Executive Summary

U.S. Rate Hike Update: Economic data consistently came in below expectations in the first quarter, and comments from the Fed have shifted markets’ expectations. It now looks like the first rate hike will be in the fall, possibly at the September meeting.

Eurozone QE Continues: European Central Bank (ECB) President Draghi announced quantitative easing for the Eurozone as they attempt to stimulate an economy that flirted with recession last year.

High Yield Bonds Rebound: Despite soft economic news in the first quarter, high yield bonds still outperformed, with credit spreads narrowing from 444 basis points at the beginning of the year to 426 basis points at the end of the quarter.


The first quarter of 2015 was characterized by a few macro trends that dominated the investing landscape including the Federal Reserve pushing off rate hikes, foreign central bank easing, U.S. dollar strength, and oil weakness. These all influenced asset flows and contributed to a choppy market environment. The Federal Reserve ended QE3 in October, and then spent the first three months of 2015 preparing the markets for a rate hike later this year. The U.S. economy went through a soft patch in the first quarter, not unlike the weather-related weakness in the first quarter of 2014 in which the economy declined at a 2.1% annualized pace. We don’t expect anything like that this time around but, nonetheless, data has been soft due to the ending of quantitative easing, the strong dollar, poor weather across much of the U.S., West Coast port strikes, and oil weakness. Growth should pick up for the balance of the year and we already see evidence of strong underlying trends. Coming into the year it looked like the Fed would hike rates at their June meeting. However, the soft first quarter economic data and comments from the Fed have shifted markets’ expectations and it now looks like the first rate hike will be in the fall, possibly at the September meeting.

Meanwhile, in Europe, European Central Bank President Draghi announced quantitative easing for the eurozone as they attempt to stimulate an economy that flirted with recession last year. Central banks across the globe from London to Tokyo remain in easing modes. The effects on currencies and equity markets have been dramatic. The euro fell 11.2% in the first quarter, the largest quarterly decline in the single currency since its inception in 1999. Even after the steep losses, the euro looks lower as negative interest rates across Europe prompt investors to sell euros and buy dollars, putting further pressure on the continent’s currency. At quarter end the euro stood at 1.0731 dollars/euro, down from 1.40 dollars/euro in the last year. Analysts expect it to continue weakening with many forecasting 0.85 dollars/euro in 2016. Increasing currency volatility remains a major source of macro risk in global markets today. While it remains to be seen if history will repeat itself, currency turmoil has often led to global equity declines due to the large leverage effect of currency trades.

Relative central bank policies have boosted international equities with foreign markets outperforming the U.S. The MSCI EAFE Index rose 5.0% while the S&P 500 gained a mere 0.95% on a total return basis. The EAFE outperformed the S&P 500 by the most since the first quarter of 1998. In local currencies, the foreign markets were up even more, with the MSCI EAFE Index up 10.9% in local currencies. The dollar strength and central bank easing had a profound positive impact on foreign markets.

In the U.S., as noted above, economic data consistently came in below expectations in the first quarter. As a result, investors put a premium on companies that could grow their businesses without the benefit of a strong economy. Stocks with high long-term earnings and sales growth outperformed. Sector leadership largely favored the consumer. Health Care, which continued its winning streak from 2014, and Consumer Discretionary were the strongest sectors. In addition, small cap and mid cap stocks outperformed large cap in part due to the strong dollar and higher valuations of larger cap stocks. In fixed income, high yield outperformed with credit spreads narrowing from 444 basis points at the beginning of the year to 426 basis points at quarter-end. High yield bonds rebounded nicely from their December energy crisis lows and are trading close to new highs on a total return basis. For the quarter, the Barclays High Yield Index gained 2.52% and the Barclays Aggregate Bond Index was 1.61% higher.

Q1 Portfolio Analysis & Performance

Top Contributors
iShares Russell 2000 Growth ETF
iShares S&P 500 Growth ETF

Top Detractors
iShares Russell Midcap Growth ETF

The U.S. Style Opportunity portfolio was gradually moved from large cap growth stocks to mid and small cap growth stocks as the quarter progressed. Despite some short-term hiccups for the U.S. economy recently, we continue to see the underlying metrics as positive in the longer run. The underlying trend technicals of the market are mildly bullish, and while valuations are high, they can be said to be only at the high end of a normal valuation range. Within U.S. equities, our relative strength based models have drifted towards mid and small cap growth stocks, and slowly we see even mid and small cap value stocks gaining ground. For the first time in quite a while, we have zero large cap stock exposure. That may well be a result of the strong dollar, which acts as a drag on large cap multinational earnings. Currently two thirds of the Style portfolio is dedicated to mid and small cap growth ETFs, with the remainder in mid and small cap blend ETFs. A stronger U.S. economy and a stronger dollar historically provide strength to small cap stocks, and this appears to again be the case. In aggregate, the Style portfolio has a very aggressive and bullish stance. The portfolio’s forward P/E ratio is 25.7 versus 16.8 for the S&P 500. In return for paying a premium versus the broader market, the portfolio does own stocks that have a 16% long-term growth rate versus 11.5% for the S&P 500. From a sector perspective, the Style portfolio overweights the Consumer Discretionary, Health Care, and Industrials sectors while underweighting Energy, Financials, and Consumer Staples. The portfolio has a relatively low percentage of debt-ridden companies. The portfolio’s style tilt towards growth drove performance during the quarter, as the iShares Russell 2000 Growth ETF (IWO) and the iShares S&P 500 Growth ETF (IVW) were both top contributors. The SPDR S&P 500 ETF (SPY) and the iShares Russell Mid-Cap Growth (IWP) were the top detractors.

