February 2016 was the 3rd most “chaotic” in the history of the S&P 500


By Rob Edel, CFA

Highlights This Month   

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The NWM Portfolio

Returns for NWM Core Portfolio declined 0.8% for the month of February.  The NWM Core Portfolio is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships.   Actual client returns will vary depending on specific client situations and asset mixes.

The Canadian yield curve flattened last month, with 2-year Canada yields increasing from 0.42% at the beginning of the month to 0.52% at the end of the month, while 10-year Canada’s fell from 1.22% to 1.19%.  The U.S. yield curve also flattened, with 2-year treasuries unchanged at 0.77%, while 10-year treasury yields ended the month at 1.74%, down 19 basis points.  The NWM Bond performed well in this environment, down only 0.1% with all of our alternative managers in positive territory.

Wider credit spreads and currency impacted high yield bonds, which were weaker in February with NWM High Yield Bond -2.7%.  The Canadian dollar appreciated 3.1% against the U.S. dollar last month, so any unhedged U.S. high yield positions would have declined by this amount as a result of currency.

The stronger Canadian dollar also hurt global bonds, with NWM Global Bond down 4.2% in February.

The mortgage pools continued to delivered consistent returns, with NWM Primary Mortgage +0.3% and NWM Balanced Mortgage +0.5% in February.  Current yields, which are what the funds would return if all mortgages presently in the fund were held to maturity and all interest and principal were repaid and in no way is a predictor of future performance, are 4.5% for NWM Primary Mortgage and 5.7% for NWM Balanced Mortgage, unchanged from last month.  NWM Primary Mortgage ended the month with negative cash of $1.9 million, or -1.1%, meaning the fund was into its bank line for the second month in a row.  NWM Balanced Mortgage ended the month with $15.6 million in cash, or 4.0%.

NWM Preferred Share returned -3.6% for the month of February outperforming the Laddered Preferred Share Index ETF which returned -4.2%. The beginning of the month was marked by two proposed redemptions for preferred shareholders that were a windfall for their respective holders. A friendly takeover of Rona by Lowe’s caused the Rona preferred shares to spike up over $20 when previously they were trading around $12. Riocan also announced redemption of their outstanding Series A preferred shares at $25 when they were trading at $15.50. The current expensive nature of issuing preferred shares versus other forms of debt will hopefully cause other issuers to redeem and provide stability in the marketplace.

Canadian equities were marginally stronger in February, with the S&P/TSX up 0.5% (total return, including dividends), however NWM Canadian Equity Income and NWM Canadian Tactical High Income were both lower, declining 1.2% and 0.7% respectively.  NWM Canadian Equity Income established a new position in Maple Leaf Foods and wrote covered call options on three existing positions.  As for NWM Canadian Tactical High Income, no new positions were established, but we did add to our existing position in Guardian Capital Group.

Foreign equities were also weaker in February with NWM Global Equity down 3.1% compared to a 4.2% decline in the MSCI All World Index and a 3.7% fall in the S&P 500 (all in Canadian dollar terms).  Of our external managers, Edgepoint was the only manager with a positive return, increasing 2.7%, while Value Invest was -3.4%, BMO Asia Growth & Income -1.2%, Lazard Global Small Cap -6.5%, and Pier 21 Carnegie -7.0%.  NWM U.S. Equity Income was down 0.5% in U.S. dollar terms and NWM U.S. Tactical High Income was up 0.1% versus a 0.1% decrease in the S&P 500 (all in U.S. dollar terms).  In NWM U.S. Equity Income, we trimmed our position in Verizon and added to our existing positions in Comcast and Walmart.  We also wrote covered calls on five existing long positions.  As for NWM U.S. Tactical High Income, we sold the majority of our position in Oaktree.

Real estate was relatively flat in February with NWM Real Estate up 0.3% while the iShares REIT ETF increased 3.1%.

NWM Alternative Strategies was down 2.2% in February (these are estimates and can’t be confirmed until later in the month).  Of the Altegris feeder funds, Winton, Brevan Howard, Millenium, and Citadel were down 2.1%, 2.3%, 5.9%, and 7.6%.  Again, the appreciation of the Canadian dollar hurt these managers last month. The performances of our other alternative managers were mixed in February, with RP Debt Opportunities and MAM Global Absolute Return Private Pool down 0.2% and 0.8% respectively, while RBC Multi-Strategy Trust and Polar North Pole Multi-Strategy was up 0.4% and 1.4%.   Precious metals had another good month, with NWM Precious Metals up 19.8%, with bullion increasing 7.3% in Canadian dollars.

