Welcome to the quarterly ECAM update newsletter.

Transcription

1 Quarterly Newsletter July 2014 CONTENTS: MARKET OVERVIEW FUND PERFORMANCE ECAM MODELS Welcome to the quarterly ECAM update newsletter. We hope you ll find the quarterly updates of interest as we review the past quarters performance, updated models and various investment themes. Should you currently not be an ECAM subscriber but would be interested in participating in our various programs please visit our website for further information or contact us directly at: ODDS AND ENDS Reminder: A reminder to all ECAM subscribers who have yet to complete the FinaMetrica financial risk tolerance psychometric questionnaire that it is recommended to do so in order to align your portfolios with your personal financial risk tolerances. In addition, it is recommended to check your quarterly asset allocations (if you have not done so in the past 90 days) and rebalance your portfolio s as necessary to current ECAM 4-Factor model weightings. Market Overview: Equity performance during the 2nd quarter of 2014 followed a slow but steady progression throughout the quarter. Early weakness in April was recovered by the end of the month resulting in a quarterly return for the ishares MSCI ACWI Index (ticker symbol ACWI; our benchmark for a total world equity benchmark) of +5.86%. This performance was matched by the performance of the S&P 500 index in the U.S. which returned +5.52% over the same period. Page 1 of 15

2 For the year 2014 ending 30 June ACWI has returned +6.49% and is exactly in line with the return on the S&P 500 index of +6.47%. It is interesting to note the 60 day correlations on the bottom of the chart remain very close throughout both periods indicating world markets are currently closely tracking the performance of U.S. markets. A common observation we have begun to witness over the past quarter is market pundits commenting on equity markets being overvalued and due for a correction. It is important to Page 2 of 15

3 understand the concept of value is very much like the concept of beauty and extends to the eye of the beholder. We hope to put some context into this concept of valuations. There are a number of different ways to value markets. We are proponents of using historical data to create the framework by which to judge market valuations but are cognizant of the fact overvalued markets can become much-more overvalued markets before a significant correction occurs. Of all forms of historical valuation metrics, we are fond of the Shiller Cyclically Adjusted Price Earnings Ratio (also referred to as the CAPE Ratio or Shiller P/E 10 Ratio). While the official definition is below, in essence what the CAPE does is take the 10-year average of equity earnings (inflation-adjusted) and divides it by its current price. This basically measures the market's underlying fundamental earnings power smoothed out for the effects of the business cycle (business cycles can range anywhere from five to seven years). In doing so it allows an apples-to-apples comparison of historical market valuations going back to Definition from Investopedia: Definition of 'P/E 10 Ratio' A valuation measure, generally applied to broad equity indices, that uses real per-share earnings over a 10-year period. The P/E 10 ratio uses smoothed real earnings to eliminate the fluctuations in net income caused by variations in profit margins over a typical business cycle. The ratio was popularized by Yale University professor Robert Shiller, who won the Nobel Prize in Economic Sciences in It attracted a great deal of attention after Shiller warned that the frenetic U.S. stock market rally of the late-1990s would turn out to be a bubble. The P/E 10 ratio is also known as the "cyclically adjusted PE (CAPE) ratio" or "Shiller PE ratio." Investopedia explains 'P/E 10 Ratio' The P/E 10 ratio is based on the work of renowned investors Benjamin Graham and David Dodd in their legendary 1934 investment tome Security Analysis. Graham and Dodd recommended using a multi-year average of earnings per share (EPS) such as 5, 7 or 10 years when computing P/E ratios to control for cyclical effects. The P/E 10 ratio is calculated as follows take the annual EPS of an equity index such as the S&P 500 for the past 10 years. Adjust these earnings for inflation using the CPI. Take the Page 3 of 15

