Financial Partners Capital Management, LLC FPCM...Financial Partners Capital Management, LLC-8- FPCM...

Financial Partners Capital Management, LLC

FPCM

INVESTMENT UPDATE February 2014

We remain relatively positive on the economic outlook for 2014

Investors are facing a difficult investment environment as bond yields are still close to record low levels, and credit spreads have narrowed, thus negating the traditional “safety” choice of the bond markets.

Global liquidity conditions will remain extremely accommodative as central bankers focus on extinguishing “fires” and attempt to restart global GDP growth. Inflation is not on the radar screen for central bankers.

In spite of strong 2013 performance, equities offer value versus fixed income at current levels; however, risk has certainly increased at this valuation level and investors should keep some opportunistic cash on the sidelines.

We will not be surprised by an equity market correction in 2014, but at this point, we would regard a pullback as an opportunity to deploy cash.

We continue to believe there are good investment opportunities in commercial real estate, but at this stage, selectivity is critical.

Political and geo-political risks are high, and represent tail risks critical to consider in asset allocation.

Investors need to continue to be patient, proactive, creative and forward-looking in the current environment.


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No Pain No Gain?

I am sure many of us have noticed how the role of parents has changed over the past 30 or 40 years. Our generation of parents has taken their role of "guardians" well beyond that of the past, regarding as our duty not only to protect our children, but to "shelter" them from suffering, stress, struggle and a world that we perceive as more dangerous and challenging than the one we encountered growing up. We go out of our way to make our children feel safe and feel good. We give them trophies for participating instead of winning, we welcome, or at least do not complain about, grade inflation, we practice positive reinforcement and seldom criticize them, and we continuously aim to build up their self-image to a point that most likely will be difficult to sustain.

Trying to find an answer to the question of why this generation has a higher need for drugs, stimulants, psychiatric and psychological help, and a higher tendency for depression and suicidal thoughts, Abraham Twerski, a noted psychiatrist and Rabbi, suggested that one reason we crave outside help is the lack of practice with “struggle”. He points out that prior generations regarded “struggling” as a natural part of life, a default condition. Life was difficult, there was hunger, little protection against the weather, high child mortality, most people were touched by wars, and there was no "social safety net" to protect families against economic downturns and unemployment. From an early age, people had to deal with difficult and adversarial conditions, and as a result, they learned what was necessary to survive, to be successful, and to overcome the obstacles that life threw their way. Rabbi Twerski's point was that by sheltering our children too much we were robbing them of the necessary skills to overcome difficulties, so that when confronted as young adults with challenging situations they become easily frustrated and/or depressed, and conditioned by the past, to look for help not from within, but as usual, from the outside.

By no means, am I claiming that comfort and peace is the rule today; unfortunately, many people have very hard lives. My point is that the "perception" of what is "normal" has changed. Today, "struggle" is regarded as the exception; we expect and demand that life be "fun", "relaxed", or as the millennials like to say, "chilled".

Our governments have not been immune to this trend. Politicians and the public have pressured the government to intervene anytime there is "pain" or "suffering". We regard any discomfort, setback, or accident as unfair and unnecessary, hence avoidable. We want our leaders to eliminate or reduce our "pain" at any cost: lower risk, lower interest rates, avoid or at least shorten recessions, give us prosperity, give us health, regulate and re-regulate. We want relief, and we want it now.

The problem is that pain and struggle are part of life. Solutions sometimes can be delayed, but usually at a much higher cost in the long-term. Look no further than our current economic policy debate to see symptoms of this condition. We clearly recognize that today’s interest rates are artificially low, yet we would like the inevitable increase in rates to be delayed in order to avoid the “pain” that it will cause; we know that Medicare and Social Security will be bankrupt unless they are reformed, yet we want to delay potential solutions for a more “opportune” time; we want affordable health care but we don't want any type of rationing, and we want a peaceful world yet we don’t want to fight for peace. By no means is this a domestic problem. The EU gave plenty of proof by the way they have handled the European credit crisis, and more recently, China, an obviously non-democratic state, chose to save a single, small “shadow lender” rather than deal with the minor, short-term “painful” decision of letting it fail. We wish our problems would go away, and we could just "chill".

Back to the current economic and financial outlook, we are in the midst of a recovery, but a slow one, especially with regard to employment and income, relative to the depth of the recession and prior upturns. On the other hand, the recovery on the industrial side has been better than average and household net worth is close to the 2007 peak. Moreover, slow growth might be exactly what developed economies need. Slow


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growth will help keep inflation tame, keep pressure on consumers and the government to deleverage, increase savings, force firms to remain efficient and keep speculative tendencies in check.

