year end update - raymond james financial · • fixed income managers favoring corporate over...

2013 Market CommentaryYear End Update

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Table of Contents:

2013 Thoughts & Themes (Year Ahead)

Stepping Back for Perspective (Summer Update)

Tactical Portfolio Adjustments (Summer Update)

Two Steps Forward, (waiting on…) One Step Back (Year End Review)

Objectivity² Portfolio Overview & Strategy

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2013 Thoughts & ThemesIn their book, This Time is Different, economists Carmen Reinhart and KennethRogoff argue that once a government’s debts become unsupportable thengovernments must resort to one of three debt reduction strategies:

• Default: Simply refuse to repay the owed obligations (e.g. Russia in 1998,Argentina in 2000, Greece currently and for much of its existence)

• Lower Standard of Living: Endure higher taxes and fewer government servicesas debt obligations are repaid (e.g. Brazil and Korea in the 1990s, Portugal andIreland currently).

• Financial Repression: Print enough money to lower interest rates below the rateof inflation and keep rates there until debts are inflated away (e.g. US and GreatBritain post WW II, China in the 1990s, much of the world economies currently).

Default or lower living standards typically occur only if the indebted country cannotprint the currency in which it has borrowed. If the country owes its own currency, thendepressing interest rates by printing more of that currency (financial repression) tendsto be the least painful way to reduce excessive debt.

History in the US provides us with an example of this policy. The Fed used its printingpress to keep interest rates below the rate of inflation throughout the 1940s and early1950s in response to the large debt burden left over from World War II.It is estimated by the CBO (Congressional Budget Office) that that the potentialbudgetary impact of short term interest rates rising to 3.5% combined with rising debtwould add more than $1 Trillion to the annual budget deficit by 2017.

We believe that this budget reality compels the Fed to emulate its post-World War IIfinancial repression strategy. Should the Fed continue this strategy in the next fewyears, as much as half of the associated purchasing power losses could be borne bythe Foreign Creditors such as the central banks of China and Japan. The ability toshift much of the cost of reducing US debt burdens to foreign institutions is a powerfulincentive for the Fed.

So……… what are the implications of this policy, how does it distort the capitalmarkets and what are the perverse ways in which it alters the relationship of “safe vs.risk” assets. We feel these are all important factors to question as we enter thesecond half of this deleveraging cycle.

Objectivity² Wealth Management’s

Top Themes for 2013:

• Defensive vs. Offensive Strategies acknowledging that sometimes the best defense is a good offense

• Global Equities with Dividend Growth

• Long/Short Equity Managers that can be Tactical

• Fixed Income managers favoring Corporate over Sovereign Debt and short vs. longer duration

• Larger Allocations to Alternative Asset Managersthat are unconstrained

• Gold as a hedge against political uncertainty and competitive currency devaluations

• Focus on Risk Adjusted Returns vs. Benchmarks

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2013 Thoughts & ThemesWe think GaveKal Research said it best in a piece they wrote earlier this year titled “Feeling Sorry for People who Don’t Drink”: To wit:

“As we embark on the second decade of the 21st century, we are entering into a bravenew world in which central bankers (whether Bernanke, Carney, or Draghi) have decidedthat the value of assets must no longer be driven by price that would be reached today,but instead by what best price a given asset may have reached in the past……. We havenow moved from a world where money was at the center of the system and asset pricesat the periphery to a world where some specific asset prices are at the core of thesystem, while money has moved to its borders. If nothing else, this means the supplyand demand for money, along with its price now has a lot less to do with economicactivity, or individual capital and time preferences as expressed in a market. The supplyof money has become the de-facto variable of adjustment; a supply managed by centralbanks with the sole purpose of preventing selected asset prices from going down….. Thisis a revolution which requires us to rethink the way we analyze economies and financialmarkets.”

Or as our good friend and trusted voice of reason David Rosenberg states:

“The Fed has completely altered the relationship between stock and bonds by nurturingan environment of ever deeper negative real interest rates. Therein lies the rub. Theeconomy and earnings are weak, and getting weaker, but the interest rate used todiscount the future earnings stream keeps getting more and more negative, and thatlowers the corporate cost of capital and in turn raises the present value of expected futureprofits. It’s that simple.”

