I ve been thinking about emerging trends in portfolio construction

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2 I ve been thinking about emerging trends in portfolio construction Kenneth R. Solow, CFP Pinnacle Advisory Group, Inc. PortfolioConstruction Conference 2006

3 Caveats This presentation is U.S. centric. The phrase New Paradigm belongs to Bob Veres. This presentation reflects the perspective of Pinnacle Advisory Group, Inc. as a Private Wealth Manager.

4 What is the old paradigm of portfolio construction for Registered Investment Advisors? Equities outperform other asset classes over time. Risk premia are stable and positive. Non-correlated asset classes reduce portfolio risk. Time diversification is the best method of preserving capital. Market timing is impossible.

5 What is the old paradigm of portfolio construction? Value tilts and small cap tilts add value. Active management by using money managers to invest various asset classes can add value.* Systematic rebalancing adds value. * Still very controversial among U.S. institutional investors

6 The New Paradigm (NP) What if.. Equities don t always outperform other asset classes over long periods of time and risk premiums are time varying? Correlations can spike in bear markets adding surprising volatility to portfolios? Time diversification is a worthless concept in the real world for most retirees? Market timing is necessary and expected by our clients? Traditional style constraints become irrelevant?

7 Average equity returns are not always returned over 20-year periods. Source: Crestmont Research, Net total returns including market gains, dividends, & transaction costs of 2%.

8 Expanding and contracting P/E multiples characterize secular market cycles.

9 Secular Market DJIA Returns (exdividends) Source: Crestmont Research

10 Inflation and P/E multiples over long time periods. LONG-RUN OSCILLATION BETWEEN P/E RATIOS AND INFLATION 40 U.S. S&P 500 Price-To-Earnings Ratio 40 30? Ann% Chg Core* Consumer Prices Ann% Chg BCA Research * Excluding food and energy. 2

11 Liquidity and P/E multiples over long periods of time P/E RATIOS AND LIQUIDITY 40 U.S. S&P 500 Price-To-Earnings Ratio Easy Conditions Liquidity Index Tight Conditions BCA Research

12 Will Inflation Depress Multiples Going Forward?

13 Short-term or cyclical market moves within the last secular bear market.

14 Profits are Cyclical 16 MARGINS ARE CYCLICAL % Ann% EBIT MARGINS* (LS) Chg REAL GDP (RS) BCA Research *EARNINGS BEFORE INTEREST AND TAXES AS A % OF NON-FINANCIAL CORPORATE SECTOR GDP NOTE: BOTH SERIES ARE SHOWN AS 4-QUARTER MOVING AVERAGES

15 Business Cycles three components-bca

16 S&P Year Real Returns from Earnings Peaks S&P 500 Real Returns - 20 Year increments post peak SP500 CPI Real SP500 Peak Month Peak Yr. End Yr. Annualized Annualized Annualized Dec March March March March Sept June Dec / Sept / Mean

17 March 2006, Financial Planning, Test Your Tactical IQ If the stock market were to reach a forward P/E of 28, which portfolio construction strategy would you pursue? 1. Fully invest the stock allocation. The New Economy really does exist. 2. Underweight stocks versus the benchmark. Little to no chance of getting avg. historic returns over the next twenty years. Find a better idea. 3. Adjust my portfolio modeling software for lower returns, but make sure that client s don t think I m market timing. 4. Trick question. The value of my client relationships has nothing to do with stock market returns.

18 Predictions, Forecasts, and Guarantees Random House Webster s Dictionary defines forecast as, to predict, by observation or study; however it is most often used of phenomena that cannot be accurately predicted: Rain is forecast for tonight.

19 Ben Bernanke, U.S. Federal Reserve Chairman, July 19 th Congressional Testimony The lags between policy actions and their effects imply that we must be forward looking.

20 Bill Gross, Managing Director PIMCO, Investment Outlook, August tricky business this forecasting. Even when posing as a long-term oracle as Francis Fukuyama did when he wrote his famous The End of History and the Last Man in 1989, the world can zig and zag and stone you intellectually faster than you can say Islamic radicalism. I shall don sufficient armor and prepare to be stoned.

21 NP Advisors CAN Predict the Future! SAA Prediction: A portfolio construction will deliver a 5% premium over inflation over time. NP Prediction: Buying the stock market when multiples are high will lead to less than average returns over secular time periods. Restrictive monetary policy & inflation will result in lower multiples.