February In Review

February was a tough month for investment managers.  Not only did most equity indices end the month in the red, but the market was extremely volatile.  According to Bespoke Investment Group, the first two months of 2016 was the third most “chaotic” in the history of the S&P 500, with only 1932 and 2009 seeing more days with at least a 1% move (either up, or down) in the market.

Volatility, in fact, became a favourite trade for hedge funds, with managers going long the VIX (Chicago Board Options Exchange Volatility Index), which enables traders to profit if market volatility increases, while shorting equity indices.  Volatility typically increases when stocks go down, which they mainly did last month.

For the second month in a row Canadian equities performed better than their global peers, with the S&P/TSX managing a 0.5% increase versus a 0.1% decline in the U.S. benchmark, the S&P 500.  Europe, however, was down over 2% while China lost 1.8%. Another favourite trade for hedge funds recently has been to go long Japanese stocks, which didn’t work out as well as being long the VIX, as the Nikkei 225 fell 8.4% last month.

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What worked in equity portfolios in February was dividend paying stocks and commodities, especially gold.  Also doing well were the most unloved stocks with the greatest short interest (companies in which traders have taken large short positions), which included emerging market laggards Russia and Brazil.

What didn’t work were banks, energy, and strangely, anything that worked last year and was ranked favourably by sell-side analysts.  The so called FANG stocks (Facebook, Amazon, Netfix, and Google) that dominated the market last year were all under pressure, and according to Bespoke, stocks with the most buy ratings have performed materially worse than those analysts recommended investors stay away from.  This makes sense given analysts tend to favour growth stocks, a category of which the FANG stocks squarely fit into, and growth did poorly last month.

What doesn’t make sense is why growth did poorly, and value stocks (like commodities and beaten up emerging market equities) did relatively better. Historically, investors tend to shun growth stocks when the economy is strengthening, thinking a rising tide should lift all boats and cheaper value stocks have more upside.  A tougher economic environment, when corporate earnings are under pressure and growth is scarce, is when growth stocks become more valuable.

If anything, the global economy weakened last month.  At best, we would say it was a wash, so why did the market prefer value stocks?  Also, the fact bank stocks were down is hardly an endorsement for a stronger economy.  A preference for dividend paying stocks and gold would also indicate investors were becoming more defensive rather than the opposite.

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Confirming the view of a slowing rather than a strengthening economy was the bond market; with both investment grade and non-investment grade credit spreads widening in February while U.S. treasuries rallied (yields went down).  In fact, most market-based economic indicators were flashing warning signals last month, while macroeconomic indicators, like initial jobless claims, show no signs of a potential recession.  Many worry that fears of a recession could actually be self-fulfilling if consumers and businesses curtail spending based on beliefs a recession is around the corner.  Regardless, one would have expected investors to stick with growth stocks versus more economically sensitive companies and markets, given this environment.  It’s a bit of a conundrum.

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While not claiming to have all the answers, we believe part of the explanation on why the capital markets acted as they did last month can be attributed to some of the unprecedented events happening around the world, particularly in regards to monetary policy and the move to negative interest rates.  Negative interest rates are bad for banks, and combined with potential credit losses emanating from the oil industry, have resulted in bank valuations coming under close scrutiny.

Alternatively, low interest rates are very good for gold, which acts as a stable store of value and looks particularly attractive when real interest rates are negative and countries are fighting to depreciate their currency.  Weak global growth and concerns about demand in general also make it less likely the U.S. will follow through with their stated desire to increase short-term interest rates, which makes stocks relatively more attractive.

If the U.S. economy is able to stay out of trouble and interest rates remain accommodative, stocks actually look pretty good here.  If growth is not as bad as people think, and the world is not headed for recession, buy the dogs.  They are very cheap, and have been out of favour for a long time.  Alternatively, if you’re wrong and the market is about the crash, sell the expensive growth names, because they have further to fall.  A delay by the Fed in raising rates also puts a cap on the rally in the U.S. dollar, which in turn helps strengthen commodities and brighten the prospects for emerging market economies, especially those that have borrowed in U.S. dollars.  Even better, China looks to be more serious about stabilizing its currency and shoring up its economic growth.  A resurgent China is good news for commodities.

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But how long can monetary policy continue to keep investors happy?  Recent moves by both Japan and the Euro-zone to increase monetary stimulus by buying more bonds and moving interest rates deeper into negative territory have been met with less than enthusiastic markets.  With inflation remaining dangerously low (their words, not mine) and economic growth sluggish at best, more and more strategists are expressing concern that monetary policy has run its course and central banks are effectively out of ammo.  Their last stand might be so called “helicopter money,” where the central bank prints money, but rather than using it to buy back government debt, they effectively distribute it to their citizens (metaphorically dropping it from helicopters).  This would permanently inflate their monetary base and put cash directly into the consumers’ hands.