4 average of these real EPS figures over the 10-year period. Divide the current level of the S&P 500 by the 10-year average EPS number to get the P/E 10 ratio or CAPE ratio. The P/E 10 ratio varies a great deal over time. According to data first presented in Shiller s bestseller Irrational Exuberance (which was released in March 2000, coinciding with the top of the dot-com boom), updated to cover the period 1881 to November 2013, the ratio has varied from a low of 4.78 in December 1920 to a peak of in December A criticism of the P/E 10 ratio is that it is not always accurate in signaling market tops or bottoms. For example, an article in the September 2011 issue of the "American Association of Individual Investors Journal" noted that the CAPE ratio for the S&P 500 was in July Comparing this ratio to the long-term CAPE average of would suggest that the index was more than 40% overvalued at that point. The article suggested that the CAPE ratio provided an overly bearish view of the market, since conventional valuation measures like the P/E showed the S&P 500 trading at a multiple of (based on reported earnings) or (based on operating earnings). Although the S&P 500 did plunge 16% during a one-month span from mid-july to mid-august 2011, the index subsequently rose more than 35% from July 2011 to new highs by November Below is a chart of the Shiller P/E 10 from 1871 to present (Source: Doug Short) Page 4 of 15

5 Looking at the 1 st graph we can clearly see the current CAPE of 25.5 at the end of June, 2014 puts equity valuations near the top of historical ranges. In fact, the only time the market has been more expensive has been in 1929, 2000 and 2007 (all significant market tops). An interesting thing to note on the above graph is all previous market overvaluations prior to 2000 were followed by significant declines to bring valuations well below both the price and ratio regression lines. This did not occur since the market top in 2000 and, as such, it cannot be expected stock market returns into the future will be as robust as would be expected if the markets were allowed to follow their natural course to undervaluation. When viewed in percentiles it can be seen the current 92 % puts us slightly below the 2007 CAPE peak of 95%, the 1929 CAPE peak of 97% and the ultimate overvalued peak of 2000 at 100%. However, it does put market valuations well into the top 10 th percentile of overvaluation since The significance of the CAPE level is not that it is a great market timing indicator. What it does best is to allow investors to accurately assess of what the expected forward returns will be on equity investments into the future. Page 5 of 15

6 Looking at the above graph it can be seen historically equity percentage returns once the CAPE has crossed into the top 10 th percentile (above 25.1) have resulted in an average return over the next 10 years of +0.5% per year real returns with the potential for a worst case scenario of -6.1% per year real return. In other words, current market valuations are not conducive to strong equity returns over the next decade. Those hoping to buy-and-hold equities and expecting historical returns of 6-8% per year are going to be sadly disappointed. The question is why market participants are continuing to bid up the price of equities given their historical overvaluation. In our opinion it comes down to an excess of savings worldwide that need to be invested SOMEWHERE. Based upon the current cyclical P/E of 25.5, you can invert the CAPE to calculate the current cyclical adjusted earnings yield on equities (1/25.5 = 3.92%). In the current investment world where 10 year U.S. treasuries are yielding 2.45% the cyclical yield of 3.92% remains attractive on a relative basis. This will change when bond yields finally rise and equities become less attractive on a relative basis. Given the current market overvaluations, what could be the trigger that finally ends this bull market? While there are a number of possibilities, historically equity markets will continue to do well on a longer term basis (with minor corrections of up to -20% along the way) until the U.S. Federal Reserve pulls the punchbowl away and creates the next significant market decline through raising interest rates (monetary tightening). It must be remembered the FED as has a dual mandate of both full employment and price stability. While many times these tend to move in tandem, our fear is structural unemployment in the U.S. (due to the loss of manufacturing jobs in the U.S. leading to a glut of low skilled manpower) will force the FED to keep interest rates much too low for much too Page 6 of 15

