overview - fourth quarter 2016 final - capitaladv.com · overview fourth quarter 2016 ......

Overview

Fourth Quarter 2016

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Key Points

• Our last two Overviews can be characterized as a two-part series on the topic of low expected returns in the asset markets.

• Readers of those reports are justified to wonder if the post-election surge in the stock market invalidates the world view we have been expressing.

• The short answer is no, although our expectations for 2017 have shifted materially since the election.

• Specifically, conditions seem ripe for an upside overshoot in the U.S. stock market in 2017 due to the emergence of a new narrative of optimism for corporate America based on expectations for tax reform, regulatory relief, and fiscal stimulus through infrastructure spending.

• Importantly, investors’ hopeful narrative for the future may have plenty of time to blossom before the impact of actual policy changes becomes measurable in 2018 and beyond.

• Unfortunately, our long-term expectation for the stock market remains subdued because the primary drivers of this forecast are less responsive to government policy, regardless of who had won the election in November.

• Moreover, if stocks overshoot to the upside in 2017 the long-term outlook would become even more discouraging due to the excessive valuation metrics that would result from such a surge.

• It seems reasonable to speculate that the domestic bond market may have reached a lasting turning point in July.

• The sharp reversal in interest rates since summer has been painful for bond portfolios, but we believe the worst of the adjustment may be over.

• Investors with balanced portfolios deserve to feel frustrated by the recent weakness of their “safe money,” but expected future returns for bonds improve with each tick higher in interest rates, and fixed income plays a critical role in risk management.

• It can be highly rewarding to participate in a stock market overshoot, and we encourage investors to “stay at the table” with whatever risk capital is appropriate for them in case an overshoot occurs in 2017.

• However, if stocks do advance materially in 2017 we believe it may be appropriate for many investors to lighten up into the strength.

Please see important disclosures at the end of this document 2

This particular shift by the Trump administration could have a much

bigger impact on the U.S. economy than one would calculate on the

basis of changes in tax and spending policies alone because it could

ignite animal spirits and attract productive capital. Regarding igniting

animal spirits, if this administration can spark a virtuous cycle in which

people can make money, the move out of cash (that pays them virtually

nothing) to risk-on investments could be huge.1

-Ray Dalio Bridgewater Associates, LP December 19, 2016

Anatomy of a Stock Market Overshoot The quote above comes from a recent blog post from the founder of the world’s largest hedge fund, Bridgewater Associates.2 It is representative of a building narrative among many investors about the possible investment implications of the incoming Trump administration. Specifically, investors seem increasingly hopeful for sensible tax reform, a lighter approach to regulatory policy, and a transition toward fiscal stimulus through infrastructure spending, while moving away from “emergency” monetary policy in the form of zero-percent interest rates forever. January 1, 1998 to December 27, 2016

1 Source: LinkedIn blog post, “Reflections on the Trump Presidency, One Month after the Election” 2 Source: Ernst & Young – 10th Global Hedge Fund and Investor Survey; Bridgewater Associates managed $104.2 billion as of March 31, 2016


Periodic booms and busts are a structural feature of stock markets. The most noteworthy booms in the past share a common trait in the form of a prevailing narrative that seems to justify elevated stock prices at the time. The most extreme example is the technology bubble in the late-1990s, when visions of a new era of technological progress allowed companies with little more than a business plan to raise billions of dollars in the stock market.

NASDAQ Composite Index3

January 1, 1994 to December 31, 2004

Source: Wikipedia; NASDAQ

A bullish narrative needs two features to drive an upside overshoot. First, it must be plausible. For example, the proliferation of the Netscape internet browser in 1996 did in fact change the world. Investors were correct to recognize that something profound was happening in the fields of technology and science between 1996 and 1999, and they were not irrational to try to participate in it. The second feature necessary for a narrative to blossom is the presence of structural change. With the benefit of hindsight it is easy to scoff at investor behavior during the technology boom, but at the time, nothing like the emergence of the internet had ever happened before. Such is the nature of structural change…it has no historical precedent.

3 NASDAQ Composite Index is a market capitalization-weighted index of approximately 3,000 common equities listed on the Nasdaq stock exchange.


When there is no historical analog for a given narrative about the future almost anyone’s expectations might be considered rational. If I believed in 1999 that an online pet store might one day achieve $1 billion in annual revenue, no one could prove me wrong at the time because there was no such thing as an online pet store until that moment. In the presence of structural change, visions of the future that ultimately turn out to be wrong can persist for a time because the outlook cannot be falsified objectively from current data, or past experience.

