Q3 WEALTH MANAGEMENT QUARTERLY COMMENTARY

Contacts

LEN A. HAUSSLER, CFA, CPA Founder and Portfolio Manager

lenhaussler@opusinc.com

KEVIN P. WHELAN, CFA Principal and Portfolio Manager

kwhelan@opusinc.com

NATHAN A. BISHOP, CFA Principal and Portfolio Manager

nbishop@opusinc.com

221 East Fourth Street, Suite 2700 Cincinnati, Ohio 45202

p (513) 621-6787f (513) 639-3072

www.opusinc.com

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Quick Look

» For the quarter, the S&P 500 Index gained nearly 4%, while the Barclays Aggregate Index advanced 0.5%.

» Unlike recent quarters, international equities were additive to client portfolio returns. In general, the more aggressive the equity allocation, the higher the portfolio gains in what was a risk-on quarter.

» After early quarter gains, markets went extremely quiet as investors waited on more clarity from the presidential election and Fed policy.

» U.S. GDP has grown at just 2.1% since 2009, making this the weakest economic expansion since the Great Depression.

» At 19 times trailing earnings, stocks are trading at a premium to their historical average, but valuations are far removed from our last stock market bubble.

» Investor expectations will be critical when evaluating bonds going forward. Investors expecting to replicate the year-to-date 5.8% return of the Barclays Aggregate will almost certainly be disappointed.

» While stock prices and interest rates are historically positively correlated, this relationship is not guaranteed.

The Waiting Game

About Opus Capital ManagementOpus Capital, headquartered in Cincinnati, Ohio, is a registered investment advisory firm specializing in assisting endowments, foundations, public funds, corporations, institutions and high net worth individuals develop and execute investment strategies and policies. Our team designs customized, integrated investment programs for each client based on individual goals and objectives.

Tom Petty told us that the waiting was the hardest part, but that did not necessarily apply to investors this quarter, as clients watched and waited while their portfolios quietly added to their 2016 gains.

The S&P 500 Index gained nearly 4% for the quarter, while the Russell 2000 Index jumped 9%. Unlike recent quarters, international stocks finally participated in the upside as well. The MSCI EAFE Index gained 6% and emerging markets surged 9%. High yield bonds continued their resurgence since February, gaining nearly 5% for the quarter. High quality bonds mostly captured their coupon, as the Barclays Aggregate Index advanced 0.5%. In general, the more aggressive the equity allocation, the higher the portfolio gains in what was a risk-on quarter.

The quarter started with a surprising bounce in equities, as global central banks made it known that they were ready to backstop any fallout in the aftermath of the Brexit vote. The gains made in early July represented the lion’s share of the quarterly gains, as markets went extremely quiet after the early advance. In fact, between July 11 and September 8, the S&P 500 Index did not rise or fall 1% for 43 consecutive trading days. In our office, there were days when the ticks on the screen were infrequent enough to make us wonder if our FactSet terminals had gone offline.

In hindsight, this past quarter was mostly a waiting game. It was episodes four through six of the 15 episode TV show you binge-watched on Netflix. No crazy plot twists, no characters killed off. Time passed while we waited for the presidential election to heat up, or for the Fed to make a move, or for signs of positive EPS growth, or for long term rates to increase.

Historically, the September-October season is the most volatile time of the year for markets (though ask market timers how “Sell in May” worked out for them this year). Additionally, with an upcoming open Presidential election between the two most unpopular candidates in U.S. history, there should be plenty of noise available between now and the November 8 election.

Speaking of elections, Strategas recently provided some interesting research that found that the market movement 90

days before election day has predicted 19 of the last 22 elections. If the market is higher 90 days before election day, the incumbent party wins. If the market is lower, the opposing party takes over office. We closed the quarter 36 days away from the election, and since August 8, the S&P 500 Index was essentially flat over those 54 days. Thus far, the market indicator seems to have followed consensus election forecasts, which is that the race had tightened heading into the first debate.

The buildup of the past few months finally came to a head when a record 84 million viewers tuned in to watch the first Presidential Debate on September 26. We will thankfully save the full debate recaps and analysis for cable news. However, we would be remiss if we didn’t expound on one specific comment from Mr. Trump, which came about halfway through the first debate.

“Now, look, we have the worst revival of an economy since the Great Depression. And believe me: We’re in a bubble right now. And the only thing that looks good is the stock market, but if you raise interest rates even a little bit, that’s going to come crashing down.”

“We are in a big, fat, ugly bubble. And we better be awfully careful. And we have a Fed that’s doing political things. This Janet Yellen of the Fed. The Fed is doing political — by keeping the interest rates at this level…. The Fed is being more political than Secretary Clinton.”

