Download - 2009 - August (Autumn)
MARKET OVERVIEW
Global equities climbed higher last month, despite grumblings that gains were outpacing fun-
damentals. The S&P 500 rose 3.6%, its best August performance in nine years and sixth con-
secutive monthly advance. From the ashes of early March, the benchmark has soared 53%.
Reports showed Japan, Germany, France and at least five other countries officially exited
recession in the second quarter.
The U.S. manufacturing sector stirred back to life. Invigorated by vehicle sales and the gov-
ernment’s “cash for clunkers” program, industrial output rose for the first time since October.
Factory gauges for the New York and Philadelphia regions cranked back to pre-recession
levels. Americans traded in just under 700,000 gas-guzzling cars and trucks between July 27
and August 24 at a taxpayer cost of $2.9 billion. The impact was evident in July retail sales
figures. Although broader spending fell 0.3%, the first decline in three months, receipts at
dealerships and parts vendors rose 2.4%.
Opposing reports highlighted hope and fear in the housing market. Bulls were encouraged
by a 7.2% month-over-month spike in July existing home sales, the largest increase since
1992. Bears noted a record 13.2% of U.S. mortgages were either delinquent or in foreclo-
sure in the second quarter. Absent sup-
port from Washington, the market would
likely be in rougher shape. The Federal
Reserve is keeping mortgage rates low by
purchasing $1.25 trillion in housing-related
debt, while Congress’s $8,000 first-time
home buyer tax credit spurs demand. The
credit is set to expire November 30.
From an earnings standpoint, August was
a period of relative calm. Second quarter
S&P 500 profit estimates improved mod-
estly from -29.5% to -27.3%, according to
Thomson Reuters. The third quarter
earnings season kicks off October 7 with
bellwether aluminum producer, Alcoa. Led
by declines in the materials and energy
sectors, overall S&P 500 profits are
expected to drop 20.8%. The financials
sector should do best, with profits
bouncing 371% off crisis-ravaged year-
over-year comparables.
by Greg Meier
A U T U M N 2 0 0 9
AT THE MARGIN
IN THIS ISSUE
Market Overview . . . . . . . . .1
Perspective . . . . . . . . . . . . .2
Equity Update . . . . . . . . . . .2
Firm Update . . . . . . . . . . . . .3
Portfolio Manager Insights:
Quantitative’s
Complementary Role in
Portfolios . . . . . . . . . . . . . .4
Feature:
The U.S. Federal
Reserve — Post-Crisis
Policy . . . . . . . . . . . . . . . .6
Focus:
Risk Management . . . . . . .8
Chartbook . . . . . . . . . . . . .12
August YTD
S&P 500 3.6 15.0
NASDAQ Composite 1.5 27.4
Dow Jones Industrials 3.8 10.6
MSCI EAFE 5.5 24.8
MSCI EAFE Growth 3.2 19.7
MSCI EAFE Value 7.6 30.0
MSCI EM -0.3 51.1
MSCI ACWI xUS 3.7 30.2
MSCI Europe 6.3 26.6
MSCI Japan 3.9 11.3
Russell 1000 3.6 16.4
Russell 1000 Growth 2.1 21.9
Russell 1000 Value 5.2 10.6
Russell Midcap 4.9 25.5
Russell Midcap Growth 3.1 29.7
Russell Midcap Value 6.6 20.8
Russell 2000 2.9 15.8
Russell 2000 Growth 1.0 21.2
Russell 2000 Value 4.7 10.8
ML High Yield Master II 2.0 40.2
As of 31-Aug-09
Market Performance (USD)
VOL. 13 NO. 8
PERSPECTIVE
Christopher A.Herrera
Senior Vice President,Portfol io Manager
EQUITY UPDATE
STYLE AND MARKET CAPITALIZATION
Mid-cap stocks were top performers last month.
Mid caps have led just three times in 2009, yet
for the year retain a considerable lead. The
Russell Midcap Index is up 25% since January 1.
That compares with 16% gains in the large-cap
Russell 1000 and small-cap Russell 2000
indexes. From a style standpoint, investors again
favored value over growth in August. Growth
stocks still hold a solid lead for the year.
