GKV Capital Management

Economic and Investment Outlook

First Quarter 2015

2015 March Quarter Review

Does “It” Matter This Time?

Updating Expectations for 2015

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A note from:

PETER VOGEL

In our view there are two principal drivers to the stock market- sentiment and fundamentals. In the short-term, sentiment holds the greatest influence over stock valuations. A “feeling” that the market is overvalued or that the bull market has “grown tired” are merely opinions and don’t require any rigor to their invocation. Despite the lack of any necessary basis in truth, if enough people are convinced, the prognostication becomes reality– at least for a time. Markets will rise and fall with outsized expectations or predictions of doom. It is important to remember that valuations based on senti-ment cut both ways but are generally fleeting. The latest fad can send prices skyward without any sound economic basis (bubble) and the latest sensational headline can cause the market to momentarily swoon (panic). The fickle nature of market sentiment can make investing feel like gambling. Fortu-nately, over the long-term, sentiment gives way to the fundamental financial met-rics. The underlying sales, expenses, and ultimately earnings do matter. The chal-lenge becomes trying to discern what things will affect the fundamentals in the fu-ture. Will low unemployment cause wage pressure, inflation, raising interest rates and depress earnings? Will unrest in Eastern Europe cause greater unrest leading to lower global product demand? Human nature has a poor track record at predicting the future and people are not very good at anticipating the next big event. The tendency is to focus on a recur-rence of the last crisis and the next one is almost always a surprise. Current trends are frequently imagined to continue into the future at a constant rate and unfore-seen changes are, well…, unforeseen. Based on the current fundamentals we think the market is expensive, however there are few investment alternatives with low interest rates around the world. Sentiment has been positive and the fundamentals are just good enough to maintain the rosy outlook of “increased growth around the corner”. We think there is more money to be made in the current market. But like a lot of investors, we find ourselves holding our breath, hoping that the fundamentals over the next three quarters make a marked improvement over a very weak first three months of 2015. If you wish to further discuss our financial outlook and how it pertains to your per-sonal situation, please do not hesitate to contact me at pvogel@gkvcapital.com.

President and Chief Investment Officer

GKV Capital Management is an independent registered investment advisor. For more information about us please call (805) 497-2616 or visit gkvcapital.com

1Q15 Data Points

DJIA YTD -0.3%

S&P 500 YTD 0.4%

NASDAQ YTD 3.5%

Int-Term

Bond YTD

1.9%

10-Year

Treasury Yield

1.9%

S&P 500 LTM

Dividend Yield

2.0%

S&P 500 EPS

2015 EST

$118.36

S&P 500 P/E 17.5x

GKV Capital Management

itive growth. However, the first quarter weakness certainly raises questions whether economic gains can meet the opti-mistic expectations for 2015. With the weaker economic performance in the March quar-ter, we did take the conservative step of slightly reducing our equity exposure. Although we do not anticipate contin-ued fundamental weakness, the sharp revision in earnings estimates for 2015 from $137.24 to $118.36 has caused us some concern. For some time we have viewed the early

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First Quarter Review

2015 got off to a slow start with weaker than anticipated economic activity in the quarter due largely to severe winter weather on the East Coast, a labor dispute holding up ship-ping traffic at West Coast ports, the strength of the dollar and continued weakness in energy prices. These events re-sulted in sharply reduced corporate earnings forecasts for the March quarter and for the year, making stocks appear more expensive. Fortunately these events are viewed by Wall Street as transitory and expectations are for a rebound as the year progresses. The equity markets finished the first quarter mixed with a loss for the Dow Industrial Average of 0.3%, a marginal gain of 0.4% for the S&P 500, and a posi-tive 3.5% gain for the Nasdaq Composite. Growth has come more slowly than anticipated. However, by nearly all measures the U.S. economic picture continues to improve, unemployment has returned to pre-crisis levels, corporate earnings continue to grow albeit slowly, inflation is low and corporate profit margins remain near their highs. U.S. GDP declined by 0.7% in the March quarter. Our expec-tation is that the first quarter slowdown will prove to be short lived and the year as a whole will show continued pos-