The Donald has given us plenty to work with here, so let’s try to unpack this piece by piece.

OPUS CAPITAL MANAGEMENT | QUARTERLY COMMENTARY

Review of Third Quarter 2016

2 3Q16 Commentary Opus Capital Management

U.S. EQUITY RETURNS (%)

As of 09/30/16 Q3 2016 YTD 1-Year 3-Year 5-Year 10-Year

S&P 500 3.9 7.8 15.4 11.2 16.4 7.2

Russell 1000 (Large Cap) Growth 4.6 6.0 13.8 11.8 16.6 8.9

Russell 1000 (Large Cap) Value 3.5 10.0 16.2 9.7 16.2 5.9

Russell 2000 9.1 11.5 15.5 6.7 15.8 7.1

Russell 2000 (Small Cap) Growth 9.2 7.5 12.1 6.6 16.2 8.3

Russell 2000 (Small Cap) Value 8.9 15.5 18.8 6.8 15.5 5.8

Source: Morningstar

Source: Strategas

“We have the worst revival of an economy since the Great Depression”.

Hard to argue with this one. Technically, quarterly GDP data is available only back to 1947, but that is beside the point, as Mr. Trump’s statement is accurate. GDP growth over the last seven years has advanced at an annual rate of 2.1%, which is the weakest of the 14 economic e x p a n s i o n s we have had since the Great Depression. Over the past two quarters, we have grown at half that number, coming in at 1.1%.

Despite (or because of) the middling growth since mid-2009, the length of the expansion is the fourth longest of the 14 expansions. While the recovery can now boast more than 70 consecutive months of job growth and an unemployment rate below 5%, median household income remains below 1999 peak levels and labor participation rates hover near 40 year lows. Trend growth has seemingly been reset lower during this expansion, and is at the root of voter angst both in the U.S. and abroad. Unfortunately, The Federal Reserve’s latest revisions forecast more of the same pedestrian growth for the remainder of the decade, as unfavorable demographics and weak productivity present long run challenges.

“We’re in a bubble right now. And the only thing that looks good is the stock market, but if you raise interest rates even a little bit, that’s going to come crashing down.”

We would be the first to admit that U.S. stocks are not cheap; at 19 times trailing earnings, the S&P 500 Index is trading at a premium to the historical average of 16 times. Thanks to declining oil prices and a stronger dollar, S&P 500 aggregate earnings have d e c l i n e d for five consecutive quarters, so gains in the S&P 500 have come strictly from multiple e x p a n s i o n since early last year.

However, this market has a long way to go before it can be compared to the bubble of 1999, when stocks were trading at more than 30 times trailing earnings (or 42 times Shiller, which is cyclically adjusted. See chart at the bottom of this column). Additionally, equity portfolio valuations are reduced by the diversification of international equities, which are trading at a discount to U.S. stocks.

Stocks look more attractive on a relative basis, given where other financial assets are priced. NYU Professor Aswath Damodaran currently estimates the implied equity risk premium, which is the extra return investors demand above the risk-free rate, to be 4.86%. The average ERP since 1928 has been around 4.20%, so stocks are mostly undervalued when compared to the 10-Year Treasury (our proxy for the risk free rate). Should interest rates rise a bit, as Mr. Trump alluded, stocks should have a bit of cushion thanks to a higher than average ERP.

Furthermore, bubbles typically exude irrational exuberance from investors, and there is little evidence of animal spirits being exhibited by market participants. Bank of America’s Global Manager Survey shows equity sentiment at bearish levels, and portfolio cash balances are at their highest levels in 15 years. Over this seven year bull market, net fund flows into equities have been negative. Even with our recent market highs, net outflows have continued this year. These flows have of course found their way into bond funds, continuing a near decade long theme of investors preference towards investments with lower risk than stocks.

We think a bond bubble is an easier argument to make. As seen in the chart below, Damodaran’s Treasury Bond P/E estimate has climbed from a trough of 8 times back in 1982 to about 65

Continued from page 2 . . .

OPUS CAPITAL MANAGEMENT | QUARTERLY COMMENTARY

3 3Q16 Commentary Opus Capital Management

-15%

-10%

-5%

0%

5%

10%

5.3%

2.4%

-11.1%

-3.2%

-11.6%-9.1% -9.3%

Source: Strategas

4Q’15 1Q’15 2Q’15 1Q’15 3Q’15 1Q’16 2Q’16Est.