S&P 500 SECTORS AND INDUSTRIES
Prodigal sons of Wall Street, banks outperformed
again in August. In the past six months, banks
have led the overall market four times, up 137%,
on average, since March 9. Some of the most
beaten-down names have become unlikely star
performers. American International Group, 80%
owned by the U.S. government, returned 245%
last month. Citigroup, 34% government owned,
gained 58%. Both issues are still trading more
than 70% lower than a year ago. Credit crisis-
related losses and writedowns now total $1.6
trillion, according to Bloomberg.
INTERNATIONAL EQUITY
Foreign investors dialed up a second monthly
advance in August, amid fresh signs the Great
Recession was easing. Developed world stocks
captured the lion’s share of gains, bolstered by
strong results in Europe and a falling dollar.
Emerging markets shares trended lower, under-
performing developed markets for the second
time in 2009. Reports showed Japan, Singapore,
Hong Kong, Germany, France, Norway, Thailand
and Israel returned to economic growth in the
second quarter, officially exiting recession.
Chinese shares tipped into a bear market, as a
prime mover behind a local rally — unfettered
bank lending — tightened up.
2
Global equities have rebounded significantly
from the low in March. As of the end of
August, the MSCI All Country World Index
was up 23.6% year to date. The rebound
from the low was driven by a combination of
improving economic news and positive
earnings announcements. Global equities
now trade at 14.6x next twelve month’s
expected earnings, a significant re-rating
from the 9.0x low over the last year.
In aggregate, the positive earnings season
was mostly driven by better-than-expected
cost cutting by companies. Sales growth
was not as prominent a factor in the out-
come versus expectations. In response,
analyst expectations for future earnings
have been revised up significantly over the
last few months. The key to sustaining the
recent rally will be a continued positive
earnings outlook driven by improving eco-
nomic and company-specific fundamentals.
Over the next few months, the market’s
focus will move to the potential recovery in
2010 earnings.
At Nicholas-Applegate, we focus on identi-
fying those companies that are experiencing
positive change that will drive an improve-
ment in their earnings power. In our tradi-
tional global equity portfolios, we favor Asia
ex-Japan equities which benefit from
strength in Chinese demand and improving
domestic economies. In addition, we are
overweight Europe, with an emphasis on
those companies that have a global focus in
their respective businesses. In terms of sec-
tor exposure, we are seeing the most posi-
tive changes in materials and industrial com-
panies. These sectors have high exposure
to demand from emerging markets as well
as positive sensitivity to an expected upturn
in the inventory cycle. As the market's focus
moves from valuation re-rating to earnings
delivery, our focus on bottom-up stock
picking should be an advantage.
Copyright 2009
....Nicholas-Applegate
....Capital Management
FIRM UPDATE
AT THE MARGIN is a
monthly publication of:
Nicholas-Applegate
Capital Management
600 West Broadway
San Diego, CA 92101
PHONE (800) 656-6226
(619) 687-8000
FAX (619) 645-4069
3
This quarter, we welcomed the following professional to our Marketing team:
Clifton A. Wedington — Senior Vice President, Public Funds — Clifton Wedington is respon-
sible for Public Funds marketing on the West Coast. Prior to joining the firm, Clifton was Vice
President, Institutional Advisory Group, with Morgan Stanley Investment Management; Vice
President, Global Wealth Management; Chairman of the Board of Trustees, Contra Costa
County Employees’ Retirement Association; Vice Chairman of the Executive Board of
Directors and Chairman of the Education Committee for the State Association of County
Retirement Systems; and Managing Partner, Computer Audit Systems. He has lectured for
the California Association of Public Retirement Systems conference and the Trustee
Education Program. Clifton earned his B.S. in Business Management from the University of
Maryland, and Certificate in the Advanced Investment Management Program, the Wharton
School, University of Pennsylvania. He has twenty years of investment industry experience.
NICHOLAS-APPLEGATE HOSTS THE MONARCH SCHOOL
On September 8, Nicholas-Applegate hosted the Monarch School at the La Jolla Playhouse
for a student matinee of the play, “The 39 Steps,” an adaptation of Alfred Hitchcock’s 1935
film.The La Jolla Playhouse provided a teaching artist and enrichment guide, which they used
to prepare and engage the students prior to their arrival at the theater. Founded in 1988, the
Monarch School is dedicated to providing homeless and at-risk children with an accredited
education while caring for their basic needs. Today, more than 100 students between the ages
of 7 and 18 are enrolled at the Monarch School. Nicholas-Applegate is a corporate sponsor
of the La Jolla Playhouse.