However, four years into the recovery, there are still politicians and economists clamoring for more stimulus, lower rates, or lower rates for longer. The Keynesian stimulus mechanism is not difficult to understand. During recessions, households increase savings, repay debt and reduce consumption; businesses reduce investment and raise cash. This rational response to a downturn naturally results in even lower spending, investment and employment. At the margin, government spending (fiscal stimulus) aims to break this vicious cycle by breaking pessimistic expectations and creating incentives to spend, invest and re-leverage. Notice that the key word here is "re-leverage", but it is difficult to expect rapid re-leveraging when consumers are still de-leveraging, and when U.S. government debt is at a record $17 trillion or over 100% of GDP, without counting long-term, or not-so-long-term anymore, Social Security and Medicare liabilities. Ask yourselves as rational agents of the economy what you would do if news came out of a new $2 trillion fiscal stimulus package. Would you go out and spend, increase your debt load and risk, or would you protect your future and that of your children by saving more, and reducing risk?

According to most experts, lower rates for too long were at the center of the excesses that brought us to the great recession in 2008, yet was it really necessary to expand the Fed’s balance sheet four-fold to over $4 trillion in the process? What have we learned? We agree that significantly lower rates, stimulus and emergency measures were necessary to confront the unprecedented conditions of the financial crisis, but four years into the recovery, we believe the tone and direction of public and central bank policies needs revision.

A few other questions that concern us over the medium- and long-term

How are we going to deal with our Social Security and Medicare liabilities?

Can the Fed and other Central Banks shrink their balance sheets without having a major negative impact on the markets and the economy?

If we were to face a global recession over the next few years, what options would still be open to policy makers?

When (not if) we face a bout of inflation in the future, will Central Banks be able to react promptly and strongly?

An unfortunate consequence of the great recession has been more activist and populist governments. What will the long-term effects of the existing and future policies be on the economy, the markets and society?

At what point will all these “long-term” problems become “short-term”?


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The Markets and Our Investment Outlook in Graphs…

Fundamentals have improved over the past year…

The economic recovery continues…

... and housing is finally back on its feet…


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…which has helped household’s wealth to recover… …but the recovery has been uneven…

Credit risk has also receded…

… and credit is more readily available…


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The improvement in employment has been meaningful and the trend is positive, which should help income; however, the recovery has been weaker than prior upturns, and labor participation is at record lows…

On balance, economic fundamentals still support a positive outlook for equity markets


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Even though we remain positive in the short- and medium-term, we have a few concerns….

Concern 1: the economic recovery has been at the expense of ….

…a significant increase in government debt,… … a major expansion in the Fed’s balance sheet …

…. and artificially low interest rates…


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Concern 2: Interest rates will eventually have to move higher….current expectations are for a slow increase starting in 2015-16, but there is no precedent to both the current situation and the potential subsequent reaction of the financial markets…

… market expectations are still quite mute, for example, the market expects short term rates to be only 1-1.5% in 3 years, and 1.8-2% in 5 years


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Concern 3: there are no signs of inflation yet in spite of the Fed’s balance sheet expansion, as the velocity of money has collapsed; however, complacency among central banks and investors, and the huge amount of readily available bank reserves make for a potentially nasty surprise in the future ….

Inflation fundamental still benign… …but Fed was wrong about “output gap” in the 70s…

Source: BCA Research

… and inflation can quickly get out of control….


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Concern 4: China and emerging economies growth has slowed down. Further deceleration could have a significant impact on global growth and corporate profitability; on the positive side, we think China has plenty of policy options in the short and medium-term…

Total credit growth has been too fast for comfort… … Middle class growth continues to fuel consumption…


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Source: McKinsey

….Emerging markets and currencies have been very volatile lately…

EMs are highly dependent on commodities…

… and some currencies have been under pressure; however, as seen in the graph there are significant differences in relative performance, so differentiation is important…


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Concern 5: Equities seem only “fairly” valued, which leaves the market vulnerable to disappointments; however, valuation is not extreme and fundamentals continue to be supportive…

... stocks are currently capitalizing on little growth …10 & 20 years trailing annualized returns consistent with and multiple expansion historical average

Source: FPCM. Pink indicates equity returns below 10-year Treasury. Assumes 3% dividend yld, 40% retention rate; $115 S&P 2014 EPS

Stocks are still inexpensive vs. bonds … ….but gap has narrowed a bit since May…

P/E of Equities vs. “P/E” of Bonds Next 12m P/E vs. “High Yield Bonds “P/E”

Source:JP Morgan

…2-4% real rates and 2-3% inflation ideal for stocks….