The Narrative of Trump With more than two centuries of American politics to draw from it may be a stretch to characterize the incoming Trump administration as a structural change. Yet the inability of virtually anyone to anticipate Trump’s nomination and subsequent election suggests that something unprecedented may be at work. As for plausibility, Trump’s policy platform of tax reform, regulatory relief and fiscal stimulus seems to have a legitimate shot at improving the growth rate of the U.S. economy. Importantly, investors’ hopes for this policy prescription have an opportunity to blossom unchecked for several months before actual policy changes take shape in Washington, and it will take longer still before the impact of any policy actions becomes measurable. In the meantime, rising stock prices might help to validate the bullish narrative. As long as investors can dream about the future without being interrupted by objective facts – like an actual tax reform bill, for example – a rising stock market has the potential to embolden the bullish narrative by implying that it seems to be correct. To be clear, an upside overshoot is just one of several possibilities for the stock market in 2017, and we do not expect anything comparable to the internet mania of the late-1990s. Our point is that the probability of an overshoot in 2017 may have increased materially due to the willingness of many investors to imagine a “best case scenario” for the incoming Trump administration (for now).

Update on the Long-Term Case for Low Returns Regardless of what happens to the stock market in 2017, our outlook for the next decade remains subdued because even a best-case-scenario for the Trump administration may be insufficient to overcome the primary drivers of low expected returns. Specifically, we expect the total return of the U.S. stock market over the next 10-years will be driven by the magnitude of reversion to the mean that occurs in two variables: corporate profit margins and the price-to-earnings ratio (P/E).


The concept of reversion to the mean is critical to the long-term outlook for stocks because corporate profit margins and the P/E ratio are currently sitting well above their long-term average values. Many economists believe the long-term experience of these variables represents a structural base rate that should be relatively stable over time. In other words, cyclical moves above and below the long-term trend should roughly offset one another to deliver a stable average over time. If this view is correct, some magnitude of reversion to the mean should be expected for both profit margins and the P/E ratio over the next decade. From today’s starting point, this suggests that both of these variables are likely to be lower 10-years from now.

Corporate Profit Margins Consider profit margins. For several decades prior to the mid-2000s, corporate profit margins fluctuated around a stable average of approximately 5.9% as a percentage of GDP.4 The maximum reading for this metric prior to 2004 was 7.9% in 1966. Yet since 2005 profit margins have averaged 8.5%, while reaching a maximum of 10.1% in 2011.

U.S. Corporate Profit Margins

Jan. 1, 1947 to July 1, 2016

It will make a big difference to the future path of the stock market if the recent step higher in corporate profit margins represents a structural change rather than a temporary cycle. For example, for any given level of corporate revenue 10-years from now, the pace of earnings growth between now and then will be vastly different if profit margins revert toward their recent mean of 8.5%, rather than drifting all the way down to the longer-term average of 5.9%. We will illustrate the impact of both scenarios below.

4 Source: St. Louis Federal Reserve FRED data https://fred.stlouisfed.org/graph/?g=cJW


Price-to-Earnings Ratio

Similar to the recent experience of corporate profit margins, the P/E ratio of the U.S. stock market has fluctuated around a much higher average over the past few market cycles compared to the average that prevailed before. We prefer to use a cyclically adjusted P/E ratio, or CAPE ratio,5 to measure stock market valuation because it smooths out the volatility of the business cycle. Even if we exclude the peak of the tech bubble in 2000, the average CAPE ratio since 2001 has been 24.4, compared to an average for the entire 135 history of the series of 16.7, and a post-WWII average of 18.6.

U.S. Stock Market CAPE Ratio

Jan. 1, 1881 to Dec. 1, 2016

Source: Robert J. Shiller; Yale University

Here again, it will make a big difference to the 10-year return of the U.S. stock market if the CAPE ratio is still hovering in the mid-20s a decade from now, versus drifting toward the post-WWII average of 18.6, or heaven forbid, the long-term average of 16.7.

5 The CAPE ratio was popularized by Yale University economist, Robert Shiller, who maintains a public database for the metric at http://www.econ.yale.edu/~shiller/data.htm It is calculated by dividing the 10-year average earnings per share of a stock market index by the recent price of the index.