By Cathleen Bramlage
A scene from the play, "The 39 Steps," produced by the La Jolla Playhouse.
4
Modern portfolio theory stresses the impor-
tance of investment diversification to reduce
portfolio risk and smooth investment returns
throughout various market cycles. The back-
bone of portfolio diversification is investment
in uncorrelated assets, which most typically
includes a blend of fixed income and equity
assets, with those further diversified by
quality and duration in the case of fixed
income, and country, market capitalization,
and style tilt in equities. Beyond these tradi-
tional equity diversifiers, research suggests
that the inclusion of quantitatively managed
strategies as a complement to fundamentally
managed ones also reduces risk and
results in a more efficient total portfolio. The
correlation of excess returns of quantitative
versus fundamental managers over the past
five years has been quite low. Please see
Exhibit 1.
Investors have often shied away from quanti-
tatively managed strategies because their
seemingly complex nature violates one of
Warren Buffett’s top investment principles:
“Never invest in a business you cannot under-
stand.” The reality, however, is that most
quantitative strategies are not managed as
black boxes of fancy math, but rather are
simply formulaic representations of finan-
cial theory, supported
by sound economic
principles. These fac-
tors include meas-
ures such as increas-
ing earnings, positive
guidance by man-
agement, and strong
balance sheet ratios.
Although a formulaic
approach eliminates
the stock story ele-
ment that is often part
of qualitative investing, it also removes the
behavioral and emotional bias of stock selec-
tion in favor of an objective and disciplined
process of risk-controlled investing.
As with all investment styles, quantitative
investing will not always be in favor and fully
rewarded by the market. Indeed, at times in
the investment cycle when sentiment is driv-
ing stock prices, fundamental managers often
are better rewarded than the disciplined,
objective investment process of quant man-
agers due to their process allowing for subjec-
tive adaptations in response to current market
trends. Further, during periods of rapidly
changing information quant managers will
also have difficulty. We’ve experienced such
inflection points twice in the past year, first in
the summer of 2008, then again in the second
quarter of 2009. During these periods of
inflection when, for instance, commodity
prices are falling but earnings estimates
reflect their previous highs, quantitative
models will be at a disadvantage as they
objectively rely on data that fundamental man-
agers are instead able to alter according to
changing information. However, the inverse is
also true, with quantitative managers having a
keen advantage during periods when stock
prices follow a company’s underlying valua-
Blair E. Vaughan, CFA
Product Manager,Systematic
PORTFOLIO MANAGER INSIGHTS: QUANTITATIVE'SCOMPLEMENTARY ROLE IN PORTFOLIOS
Exhibit 1
Correlation of Quantitative vs. Fundamental Active Managers’Excess Returns
US Small Cap Core US Large Cap Core Global Equity
5-year
correlation* 0.45 0.33 0.23
*Quarterly median performance within eVestment asset class universes; Fundamental vs.
Quantitative style is manager-defined; Excess return is the difference between the median
manager return (separate account composite, gross of fees) and the asset class benchmark: US
SCC: Russell 2000; US LCC: S&P 500; Global Equity: MSCI World; Average universe size of man-
agers during the period: US SCC – Fundamental: 71 Quantitative: 41; US LCC – Fundamental: 157
Quantitative: 83; Global Equity – Fundamental: 197 Quantitative: 41.
Source: eVestment Alliance
As of 30-Jun-09
tions, as their models are able to scour the
entire universe for such opportunities effici-
ently and objectively, sometimes identifying a
trend before it has been identified by analysts
who are often the source of ideas for funda-
mental managers. Additionally, we believe that
over the long-term, equity market prices must
trade according to fundamental valuations, and
as such, constructing portfolios according to
such principles in a disciplined fashion will pay
off over a full market cycle.