22 Current Example of Possible Mispricing #1?

23 Current Example of Possible Mispricing #2? 2.0 S&P 600* / WILSHIRE 5000 Trend Trend +/- Two Standard Deviations BCA Research *Russel 2000 shown prior to 1990, rebased to starting point of S&P 600.

24 If This Makes So Much Sense, Then Why Can t We Talk About it? Academics can t tell us how to do it. Subjective decision making. Implication that all advisors can t be equal as money managers. Terrible business model that implies significant additional expense. Unnecessary to grow business in robust FA market place. Business risk if clients misperceive the meaning of a forecast.

25 Market Valuation Methodologies Discounted earnings, cash flow, dividends P/E relative to historic mean Earnings yields relative to bond yields (Fed Model) Derivations of Fed Model Forward, trailing, normalized earnings Operating, GAAP, Core earnings

26 Market Cycle Methodologies: Consumer Spending as Leading Indicator Real wages Housing values Interest rates Oil and gas prices Home equity extraction

27 Market Cycle Methodologies: Bond Market as Leading Indicator Inflation indicators Money supply Yield spreads Yield curve New issuance

28 Three Methodologies For Constructing New Paradigm Portfolios 1. Outsource to larger more experienced firms, or follow outside research/asset allocation service with no in-house analysis. 2. Strategically own non-style constrained money managers. 3. Use in-house analysis to change portfolio construction based on valuation and market cycle.

29 Strategic NP Portfolio Construction Best 12-month return: 19.8% Worst 12 month return: -2.9% 3-yr Standard Deviation: Portfolio 3.65 S&P Client Expectation: Short-term- positive rolling 12-month return, Long-term Beat T- Bill Return. Absolute Return Allocation 3-yr MPT Stats (vs S&P500) Alpha 4.3 Beta 0.33 R-Squared 51 Diversified Commodities 5% T-bills 10% Long/Short Equity 35% 3-yr % Ann. Returns thru Portfolio S&P mo. T-Bills 2.3 Flexible Fixed Income 30% Hedge Fund of Funds 10% Market Neutral Equity 10%

30 In-House Analysis NP Portfolio Construction: Early Cycle Early Cycle Allocation Bonds 20% Emerging Markets 5% Foreign Mid/Small- Cap 5% Alternative Investments 10% Foreign Large Cap 10% Cash 0% U.S. Large Cap 25% Cyclical Sector 1 5% Cyclical Sector 2 5% U.S. Mid/Small-Cap 15% Benchmark: 60% Equity. Rotated to 70% equity, Emphasis on beta, small-cap, cyclical sectors.

31 In-House Analysis NP Portfolio Construction: Late Cycle Late Cycle Allocation Foreign Mid/Small- Cap 3% Cash 7% U.S. Large Cap 20% Defensive Sector 1 5% Bonds 35% Emerging Markets 0% Alternative Investments 15% Defensive Sector 2 5% U.S. Mid/Small-Cap 5% Foreign Large Cap 5% Benchmark: 60% Equity. Rotated to 43% equity, Emphasis on Large-cap & defensive sectors, 42% fixed, 15% alternatives

32 Becoming an Investment Expert BCA Global Investment Strategy, BCA Research BCA Equity Sector Strategy, BCA Research The Bank Credit Analyst, BCA Research John Kosar, Asbury Research John Mendelson, Stanford Research Company Francios Trahan, Bear, Stearns & Co. Inc Liz Ann Sonders, Charles Schwab and Co, Inc. John Roque, Natexis Bleichroeder, Inc. Jim Bianco, Bianco Research Brian Reynolds, MS Howells Bill King, M. Ramsey King Securities, Inc. Steven Roach, Morgan Stanley Dick Berner, Morgan Stanley John Mauldin, InvestorsInsight Publishing, Inc. Jim Grant, Grant's Interest Rate Observer Gloom Boom & Doom report, Marc Faber Limited Ken Tower, Cybertrader Bill Gross, PIMCO Paul McCulley, PIMCO Van R. Hoisington, Lacy H. Hunt, Van Hoisington Investment Management Company Ed Yardeni, Oak Associates, ltd. Business Week Magazine

33 Summary and Conclusion Strategic asset allocation may not always be the best investment strategy. If advisors believe that risk premiums can vary, then other investment strategies may be appropriate. New trends in portfolio construction will evolve where forecasting is an accepted method for managing portfolio risk. Advisors will have many choices in determining how they will participate in NP investment strategies.

34 I ve been thinking about emerging trends in portfolio construction Kenneth R. Solow, CFP Pinnacle Advisory Group, Inc. PortfolioConstruction Conference 2006

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