Stock Market Scenarios – Base Case The table below presents four hypothetical scenarios for the S&P 500 Index over the next 10-years. Each scenario uses different assumptions for the future path of profit margins and the CAPE ratio. For this exercise we have assumed a 10-year annualized revenue growth rate of 4.9% for the S&P 500 Index.6

S&P 500 Index

Estimated 10-Year Returns

Dec. 31 2016 to Dec. 31 2026

Annualized Returns Including Dividends

Profit Margin (PM) & Est. 2026 Estimated Valuation Scenario Mean Reversion Index Level 10-Yr. Return 8.5% PM / 24.4 CAPE None 3059 5.3% 7.5% PM / 21.0 CAPE Limited 2452 3.0% 6.5% PM / 18.6 CAPE Partial 2003 1.0% 5.9% PM / 16.7 CAPE Full 1706 -0.6%

Note: The projections above are hypothetical. It is not possible to invest directly in the index. Estimated 10-Yr. Return includes an estimated contribution from dividends of 2.1% per annum. The starting value for the index as of Dec. 31, 2016 is 2238.83.

Stock Market Scenarios Assuming a Boost from “Trumponomics” To illustrate the potential impact of a meaningful improvement in the economy over the next decade we duplicated the exercise above with one important difference – corporate revenue was assumed to grow at 6.1% per annum for the next 10-years instead of 4.9%. This change reflects a hypothetical scenario in which GDP per capita,7 or “productivity,” increases 3.3% annually for the next 10-years, instead of 2.1%, as was assumed in the data above. For context, the average growth rate for GDP per capita since 1960 has been 2.1%, while the threshold for the highest quartile within this data series has been 3.3%.8 Thus, for the illustration below we have given the Trump administration the benefit of the doubt to deliver top-quartile economic performance for a decade without a recession.

6 Aggregate corporate revenue growth is highly correlated to nominal GDP, such that nominal GDP can serve as a proxy for expected future revenue growth. Nominal GDP is comprised of three inputs – population growth, productivity, and inflation. The U.S. Census Bureau expects U.S. population growth to average 0.8% per annum over the next decade. GDP per capita (i.e. productivity) has averaged 2.1% since 1960. We estimate inflation at the Fed’s target rate of 2.0%. The sum of these three inputs is 4.9%. 7 GDP per capita is a measure of average income per person in a country. GDP stands for Gross domestic product. 8 Source: Federal Reserve Bank of St. Louis


S&P 500 Index9

Estimated 10-Year Returns – Assuming Faster Revenue Growth

Dec. 31 2016 to Dec. 31 2026

Annualized Returns Including Dividends

Profit Margin (PM) & Est. 2026 Estimated Valuation Scenario Mean Reversion Index Level 10-Yr. Return 8.5% PM / 24.4 CAPE None 3268 6.0% 7.5% PM / 21.0 CAPE Limited 2615 3.7% 6.5% PM / 18.6 CAPE Partial 2135 1.6% 5.9% PM / 16.7 CAPE Full 1815 0.0%

Note: The projections above are hypothetical. It is not possible to invest directly in the index. Estimated 10-Yr. Return includes an estimated contribution from dividends of 2.1% per annum. The starting value for the index as of Dec. 31, 2016 is 2238.83.

The Path to 6.0%

For those most hopeful about the long-term potential of Trump’s preliminary policy proposals, we wish to highlight just how difficult it might be to achieve the best-case scenario above. Here are the assumptions we used to arrive at a 6.0% annualized return forecast for the S&P 500 Index over the next 10-years:

1) The U.S. economy is assumed to experience consistent top-quartile productivity growth of 3.3% per annum for a decade, with no recessions.

2) The recent jump in average profit margins from 5.9% to 8.5% is assumed to be structural and sustainable through 2026.

3) The recent jump in the CAPE ratio from its long-term average of 16.7 to the post-2001 average of 24.4 is assumed to be structural and sustainable through 2026.

4) Inflation is assumed to remain in the Fed’s “comfort zone” of 2.0% per annum for the next decade.

In other words, we must assume virtually zero reversion to the mean for each of the inputs that determine long-term stock market returns. Anything is possible, but such a scenario would contradict established economic relationships, and it would require a sustainable deviation from historical trends that have been in place for decades. We believe it is far more likely that a modest amount of mean reversion from at least one of these variables could put even a 6.0% return out of reach for a passive, buy-and-hold investor in domestic stocks.