The past two years have exemplified a period
when quantitative money management styles
have been out of favor, and quant managers
have struggled. According to research pub-
lished by the Research Foundation of CFA
Institute, in 2007, U.S. large-cap quantitative
strategies were the only asset classes to out-
perform their fundamental peers.1 Given this
seemingly long period of underperformance, it
is reasonable to question whether these
returns signal that quantitative management
has lost its advantage. Similar to how funda-
mental managers lagged quantitative ones
through the 2001-2005 period, only to cycle
back into favor, we believe the ability of quants
to produce alpha will return as the market
again consistently trades on underlying com-
pany valuations. This cycle of how the broader
market rewards different investment styles
makes a compelling case for fundamental and
quantitative managers complementing rather
than competing with each other in a client's
portfolio.
5
THE BENEFITS OF QUANTITATIVE INVESTING
Quantitative processes are defined by their objective application of investment principles
across their investment universe. Beyond removing emotional and behavioral biases, these
models inherently lend themselves to sophisticated risk controls and trade-cost management
as part of the portfolio construction process. While fundamental processes necessitate an
allocation of intellectual capital by the portfolio manager, limiting breadth both in universe cov-
erage and portfolio impact due to finite resources, quantitative ones lend themselves to appli-
cation of robust selection criteria across a wide universe. During rational market cycles when
company valuations and stock prices align, a manager’s ability to quickly and efficiently canvass
the entire investment universe for mispricing opportunities is advantageous to clients.
The ability to incorporate risk estimates, including interaction effects with other holdings, and
trading costs into the process maximizes coverage breadth while ensuring a consistent appli-
cation of the investment philosophy. This process lends itself to quantitative managers
having an advantage in customizing and researching specialty mandates according to client
needs. Whether client mandates dictate a finite holdings concentration, portfolio targeted
tracking error, or regional or style focus, quantitative managers need merely to alter con-
straints within the model to deliver a portfolio according to the customized specifications, and
can do so with precision. Further, these specialized portfolios can then be back-tested to gain
insight on such a construction’s behavior over time through various market cycles. Back-
testing altered constraints or model specifications provides a valuable research tool when
analyzing how a similar portfolio may behave and is a particular strength for quantitative
managers.
1F. Fabozzi, S. Focardi and C. Jonas, “Challenges in Quantitative Equity Management,” Research Foundation of CFA Institute,
July 2008.
6
FEATURE: THE U.S. FEDERAL RESERVE — POST-CRISIS POLICY
The global recession is over, according to
Olivier Blanchard, top economist at the
International Monetary Fund. He may be
right. Economic uncertainties have dimin-
ished markedly, and the deep contractions
witnessed during the heat of the financial
crisis shouldn’t be repeated. Behind this
argument stands a wall of government stimu-
lus money, dramatically narrowed bond
spreads, a historic equity rally and unprece-
dented monetary easing. The U.S. economy
will return to growth during the current quar-
ter, according to Bloomberg News. Corporate
earnings expansion is expected next.
At their annual symposium in Jackson Hole,
Wyoming in August, central bankers world-
wide congratulated one another on a second
Great Depression averted. They deserve
unabashed credit for a battle well fought. But
the war isn’t over. Without an effective exit
strategy, Federal Reserve policies risk
igniting a conflagration that could rival the
financial crisis in destructive tenacity.
DECONSTRUCTING POLICY
The U.S. economy is stabilizing, but far from
healthy. Fear of a Japan-style deflationary
spiral persists in some circles. Deflationists
note that the Consumer Price Index (CPI)
fell 2.1% in July, the most since 1950.
Worker wages plunged a record 5.1%.
Unemployment, at decades’ highs, will prob-
ably climb further. More than a third of U.S.
factories sit idle.
Policymakers at the Fed recognize these
issues. Chairman Ben Bernanke, in parti-
cular, is learned in the Great Depression and
keen to avoid a repeat. To this end, he has
kept the monetary throttle wide open,
launching liquidity facilities and asset pur-
chase programs, and maintaining overnight
rates at a record low 0.00%-0.25%.
Commenting on the bank’s strategy of
“exceptionally low" rates for “an extended
period,” on August 21, St. Louis Federal
Reserve President James Bullard said, “I
don't think markets have really digested what
that means.”