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Good for them for doing everything they can, but really, the Central Banks have done enough.  Many economists feel it is long overdue for governments to get their act together and use fiscal policy to stimulate economic growth.  Government debt is still historically high, but deficits have come down since the financial crisis.  So far, however, only China and Canada have indicated that they plan to ramp up their fiscal deficit in order to help the economy out.  Germany is actually running a primary budget surplus but is firmly against the idea, and with the political environment the way it is in the U.S., even passing legislation to keep current funding in place is a battle.

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Uncertainty is a big factor driving the markets in 2016.  We have written in past months about the uncertainty surrounding the Chinese economy and whether there is a looming debt crisis or future currency devaluation.

Oil is also tough on investors, as everyone knows prices have to eventually move higher, but the magnitude and timing are hard to predict.  U.S. supply is taking longer than expected to decline while OPEC is still increasing production. The International Energy Agency believes the crude market will remain over supplied until at least the end of 2017, despite predicting U.S. shale-oil production will fall by 600,000 barrels a day this year, and 200,000 barrels in 2017.  The risk to the downside for crude is that storage is near capacity.  Oil tankers and rail cars are the last line of defense for producers looking to store oil until a buyer can be found.  If there is no place to store it, oil could fall much further in the short-term.

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At the same time, a deal between OPEC and large non-OPEC producers, like Russia, could change the prospects for oil virtually overnight.  Recent talk of a production freeze has already resulted in a bounce in crude prices.  It makes for a very volatile market, with speculators making sizable bets on both the long and short side of the market.

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Perhaps the most visible source of uncertainty, however, is the drama that’s playing out on American television screens every night, namely the upcoming U.S. elections.  Anti-establishment candidate Bernie Sanders is giving Hilary Clinton a tougher test than many expected, and while she will likely be the Democratic nominee, low voter turnout in recent primaries bodes ill for her chances of winning the Presidency in November.

The key to President Obama’s success in 2008 and 2012 was his ability to excite the electorate and get previously uninterested and disillusioned voters out to the polls.  Hilary is the establishment choice, and not very exciting.  Of course, much depends on who she will be running against from the Republican side, and that is very exciting.

Incredibly, Donald Trump looks more and more likely to be the Republican nominee, much to the dismay of most Republicans.  The Donald is also a non-establishment candidate in an election that appears to want anything but the same old mainstream politicians.  Trump is short on experience, a poor debater, makes the most outlandish statements, and has avoided disclosing a policy of any substance…and yet people love him (or at least some do, mainly angry white males). Trump is seen as someone who “tells it like it is,” despite the fact that most of what he says just isn’t true, and exemplifies the image of a tough guy you can trust to protect America.

Democrats would be wise not to write the Donald off too quickly as Republicans are likely not the only ones susceptible to his charms.  He polls poorly against Clinton right now (a recent Washington Post-ABC poll showed 67% of Americans have an unfavourable view of Trump), but wait until he has the Republican nomination and starts spinning his rhetoric to appeal to the general electorate.

Wall Street isn’t so keen on Trump, or Sanders for that matter, and the stock market has tended to move in the opposite direction of anti-establishment support in general.  Given the choices, however, we are not sure any of the candidates still in the race would be well received by Wall Street, especially since they all have openly criticized the financial industry.  Markets hate uncertainty, and there is plenty of uncertainty surrounding American politics right now.  Good theatre, however.  We can hardly wait to see The Donald and Hilary go at it.

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Overall, we find the current market action confusing.  On the one hand, declines in growth stocks and bonds would indicate investors are concerned about an economic recession, but the rally in commodities, emerging markets, and value stocks signal the opposite.  The market is effectively talking out of both sides of its mouth.  We had a rally in risk assets at the time as general market movements were flashing recession warnings signs.  Clearly both can’t be right.

We are still in the slow growth recovery camp, which means we favour growth stocks over value.  We don’t think a recession is imminent, and the recent bounce in inflation is a positive sign that deflation will be avoided.

While investors are concerned about China, conditions appeared to stabilize last month, leading some to become more bullish towards commodities, or at least not bearish.  The weaker dollar, which is losing some appeal as Fed rate hikes become less likely, also helped drive commodity prices higher.  The rally could be a little premature, however, as might be the recent rally in crude oil.  We believe China will avoid a hard landing, but more uncertainty and market volatility is likely.  The continued move by central banks toward negative interest rates is also concerning and fraught with non-analyzable risk, meaning we have no idea how it will work out.