S&P Operating EPS(TTM, Y/Y PCT. Chg)

Q4 1949 -Q2 1953

Q2 1954 -Q3 1957

Q2 1958 -

Q2 1960

Q1 1961 -Q4 1969

Q4 1970 -

Q4 1973

Q1 1975 -Q1 1980

Q3 1980 -Q3 1981

Q4 1982 -Q3 1981

Q1 1991 -Q1 2001

Q4 2001 -

Q4 2007

Q2 2009 -Q2 2016

6.0

4.0

2.0

0

Source: Commerce Department The Wall Street Journal

Expansion StrengthAverage annual change in GDP, by expansion

8.0

Source: Strategas

Source: Musing on Markets

times currently. Long-term treasury bonds have returned nearly 15% this year, even though a 30-year Treasury bond yields less than 2.5%. International bonds are up double digits on the year despite the fact that half of developed nation sovereign bonds have traded at negative rates.

Investor expectations will be critical when evaluating bonds going forward. The appeal of bonds in a balanced portfolio is their steady income stream and the ballast they can provide during rocky equity market periods. Long-term investors who buy a 10-year Treasury paying 1.5% and hold it to maturity can expect a 1.5% annualized rate of return ten years from now. Investors who buy it expecting to replicate this year’s Barclays Aggregate return of 5.8% will almost certainly be disappointed. We have positioned fixed income portfolios appropriately for the risk/return opportunities they currently present.

Counter to Mr. Trump’s comment, stocks typically rise in conjunction with interest rates, particularly when rates are low. This relationship has held mostly steady since 2000 and was also evident during the 1950s and 1960s, another time period noted for low interest rates. Traditionally, stock prices and interest rates are driven higher by stronger economic growth. This correlation is not guaranteed however, and can break down if rates rise for non-growth reasons (the 1970s stagflation period, for example). With yields near all-time lows, the table is admittedly set for future time periods in which stocks and bonds both occasionally exhibit periods of weakness simultaneously, something that really hasn’t occurred in an investment generation.

“And we have a Fed that’s doing political things.…. The Fed is being more political than Secretary Clinton.”

We will ignore the latter comparison and just focus on the Fed, which whether intentionally or not, has moved closer to the political sphere of influence. Now in its eighth year, the Fed’s cautiousness and/or inability towards taking off emergency policy may in fact be the appropriate course of action, but it leaves it vulnerable to Washington finger pointing as a new President takes office.

Thanks to a dearth of targeted fiscal policy, the heavy lifting of attempting to reflate the economy since the Great Recession has fallen almost entirely on the shoulders on the Fed. Accommodative policy has arguably done an effective job at reviving financial asset prices, but economic growth has proved more vexing. According to the Case Shiller Home Price Index, home prices are now just 2% below their 2007 peak. With stocks, bonds and home prices all flirting with respective all-time highs, this has naturally pushed household net worth to a record high. The most evident benefactors of this are affluent households, opening the Fed to blame for accelerating rising income inequality concerns.

Judging by its change in language in their September statement, the Fed would like to raise the federal funds rate a quarter of a point before year-end. However, the next FOMC meeting is scheduled for the first week of November, which seems like a non-starter immediately in front of an election. If the Fed moves in December, the President Elect will have already caught as many rate hikes as President Obama experienced in his eight-year tenure. Thanks to the unintended optics of policy decisions around election season, coupled with aggressive monetary policy by the world’s other large central banks, the Fed’s water is getting hotter.

So make sure to vote, and if your preferred candidate does not win, Tom Petty will tell you that even the losers get lucky sometimes. As always, please feel free to contact us should you wish to discuss these matters in greater detail.

Opus Capital Management 221 East Fourth Street, Suite 2700

Cincinnati, OH 45202(513) 621-6787 • www.opusinc.com

FIXED INCOME RETURNS (%)

As of 09/30/16 Q3 2016 YTD 1-Year 3-Year 5-Year 10-Year

Aggregate Bond 0.5 5.8 5.2 4.0 3.1 4.8

Muni -0.2 3.4 4.8 4.5 3.8 3.9

Int’l Bonds 1.5 8.2 7.6 2.1 2.4 4.4

High-Yield 4.7 11.4 9.1 3.8 7.0 6.2

Short-Term 0.5 2.5 2.1 1.4 1.7 2.8

90-Day T-Bill 0.1 0.2 0.3 0.1 0.1 0.8

Source: Morningstar

OPUS CAPITAL MANAGEMENT | QUARTERLY COMMENTARY

INTERNATIONAL RETURNS (%)

As of 09/30/16 Q3 2016 YTD 1-Year 3-Year 5-Year 10-Year

EAFE Int’l 6.4 1.7 6.5 0.5 7.4 1.8

Emerging 9.0 16.0 16.8 -0.6 3.0 4.0

Source: Morningstar