WHAT ‘THAT’ MEANS
Even before Mr. Bullard’s comments, expec-
tations for belt tightening had collapsed. On
June 5, when the Labor Department’s
monthly nonfarm payroll report showed the
fewest job losses in eight months, investors
gave a 67% chance for a rate hike to 0.75%
by November. As of August 28, odds for no
change stood at 98%. Further out, investors
price a 31% chance the current policy will
remain intact through at least June 2010.
If peak unemployment is a reference for pre-
dicting post-recession tightening, the Fed’s
first move could come substantially later. The
Fed didn’t raise rates for a full year after
unemployment crested after the last reces-
sion. The Fed waited twenty months after
peak joblessness during the 1990-91 down-
turn. By White House estimates, joblessness
will breach 10% in late 2010. If the govern-
ment raises tax rates, peak joblessness will
probably arrive even later, according to
Horacio Valeiras, CFA, Chief Investment
Officer. In either case, Mr. Bernanke may be
hoping to keep policy loose well into 2011.
Greg Meier
Financial Writer
“Recent increases in the monetary base are far greater than any previously in
American history… Will these policies be successful without accelerating inflation?
The epitaph to this curious case of monetary base expansion is yet to be written.”
Richard G. Anderson, Vice President, Federal Reserve Bank of St. Louis, July 2009
7
THE THREAT WE FACE
With little room for further cuts, the Fed’s primary tool
for firing up growth isn’t interest rates. It is quantita-
tive easing – asset purchases. Purchase programs
launched in the wake of the financial crisis include
$300 billion in Treasuries, up to $1 trillion in securities
backed by student, auto, credit card and commercial
real estate loans and $1.25 trillion for residential
mortgages. This buying spree has exploded the Fed’s
balance sheet.
At $929 billion at the end of 2007, the Fed’s balance
sheet increased to $2.29 trillion last December. It has
since fallen, but the decline should be temporary. In a
July 29 speech, New York Federal Reserve President
William Dudley reckoned the balance sheet would
“grow to roughly $2.5 trillion.” That equates to near 20% of
annual U.S. economic output.
In economic terms, the balance sheet expansion is essen-
tially an increase to the U.S. money base. As the Fed buys
private sector assets it simultaneously injects new cash into
the economy.
In historical terms, what we are witnessing is unprece-
dented. According to economist Dr. Arthur Laffer, the rise in
the U.S. money base is larger than anything ever at-
tempted by a factor of ten. Please see Exhibit 2. The result
could be highly inflationary. The previous record for mone-
tary base expansion occurred during preparations for the
Y2K millennium rollover. Between October 1999 and
January 2000, the Fed’s balance sheet grew from $572 bil-
lion to $639 billion. Within five months, the CPI spiked from
2.6% to 3.8%. Commenting on the dangers of quantitative
easing this summer, Mr. Bullard noted "permanently dou-
bling the money supply eventually doubles the price level…
This gives a rough idea of the type of threat we face."
The Fed’s balance sheet problem is multidimensional.
According to Banc of America-Merrill Lynch, the Fed’s port-
folio has hardened substantially since the start of the crisis.
As asset purchase programs ramp up and liquidity facilities
wind down, the illiquid component of the Fed’s portfolio has
more than doubled to $1.4 trillion. This structural shift is
expected to quicken as the Fed’s portfolio grows, making it
increasingly difficult to unwind policy. Once the economy
regains traction, if the Fed can’t pull back quickly, a desta-
bilizing spike in inflation becomes likely.
PAYING DEBT WITH DEVALUED DOLLARS
Victor Canto, Ph.D., Founder, La Jolla Economics, and
Steve Sexauer, Chief Investment Officer, Allianz Global
Investors Solutions LLC, reviewed potential Fed exit strate-
gies in a May 2009 paper. Their conclusion was, because
fear of a Great Depression outcome is so intense, the Fed
will hold policy loose for too long.
Such a result could be politically expedient in Washington.
The White House forecasts deficit spending will cause a
near doubling in the national debt to almost $20 trillion by
2019. The U.S. debt to GDP ratio will surge from 48% to
69%. Servicing the debt will be costly. It could force tax
hikes, service cuts or both. A ratcheting up in price levels
would allow the U.S. government to pay debts using de-
valued dollars.