9S&P 500 Index is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.


End of an Era in the Bond Market? It seems reasonable to speculate that July 8, 2016 may represent a lasting turning point for the U.S. bond market. On that date the yield on the 10-Year U.S. Treasury Note reached an all-time historical low of 1.37%.10 As the chart below reflects, interest rates drifted higher throughout the fall, but the surprise election outcome triggered a parabolic surge to the upside, presumably based on an expectation for aggressive fiscal stimulus and a less accommodative Federal Reserve under a Trump administration.

10-Year U.S. Treasury Yield

July 31, 2012 to November 30, 2016

To put the recent move in interest rates into perspective, the 10-Year Treasury just experienced the largest percentage increase within a two-month period in 50 years. Over this same two-month period the Barclays Aggregate Bond Index11 dropped approximately 3.1%. Clearly, a quick decline of 3.1% in any asset class is undesirable, but it seems worth highlighting that one of the most extreme interest rate moves in a half-century triggered a relatively modest negative return for investment-grade bonds as an asset class. Moreover, the Barclays Aggregate Bond Index ended the calendar year with a positive total return of 2.65%, despite the give-back since July.

10 Source: Wall Street Journal – Dec. 31, 2016; Bloomberg; 10-Year U.S. Treasury yield rose from 1.60% on 9/30/16 to 2.38% on 11/30/16 for a percentage change of 48.8%. 11 Barclays Aggregate Bond Index is a broad base index used to represent investment grade bonds being traded in United States.


For perspective, the S&P 500 Index has experienced two-month drops of 10% or more 10 times in just the last 25 years. The average decline for these quick downturns in the stock market was approximately -16%.12 This helps to illustrate why investment-grade bonds are considered a safer asset class than stocks, even though “safe” does not mean bonds can never go down.

A Brief Review of Bond Math Assuming a given bond does not default, its expected return to maturity is measurable within a narrow margin at the time of purchase. However, the price of the bond can take a varied path between the purchase date and maturity. The magnitude of these interim price swings is a function of the bond’s time to maturity, and the magnitude of the interest rate move. The graphic below illustrates the impact of a hypothetical one percentage point change in interest rates on the price of a 2-year bond versus a 10-year bond. It is important to note that in both cases, the interim price move has no effect on the outcome at maturity.

Bond Pricing Illustration

Source: Capital Advisors

12 Source: Bloomberg

2-Year Maturity, "AA" Quality Bond, Noncallable, 2% Annual Coupon, Purchased at 100 (Assuming No Default)

10-Year Maturity, "AA" Quality Bond, Noncallable, 3% Annual Coupon, Purchased at 100 (Assuming No Default)

108

102

100 100

98

92

Year 0 ………………………………………..……………………..………………

2- Year Cash Flow 2% ……………... Subject to Reinvestment Risk ………………

10-Year Cash Flow 3% …………….. 3% Each Year …………….….

Bo

nd

Pric

e

rates rise +1%

rates fall -1%

Year 1 Year 2

100% + 2%

3%

Year 10

100% + 3%

Time

100


Capital Advisors’ fixed income strategies are currently designed to withstand a shift to higher interest rates by including exposure to bonds with staggered maturities. By combining bonds with shorter maturities and longer maturities within a deliberate strategy, a bond portfolio can accomplish multiple objectives, including:

• Income: Long-term bonds provide higher current income compared to short-term bonds. Moreover, reinvestment risk is lower for long-term bonds. Should interest rates decline, long-term bonds extend the time period for the investor to enjoy a locked-in yield without needing to reinvest into a lower interest rate environment.

• Liquidity: Short-term bonds provide greater liquidity and less price volatility. These bonds benefit from rising rates because they provide the portfolio an earlier reinvestment opportunity into a higher yielding interest rate environment.

• Risk Management: One key benefit of investment grade bonds within a balanced portfolio is risk management. Historically, when there have been hiccups in the stock market bonds frequently acted as a safe haven, with greater demand pushing interest rates down – and bond prices up – at the time when stocks were doing the opposite. On this front, long-term bonds have often provided greater risk management benefits than short-term bonds.

Despite the recent pain in the bond market, we view the current situation favorably because the ability to generate future returns in the fixed income markets improves with each tick higher in the general level of interest rates. With 10-year rates having moved higher by more than one percentage point over the past two quarters, we are finding much better opportunities across the yield curve to invest.