Gold is a way to hedge this risk, and likely why precious metal prices have moved higher.  Never has a diversified portfolio been more appropriate or appealing than in the volatile and uncertain investment environment that we are confronted with today.

The U.S. Economy

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Fourth quarter U.S. GDP growth was revised higher in February to +1.0% versus the +0.7% previously reported.  Consumer spending was adjusted slightly lower, but still increased at its fastest pace in a decade for all of 2015.  Helping brighten prospects for Q1, industrial production turned positive in January and new durable goods orders were strong in February.

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On the negative side, most manufacturing indices are still in contraction territory, and were joined by the PMI Services Index last month, which also dipped below the 50 level.  The ISM Non-Manufacturing Index was still in expansion territory, though it too has been weakening.

There is no doubt, the U.S. economy has slowed, but we don’t think that means we are headed for a recession.  The Atlanta Fed estimates U.S. economic growth will rebound in the first quarter and increase 2.6%.  Capital markets are less optimistic, with 10-year bond yields trading below levels associated with GDP growth of that magnitude, and credit spreads are still under pressure.

The relationship between 2 and 10-year bond yields, however, is not flashing any warning signs.  Usually short rates start to trade at higher yields than long rates, meaning the yield curve has inverted, just before the economy tips into recession.  The reason for this is monetary tightening in reaction to an overheating economy has historically been responsible for most recessions.  Short rates rise in reaction to tighter overnight money, while long-term yields fall in anticipation of weaker future economic conditions.  So far, the yield curve is in no danger of inverting.

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The February job reports more than made up for last month’s disappointing topline number, with over 240,000 new jobs created, and December and January’s tallies were revised 30,000 higher.

Unfortunately, unlike February, where the underlying data was stronger than the headline result, February was perhaps not as strong as the headline would suggest.  Wage growth disappointed and hours worked declined versus the previous month.

The participation rate did move lower, however, and the U6 unemployment rate (which includes workers too discouraged to look for work or are stuck in part time jobs when they would rather have full time employment) dropped down to 9.7% from 9.9%.  Overall, a good report, but perhaps still not definitive enough to compel the Fed to raise rates.

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Low and declining inflation has been one of reasons the Federal Reserve has been cautious to begin normalizing interest rates.  Remembering lessons learned during the great depression and how hard it was to change consumer expectations once deflation became entrenched, policy makers have been more inclined to risk higher inflation than deflation.  Inflation, after all, was successfully dealt with by Paul Volcker in the early 1980’s.

The Federal Reserve targets a 2% inflation rate, but actual inflation has been well below this level for years.  Even worse, consumer expectations for inflation have been moving lower, with the University of Michigan’s consumer sentiment survey showing Americans expect inflation to average 2.4% over the next five years, the lowest this indicator has registered since its inception in the late 1970’s.

Finally in February, however, we saw some signs this trend might be starting to turn as core inflation rose to 2.2%, its fastest rate since July 2012. Headline inflation, with includes more volatile food and energy prices, is still well below 2%, but with energy prices beginning to stabilize, most feel the gap between headline and core inflation should narrow over the coming months.

Services inflation, in fact, has already recovered and is running much higher than the Fed’s 2% target level. Wage growth, which as mentioned above was disappointing in February, is also seen as a future driver of inflation and a strong jobs market should translate into higher future wage inflation.

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Consumer confidence moved lower in February, but the decline was not dramatic.

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Consumer spending moved higher in January, as did retail spending.  The strength was broad based with vehicles, groceries, and building materials leading the way.  Despite the increase in spending, the personal savings rate also continued to trend higher, indicating American disposable income is growing, despite a slowing global economy.

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Existing home sales continue to trend higher, but housing starts declined for the second month in a row.  A shortage of construction workers and land is making it hard on builders to ramp up supply.  The lack of supply is causing prices to move higher, which impacts demand, especially for entry level homes.

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Existing home sales continue to trend higher, but housing starts declined for the second month in a row.  A shortage of construction workers and land is making it hard on builders to ramp up supply.  The lack of supply is causing prices to move higher, which impacts demand, especially for entry level homes.

The recovery in the housing market has hit a soft patch, but we still believe it will gain momentum as the year progresses, especially given the strong increase in rents and low interest rates.   The housing sector added about a quarter of a percentage point to U.S. GDP last year and we expect at least as much in 2016.

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The U.S. trade deficit widened again in January and hit a five and a half year low, with both imports and exports declining.  Exports, in fact, fell to their lowest level since November 2010.  Slower trades are a concern.