If we go further back in history we can turn to Ben Graham’s writings. Thequotation comes from the Intelligent Investor, which was written right inthe middle of the post-World War II period of US financial repression:

“It must be evident that we have no enthusiasm for common stocks at theselevels…..However we feel that the defensive investor cannot afford to be without anappreciable proportion of common stocks in his portfolio, even if we regard them as thelesser of two evils- the greater being the risks in an all-bond holding.”

We conclude with thoughts from the folks at GMO. To wit:

“We don’t like stocks as an asset class compared to what we think fair value should be. However, the alternatives are generally really awful. This problem is further exacerbated if the Fed continues to engineer a policy of financial repression beyond our forecast horizon.”

Objectivity² Wealth Management’s

Top Themes for 2013:

• Defensive vs. Offensive Strategies acknowledging that sometimes the best defense is a good offense

• Global Equities with Dividend Growth

• Long/Short Equity Managers that can be Tactical

• Fixed Income managers favoring Corporate over Sovereign Debt and short vs. longer duration

• Larger Allocations to Alternative Asset Managersthat are unconstrained

• Gold as a hedge against political uncertainty and competitive currency devaluations

• Focus on Risk Adjusted Returns vs. Benchmarks

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Stepping Back for PerspectiveSignificant allocations to bond investments over the past 5 years have had

meaningful benefits to our allocations from a risk/return perspective. However, we

believe over the next 3 to 5 year period, fixed income assets do not represent either a

good hedge against market volatility nor an opportunity for capital appreciation.

Simply put, we believe the Fixed Income markets are in the 8th or 9th inning of a

30 year bull market and when (not if) rates begin to rise, fixed income investors

could experience more volatility (and potential loss of capital) than they’ve seen in

three decades.

With the recent cash raised from reductions in fixed income across our portfolios, we

will be looking to add to our existing opportunistic equity positions at either the 50,

150 or 200 Day Moving Average, basis the risk parameters for each model. In a

world full of liquidity, we acknowledge no asset classes are cheap, but one could

argue that equities look attractive, on a relative basis, using these metrics.

Current P/E on the S&P 500 of 15 is below the 17 average multiple

the market has traded at over the last 15 years

The Earnings Yield on equities has hit a 50 year high, signaling that

stocks are an attractive investment from a risk/return perspective

versus bonds

Equities have traded in a similar consolidation pattern over the last

13 years to what was seen in late 60’s/70’s. When this pattern ended

the S&P 500 experienced an 18 year long bull market that ended in

2000, after a 1500% gain in the index.

“Have a look at Ben Bernanke’s analytical piece called Long-Term Interest Rates back on March 1st and it assess the balance of risks—visibly one-sided even if the timing is up for debate. The prospect that we are sitting at 3% on the 10 year T-Note yield a year from now and north of 4% by 2017 is hardly trivial. I’ve been in the deflation camp for two decades…but strongly feel it is time to move on. It is a crowed trade to the extent my three sons can explain what deflation is all about (and they know what QE stands for!). I used to say in the 1990s and 2000s that we had a generation of market pundits and players who only know higher interest rates and inflation. Today, we have a group of twenty, thirty and even forty-something’s who know little about bond sell-offs, inflation or even what a normal Fed tightening cycle looks like. The new paradigm has shifted in the opposite direction and today’s ever-more consensus forecast of 1% yields on the 10 year T-notes and 2% on the long bond based on deflation reminds me of the bold calls for 30% bond yields back in the early 1980s based on runaway inflation. Rosie’s Rule #4: “Fall in love with your partner, not your forecast.”

David RosenbergBreakfast with Dave May 8th, 2013

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© 2012 Raymond James & Associates, Inc., member New York Stock Exchange/SIPC. All rights reserved.International Headquarters:The Raymond James Financial Center | 880 Carillon Parkway | St. Petersburg, Florida 33716 | 800-248-8863

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Wednesday, September 18, 2013

RAYMOND JAMES Technical Strategy Team – Technical Chart Book

May Jun Jul Aug1.4

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May 1st - Aug 31st 2013 / US 10 Year Yield

US Benchmark Bond - 10 Year - Yield . . .(High =2.89% . . . Low =1.63%)

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'84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '130

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2.87%

30 Year Chart / US 10 Year Yield

US Benchmark Bond - 10 Year - Yield . . .(High =13.99% . . . Low =1.39%)