Whether bankers have the inclination or ability to unwind
policy before inflation entrenches is unclear. The Fed hasn’t
been stress-tested on inflation in years. The core CPI
hasn’t pierced 3% since 1995. The core PCE hasn’t since
1992. In a 2002 speech, Mr. Bernanke touched on the topic
of government debt and inflation, saying, "People know that
inflation erodes the real value of the government's debt and,
therefore, that it is in the interest of the government to
create some inflation."
continued on page 10
Exhibit 2
8
FOCUS: RISK MANAGEMENT
In June of this year, the research group at
MSCI Barra published a report entitled “Best
Practices for Investment Risk Management”
that proposed a framework which included:
n analyzing multiple aspects of risk, not just
one measure,
n investigating factors that affect risk across
an entire firm,
n scrutinizing risk during normal time periods
versus risky time periods and
n aligning risk management with the invest-
ment goals of the firm.
Nicholas-Applegate’s Research and Risk
Management team had already created a risk
management system that parallels the frame-
work set out by the consultants at MSCI
Barra. Many investment managers, how-
ever, refer to tracking error as the single gold
standard for risk management. In the 1980s,
standard deviation of the portfolio returns was
considered the ne plus ultra of risk analysis.
Our risk management program began in the
late 1990s during the heyday of the tech-
nology bubble. It began as a series of printed
reports — one report for each investment
strategy based on a fundamental factor risk
model. We later expanded it by looking not
just at the most recent portfolio statistics but
also at how the statistics evolved over time.
Above all, though, we took to heart the idea
that investment risk is multi-faceted. One can-
not look at one or two statistics and know the
risk of a portfolio: one must look at many risk
measures.
Beginning in the fall of 2001, we developed
and implemented an automated system of risk
management. Our goals were threefold. First,
we recognized that risk could be measured in
many different ways. Second, we wanted the
risk system to produce timely and accurate
daily reports. Third, we wanted everyone on
the investment staff to have access to the
results. We created a system that produces
approximately 1,600 charts, tables, and
reports. Some of these are based on daily
data and some on monthly data. The system
includes reports on:
n tracking errors and information ratios —
both long-term and short-term
n the split between systematic risk and stock-
specific risk
n performance in up and down markets
n returns-based style analysis
n capitalization distribution of the portfolio
versus the benchmark
n a quality control measure
n stock-specific volatility through time
n active risk factor bets through time
n several analyses based on the work of
Eugene Fama and Kenneth French
n Value-at-Risk analyses for portfolios with
the potential for non linear returns
n liquidity
We meet quarterly with each of the portfolio
teams to review the intended and unintended
risks in the portfolios and to review the multi-
faceted risk analysis of each strategy. The
reports can be viewed on an Intranet site by
each of the portfolio teams. In addition, we've
developed software to analyze risks that could
affect the entire firm and have researched
what may happen to our strategies during
extreme risk events.
While our risk system predated MSCI Barra’s
best practices research, we are always
looking for new measures or new statistical
techniques that will enable our investment
teams to have a better understanding of risk
and to integrate risk management into the
investment decision process.
Douglas B. Stone
Senior Vice President,Director of Researchand Risk Management
Exhibit 5 shows the results of running Ordinary Least
Squares (OLS) regression over 114 months ending in June
2009.
OLS regression models provide coefficient estimates for
the average of the dependent variable. In this example, I
use the Fama-French, three factor model which is an
extension of the Capital Asset Pricing Model (CAPM). In
addition to a constant, often referred to as alpha, there is a
market variable, commonly known as beta, a size variable
calculated by subtracting returns on large stocks from the
returns on small stocks, and a variable measuring value,
which is calculated as the returns on low book-to-price
stocks subtracted from high book-to-price stocks. We use a
regression model to estimate a portfolio’s sensitivity to
these factors. One might ask an additional question: what
are the sensitivities when the portfolio’s performance is
poor or when it is good?
While the adjusted r squared is somewhat low at 64 per-
cent, the analysis indicates a relatively high beta to the
market and a risk adjusted return of 20 basis points per
month. The size coefficient indicates that this is a small-cap
portfolio and the value coefficient indicates that this is a
growth portfolio.