Conclusion Participating in a stock market overshoot can be very profitable, but it is critical to recognize that the fundamental foundation for a substantial move higher from here looks weak. Nonetheless, we believe the odds of an upside overshoot in 2017 are high enough to justify continued participation for all but the most risk-averse investors. We hope to use whatever rallies the stock market might offer in 2017 to reduce risk into the strength, and we will be on the lookout for signs that market conditions may be deteriorating.


Looking beyond 2017, our longer-term outlook for stocks remains uninspiring. Moreover, this outlook would be further depressed if stocks move significantly higher this year. As illustrated above, we believe investors who buy and hold the S&P 500

Index over the next decade should expect around a 2% to 4% annualized return from today’s starting point. Now consider that the yield-to-maturity for the Barclays U.S. Credit 5-10 Year Index recently hit 3.45%, while the tax equivalent yield to maturity for the Barclays Municipal

Bond 10-Year Index reached 4.32%13 (for investors in the top income tax bracket). As we speculate about the possibility of a rush toward risk assets by many investors in 2017, we question when it might make sense to do the opposite for ourselves. If a basket of investment-grade bonds can deliver a stable 10-year return in the 3.5% to 4.5% range (assuming the bonds are held to maturity), when might it make sense to back away from stocks, which seem poised to do no better with a lot more risk? Getting this question less wrong than the crowd may be the key to success in 2017 and beyond.

Current Design of Our Investment Strategies14

The remainder of this report addresses the current positioning of each of our seven investment strategies. We offer the standard reminder that our seven investment strategies serve different roles within a diversified portfolio. The strategies are designed to complement one another when used in combination.

Managed Equity Growth15

The Managed Equity Growth strategy serves as a core allocation to the domestic equity asset class to achieve long-term capital appreciation. The graph below has been updated since the last Overview to reflect the recent risk profile of the portfolio model.

13 Source: Bloomberg; Barclays; The Barclays U.S. Credit 5-10 Year Index measures the yield and return of a diversified basket of investment grade corporate bonds with maturities in the 5 to 10 year range; The Barclays Municipal Bond 10-Year Index measures the yield and return of a diversified basket of investment grade municipal bonds with an average maturity of 10 years. 14 The portfolio strategy discussions in this section are supplemental to a compliant presentation. A complete list of Capital Advisors’ portfolio models and compliant presentations are available by contacting Capital Advisors. 15 The portfolio strategy discussions in this section are supplemental to a compliant presentation. A complete list of Capital Advisors’ portfolio models and compliant presentations are available by contacting Capital Advisors.



The graph reflects the strategy’s relatively cautious approach since the financial crisis. After taking the risk level higher during the recovery years of 2010-13, we began a downward shift in the risk level in the second half of 2013 in response to higher valuation multiples in the stock market following a strong advance that year. We are comfortable with the current positioning of this strategy for now. We believe the portfolio includes plenty of exposure to stocks that ought to participate in a rising stock market trend, should such an outcome unfold. Conversely, if new fears emerge that translate into a correction for the domestic stock market, the steps we have already taken to dial-down the risk profile for this strategy might help to soften the damage.

Managed Equity Dividend16

The Managed Equity Dividend strategy is designed to complement the equity and fixed income allocations of a diversified portfolio. For the equity portion of a portfolio this strategy provides a value tilt due to its emphasis on mature companies trading at low valuation multiples. For the fixed income portion of a portfolio this strategy diversifies the sources of cash flow to include dividend income in addition to interest from bonds.

16 The portfolio strategy discussions in this section are supplemental to a compliant presentation. A complete list of Capital Advisors’ portfolio models and compliant presentations are available by contacting Capital Advisors.


We like the outlook for high-dividend stocks in 2017 because we believe the worst of the adjustment to higher interest rates may be over for now. Assuming the Fed follows through on its current forecast to raise the Fed Funds Rate three times in 2017, it would not be surprising if interest rates drifted a bit higher throughout the year. However, we suspect longer-term interest rates may have already priced in another rate hike or two, and long-term rates provide the greatest competition for high dividend stocks in the marketplace. Meanwhile, the weighted average dividend yield for the Managed Equity Dividend strategy model was 4.6% (Source: Fiserv APL) as of December 31, 2016. As noted above, we suspect the long-term outlook for the broad domestic stock market may be no better than 2% to 4% annualized for buy-and-hold investors, with plenty of volatility in between. Within this context a 4.6% cash yield makes a lot of sense to us.