Despite what Donald Trump and Bernie Sanders might say about NAFTA and other trade agreements hurting the American economy, trade is good for growth. When counties make more goods in which they have a competitive advantage and import goods in which they don’t, everyone gets richer.  It’s economics 101.  It’s true that there are winners and losers within an economy, but if you have a flexible workforce, overall wealth should increase over time.

January’s trade numbers are likely more indicative of a weak global economy, but recent trends in world trade and protectionist political rhetoric emanating from the U.S. presidential debates is bad news.  Even without Trump or Sanders, the recent record of protectionism by U.S. Presidents is worrisome.

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Apart from the job market and inflation, February was not a good month for the U.S. economy.  We don’t believe a recession is in the cards, but weaker growth and the strong dollar are taking a toll on the American economy.  The U.S. consumer can’t be the sole growth engine for the global economy.  

The Canadian Economy

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First, the bad news.  The OECD (Organization for Economic Co-operation and Development) slashed their 2016 forecast for Canadian GDP growth to just 1.4% versus their previous 2% forecast made last November.

The energy sector, which makes up about 12% of the Canadian economy, continues to contract and was mainly responsible for the nearly 5% decline in business investment in 2015 which shaved a full percentage point off GDP growth last year.

Even worse, Canada’s five professional hockey teams are all in jeopardy of missing the playoffs and have a combined win/loss ratio of less than .500 for the first time since the 1998-99 season.

The good news?  Apart from the oil producing western provinces, the prospects for the rest of the country actually look pretty good and OECD estimates for 2017 GDP has Canada near the top of the list for growth.  The low dollar helped Canada’s non-energy exports increase 2.3% in January versus the previous month and nearly 10% compared to last year.

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Core inflation moved slightly lower in January, but is still approaching the Bank of Canada’s 2% target.  Headline inflation is already there, hitting 2% for the first time since November 2014.  The fading impact of lower energy prices and higher food costs, which rose 4% year over year in January, was largely responsible for January’s strong CPI numbers.

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After a strong December, January’s poor job report was worse than expected, but was not a big surprise.  Only Ontario added new jobs, with 20,000 new positions created, while Alberta lost 10,000 jobs and saw its unemployment rate increase to 7.4%.  Migration is likely to limit the upside in the Alberta unemployment rate as workers move to other provinces, which could put pressure on the unemployment rates in stronger provinces like Ontario and British Columbia.

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Retail sales contracted a worse than expected 2.2% in December, recording its largest drop since April 2010.  The pullback was broad based with only furniture and home furnishing stores recording gains.  Stronger sales in November were likely part of the reason December sales were so disappointing, though even if November and December sales were combined, growth was still below expectations.

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We thought some cracks in the Canadian housing market might be beginning to surface as the Terenet-National Bank Index contracted for the second month in a row in January and housing starts fell nearly 4%.  Then we saw results from February, which showed a massive rebound in housing starts and strong new home prices in January.

Prices in the oil producing western provinces have predictably started to retreat, but Toronto prices also declined for the first time in a year. Vancouver, and British Columbia in general, is still red hot however, with housing starts up 60% in February to their highest level since the early 1990’s.

According to the B.C. Finance Minister Mike de Jong, the real estate industry in B.C. accounted for nearly a quarter of the Province’s entire GDP in 2014, up from 18% in 2000.  Real fixed capital formation in B.C soared 5.4% in 2014 while the rest of the country declined 0.3%.  As a result, B.C. real household consumption increased 3.5% versus 2.4% for the rest of the country and retail sales increased 6.8% for the first 11 months of 2015 compared to +1.5% outside of British Columbia.

Housing should continue to moderate as a driver of economic growth for Canada, but we don’t see a U.S.-style housing bust.  Vancouver is more of a concern and is largely dependent of foreign capital flows coming into the country.

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Canada’s balance of trade was in a deficit position for the 17th month in a row in January, though there were some signs the weak Canadian dollar is starting to have a positive impact on exports.  Excluding energy, the value of exports increased 2.3% during the month, led by higher sales to the United States.

While the impact from a contracting energy sector is likely to continue to weigh on Canadian economic growth this year, the impact should be moderate and the benefit of a weaker loonie and stronger U.S. economy should start to have a more meaningful impact.

Also expected to help is fiscal support from the federal government, the prospect of which will likely delay any further action by the Bank of Canada in lowering interest rates, assuming of course, the loonie remains weak.   

We remain concerned about the impact a slowing housing market could have on the Canadian economy, but other than regional corrections, higher interest rates and increased unemployment would be required for a broader and more severe correction in the Canadian housing market.  At present, we don’t see a meaningful risk of either.   

What did you think of February’s economic activity?  Let us know in the comments below!

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. NWM fund returns are quoted net of fund level fees and expenses but before NWM portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.