7 long. This will eventually be reflected in an increase in inflation. Once this becomes apparent we believe the FED will abandon its full employment mandate for its price stability mandate and rapidly increase interest rates to attempt to offset rising inflation. This will ultimately end the bull market. While we monitor a number of inflation indicators (most of which remain subdued to-date), we are mindful that the amount and velocity of money are many times leading indicators of impending inflation. The following 2 graphs from the FED clearly show the amount of money (MZM) is at an all-time high and the current velocity of money is at an all-time low. Significant turnarounds on both these indicators will need to be closely monitored as these should provide the 1 st indications future inflation has begun. Page 7 of 15

8 Conclusion: Based upon current market valuations the projected forward percentage returns on equities over the next decade is low. However, it is possible current market prices can continue to advance above current levels to become even more overvalued. This is what we are expecting. Market participants who are not prepared to actively manage their positions would be wise to reduce equity exposure near current levels given the overvaluation. However, those who employ an active market analysis process may achieve additional equity returns before the FED tightens monetary policy in response to inflation increases ultimately ending the current bull market. We do not expect this to occur until late 2015-early Performance: For those who are members of the Emirates Group Provident Scheme below is the performance returns for the 2 nd quarter and year-to-date for the various funds offered as of 30 June 2014: 2 nd Quarter 2014 (01 Apr-30 Jun 2014) Name Currency -- Period Start Period End -- % Change Date Price Date Price in Period BGF US Dollar Reserve USD 01/04/ /06/ Emirates NBD Islamic Money Market USD 01/04/ /06/ Fidelity US Dollar Cash USD 01/04/ /06/ Russell US Dollar Liquidity II USD 01/04/20141, /06/20141, Fidelity Australian Currency AUD 01/04/ /06/ BGF US Dollar Reserve Hedged GBP GBP 01/04/ /06/ Fidelity Euro Currency EUR 01/04/ /06/ BGF World Bond USD 01/04/ /06/ Page 8 of 15

9 BGF Global Inflation Linked Bond USD 01/04/ /06/ Fidelity International Bond USD 01/04/ /06/ Fidelity US Dollar Bond USD 01/04/ /06/ BGF Global Government Bond USD 01/04/ /06/ Russell Global Defensive USD 01/04/ /06/ Emirates NBD Global Sukuk USD 01/04/ /06/ Russell Global 35 USD 01/04/ /06/ BGF Global Allocation USD 01/04/ /06/ BGF Emerging Europe EUR 01/04/ /06/ BGF European EUR 01/04/ /06/ BGF Latin American USD 01/04/ /06/ BGF United Kingdom GBP 01/04/ /06/ BGF US Flexible Equity USD 01/04/ /06/ BGF Global Equity USD 01/04/ /06/ Emirates NBD Islamic Global Balanced USD 23/04/ /06/ Fidelity International USD 01/04/ /06/ Fidelity America USD 01/04/ /06/ Fidelity Emerging Markets USD 01/04/ /06/ Fidelity Euro Blue Chip EUR 01/04/ /06/ Fidelity FE ASEAN USD 01/04/ /06/ Fidelity FE Australia AUD 01/04/ /06/ Fidelity FE Japan ** JPY 01/04/ /06/ Fidelity Nordic SEK 01/04/ /06/ Fidelity FE South East Asia USD 01/04/ /06/ Fidelity United Kingdom GBP 01/04/ /06/ Russell Global 50 USD 01/04/ /06/ Russell Global 70 USD 01/04/ /06/ Russell Global 90 USD 01/04/ /06/ Fidelity European Smaller Companies EUR 01/04/ /06/ BGF European Special Situation * EUR 01/04/ /06/ BGF Asian Dragon USD 01/04/ /06/ BGF Global Opportunities USD 01/04/ /06/ BGF Japan Small & MidCap Opportunities USD 01/04/ /06/ BGF US Small & MidCap Opportunities USD 01/04/ /06/ Emirates NBD MENA Opportunities USD 01/04/ /06/ Page 9 of 15