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Europe and Japan look a bit cheaper than the U.S., but discount disappears adjusting for index composition and normalized profitability…

EMU Valuation Multiples Japan Valuation Multiples

Source: Goldman Sachs

Concern 6: There is little room to generate positive returns on bonds over the next year. Currenly low yield plus “roll” (gain from a bond becoming “shorter” one year out) is probably our best hope…

Default rates are low, but spreads reflect low default rates …we still like credit but we expect to earn the yield and roll at best


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Concern 7: too much complacency?

Source: Barron’s

…2014 early pullback will probably be helpful to the market in the medium-term…


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Concern 7: Political risks….

Increase in income inequality is a global problem, probably the result of globalization and technological change; but has been taken as an excuse for populist politicians to justify a new wave of government intervention…

There is little doubt income and wealth have …but skills and education matter …for example, the accrued faster to the top 20%... unemployment rate for college graduates is below 4%

Source: BCA Research Source: Ned Davis Research

..Persistent unemployment among the young could have major political consequences in the long term


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…and this is a global problem….

….can “redistribution” solve the problem without threatening our political system?

Three final comments… Gold: pullback and our concern about inflation and potential currency debasement in the long-term make gold more

attractive at this level…


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The average Hedge Fund has not been worthwhile over the past decade, as it has underperformed both the equity and bond markets, and has had a high correlation with equities...

An important reminder: “timing” the market is not a useful exercise… return of the average mutual fund has been significantly better than the average return of customer-flows into mutual funds…

Investment Strategy We have certainly spent a lot of time writing about our concerns in this commentary; however, we do not want to leave you with a bearish impression of our current stance. We remain constructive in the short-term regarding risky assets, especially when considering the available options to preserve and grow the real value of capital over the long-term. We believe that global economic fundamentals, monetary and fiscal policy, reasonable valuation and investor’s flows will support equity markets over the next 12-18 months; however, we are conscious that the margin of safety has been reduced and we remain vigilant regarding the numerous risks that we face in the near future.


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In last year’s commentary, we outlined our investment guidelines for the next several years. We believe these guidelines are still as current and valid as a year ago. To summarize:

Risk vs. Volatility: Risk is the probability of a permanent loss of capital, or more broadly, the chance of earning a less than adequate return. Volatility, on the other hand, is only a risk when it forces us to sell an investment prematurely at a loss; thus, volatility increases risk when the investment horizon is short, or liquidity reserves are insufficient. For the knowledgeable investor, volatility can actually be a positive as it increases the chances of “buying low” and “selling high”. Thus, we should welcome and take advantage of these “one-liner” reactions by being patient, holding opportunistic cash, and above all, having the right asset allocation based on the needs and risk tolerance of our clients. In other words, we should be always “thinking through” volatility.

Risk management is essential in the current environment, and we believe that the most efficient risk-management tool is to buy good quality assets at the right price. While it will not necessarily protect us from a market decline, it will increase the chances of capital recovery once the economy and markets normalize.

We continue to invest in real estate through our “FPCM Real Estate Portfolio”, but remain selective and price sensitive at this stage.

In spite of nil interest rates, cash is an attractive investment asset at this time given its low opportunity cost vs. fixed income.

We continue to advise clients to think about their savings as belonging in four different buckets:

(1) Liquidity: cash instruments needed to support regular expenses and needs. Includes money market funds, time deposits, and other cash equivalent instruments.

(2) Safety Cushion: very secure, highly liquid, and short and medium duration securities such as U.S. Treasuries, Inflation-Protected bonds (TIPS), and other highly rated and liquid bonds.

(3) Intermediate: assets that have a low probability of principal loss, but difficult-to-sell at times of distress. This includes most investment grade corporate and tax-exempt bonds, mortgage backed securities and other fixed income instruments.

(4) Higher Return: assets with higher expected returns but low liquidity at times of need, i.e. assets that you can sell when you “would want to”, not when you “would have to”. This bucket includes equities, high-yield bonds, real estate investments, alternative investments, etc. “We must base our asset allocation not on the probabilities of choosing the right allocation but on the consequences of choosing the wrong allocation” John Bogle

As always, we encourage you to call us with comments and questions. We welcome your feedback on both the content and structure of this commentary. As always, we thank you for your continued confidence and support.