As the pie chart above reflects, attractive dividend yields can still be found across a broad spectrum of industries. Although the strategy model includes a healthy dose of “standard” dividend payers in the utility, telecommunications and real estate sectors, these three traditional dividend sources represent less than half of the total portfolio allocation.


Tactical Dynamic Allocation17

The Tactical Dynamic Allocation strategy is designed to be highly responsive to changing market conditions. By systematically responding to a quantitative indicator called a “moving average,” this strategy is likely to be mostly exposed to risk assets when the recent trend in global markets has been positive, and mostly out of risk markets when the recent trend has been negative. We use this strategy to complement a diversified portfolio of equity and fixed income assets because the variable portfolio mix within this strategy allows the overall risk exposure of the broad portfolio to react to changing market conditions un-emotionally. This strategy may be a particularly good match for the current stage of the market cycle because it is specifically designed to reduce risk whenever market conditions deteriorate. As of December 31, the strategy model included 50% exposure to risk markets and 50% in fixed income and cash reserves. The un-invested risk markets as of year-end were international equity, emerging markets and real estate. We suspect that all three of these sectors might return to the portfolio in 2017 if the recent rally in global risk markets sustains its momentum. The beauty of the Tactical Dynamic Allocation strategy is that it doesn’t require us to predict the future. Whenever investor sentiment changes for a major risk market, the shift reflects itself in market prices. Once a new trend in price has been established it can be measured objectively with a moving average indicator. This strategy will never catch the top, or bottom of a risk market cycle because a moving average is a lagging indicator. However, the strategy should never experience the full depth of a bear market cycle due to its weekly discipline of measuring market trends and reacting accordingly. We frequently advocate keeping 10% to 15% of a balanced portfolio in the Tactical

Dynamic Allocation strategy to enable a 10% to 15% swing factor in the equity-to-fixed income ratio of the total portfolio. Such a shift is enough to make a difference in the resilience of the portfolio during stressful market conditions, without going too far toward an all-or-nothing bet on the short-term direction of unpredictable asset markets.

17 The portfolio strategy discussions in this section are supplemental to a compliant presentation. A complete list of Capital Advisors’ portfolio models and compliant presentations are available by contacting Capital Advisors.


Tactical Diversified Strategies18

The Tactical Global Growth and Tactical Global Income strategies participate in the long-term growth of the global equity markets. A discipline of systematically tilting the sector weightings toward relative strength incorporates a momentum effect into both portfolios. These strategies can serve as a core position for investors seeking global diversification within the equity portion of their portfolio. Both strategies spread investments among 10 broad sectors of the global asset markets using exchange traded funds (ETFs) for each market sector. The portfolio weightings change according to an objective measure for relative strength among the 10 sectors. We believe the global diversification inherent in these strategies may be helpful over the next several years because international equity markets might offer higher potential returns than the domestic stock market from today’s starting point. Broadly speaking, the international equity markets trade at a lower price-to-earnings multiple, and a higher dividend yield relative to domestic market benchmarks. This difference in initial conditions might produce comparatively higher returns for international and emerging market equities over the next 5-to-10 years. Most recently, these strategies benefited from a shift to a maximum over-weight position in domestic small-cap stocks in early October, just in time for a double-digit rally in small-cap stocks in the fourth quarter.19 For the upcoming quarterly holding period these strategies will be over-weighted in domestic small-cap stocks, mid-cap stocks and natural resources, while the under-weighted sectors will be real estate, international equities and small-cap international.

Fixed Income

Our Fixed Income strategies are customized according to three broad priorities – Liquidity, Income or Aggregate. A Liquidity portfolio invests exclusively in high credit quality securities and short-term maturities to ensure stability of principal and ready access to capital. An Income portfolio extends further out on the yield curve and includes a broader range of credit quality to generate a higher level of income. The Aggregate approach incorporates elements of both designs for a “core” exposure to the fixed income asset class.

18 The portfolio strategy discussions in this section are supplemental to a compliant presentation. A complete list of Capital Advisors’ portfolio models and compliant presentations are available by contacting Capital Advisors. 19 Source: Bloomberg; The S&P SmallCap 600 Index delivered a total return including dividends of 11.13% from 9/30/16 to 12/31/16.


