As of July 10, 2015 Quarter in Review The following are the total returns for many of the major asset classes in the second quarter of 2015 (note that as a client you do not have exposure to all of these asset classes, but these are some of the major ones we watch): 5.0 Asset Class Returns 2nd Quarter 2015 0.0-5.0 U.S. LC U.S. MC U.S. SC Foreign LC Foreign SC Emerging Markets LC Emerging Markets SC REITs Preferred Stocks Utilities Energy Precious Metals Aggregate Bond TIPS Munis High Yield Mortgages EM Bonds -10.0 The key events this quarter were the following: Improving U.S. Economy Job growth is well above 200,000 a month, and the real estate market is appreciating in most states. Significant Increase in Interest Rates Long-term this is good for our clients, shortterm it causes some headwinds to returns which you can see in the fixed income returns this quarter. The 10 year Treasury finished at 2.35% from 1.94% on March 31 st. Our focus on active managers continues to pay off, with all but one of our fixed income funds outperforming the bond index. Pimco Income continues to do well, up almost 3% for the year. This significant increase in rates also caused some overreaction in other interest rate sensitive asset classes like utilities, real estate, and MLPs. This will likely create opportunities in these asset classes. Taking some gains in utilities and real estate in the first quarter paid off. 1
Oil Prices Recovering Contributing to the volatility in markets, oil went from $113.50 per barrel in June 2014 to $48.40 in January 2015 to $61.18 as of June 2015. We will discuss more below, but this is a good example of the benefit of volatility as we were able to increase our energy exposure near the lows. Weakening Dollar Greece Drama Reemerges China A share market goes up 100% and now down 30% as of this writing. We will discuss more in a future commentary, but the main market to watch is Hong Kong. China s A share market is ripe with conflicts, and the government changes the rules regularly. Overall, the first half of 2015 ended with mediocre investment results. International equities were the bright spot for the first half of the year and added valuable diversification benefits to offset some of the weakness in other asset classes. At the same time, no asset class you are invested in is doing terribly. The S&P 500 will finish the first half of the year with no real gain. When asked how s the market doing, a good response is to ask since when? Looking at the S&P 500 as a reasonable marker for the U.S. domestic stock market as a whole, the return from the peak of the tech bubble in January 2000 is about 3 4% a year (dividends included as reinvested). Our clients did much better than this because most asset classes outperformed the S&P 500 over the last 15 years by a wide margin. The return from the peak of the market before the great recession of 2007 2009 is about 5 6% a year. The return of the index from the bottom of the great recession in April 2009 is 16% a year. For the last fifty years, the return has been about 9% a year. So, since when? is an important question to answer and really gets to the heart of investing. As we have discussed, we do not invest client funds in equities that you will need in the next three to five years. This illustrates the equity risk premium in finance which basically means those that are willing to put up with short-term losses and some volatility should receive higher returns over long time periods. If this was not the case, then there would be no reason equities earned higher returns than cash or fixed income. Volatility has increased some, but so far U.S. markets are only off between 4% and 5% from their highs this year. We are going on three years now without a normal 10% correction sometime during the year. Volatility is good for our clients as it allows us to take advantage of these intra-year swings. It is always important to remember the difference between volatility and 2 Did you know that Greece: Has been in default or rescheduling its debt 51% of the time from 1829 to 2006 (Reinhardt and Rogoff). Greek GDP of $240 billion in 2013 is roughly equal to Detroit GDP of around $224 billion in 2013. The European Union GDP is roughly equal to U.S. GDP. European banks have decreased their exposure to Greece from $292 billion in 2008 to $33 billion today. The key concern with Greece leaving the European Union is the potential precedent this would set for other countries, like Spain, who have significant debt loads as well.