10 Fidelity FE Asian Special Situations USD 01/04/ /06/ Fidelity European Growth EUR 01/04/ /06/ BGF World Gold USD 01/04/ /06/ Russell Global Real Estate Securities USD 01/04/20141, /06/20141, Year to Date (02 Jan-30 Jun 2014) Name Currency -- Period Start Period End -- % Change Date Price Date Price in Period BGF US Dollar Reserve USD 02/01/ /06/ Emirates NBD Islamic Money Market USD 02/01/ /06/ Fidelity US Dollar Cash USD 02/01/ /06/ Russell US Dollar Liquidity II USD 02/01/20141, /06/20141, Fidelity Australian Currency AUD 02/01/ /06/ BGF US Dollar Reserve Hedged GBP GBP 02/01/ /06/ Fidelity Euro Currency EUR 02/01/ /06/ BGF World Bond USD 02/01/ /06/ BGF Global Inflation Linked Bond USD 02/01/ /06/ Fidelity International Bond USD 02/01/ /06/ Fidelity US Dollar Bond USD 02/01/ /06/ BGF Global Government Bond USD 02/01/ /06/ Russell Global Defensive USD 02/01/ /06/ Emirates NBD Global Sukuk USD 02/01/ /06/ Russell Global 35 USD 02/01/ /06/ BGF Global Allocation USD 02/01/ /06/ BGF Emerging Europe EUR 02/01/ /06/ BGF European EUR 02/01/ /06/ BGF Latin American USD 02/01/ /06/ BGF United Kingdom GBP 02/01/ /06/ BGF US Flexible Equity USD 02/01/ /06/ BGF Global Equity USD 02/01/ /06/ Emirates NBD Islamic Global Balanced USD 23/04/ /06/ Fidelity International USD 02/01/ /06/ Fidelity America USD 02/01/ /06/ Page 10 of 15

11 Fidelity Emerging Markets USD 02/01/ /06/ Fidelity Euro Blue Chip EUR 02/01/ /06/ Fidelity FE ASEAN USD 02/01/ /06/ Fidelity FE Australia AUD 02/01/ /06/ Fidelity FE Japan ** JPY 02/01/ /06/ Fidelity Nordic SEK 02/01/ /06/ Fidelity FE South East Asia USD 02/01/ /06/ Fidelity United Kingdom GBP 02/01/ /06/ Russell Global 50 USD 02/01/ /06/ Russell Global 70 USD 02/01/ /06/ Russell Global 90 USD 02/01/ /06/ Fidelity European Smaller Companies EUR 02/01/ /06/ BGF European Special Situation * EUR 02/01/ /06/ BGF Asian Dragon USD 02/01/ /06/ BGF Global Opportunities USD 02/01/ /06/ BGF Japan Small & MidCap Opportunities USD 06/01/ /06/ BGF US Small & MidCap Opportunities USD 02/01/ /06/ Emirates NBD MENA Opportunities USD 02/01/ /06/ Fidelity FE Asian Special Situations USD 02/01/ /06/ Fidelity European Growth EUR 02/01/ /06/ BGF World Gold USD 02/01/ /06/ Russell Global Real Estate Securities USD 02/01/20141, /06/20141, Commentary: During the 2nd quarter 2014 the top performing diversified core equity/bond/cash funds were as follows: -Fidelity International with a return of +3.84% (+7.04% YTD) -BGF Global Inflation Linked Bond with a return of +2.88% (+5.24% YTD) -Fidelity Australian Dollar Currency with a return of +0.36% (+0.72% YTD) Page 11 of 15