Financial Partners Capital Management, LLCi


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INVESTMENT “BALANCE SHEET”

POSITIVES

We are in the midst of a recovery, but a slow one, especially with regard to employment and income, relative to the depth of the recession and prior upturns. On the other hand, the recovery on the industrial side has been better than average and household net worth is close to the 2007 peak. Moreover, slow growth might be exactly what developed economies need. Slow growth will help keep inflation tame, keep pressure on consumers and the government to deleverage, and increase savings, force firms to remain efficient and keep speculative tendencies in check.

Except for the risk of serious external shocks, it is difficult to foresee another deep recession at this time because the typical down levers (capital expenditure, auto production, housing, excess leverage) are still close to recession level.

Consumer spending should continue to grow thanks to increasing employment, a recovery in U.S. household wealth, and the end of consumer de-leveraging.

There is a real possibility of a synchronized recovery in developed economies.

Short-term tail-winds for the economy: (1) Expansive monetary policy, (2) pent-up demand in key areas such as capital spending, autos and housing; (3) increasing employment and more robust consumer spending

Increase in gas production and reserves in the U.S. and lower prices could have a major positive impact on U.S. competitiveness and the U.S.$.

The Federal Reserve is likely to continue to keep interest rates extremely low until at least 2015-2016. Low short-term rates and ample liquidity should help sustain the recovery in the short-term, and keep a lid on long-term rates.

Even though financing is not widely available, conditions in the credit markets have improved considerably and credit spreads are back to pre-crisis levels.

The rate of inflation is expected to remain low in the short- and medium-term.

U.S. Corporate balance sheets are in very good shape. Free cash flow is plentiful, return-on-capital is high, and leverage is low.


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CONCERNS

The recovery process tends to be very slow and fragile after recessions caused by financial crises.

Recovery has been aided by artificially low interest rates in most countries. How sustainable is the current recovery if rates normalize?

Unemployment picture has improved but labor participation is at a record low. Populist actions detrimental to the economy in the long term could increase significantly if this situation were to continue for a longer period of time.

Emerging economies have slowed down and some, like Brazil, Turkey and South Africa, face a difficult situation exacerbated by currency pressure. Emerging economies are very important for developed economies and a significant slowdown could derail the fragile recovery.

Fiscal policy is likely to be restrictive for some time. Large fiscal deficits seem the norm in developed economies, with deficits as a percentage of GDP in high-single digits in most cases, and government debt-to-GDP in the dangerous 100% level. Furthermore, these percentages do not account for deficits at the local level, or under-funded pension and health plans. Higher taxes in the future are almost a sure bet, but unfortunately they will not be enough to solve this difficult situation, unless the political class puts in place long-term credible public expense reduction programs, that also target the non-discretionary portions of the budget.

The credit situation in the U.S. has improved somewhat at the consumer level, but total leverage is still above a comfortable level.

Short-term rates will eventually have to rise. The fear of unwinding the current super-loose monetary policy could be very disruptive to the markets.

Geo-political uncertainty continues to increase (Iran, Syria, Afghanistan, Iraq, North Korea, war on terrorism) and will continue to constrain market valuation in the long-term.

Valuation: Equity valuations are at best at fair levels, and that is taking into account the “subsidy” from lower-than-normal interest rates.

Potential for “new” crisis: (↓ risk decreasing; ↑ risk increasing)

Credit crisis in GIIPS ? ↓↓ Currency debasement Crisis in Emerging markets ↑ Protectionism ↑ New terrorist attack in the U.S. (not “if” but “when”)

Long-term Concerns:

U.S. fails to deal with its long-term fiscal problems Upturn in inflationary expectations ↓↓ Increased Regulation ↑ ↑ Rise in “Populism” ↑

i This commentary might contain forward-looking statements, which involve risks and uncertainties. Actual results may differ significantly from the results described in the forward-looking statements. The information contained herein is for illustrative purposes only and should not be considered an offer to sell or a solicitation of any offer to buy interests in any particular investment. Opinions and estimates expressed herein reflect the current judgment of Financial Partners Capital Management (FPCM), and are based on information obtained from sources, which are believed to be reliable, but FPCM does not offer any guarantees as to its accuracy or completeness. Nor are they intended as a forecast or guarantee of future results. The information is not necessarily updated on a regular basis; when it is, the date of the change(s) will be noted. In addition, opinions and estimates are subject to change without notice. FPCM, its officers, directors, employees, customers, or affiliates may have a position, long or short, in the securities mentioned herein and/or related securities, and from time to time may increase or decrease such position or take a contra position. FPCM may have other relationships with any company mentioned in this commentary. Past performance is not a guarantee of future results. No future or current client should assume that the future performance of any specific investment, strategy or product referred to directly or indirectly will be profitable or equal to any corresponding indicated performance levels. Reproduction without written permission is prohibited.

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