Our fixed income portfolios are currently structured to withstand a possible increase in short-term interest rates associated with a gradual monetary tightening process from the Fed. It seems reasonable to expect some upward pressure on interest rates as the Fed tightens policy, however, we don’t expect a substantial increase from here because rates already moved a lot in the second half of last year, and interest rates throughout much of Europe and Asia remain well below domestic levels. By structuring our bond portfolios in a “ladder” with maturities typically contained within the 1-to-10-year range, the overall sensitivity to rising interest rates should be moderate unless rates rise much further and faster than we currently expect. Even then, a laddered bond portfolio provides opportunities to take advantage of higher rates by shifting near-term maturities further out on the yield curve. We continue to emphasize “defined maturity” ETFs in our fixed income model portfolios. These funds include all of the features of a traditional fixed income ETF with one important difference: a specific maturity date. These funds are populated with bonds that all mature in the same calendar year. During that year, the ETF terminates, and the fund’s net assets are distributed to shareholders as cash, similar to what happens when an individual bond matures. Most alternative fixed income strategies look relatively expensive to us, but we see potential opportunities in floating-rate bank loans, along with variable rate and trust preferred securities. In all cases we will not reach for yield unless the merits of the underlying strategy prove worthwhile relative to the risk.

January 3, 2017


DISCLOSURES This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third party sources and is believed to be reliable; however, its accuracy is not guaranteed and should not be relied upon in any way, whatsoever. This presentation may not be construed as investment advice and does not give investment recommendations. Any opinion included in this report constitutes the judgment of Capital Advisors, Inc. as of the date of this report, and are subject to change without notice. This commentary does not purport to be a statement of all material facts relating to the securities mentioned. The information contained herein, while not guaranteed as to accuracy or completeness, has been obtained from sources believed to be reliable. Opinions expressed herein are subject to change without notice.

The investment return and principal value of an investment will fluctuate so that an investor’s portfolio may be worth more or less than its original cost at any given time. Due to differences in portfolio timing and position weightings, the returns for any individual portfolio managed by Capital Advisors may be lower or higher than any performance quoted. The S&P 500 Index is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S. stock market, as determined by Standard & Poor's. The index is calculated on a total return basis with dividends reinvested and is not assessed a management fee. The Barclays Aggregate Bond Index is a broad base index, maintained by Barclays Capital, which took over the index business of the now defunct Lehman Brothers, and is often used to represent investment grade bonds being traded in United States. Estimated portfolio yield represents the 12-month run-rate of interest and/or dividend payments in a strategy divided by the market value of the securities and cash reserves invested in the strategy. Estimated interest/dividend payments and market values are calculated by a portfolio accounting system from Fiserv APL using a single client portfolio that Capital Advisors believes to be representative of clients’ portfolios invested in the same strategy. The actual portfolio yield for any single client portfolio may be lower or higher than the yield quoted. The underlying holdings of any presented portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Security Recommendations: The investments presented are examples of the securities held, bought and/or sold in the Capital Advisors strategies during the last 12 months. These investments may not be representative of the current or future investments of those strategies. You should not assume that investments in the securities identified in this presentation were or will be profitable. We will furnish, upon your request, a list of all securities purchased, sold or held in the strategies during the 12 months preceding the date of this presentation. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of securities identified in this presentation. Capital Advisors, Inc., or one or more of its officers or employees, may have a position in the securities presented, and may purchase or sell such securities from time to time. The information provided is supplemental to a fully compliant presentation. A complete list of Capital Advisor’s portfolio models and compliant presentations are available by contacting Capital Advisors at the number listed below. The actual return and value of an account fluctuate and, at any time, the account may be worth more or less than the amount invested. Additional information, including management fees and expenses, is provided on Capital Advisors’ Form ADV Part 2. As with

any investment strategy, there is potential for profit as well as the possibility of loss. Capital does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. The investment return and principal value of an investment will fluctuate so that an investor’s portfolio may be worth more or less than its original cost at any given time. Past performance is not a guarantee of future results.

Capital Advisors, Inc. does not provide tax or legal advice and recommends you consult with your tax and/or legal adviser for such

guidance. Presentation is prepared by: Capital Advisors, Inc. Contact Capital Advisors for a list and description of all firm

composites and/or copy of our most recent Form ADV Part 2: 1-866-230-5879

www.capitaladv.com 20170103R Copyright © 2017, by Capital Advisors, Inc.

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