12 Our world equity benchmark (the ishares MSCI ACWI Index ETF) returned +5.86% during the 2nd quarter (+6.49% YTD). As such, all core equity funds underperformed the benchmark in the 2 nd quarter but year-to-date the Fidelity International continues to outperform the benchmark (with the others lagging). Our world Bond benchmark (50% Vanguard Total US Bond Market ETF/50% Vanguard Total International Bond ETF) returned +1.96% during the 2 nd quarter. As such, both the BGF Global Inflation Linked Bond and the Fidelity International Bond fund outperformed the benchmark with a returns of +2.88% and +2.47% respectively (+5.24% and +5.50% respectively for 2014 YTD). In terms of currencies, the top performing currency fund for the quarter was the Fidelity Australian Dollar Currency with a return of 0.36% (+0.72% YTD). Our recommended asset allocation models remain unchanged as of the end of June with our recommended funds continuing to lead the returns for those funds offered within the Emirates Provident Scheme. ECAM Models: As subscribers are aware, ECAM utilizes 4 distinct models to assist members in the selfmanagement of their various portfolios. Each model gives a factored score based upon its historical impact upon future absolute returns. The 4-Factor model is then compiled into a single 4-Factor Composite Signal used to "tilt" risk-adjusted portfolios to the upper or lower end of their respective ranges (overweighting growth assets when the risk/reward is favorable and underweighting growth assets when the risk/reward is unfavorable). As such, risk-adjusted portfolios are constantly adjusted to match current market conditions and therefore optimally weighted. The models are graphically presented to subscribers in a stoplight manner for ease of interpretation. The model overview and positions as of the end of June were as follows: Page 12 of 15

13 Economic Model: The Economic model measures the probability of a future recession in the U.S. based upon 6 independent model inputs. The model looks forward approximately 3-4 months therefore provides a reasonable warning of the possibility of a future recession to allow for adjustments to portfolio holdings (avoiding the Phase 3 declines discussed previously). The Economic model at the end of June 2014 was GREEN indicating a very low probability of recession in the U.S. in the next 3-4 months. Valuation Model: The Valuation model looks at the relative value of equity prices based upon fundamentals. The model employees 6 inputs to measure whether markets are overvalued, fair valued, or undervalued. The Valuation model at the end of June 2014 was RED indicating the market was overvalued at present levels. Technical Model: The Technical model utilizes technical analysis to determine trend. A total of 22 inputs are utilized to assess market trend, breadth and momentum. The Technical model at the end of June 2014 was GREEN indicating the market trend was strong with good follow-though breadth and strong momentum. Sentiment Model: The Sentiment model assesses the current market sentiment being displayed by various market participants including individual investors, large speculators (hedge funds) and pension funds through the use of 6 independent model calculations. When sentiment is complacent it is a contrarian negative sign and when sentiment is fearful it is a contrarian positive sign. Page 13 of 15

14 The Sentiment model at the end of June 2014 was RED indicating market participants were much too comfortable with their equity positioning. As such, most participants were all-in with respect to their mandated exposure to equities leaving very little buying power available to move markets forward. ECAM 4-Factor Composite Model: The 4-Factor Composite model takes the inputs from the above models and factors them relative to how each has contributed historically to indicate future market returns. The 4-Factor model at the end of June 2014 was YELLOW indicating a continued bullish neutral weight positioning in equity accounts was warranted. Odds & Ends: We would like to thank those who have recently joined ECAM. The response to date has been tremendous and we look forward to assisting you with the management of your portfolio into the future. We welcome those who wish to join us on our quest to provide absolute return and should you wish further information please be sure to visit our website at: As we go forward and things start to slow down, we plan on providing a number of different areas of education/analysis on various investment subjects/themes. Some of the forthcoming items are as follows: Page 14 of 15

15 Retirement Education: A prime consideration in building the new website was to provide information on retirement planning considerations. As we move forward and have more time available, this is a theme we feel strongly needs to be addressed. We hope to be able to provide insight into the basics of retirement planning, portfolio modification as you progress towards retirement, and withdrawal strategies useful during retirement to protect you from outlasting your money. A number of articles will be forthcoming on this subject soon. In the interim we have added a number of links in the Resources and Tools section of the website to provide some basic education on retirement planning. We plan on adding to that list in the next month and then begin some discussion on various aspects of retirement planning in the blog section of the website. It is hoped over the next year the material provided as well as the discussions will assist our many readers in taking the 1 st steps towards planning for their retirement. Page 15 of 15