risk. Volatility is the normal ups and down, whereas we view risk as the potential for permanent loss. You are well diversified to avoid permanent loss, and you will benefit from volatility as we are able to rebalance and take advantage of it. Are Markets Overvalued? To start, the question should be what market are you talking about? You can see in your pie-chart in the quarterly report, you are invested in eight to ten different asset classes with sub asset classes within many. One of the key principles we can control is we do not invest in extremely overvalued asset classes, we overweight undervalued asset classes, and normally hold fairly valued asset classes. Much like tech stocks in the late 90s or real estate in mid 2000s, it is fairly obvious to spot overvalued markets. Today, no asset class seems particularly cheap, and the only asset class that looks extremely expensive is long-term U.S. bonds (which we are avoiding). One metric utilized to value global stock markets is the Price to Earnings (P/E) ratio. The P/E ratio tells how much an investor is paying for $1 of earnings over a twelve month period. A P/E ratio of 16 means an investor is paying $16 for $1 of earnings. A low P/E ratio means you are paying less and a high P/E ratio means you are paying more. For example, the historical average for the S&P 500 P/E ratio is 15.7. It currently stands at 16.4 which is much higher than the 10 P/E in late 2008 but nowhere near the P/E of the late 90s in the high 20s. Tech stocks were trading at P/Es in the 100s in the late 90s. As you can see from the chart, the NASDAQ is just getting back to its highs 15 years later. You can see the differences in valuations from 2000 and today. The chart below takes some studying, but look at the last 25 years for the S&P 500 (U.S. stocks), and the graphs of the one year and five year annualized returns (y-axis) with their corresponding starting Price to Earnings (P/E) ratios (x-axis). The chart on the left shows that returns are random, and it is hard to predict over a one year period what returns will be, no matter what the valuation. However, the chart on the right demonstrates a potential link between lower starting P/E ratios (the left side of the x-axis) and higher five year returns compared to higher starting P/E ratios. When looking solely at the starting P/E ratio, a lower P/E ratio tends to predict higher returns over the next five years when compared to a higher starting P/E ratio. 3
Implications for Two Asset Classes in Your Portfolio U.S. and International Equities U.S. Stocks In the chart, you can see at around a 15 to 16 P/E for the U.S. stock market, it is reasonable to expect returns in line with earnings growth, not as high as lower P/Es, but by no means a doom and gloom scenario over a 5 year time frame. So, a good takeaway, we should have decent equity returns going forward, but not as high as the last 6 years because valuations are higher now. The U.S. stock market is more expensive than most international markets. Low interest rates though could support higher than normal valuations. Given that large cap growth stocks continue to show lower valuations than value stocks, we shifted some of our exposure to a large cap growth ETF last quarter and away from a dividend value ETF. Small and mid-cap stocks continue to outperform large cap stocks and will continue to benefit from low interest rates and less exposure to the fluctuations in the U.S. dollar compared to larger companies. International Stocks International markets have more attractive valuations than the U.S. After several years of lagging, your allocation to international equities has been one of the bright spots through the first half of this year. Many of our international managers own mid and small-cap stocks that are focusing on the consumer driven sectors that will benefit from the rising middle class outside the U.S. This is a big deal and one that will likely continue. 4
Rising Rates and Implications We saw significant volatility in interest rates for the quarter as a result of a number of factors. The strengthening economy has something to do with it, but more so the impact of government intervention in the markets. In the U.S. at least, we are getting close to the end of the 0% Fed Funds rate, and the Fed discussion on raising rates contributed to the volatility. Even more so, though, is the current bond buying program from the European Central Bank. You can see this in the chart which shows the 10 year U.S. Treasury vs. the 10 year German Bond. You will notice up until mid-2014 they track fairly close together. You can easily see the end of the U.S. bond buying program (rates move up) and the beginning of the ECB bond buying program (German rates diverge from U.S.). At one point, German bonds were yielding close to 0% and then jumped up to almost 1% within a month. The potential for a rise in short U.S. rates is a welcome sign for many of our clients who are net savers. While in the short-term this rise in U.S. rates resulted in lower returns in the fixed income asset class and caused interest rate sensitive asset classes like REITs, utilities, emerging markets to show some losses, higher rates are good for long-term returns. Many of these interest rate sensitive asset classes saw declines well below fundamentals, so we will be looking to add to some of these asset classes on further weakness. As we have discussed before, our shift to active managers in fixed income continues to pay off vs. bond index funds, as managers will continue to be able to add value over and above a static index. In fairly valued markets, it is much easier for active managers to add value over a static index. You can see the Federal Reserve officials forecast for short-term interest rates. Each board member is a dot on the chart and the dot is their forecast for short-term rates. Janet Yellen, the Federal Reserve Chairwoman, is one of the dots, but they do not disclose which one she is. Several 5
key takeaways: Even for the so called experts and the ones setting policy, there is significant disagreement on the direction of interest rates. Look at 2017 and the spread between 2% and 4%. Most people think Yellen is toward the bottom end of the range. The median forecast is around 0.5% in 2015, 1.5% in 2016, 3.0% in 2017, and around 3.75% in 2018. These increases will impact the interest rate you pay on variable loans and lines of credit. For cash returns and fixed income returns, these increases will directly impact the rate of return on these investments as well. It is important to keep in mind that even with these rate increases, cash will only earn the same rate as inflation sometime around mid-2017. This is hardly an ideal scenario for clients saving for long-term goals, but will hopefully end the significant negative rates of return on cash. It is also important to note that interest rates can stay low for a significant period of time. Analysts have been forecasting much higher rates for six years now, and ten year rates are not materially higher. This is important as we are not only managing investments but also as we run retirement cash flow projections and discuss reasonable withdrawal rates from the portfolio for clients in retirement. We will discuss this more in our meetings and in our next commentary on some of the latest research that is coming out of the impact of low interest rates on sustainable withdrawal rates. As always, we value the relationship we share with you and appreciate the trust you have placed in us to help you make sound financial decisions. If you would like to discuss any of these topics further, please feel free to contact us. Respectfully Yours, Preston & Cleveland Wealth Management 6