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Tactical Portfolio Adjustments

We have made substantive tactical and strategic changes to our three

portfolios over the past 6 months. Below is a summary of those adjustments

and the rationale behind them:

Significant reduction in fixed income basis our believe that the 30

year bull market for that asset class is coming to an end (May 2013)

A material reduction in the exposure to Gold, Precious Metals,

Commodities basis deteriorating technical charts/data (March 2013)

In the Strategic/Alternative space, we increased the allocation

toward more dynamic & tactical alternative managers and away from

management with significant fixed income exposure (March & May

2013)

Increased equity allocation targets (Dec 2012/May 2013)

A move away from our Asian exposure due to our growing concerns

over China (May 2013)

Portfolio Manager Interviews

Below are some interesting interviews with two of our portfolios management teams, Michael Shaoul of Marketfield and Jeremy Grantham & Ben Inker of GMO, that give some perspective on the current market environment. Please click on the links to view these interviews:

Marketfield

Significant Bull Rally Likely to Extend (May 2013)• http://www.bloomberg.com/video/significant-bull-

rally-likely-to-extend-shaoul-R0~msON6RjaQztmCq09KfQ.html

There’s No Reason to be in Bonds (May 2013)• http://www.bloomberg.com/video/there-s-simply-no-

reason-to-be-in-bonds-shaoul-t2Z5RqODQUmBMMMAfQwvBA.html

GMO

Jeremy Grantham on Charlie Rose (March 2013)• http://www.charlierose.com/view/interview/12812

Ben Inker on WealthTrack (April 2013)• http://www.charlierose.com/view/interview/12812

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Year End UpdateTwo Steps Forward, (waiting on..) One Step Back

Prices of equities typically rise for one of two reasons: 1) earnings of acompany are growing and the overall economy is stable or 2) investors arewilling to pay more for each dollar of current earnings, typically due to the lackof suitable alternatives. We clearly think the later is the case in this mostrecent equity market rally, which has been nearly unabated since June of2012, and has the US equity market soaring to new highs.

In his “Thoughts from the Frontline” piece on Aug. 3rd, John Mauldinwrites:

“To many investors, developed markets appear healthier and stronger than they havein years. Major equity markets are rallying to record highs; corporate credit spreadsare tight vs. US Treasuries and getting tighter; and broad measures of volatilitycontinue to fall to their lowest levels since 2007.

This kind of news would normally point to prosperity across the real economy and callfor a celebration—but prices do no always reflect reality. Moreover, the combination ofhigh and rising valuations, low volatility, and a weakening trend in real earnings growthis a proven recipe for poor long term results and market instability.

Let’s take the S&P 500 as an example. It returned roughly 42% from September 1st,2011, through August 1st, 2013, as the VIX index fell to its lowest level since the globalfinancial crisis. Over that time frame, real earnings declined slightly (down about 2%through Q1 2013 earnings season), while the trailing 12-month price-to-earnings (P/E)ratio jumped from 13.5x to 15.7x. That means the majority of the recent gains in theUS equity markets were driven by multiple expansion in spite of negative real earningsgrowth. This is a clear sign that sentiment, rather than fundamentals, is driving themarket.”

We think this excerpt very clearly articulates our thinking on the equitymarkets. While we’ve tactically increased our equity allocations over the last12 months, we have done so primarily through our hedged long/shortmanager. This has allowed us to capture upside, while continuing to adhereto our risk management philosophies.

Reasons for Practical Cynicism:

• Margin Debt Levels have expanded to levels last seen in 2000 and 2007. As we know, the periods that followed those years destroyed enormous amounts of household wealth. In our view, this piece of data is a warning sign that bullish sentiment is becoming extreme

• Valuations measures are contradictory, but none suggest that equities are inexpensive, in a historical context

• The 12 month Trailing P/E is currently 15.7x versus 15.8x (10 year average)

• The Shiller P/E shows a more extreme overvaluation of 23.9x vs. 19.1x (60 year mean average)

• The very low discount rate that exists in the market today is the primary cause of assets being overvalued. When cash rates begin to rise, you could see normally unrelated risk assets, that have been bid up for the last 12 months, become highly correlated.

• Faith in central banks today is rivaling faith in dot.com companies in 1999 or the faith in the eternal rise in housing prices in 2006. What happens when the QE music stops?

