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Q1 2013 Market Commentary

With the S+P continuing its push to highs not seen since 2007 a kind of euphoria has gripped the equity markets and one could extrapolate that the economy, and the prospects for global growth, must be better for investors to have become so happy. But is that really the case? Here at Northstar we feel the recent market movement is tantamount to a child eating too much candy. But instead of a parent mistakenly buying their kids too much chocolate we have the Fed providing investors with the false energy of an equity market sugar rush. The difference is they did it on purpose. Since the financial crisis, we have supported the actions taken by the Fed to ease the country through the deepest economic meltdown since the Great Depression. But one negative aspect of the Feds action is that it eliminates the pain of the event. This is not to say that there has been no pain. Many people have become adversely and irrevocably affected by the downturn. But the deep pain that was felt by the Nation as a whole in the 1930s has not been seen this go around. Unfortunately, that tends to create a false sense of normalcy , a sense that no matter what happens everything will be fine because someone will step up to the plate and solve the problem. It is the moral hazard discussed during the bailout debates come home to roost. Since 2008 the Fed has taken steps to lower the Fed Funds rate used in interbank lending to zero percent in an effort to provide liquidity to the economy. Once at zero, the Fed then began to implement rounds of quantitative easing (QE), which in effect is buying assets from financial institutions to provide even greater amounts of liquidity in hopes that it spurs growth. The QE actions have culminated with the recent implementation of the Fed purchasing $85 billion a month of agency mortgage backed securities securitized bonds backed or issued by Ginnie Mae, Fannie Mae and Freddie Mac. According to Reuters the Federal Reserve balance sheet has ballooned to $3.198 trillion dollars as of April 3rd, 2013. To put that into context before the financial crisis the Fed balance sheet was roughly $859 billion. So the amount of liquidity the Fed has pumped into the economy through monetary policy has been historical in nature and enormous. But why should we care? On one hand the actions have had positive results. For example, as the Fed became a large buyer of Treasury bonds, it forced up the price of those bonds (due to the volume of their buying) and pushed down their yields. This helped to lower mortgage rates to historical lows which in turn helped to strengthen a weak housing market. Low rates have allowed corporations to issue new bonds at much lower interest rates, raise capital and then retire older, higher interest rate debt. This has strengthened their corporate balance sheets and cash flows making corporate America financially healthier than it has been in years. It has allowed all of us to refinance

mortgages and make larger purchases at lower interest which has helps our own personal household cash flows, leaving more money each month in our pocket to purchase other items and this has helped strengthen the economy in general. But for all these positives, there are also some negative effects. Low short term interest rates also affect the yields on cash and Certificates Of Deposit as well as the yields in many bond sectors. Too much cash chasing too few bond opportunities has pushed up prices but lowered yields. These yields are typically used by individual investors for their retirement income or for risk mitigation in investor portfolios. By driving down yields it creates changes in investor behavior. Starved for yield, investors begin to walk down the quality ladder of fixed income, uncomfortably leaving the security of investment grade bonds for the risks and yield associated with junk bonds. With all this new influx of investor cash the prices of these bonds also rise, thus forcing investors with new cash or maturing securities further afield, into emerging market bonds or unrated bonds. And, if it goes on long enough, eventually all bond sectors become too pricey to deliver the yield that investors want or need. Investors then start looking at the only other game in town with a modicum of stability equities. Like any other auction driven market, as new money comes in seeking to buy stocks, the demand increases and prices go up. That is what we have seen occur in the equity markets. New cash has come in from investors with nowhere else to go and prices have begun to rise. As they have risen those that had have been on the sidelines feel compelled to enter afraid of missing the boat. And so we continue to make new daily highs as the sugarrush of cheap monetary policy continues. This type of price growth, in our opinion, is not sustainable. We have discussed in the past that the most basic tenet of equity investing is that investors accept the additive risk of owning equities in exchange for participation in the potential growth of a company. Both the risk and the potential growth are reflected in the demand for that companys stock. Growth is a result of many things, from good management to an exceptional product or service that is in demand and much of that is driven by a robust economy driving that demand. The stronger the economy, the greater the increase in revenues, the greater the increase in potential bottom line earnings, and the more we should expect investors to bid up that stocks price as more investors seek to participate in that companys success. So why then do we disagree with recent market movement? Earnings and Revenues According to FactSet the estimated growth rate for revenues of the S+P 500 for 2013 has been reduced from 4 % to 3.6 %. As well they estimate that earnings growth for Q1 will decrease to .5 % down from previously forecasted 2.4 %, Q2 has been lowered from 6.7% to 5.4% and full year earnings growth estimates have decreased from 9.6% to 8.5%. Full year estimates for the S+P 500 are roughly $108 a share. It is our contention that the full effects of Sequestration have yet to be felt in the economy. Also, as upwards of 50 % of the S+P 500 earnings come from developed Europe, the persistent recessionary environment there will continue to be a