Benchmarks are critical to the analysis of portfolios. In
addition to analyzing returns, we use benchmark holdings
to compute active sector bets. We look at the portfolio’s
sector weights and the benchmark sector weights and cal-
culate the active exposures (portfolio minus benchmark).
We compute the active exposure for every month over the
last three years, and then we create a display showing the
median exposure, the interquartile range which is the 75th
percentile minus the 25th percentile, and the individual sec-
tor exposures for the last three months.
Exhibit 6 shows active sector weights for a hypothetical
large-capitalization portfolio that is benchmarked to the
Russell 1000 Growth Index. First of all, the zero line repre-
sents the benchmark. The solid line inside each box is the
median active exposure and the length of the box is the
9
OLS Estimate of a Hypothetical Small-Cap Growth PortfolioVariable Coefficient
Alpha 0.2083
Beta 1.3633
Size 0.1901
Value -0.0343
Adjusted R Squared 64%
Source: MSCI Barra; Nicholas-Applegate
As of Jun-09
Exhibit 6
Exhibit 5
continued on page 11
10
Feature: The U.S. Federal Reserve –
Post-Crisis Policy
continued from page 7:
The largest buyer of U.S. debt, China is growing anx-
ious. If U.S. inflation spikes, the greenback could sink in
currency markets, damaging the value of China’s
holdings. In March, Prime Minister Wen Jiabao made
public his concerns “about the safety of our assets.” He
is not alone. Officials in Japan, France, India, Russia
and Brazil have also voiced unease. The greenback is
already weakening, down 12% against a basket of cur-
rencies since March. Mr. Valeiras expects this trend to
continue.
FLASHBACK TO THE 1980s
Viewed through the lens of a soft dollar, government debt
and the Fed’s asset purchases, the case for inflation comes
into focus. Recently rising energy prices could add another
complication. Some of America’s worst post-war recessions
revolve around oil crises. When crude jumped from $16/bbl
to $40/bbl between 1979 and 1980, core inflation cracked
13%. To force prices down, then-Fed Chairman Paul Volcker
took the fed funds rate to an all-time high of 20% twice.
Please see Exhibit 3. Economic output plunged 7.9%, the
most since 1958.
Crude is up more than 60% in 2009. While energy markets
are notoriously volatile and highly seasonal, this occurred at
a time when U.S. demand decreased. American oil import
volumes are down 12% this year. By the same token, imports
to China, the world’s second-largest energy market,
are up 6% in 2009 and 42% in the past year.
DEFLATION IS DEAD
As a matter of straight math, the epitaph on defla-
tion has already been written. Recall the CPI was
-2.1% in the year to July 31? The 2008 commodi-
ties bust is about to roll off trailing twelve-month fig-
ures. When it does, forthcoming calculations will
have lower year-over-year comparisons. If prices
simply hold steady on a monthly basis through
December, an unlikely but reasonable assumption,
the annual change in the CPI will approach 2.5%.
Please see Exhibit 4. The same process applied to
the PCE results in a move from -0.8% to 1.1%. A similar
increase will be seen in Europe.
Forward-looking indicators are rising. The breakeven
between nominal 10-year Treasuries and inflation protected
Treasuries (TIPS), a gauge for future inflation, shot from
0.9% in January to 1.9% in August. TIPS have gained 6.5%
this year, while nominal Treasuries have fallen -3.5%,
according to Banc of America-Merrill Lynch.
At last month’s Jackson Hole convention, Fed officials paid
lip service to the issue of unwinding policy. This was an
opportunity lost. Plotting a clear exit strategy would have
sent a vital and timely message to investors that inflation will
be addressed before it becomes unhinged.
Exhibit 4
Exhibit 3
Securities and sectors discussed herein reflect general market
commentary and should not be construed as a recommendation
(current or past) of the company or any of its portfolio managers.
There is no guarantee that any opinion, forecast, or objective will be
achieved. The information herein is provided for informational
purposes only and should not be construed as a recommendation of
any security, strategy or investment product.