Source: GKV Capital Management

Firm Wide Asset Allocation March 31, 2015

First Quarter 2015

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forecast for 2015 as overly optimistic, but the downward revision after the first quarter was greater than we expected and the magnitude of the change increases the risk that more downward revisions could follow. Our exposure to equities, firm wide, remains significant, ending the first quarter with 48% of assets under management in equities, 38% in fixed income and 10% in cash. The remaining 5% is in various real estate investments. Despite our earnings expectation concerns, the outlook for equities is positive, in our opinion. Energy prices will stabi-lize, winter weather can create pent-up demand as we move into spring and the geopolitical environment, while far from perfect, seems to be in a period of relative calm. Small-cap stocks out-performed in the March quarter as larger companies making up the S&P 500 were adversely affected by strength in the dollar and weakness in the ener-gy sector in particular. The Russell 2000 index which tracks smaller companies ended the March quarter up 4% versus 0.4% for the S&P 500. The Nasdaq biotech index continued to lead with a gain of 13.2% in the quarter. Interest rates remain low with a paltry 1.9% yield for the 10-year Treasury after dipping as low as 1.7% in January. While we continue to anticipate a rising interest rate environment in the long-term, our expectation is predicated on the long awaited acceleration in economic growth. So far the Federal Reserve, under Janet Yellen, has shown reluctance to push

rates higher without increased economic activity. At the current rate of economic grpwth, we should anticipate in-terest rates to remain near current levels until the fall. The expectations of rising rates has had a negative impact on our bond portfolio. In the first quarter our bonds eked out a 0.2% gain. We expect this performance to improve as the year progresses assuming there is not a dramatic increase in interest rates. In the first quarter the non-U.S. equity markets showed strong gains. Developed countries excluding the U.S. posted a 5.0% gain as measured by the MSCI EAFE index. Japan and China rebounded sharply in the March quarter with gains of 10.1% for the Nikkei and 15.9% for the Shanghai Composite. An improving global outlook would significantly improve the economic picture for the U.S. economy, particularly for the larger capitalized U.S. companies which derive most of their revenue and growth internationally. We anticipate interna-tional growth to remain uneven and volatile in the near-term but are optimistic for an improving long-term outlook. Our international equity exposure is currently negligible, but we will look to increase exposure as improvements become more apparent.

GKV Capital Management

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A very interesting phenomenon for the past 18 months is the frequent reoccurrence of events auguring incipient crisis, which are immediately flashed worldwide, cause sudden specters of rolling financial collapse, generate actual quick declines in security prices for several days and are followed by almost complete investor neglect and indifference. An attitude of who cares. Ever since 2008 and the collapse of the mortgage market, investment pundits have been attempting to identify early the catalyst which will cause another unwinding of the world financial system and its economies. After a few days of predicting ricocheting calamitous disasters in the global economic system from a negative event, these commentators have sought absolution from their need-lessly dire predictions and quickly recommenced buying securities. Each potential negative headline has been met with a response of “this really matters” only to be quickly followed by “who cares.” Let’s look at a litany of such events:

The rising value of the U.S. dollar versus other curren-cies would punish U.S. corporate profits and cause the advent of a sell-off in the U.S. stock market. U.S. retail sales remain sluggish. Poor growth in this major sector of the U.S. economy will produce lower than expected GDP growth which in turn will cause lower stock market valuations. Cheap money caused by years of worldwide mone-tary stimulation has stretched valuations beyond real-istic levels, creating asset bubbles which will collapse. U.S. corporate revenue growth has never rekindled after the Great Recession. This ongoing trend of weak revenue growth will eventually hurt corporate earnings as profit margins have reached a ceiling. The consequence will be a serious decline in equity prices.

Geopolitical conflict will spread to more and more

regions of the world disrupting commerce and increasing political tensions. The growth in hostilities will adversely affect confidence and asset valuations. China’s growth is permanently slowing from previous hy-per growth rates. This will cause a reduction in global demand for goods and cause cascading slow growth in Western and emerging market economies. Lower growth will precipitate lower stock prices. China’s very high debt level is beyond the point of no re-turn. A default in any of its debt will lead to an unchecked downward spiral in its economy and have a calamitous effect on the rest of the world. The stock market is being artificially supported by acquisi-tions and corporate repurchasing of stock which is fos-tered by unprecedented cheap money. An eventual rise in the cost of money will end these stock market sup-porting maneuvers and result is a significant decline in stock prices. Worldwide monetary stimulus, led by the U.S., has creat-ed a false “wealth effect” among a very small segment of the public which is driving much of the country’s econom-ic growth since 2009. As increasing disparities in wealth and their genesis are politically condemned, the “wealth effect” will be contained by very disruptive government economic policies and taxation. Critics of monetary poli-cies think this is inevitable and will produce a serious con-traction in stock prices. The financial collapse of Greece is inevitable and the re-sult will be serious pressure on the European community and the Euro. Stock prices will not be able to ignore this destabilizing event. The sharp decline in the demand for earth’s minerals along with the sharp drop in the price of oil will lead to deflation, poor demand for goods and services and declin-ing corporate revenues and profits. An environment for unstable and declining stock prices.

