the stated gross performance is 10.0% annualized over a 10-year time period, the compounding effect of the deduction of advisory fees will result in net of fees performance of 8.9%. The dollar amount of the account would be $2,345,734.19 (net of fees) as opposed to $2,593,742.46 (gross of fees). Cedar Hill s advisory fees are described in Part 2A of Form ADV. 27
Disclosures (continued) Performance results for the S&P 500 Index are provided by Standard and Poor s, and include the reinvestment of dividends, interest and capital gains. Cedar Hill has made assumptions about the appropriateness of this benchmark for the Core Equity investment strategy. Performance results for the 50% S&P 500 Index/50% Barclays Aggregate: S&P 500 is an unmanaged benchmark; results are provided by Standard and Poor s and include the reinvestment of dividends, interest and capital gains. Barclays Aggregate is an unmanaged benchmark; results are provided by Barclays Capital and include the reinvestment of interest payments and capital gains. Cedar Hill has made assumptions about the appropriateness of this benchmark for the Equity Income investment strategy. Inclusion of index information is not intended to suggest that its performance is equivalent or similar to that of the historical investments whose returns are presented or that investment with our firm is an absolute alternative to investments in the index (if such investment were possible). Investors should be aware that the referenced benchmark funds may have a different composition, volatility, risk, investment philosophy, holding times, and/or other investment-related factors that may affect the benchmark funds ultimate performance results. Therefore, an investor s individual results may vary significantly from the benchmark s performance. The information presented herein is intended for reference purposes only. Past performance is not necessarily indicative of any specific investment or future investment results. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. This Market Review is intended to provide general information only and should not be construed as an offer of specifically tailored individualized advice. 28