THIRD QUARTER REVIEW & OUTLOOK ~ WELCOME …...generate higher relative income (dividends) while waiting for the interest rate curve to shift higher. Importantly, while the U.S. 10-year

t: 516.439.5100 f: 516.439.5102

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THIRD QUARTER REVIEW & OUTLOOK

~ WELCOME TO THE NEW WORLD ~ Since the recession low reached by the stock market in the first quarter of 2009, equities have staged a dramatic recovery. The bulk of these gains reflected strong earnings growth, and more recently, a significant improvement in valuation to more normal levels relative to inflation and interest rates.

CORRECTIONS SINCE 2009

Source: Strategas

The recent rise in volatility and the pullback in stock prices generally reflect a more normalized pattern of equity price fluctuations than has been the case for some time. There are a number of factors that suggest this standard level of volatility and increasing investor anxiety will continue for some time. First, the Federal Reserve will end its Quantitative Easing (QE) program before the end of the year. This effort has pushed down interest rates to a point where any further decline would have little positive impact on stimulating the economy. With the completion of this program, the equity markets will no longer have a support mechanism in place to absorb more volatility. Moreover, expectations should focus on the possibility of rising interest rates over time. Second, global GDP growth forecasts continue to come down, most recently in Europe and Japan. Additionally, given that European interest rates are already lower than those in the U.S., any

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quantitative easing similar to what occurred in the U.S. may have little impact. Indeed, calls for fiscal policy reform are surfacing in a number of countries. Third, the equity markets are fairly valued. As such, the stock markets’ continued upward trend should now be largely fueled by expected profit growth rather than by multiple expansion. When viewed from a broader perspective, we think the equity market is likely to generate 5-10% returns in the next 12-24 months. This assumes continued global growth in GDP consisting of approximately 2.5% in the US, 0% -1% in Europe, and a similar amount across the Asian regions. Within this context, we expect corporate profits to increase approximately 5% - 10%. The wild card remains the U.S. consumer. To a large degree, middle to upper income households have maintained a reasonable spending level. However, lower income families continue to be reluctant to accelerate spending. A strong growth in jobs would go a long way to improving the tone of consumer spending. Regardless, with the general expectation that long term interest rates may rise, we suspect that the current valuation of the market at around 15-16 times projected profit may be the average for the foreseeable future. Thus, our expectation of projected market appreciation is now principally based on corporate profit growth. FIXED INCOME – Putting U.S. Bond Yields in Context

Source: Strategas

From a fixed income perspective, we continue to be cautious on intermediate to long-term bonds. Interest rates on a global scale are at, or near, all-time lows. As a result, expectations by most are for rising rates in the next few years. Thus, investors continue to be “pushed into equities” to generate higher relative income (dividends) while waiting for the interest rate curve to shift higher. Importantly, while the U.S. 10-year government bond looks low at 2.3% currently, it is actually higher relative to a number of European sovereign equivalents. Given the weak economic growth in Europe for 2015 and beyond, we suspect that foreign government bond buyers will favor


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investment in the US due to relative value and currency benefits. As such, this could serve to push-out the expected rise in global rates until more sustainable growth in GDP is obtained. INVESTMENT STRATEGY We have added new names to our core long-term equity portfolio. To a great degree these companies reflect our orientation to continue to build a growth oriented but defensive investment portfolio. To that end, we added Moody’s, the large global credit rating agency to our core portfolio. Moody’s should be relatively less sensitive to economic recessions as companies continue to seek debt ratings throughout the business cycle. More importantly, the growth of corporations in developing markets should be an added growth leg for this organization in the next few years. We have also added Boeing, the major commercial aircraft manufacturer. Order backlogs for new planes extend well into the future. Additionally, about 40% of the company revenues are related to the U.S. defense industry. Given the on-going civil unrest in the world and the likelihood that defense spending may rise over time, we believe that Boeing should generate strong earnings growth for the next few years regardless of economic trends. In the healthcare area, we have added Perrigo. The company is a global healthcare giant that manufactures and distributes OTC and generic drugs. Approximately 80% of the revenues come from U.S. sales. The company is also actively seeking bolt on acquisitions to bolster its strong organic growth. Currently, ~55% of revenue is represented by over-the-counter drugs, ~22% generics, and ~23% nutritional and other products. Perrigo is a category dominant player in the industry and is expected to grow revenues at the 6-12% rate. This should translate into earnings growth of 12-20% annually. PORTFOLIO STRATEGY AND MARKET VOLATILITY Ever since the start of the Federal Reserve’s quantitative easing (QE) program some five years ago, stock market volatility has steadily declined. This reflected a strong recovery in corporate profits and equity values, declining interest rates, and money flowing away from fixed income into the equity market. The fourth quarter of 2014 will mark the end of QE. As such, we believe it will signal the start of a return to more normal volatility in the future. Rising interest rates in the next few years should be one factor that can create more volatility; expectations of slowing economic growth after 5 years of sustainable gains in GDP is another. To most investors, this return to dramatic volatility in equity values will bring back memories of the great stock market decline of 2008-2009. Volatility will also likely reflect the impact from larger sized hedge funds, the continued use of derivatives and leverage, high frequency trading and (possibly the misuse of) ETF’s. Our strategy has been to focus the portfolio toward investments with good dividend yield. More importantly, we have invested in companies that can be expected to increase their dividends paid to shareholders over time. Dividends can represent a significant part of total return in good periods and especially in slow-growth periods in the market.


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Source: Strategas

As the above chart indicates, dividends generally contribute 25-75% of total returns over long periods of time. While the bull market is still intact, we also believe that gains in the intermediate future may be under 10% annually. Thus, we believe our core portfolio is well positioned to generate long-term capital appreciation with lower overall risk relative to the market. KPCM Update We are very pleased to announce a change of responsibility: Melissa Melton has provided Client Service and Operations support to many of you over the past five years. After much work, she is transitioning to the role of Associate Financial Advisor. In addition to retaining certain operational responsibilities, she will be assisting and managing certain client relationships for the firm. If there are any questions, do not hesitate to contact our offices at your earliest convenience. Jack L. Salzman Jeffrey P. Bates Senior Managing Partner Managing Partner John A. Marshall, IV CFA, CFP® Beth C. Webb, CFP®

Investment Advisor Investment Advisor Nathan T. Fend Jason D. Beaird, CFA Investment Advisor Investment Advisor


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THIRD QUARTER REVIEW & OUTLOOK ~ WELCOME …...generate higher relative income (dividends) while waiting for the interest rate curve to shift higher. Importantly, while the U.S. 10-year