“My, oh, my, the sky is falling. I must run and tell the lion about it”

- Chicken Little

First Quarter 2015

Does “It” Matter This Time?

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The commencement of increases in the interest rates in 2015 or 2016 will mark the end of the current 6 year bull market in stocks. As proof, just the harbinger of rising interest rates in the near future has led to sudden sell-offs in stock prices. As liquidity has driven stock prices higher for the last six years, illiquidity will cause their decline. According to Goldman Sachs, dividends and corporate buybacks will be responsible for supporting a stock mar-ket where the median stock in the Standard and Poor 500 index is trading at 18.2 times earnings, putting it in the 99th percentile of historical valuations. In other words, these figures imply the current level of stock prices is unsustainable. In the U.S. the level of debt in the country continues to grow rapidly. It now equals about $58 trillion, or 3.3 times the size of its GDP. It is 13 times bigger than its $4.3 trillion level in 1980. Present stock prices are in conflict with this large amount of debt and must be reduced to reflect the growing risks of debt default. Global growth will surely accelerate next year has been the mantra of optimists. We have heard it for 6 years. 2015 will again disappoint expectations voiced in 2014 for 2015. At some point investors will realize they have been paying ever higher prices based on unsupported wishful thinking. When the epiphany occurs, stock pric-es will crash. Internet stocks or social media stocks, or biotech stocks, are far too expensive and are in bubble territory. When they correct it will take the whole market with it.

The above list highlights major negative factors that inves-tors have delineated as to why the current stock market is overpriced and should decline, perhaps severely. As each of the above fears have had their day in the media, the stock market has experienced a sudden decline only to resume its advance to new highs. Some of the factors noted above could prove to be correct storm warnings at some future date. In the last twelve months there have been at least six occasions when the stock market reacted suddenly to one or more of the above listed negative hypotheses. Each of the above enumerated potential problems to the world eco-nomic system has created a negative back drop for common stock prices that the investor should be concerned about, but in our opinion, in each case the fear has been prema-ture. This stock market has proven the danger of attempting to anticipate a negative market catalyst. The catalyst for future calamity has perhaps been identified but it has not

grown to adulthood. World monetary stimulus and the ab-sence of places to invest the money still rules the day. So, investors search for “what matters” has led to some momen-tary stock market sell-offs, but quickly the realization that con-stant government intervention in the worldwide markets still controls their fates and negates the momentary importance of negative factors, no matter how real and pending. It has been the worldwide use of government intervention in the financial market which has caused investors’ opinions to fluctuate from “it matters, to who cares.” Something decisive or essential to change financial forecasting models is not about to happen very soon. Perhaps in some quarters, government’s manipulation of the capital markets has led to an attitude that “it is different this time.” In our opinion it isn’t different, it is just that the timing of the concerned pundits has been premature. Not one of the above listed “worry” factors will by itself change the present positive stock market psychology, but in time a collection of them will cause the realization that stock prices are too high. These worry points matter but the pervasive belief is that there is still time to make money. So for now “who cares” is the dominant viewpoint. In our opinion, stock prices are high, but valuations are likely to still go higher until the accepted psychology moves from “who cares” to “it matters.”