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'08 '09 '10 '11 '12 '13600

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S&P 500 (SP50-SPX) 5 Year Daily

Price 50 ma 200 ma

'08 '09 '10 '11

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©FactSet Research Systems

Volume

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RAYMOND JAMESMonday, September 09, 2013

Technical Strategy Team – Technical Chart Book


+82.94%

+35.58% +32.34%

- 17.12%

- 21.58%

- 10.94%

Credit Crisis S&P 500 -57.69%

+16.43%

- 8.89%

+27.27%

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©FactSet Research SystemsRaymond James Technical Strategy Team

Shiller, S&P 500 Price Earnings Ratio

'53 '55 '57 '59 '61 '63 '65 '67 '69 '71 '73 '75 '77 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '135

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6.64

11.54

19.09

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26.64

Shiller, Standard & Poors 500 Composite Index, Price Earnings (P/E) Ratio - United States (High =44.20 Low =6.64)Average PE over the period = 19.09Average PE over the period + 1 St. Dev.= 26.64Average PE over the period - 1 St. Dev. = 11.54

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'04 '05 '06 '07 '08 '09 '10 '11 '12 '1340

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PE = 15.67Avg PE=15.83

EPS LTM= $108.32

©FactSet Research SystemsRaymond James Technical Strategy Team

10 Years: EPS LTM, PE, Avg PES&P 500 - Earnings per Share (Left)S&P 500 - Price to Earnings Ratio (Right): High = 23.01, Low = 9.14

(AVG) S&P 500 - Price to Earnings Ratio (Right)

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Low Volatility Allocation

Current Allocation: 25% Equity, 20% Fixed, 45% Strategic, 10% Cash Alternatives

Benchmark Allocation: 15% Equity, 60% Fixed, 25% Cash (Dow Jones Conservative Index)

Target Net Return: CPI + 1% (projected 3-5% annualized over 3 years)

Our goal with this portfolio is to provide an alternative to cash, CDs and short term bonds,

for our client’s most conservative pools of money. This year we have increased our

equity target from 15% to 25% (currently 20% is allocated) and have a tactical

overweight to our long/short equity manager over the dividend paying, global equity

manager. We’ve reduced our Fixed Income exposure to 20% (from 40%) as we

believe the 30 year bull market in bonds is coming to an end and the returns for bond

investors are likely to be flat to negative over the next 3-5 years. The

Strategic/Alternative allocation is built to be the anchor of the portfolio and should not

be highly correlated to either the equity or fixed income markets. This allocation has

increased to 45% (from 35%) and is overweight our absolute return manager versus our

fund of funds manager that provides access to some of the best minds in the hedged

alternative space. We provide liquidity and an additional hedge by allocating 10% of the

portfolio toward cash alternative strategies that utilize ultra short duration municipal

paper, seeking to provide returns in excess of traditional money markets & CDs.

“The essence of investment management is the management of RISKS, not the management of RETURNS.”

-Benjamin Graham, Legendary Value Investor

We manage risk within a global asset allocation framework (within min/max ranges across the various asset classes) and overlay tactical adjustments through the use of 50, 150 & 200 Day Moving Averages.

-Objectivity² Wealth Management

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Moderate Allocation

Current Allocation: 45% Equity, 15% Fixed, 40% Strategic

Benchmark Allocation: 60% Equity, 35% Fixed, 5% Cash (Dow Jones Moderate Index)

Target Net Return: CPI + 3% (projected 5-7% annualized over 3 years)

This portfolio is built as balance between capital preservation and growth, and is an

alternative to the traditional “60/40 balanced” portfolio you will see on almost all

investment platforms. The target equity allocation has been increased from 30% to

45% (40% currently allocated) and is a blend of 15% passive strategies, designed to

track equity markets in a low cost vehicle, and 30% in Opportunistic Equity managers.

This active sleeve is overweight a global dividend paying equity manager and a

long/short manager to help lower some of the market risk. In addition, we have added a

tactical equity manager that has a long track record of investing in leveraged companies

and has the flexibility to go up to 30% short the markets and raise up to 50% cash to

help dampen volatility. We cut our Fixed Income allocation in half, to 15%, by

removing one of our managers that was primarily focused on duration management.