potential drag on earnings, and we could see further revisions downward. Bottom line, after rebounding off of the financial crisis lows, revenues and earnings have increased through organic growth and corporate cost cutting but both are showing signs of softening as the larger roadblocks to sustained growth (Europes recession, US budget cuts and persistent global unemployment) continue. Valuation Assuming the $108 a share of earnings actually occurs, then the S+P 500 is selling a multiple of 14.47x times those estimated earnings. This sits in the middle of long term averages of 12-18x earnings. From that perspective one could argue that we are fairly priced at this time. Our take would be that fair price is relative to the ability of S+P companies to sustain and increase those earnings expectations not only for 2013 but beyond. While we feel positive about the fact that we have rebounded since 2008, sustainable growth must come from consumption and not from the capital infusion being directed by the Fed, the European Central Bank and the Bank of Japan and, one could even argue, the Central Bank of China. Volume Recent increases in the market have been made on lower volume, which has trended down for the last couple of years. While this can be taken as a positive that the fuel for continued growth still sits on the sidelines it is also reflective of the lack of commitment on the part of investors on the buy side and lack of urgency on the sell side. To carry that a little further we are a bit disappointed with the lack of volatility in the market. Low volatility is an indicator of investor complacency which, as strange as it sounds, is a bearish signal. Insiders According to Vickers Stock Research, who tracks a proprietary calculation of the Buy to Sell Ratio of Insiders of publically traded companies that need to file with the SEC when they buy or sell their companys stock, the overall majority of Insiders are continuing to sell into the markets strength. This is disconcerting and counter to what you would expect if the economy were continuing its improvement and the outlook for future earnings growth was rosy. One would expect that in that case, on a broad basis, Insiders would continue betting on the ability of their companys stock to rise as their financial outlook brightened. They are after all the ones that know their companies the best. Instead we are finding that across many sectors and companies Insiders are taking money off of the table while their companys stock makes new highs. That shows a lack of expectation on their part for sustainable growth. Now before we give the impression that Northstar is so bearish that we feel the market is due for a massive decline let me ease your fears. We feel that since 2008 the global economy has gotten better. We survived one of the worst financial calamities in decades and corporations and households, on average, are in better financial shape than they have been in years with greater amounts of assets and less amounts of leverage. We are on the road to continued recovery.

But we want to point out that there is a difference between a recovery based on demand and a recovery based on the last place left to go. The action global central banks have taken has moved us away from the worst and sustained us. But, like a flywheel, the economy needs to pick up enough momentum to spin off on its own and we are not yet at that point. The longer this recovery is dependent upon the sugary treat of cheap monetary policy, the greater the risk we get ill before we get better. Increasing already burgeoning central bank balance sheets indefinitely is an untried and risky proposition. How will they wean global economies off of the ongoing infusions, and how do they liquidate the assets on their balance sheets without adversely affecting the markets? In fact do they even liquidate those assets or instead hold them for years until they mature which brings up a whole new set of unknowns. All questions yet to be answered. At Northstar we continue to look to balance these risks in client accounts and remain conservative in our attitude towards the reality of what is driving investment price increases. We have been diligent in our strategies for combating overpriced bonds; by increasing bond holdings in foreign countries in better financial shape, using bond funds with an open mandate as to which bond sectors they can own, using funds that can short the bond market, and using individual bonds to better control the duration of the bonds held in the portfolio. In equities we continue to overweight large cap multinationals with solid balance sheets. We use funds that historically have better downside performance than their peers, in the event the roadblocks cause growth recession. We also have increased our use of individual stocks which, while potentially decreasing client diversification , allows us to control the fundamental metrics of what we are buying more adroitly. Likewise we continue to use unique holdings like preferred stocks, reverse convertibles and various insurance oriented products that provide guarantees and principal protection as a hedge against potential market volatility. At the moment we feel that this defensive positioning is sufficient to manage the lows that we think must, at some point, accompany the liquidity-laced sugar highs in the markets and we are not at the point of suggesting to any client that we exit the equity market. But our concern regarding the underlying driver of this rally has kept us cautious, and we would like to encourage the same caution in our clients. While the recent returns in the broad markets have certainly been sweet, we really could do without another belly-ache. As always should you have any questions or thoughts regarding this commentary please do not hesitate to call Julia or me at 800.220.2161 or email either of us at steve@nstarfinco.com and julia@nstarfinco.com. Take Care Steven B Girard The opinions expressed are those of Northstar Financial Companies, Inc. and are based on information believed to be from reliable sources. However, the informations accuracy and completeness cannot be guaranteed. Past performance is no guarantee of future results.
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