GKV Capital Management

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First Quarter 2015

isn’t worth what investors are currently paying and the val-ue will adjust downward. While it is entirely possible that revenue growth could accel-erate with earnings improving as 2015 progresses, we have been experiencing the opposite trend with continual reduc-tions in estimated earnings. Until recently the reductions have been slight. We remain positive for the overall outlook for the U.S. economy and the prospects of individual com-panies, but given the trends in earnings, we continue to think double digit gains for the major stock market indices will be difficult to achieve in 2015. The S&P 500 closed the quarter at 2,068 which is 16.9x the earnings forecast for the next twelve months based on the latest revised earnings forecast of $122.53. We find this valuation to be expensive. Consider that at the start of 2014, the S&P500 was trading at 16.4x the 2014 actual re-sults of $113.01. We find little reason, given the slower earnings growth expectations in 2015 for the market to be trading at a premium to year-ago levels. A 16x multiple puts the S&P500 at 1,960. We expect individual stock selection to be critical for perfor-mance in 2015. We are focusing our attention in subsectors of healthcare, technology, biotech, and select companies with superior growth prospects. After reducing our expo-sure to stocks marginally in an effort to hedge the risk of a significant correction in the first quarter we now find our-selves sitting on the fence, prepared to enter the market if the economic data improves or further reduce our exposure to equities if the economic slowdown of the first quarter continues .

Looking Forward

S&P 500 Earnings Estimate Revision History

Unfortunately our concerns regarding earnings for 2015 have been prescient. The 2015 earnings estimate for the S&P 500 has been revised down to $118.36 from $121.31 at the beginning of the year and down from $137.24 a year ago. Clearly the long anticipated acceleration in growth has yet to materialize. Fortunately, and somewhat surprising to us, investors have remained patient hoping to see a re-bound as the year progresses. The multiple factors that contributed to the economic slow-down in the first quarter can be fairly viewed as temporary, but cannot be completely ignored. A substantial accelera-tion will be necessary to move the U.S. markets higher in our opinion. Wall Street for some time now has been willing to pay a significant premium for stocks with the expectation that revenue and earnings will accelerate in the near future. Generally, investors are only patient for the promise of fu-ture earnings growth for so long. Despite the substantially lower revision to the 2015 estimates, the 2016 forecast is as rosy as ever at $134.75. This estimate, if attainable, would represent 14% year-over-year earnings growth and puts the

market at a more reasonable 15.4x earnings multiple. Un-fortunately, like the last three years, we are highly skeptical of this forecast. We find this fantastic estimate more attributable to positive sentiment rather than likely funda-mental economic reality. The earnings estimates and growth rates are important be-cause they drive what investors should be willing to pay for equities. If growth accelerates, greater future earnings make what might look like an expensive market a reasonable val-ue. Conversely, if the forecast is too rosy, then the market

S&P 500 Performance and Price to Earnings Ratio

Southern California

125 Auburn Ct.

Suite 200

Westlake Village, CA 91362

Phone: 805-497-2616

Fax: 805-379-3216

E-mail: greg@gkvcapital.com

GKV Capital Management is a registered advisory firm oper-

ating since 1975. We manage separate accounts for families,

charities and retirement. Four of the largest asset bubbles have

occurred in the last 25 years. Volatility has taken a significant

toll on investment assets requiring new strategies to protect

and grow wealth. As an independent portfolio management

firm making direct investments on our clients’ behalf, GKV

Capital has the flexibility and expertise to respond to the

changing investment environment to reduce risk, minimize

losses and grow wealth.

We take a dynamic view of the macro economy to determine expected returns

in the near-term of various asset classes. Within these classes individual invest-

ments are selected for clients’ accounts on an account by account basis.

We do not buy and hold, but seek to take advantage of changes in market senti-

ment and fundamentals to avoid losses and create opportunity. As an inde-

pendent portfolio manager we have the flexibility to adjust investment expo-

sure rapidly.

We make direct investments on behalf of our clients buying individual securi-

ties, generally stocks and bonds eliminating costly mutual fund fees. We are a

fee-only advisor, we do not receive commission and we do not sell any financial

products. Client assets are held at an unaffiliated brokerage firm.

Our Investment Philosophy

Personal Portfolio Management

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Suite 300

Walnut Creek, CA 94597

GKV Capital Management is a registered investment advisor with the SEC under the 1940 act. This newsletter provides general investment information and is not

intended to provide specific financial, investment, legal, or tax advice. Any discussion of individual securities should not be taken as a recommendation for any reader

to buy or sell such securities. You should consult with your own advisor and/or do your own research before acting on any of our opinions, which we change without

notice. The data provided in this newsletter is believed to be reliable, but are not guaranteed as to accuracy or completeness. The value of the securities mentioned

herein may fall or rise and are not insured by any government or private company.

©2015 GKV Capital Management Company Inc.