The asset and industry reports contained herein are unaudited. The
summation of dollar values and percentages reported may not equal
the total values, due to rounding discrepancies. Unless otherwise
noted, Nicholas-Applegate is the source of illustrations, performance
data, and characteristics. Unless otherwise noted, equity index
performance is calculated with gross dividends reinvested and
estimated tax withheld, and bond index performance includes all
payments to bondholders, if any. Indexes may not represent the
investment style of any Nicholas-Applegate strategy. Index calcu-
lations do not reflect fees, brokerage commissions or other expenses
of investing. Investors may not make direct investments into any index.
This is not an offer or solicitation for the purchase or sale of any
financial instrument. It is presented only to provide information on
investment strategies and opportunities. The material contains the
current opinions of the author, which are subject to change without
notice. Statements concerning financial market trends are based on
current market conditions, which will fluctuate. Forecasts are inherently
limited and should not be relied upon as an indicator of future results.
References to specific securities, issuers and market sectors are for
illustrative purposes only. This presentation should not be construed as
a general guide to investing, or a recommendation regarding any
investor’s specific circumstances. Although the manager attempts to
limit portfolio risk, risk management does not imply low risk. All
investments are subject to some degree of market and investment-
specific risk. The value of investments can go down as well as up, and
a loss of principal may occur. No part of this material may be copied
or duplicated, or distributed to any third party without written consent.
Small- and mid-cap stocks may be subject to a higher degree of risk
than more established companies’ securities. The illiquidity of the
markets for these stocks may adversely affect the value of these
investments. Investments in overseas markets may pose special risks,
including currency fluctuation and political risks, and the portfolio is
expected to be more volatile than a U.S.-only portfolio. These risks are
generally intensified for investments in emerging markets.
Discussion of individual securities is presented solely to aid general
discussion of the economy and sectors thereof. No single recommen-
dation or subset of recommendations is representative of the
composition or performance of any client portfolio. Investors should not
assume that any investment discussed herein was or will be profitable;
actual accounts may vary, and there is no guarantee that a particular
client’s account will hold any or all of the securities listed.
11
DISCLOSURE:
interquartile range. The small dot is the active exposure
three months ago, the slightly larger circle is the active
exposure for two months ago and the largest circle repre-
sents the most recent month. In Exhibit 6, the manager on
average has been more heavily invested in energy, health
care, industrials, information technology and materials than
the benchmark. If we focus on industrials, we can see that
the manager has overweighted this sector for the last two
months vis-à-vis the benchmark. This would be a discus-
sion point during a portfolio review. This type of chart is also
useful in analyzing risk factors versus a benchmark.
These exhibits, along with the many other types of analysis,
allow our investment teams to monitor risks. We take as a
given that analyzing multiple risk factors is our main focus.
Our processes and determination to make the results avail-
able and understandable both in a quantitative and in a
visual sense have helped our portfolio management teams
to understand risk and to embrace the concept of risk
management.
Focus: Risk Management
continued from page 9:
12
Credit markets have opened and companies are
accessing capital evidenced by robust new
issuance and falling spreads. In addition to
access to capital, a company's cost to borrow has
become less prohibitive due to significantly tighter
spreads, which rose as high as 21% in December
2008. Fast forward eight months and high yield
spreads have narrowed to 912 basis points above
comparable U.S. Treasuries and are back to
levels not seen since September 2008, according
to Banc of America-Merrill Lynch.
Industrial production, a measure of output which
includes manufacturing, mining and utilities, has
been rising globally. Specifically, the three largest
developed economies of the United States,
Germany, and Japan have seen swift increases in
production in recent months. Skeptics point to
government programs such as "cash for clunkers"
for providing a non-recurring boost to production.
In the U.S. alone, motor vehicle assemblies
jumped nearly 42% in July. However, excluding
motor vehicle and parts, manufacturing production
in the U.S. still rose by 0.2%.
CHARTBOOK — RESEARCH FROM THE FIELD
July sales of existing homes rose 7.2% over June
and 5% over July 2008, marking the fourth con-
secutive month of sales growth and the biggest
monthly jump since the National Association of
Realtors began tracking the data in 1999.
Despite the increase in sales, prices remain
15.1% below year-ago levels, with the median
price coming in at $178,400 in July. Price com-
pression has been caused by the increase of dis-
tressed properties on the market, evidenced by
31% of the month's transactions stemming from
foreclosures and short sales.
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