Top Contributors
Health Care Select Sector SPDR
iShares NASDAQ Biotechnology ETF

Top Detractors
iShares U.S. Technology ETF
iShares U.S. Transportation ETF

The U.S. Sector Opportunity portfolio’s mission is to tactically rotate towards U.S. sector ETFs that display sustained relative strength. Over the past few quarters the Consumer Discretionary, Health Care, and Technology sectors have displayed that sustained relative strength, and the portfolio has been largely allocated there. The portfolio’s holdings and the standings in the relative strength matrix have been remarkably stable. A number of ETFs have been in the portfolio for many months now, including: Biotechnology (IBB), broad Health Care (XLV), Health Care Providers (IHF), the NASDAQ 100 (QQQ), Retail (XRT), and Aerospace and Defense (ITA). The broad economic environment, which is being driven by global central bank easing, has favored discretionary spending in particular, and the portfolio now allocates a sizeable 39% there. While owning the market’s stronger sectors is the portfolio’s guiding principle, there is an important flip side to that — avoid the weakest sectors. Over the past year that has been Energy, a sector we have completely avoided for the last two quarters. Energy’s severe underperformance seems to have ended for now, but we have no way of knowing if the worst is over. Despite massive declines in stock prices, Energy is the market’s most expensive sector, with a forward P/E of over 30. We will be waiting on the sidelines to see if Energy can find traction. As of now, it remains at the bottom of our rankings. In aggregate, the sector portfolio, like the broad market, is willing to pay up for growth; the portfolio’s forward P/E is 18.9 versus 16.8 for the S&P 500. However, in return for that premium, the portfolio has a long-term growth rate of 15.8% versus 11.5% for the S&P 500.

INTERNATIONAL OPPORTUNITY (Developed, Emerging & Frontier)
Top Contributors
iShares Japan ETF
S&P China SPDR

Top Detractors
iShares Turkey ETF

The International Opportunity portfolio’s stated mission is to allocate tactically between international country and region ETFs that display superior relative strength to the rest of the world. Central bank easing has been the big story so far in 2015, and the European Central Bank launched a massive quantitative easing during the quarter that really defined the investing environment for all others. Interest rates in continental Europe were quickly driven to negative levels. As a result the euro declined by a noteworthy 11% during the quarter, its largest quarterly decline on record. Effects on currency have become more and more pronounced over the last 12 to 18 months and, as a result, we made an effort to add a number of currency hedged ETFs to our relative strength matrix. Not surprisingly these ETFs were at or near the top of the matrix, and quickly Japan Hedged (DXJ), Germany Hedged (DBGR), and Europe Hedged (HEZU) were purchased as holdings. We now have hedged 18% of the International Opportunity portfolio to the dollar. We, along with many others, believe that the trend towards a stronger dollar is secular and long-term. Thus, we would expect that currency hedged ETFs will be a part of the portfolio for much of the next few years. Of course, we will strictly follow our relative strength matrix in deciding whether or not to include them as holdings. The performance of European equities was certainly the standout during the quarter, but Asian markets, particularly Japan, India and China were a close second, and they occupied much of the rest of the portfolio. Despite the strength in international markets, in aggregate the International Opportunity portfolio remains attractively valued, in our opinion. On a 12-month forward earnings basis, the portfolio’s P/E ratio is 14.9 versus a 14.2 P/E for its benchmark, the MSCI World ex USA Index. Both of these measures are substantially cheaper than U.S. markets. On a sector basis, the portfolio overweights Technology, Consumer Discretionary, and Industrials while underweighting Energy, Financials, and Health Care. Japan, Germany, and Taiwan are the largest country overweights, while the U.K., Switzerland, and Canada are the largest underweights.


Investors seem to have adopted a risk-on bias with small caps outperforming large caps, growth outperforming value, international equities outperforming the U.S., and high yield bonds outperforming investment grade credit. These characteristics suggest a positive tone for the markets as the second quarter begins. The question is how long will it last? There are risks to the market outlook from valuations and the currency moves, which we highlighted, have often preceded turmoil. But at this point the currency weakness has been cheered by investors.

There is certainly a lot of worry over earnings as estimates have plunged along with oil prices. The range of first quarter earnings estimates for the S&P 500 are from about -1.9% to as much as a -5% decline as a result of the strong dollar and severe winter weather. While over the long-term the economy, corporate earnings, and equity markets are highly correlated, there are instances where earnings forecasts become either too pessimistic or too optimistic and diverge from reality. We think we may be at one of those instances currently. We may be approaching a point where the estimates are too bearish and we have the potential for some upside surprises. The bar is currently set so low that it is easy to hurdle.

The U.S. economy is in a good position to rebound nicely in the second half. Employment growth is by far the best it has been in 15 years and there are some signs that meaningful wage growth, one of the factors that had been missing from this labor market recovery, may be on the horizon. With this in mind there is no reason for the Fed to keep rates at the lower bound. What does it mean if the Fed finally hikes rates later this year? For starters it will be the most telegraphed rate hike in the history of the Federal Reserve. So it should surprise nobody when it happens. A rate hike to begin normalization of policy should be tolerated by the economy and may actually have a positive impact. While some analysts believe that even a modest rate rise will disrupt markets, the Fed has made it clear that the trajectory of rate increases will be measured and gradual, a pace that should be well-anticipated by markets at this stage.

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The Dow Jones Industrial Average is a stock market index that shows how 30 large publicly owned companies based in the U.S. have traded during a standard trading session in the stock market.

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