Our Strategic/Alternative allocation has increased to 40% (from 35%) and is

overweight our absolute return manager versus our fund of funds manager that provides

access to some of the best minds in the hedged alternative space.



We manage risk within a global asset allocation framework (within min/max ranges across the various asset classes) and overlay tactical adjustments through the use of 50, 150 & 200 Day Moving Averages.


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Growth Allocation

Current Allocation: 60% Equity, 0% Fixed, 40% Strategic

Benchmark Allocation: 80% Equity, 15% Fixed, 5% Cash (Dow Jones Moderately Aggressive)

Target Net Return: CPI + 5%

(projected 7-9% annualized over 3 years)

This allocation is built to provide our client’s with the most growth opportunities, while

still adhering to our risk management philosophies. The 60% target equity allocation

has been increased (up from 45%) and is a blend of 15% passive strategies, designed

to track equity markets in a low cost vehicle, and 45% in Opportunistic Equity managers.

This active sleeve is split equally between 3 active managers: a global dividend paying

equity manager, a long/short manager, and a newly added tactical equity manager that

has a long track record of investing in leveraged companies. This new manager has the

flexibility to take the portfolio up to 30% short equities and can raise up to 50% cash to

help dampen volatility. We have sold our core Fixed Income position as we believe

the risk/return forecasts for the asset class are now very bleak and do not represent

either a good hedge against market volatility nor an opportunity for capital appreciation.

The Strategic/Alternative allocation is built to be the anchor of the portfolio and should

not be highly correlated to either the equity or fixed income markets. This 40%

allocation consists of the following: an unconstrained absolute return manager that

seeks to provide risk-adjusted returns in excess of inflation, a passive position in Gold

and a fund of funds manager that provides access to some of the best minds in the

hedged alternative space.



We manage risk within a global asset allocation framework (with min/max ranges across the various asset classes) and overlay tactical adjustments through the use of 50, 150 & 200 Day Moving Averages.


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DisclaimersThe views in this commentary do not take into account the particular investment objectives, financialsituations, or needs of every individual client.

Investments are subject to market risk, including possible loss of principal. International investinginvolves additional risks such as currency fluctuations, differing financial accounting standards, andpossible political and economic instability. These risk are greater in emerging markets.

Links are being provided for information purposes only. Raymond James is not affiliated with anddoes not endorse, authorize or sponsor any of the listed websites or their respective sponsors.Raymond James is not responsible for the content of any website or the collection or use of theinformation regarding any web site’s users and/or members.

Commodities are volatile investments and should only form a small part of a diversified portfolio.There may be sharp fluctuations even during periods when prices are rising overall. The price of goldhas been subject to dramatic price movements over short periods of time and may be affected byelements such as currency devaluations or revaluations, economic conditions within an individualcountry, trade imbalances, or trade or currency restrictions between countries. As a result, the marketprices of securities of companies mining or processing gold may also be affected.

The S&P 500 is an unmanaged index of 500 widely held stocks. It is not possible to invest directly inan index.

Dividends are not guaranteed and can fluctuate.

Past performance does not guarantee future results. There is no assurance that these trends willcontinue.

Raymond James & Associates, Inc. member New York Stock Exchange/SIPC

Views expressed in this newsletter are the current opinion of the author and are subject to changewithout notice.

Raymond James &Associates is not affiliated with Gluskin Sheff, Gavekal Research or GMO.

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Disclaimers

U.S. Treasury securities are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value.

Material is provided for informational purposes only and does not constitute a recommendation. It has been obtained from sources believed to be reliable, but accuracy is not guaranteed.

Alternative investment strategies involve greater risks and are only appropriate for the most sophisticated, knowledgeable and wealthiest of investors.

Technical Analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume.

Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.

High-yield bonds are not suitable for all investors. When appropriate, these bonds should only comprise a modes portion of your portfolio.

Asset allocation and diversification do not ensure a profit or protect against a loss. Investments are subject to market risk, including possible loss of principal.

As federal and state tax rules are subject to frequent changes, you should consult with a qualified tax advisor prior to making any investment decision.

The Consumer Price Index (CPI) is a measure of the average change in consumer prices over time of goods and services purchased by households; it is determined monthly by the U.S. Bureau of Labor Statistics. Investors cannot invest directly in an index.

P/E is the price of the stock divided by its earnings per share.

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