1Q 2015 Asset Management Letter

May 6, 2015   ·   By cfgadmin   ·   Comments Off on 1Q 2015 Asset Management Letter   ·   Posted in Asset Management Letter Archive, News

 “After Midnight”

This quarter’s missive is a little departure from our normal writings in that it pulls a lot of information and charts from an outside source. Specifically we are highlighting a report from the Office of Financial Research called “Quicksilver Markets”, http://financialresearch.gov/briefs/files/OFRbr-2015-02-quicksilver-markets.pdf. We are focused on this report because we feel it makes a very objective argument for why we continue to position portfolios in a very conservative manner. Our cautious temperament causes us to worry when we begin to hear more and more calls to get more aggressive or buy index funds when the bull market is in month 72 and the average is 57 months. Of course, as this report highlights, P/E ratios are not alarmingly high so markets may continue higher.  More important to us, though, is the analysis of other metrics that are more robust than a simple P/E ratio that point to a possible overvaluation in the market which could then lead to disappointing results. For instance, CAPE ratio, Q-Ratio and Buffett indicator included in Charts 1, 2, and 3 indicate we are almost two standard deviations above the historical norm. Meanwhile the forward PE ratio indicates we are a little above the average (Chart 4) but nothing like 1999/2000. However, please note it did not signal risk in 2007 whereas the others such as the CAPE ratio and the Buffett indicator were starting to look a little dicey. Of course, valuation alone is not necessarily sufficient to trigger a downturn. In fact, none of the valuation metrics cited predict the timing of market inflection points as markets may remain over or undervalued for a long time.  However, one of the best indicators mentioned in this report is corporate earnings. Robust growth in earnings has been the primary driver behind stock market gains since 2009. However, at the same time sales growth has been modest. This higher trend in earnings is due to profit margins and corporate profitability being well above historical averages (Charts 5 and 6). Secular and cyclical trends such as productivity enhancement, higher margin sectors rising, low interest rates and low labor costs have helped significantly but if you believe in the capitalist model, then you realize that these factors must revert to the mean. Thus, the current market valuations may be elevated if record high margins are not sustained. Also noted on the report are other areas that can drive market correction such as asset bubbles and financial instability. These areas are more complex than valuation and earnings arguments and, therefore, are left alone by many market commentators. Suffice it to say that leverage is higher than it needs to be but financial industry regulation and institutional importance have been scrutinized since 2009 to the point they are not as precarious as similar historical periods. Of course, the interconnected and complex nature of asset bubbles, leverage, financial stability and other systemic issues makes this arena such a mixed bag that the sentiment can change in a millisecond. Of course, if valuations and earnings are overly optimistic, then marketplace swings can be extremely volatile and asymmetric with even a hint of financial instability. All of this aside, the market could certainly go higher. If our Federal Reserve slows the printing of money and the raising of rates at a measured rate, then we could power higher. Add to this all of the other central banks that have joined the party and decided to refresh the punch bowl with their versions of quantitative easing and this market could move even higher. We might even see four standard deviations above the market like we did in 1999 (although we doubt it). The concern, though, is how do we know when the party is about to end and when do we need to run for the door? It is sort of like when your Mom used to tell you that nothing good happens after midnight. The risk is high at this point and we need to be mindful of the downside. For instance, consider the U.S. market that has shot up 200%+ since March of 2009, while other markets have languished. Turn to the first quarter of 2015 the S&P is only up .95% for the first quarter while global equities are up far more significantly (MSCI EAFE US dollar denominated was up 4.88%). In addition, the hedge fund index was up 2.06%. This hedge fund index most closely resembles what we are trying to do with our flexible mandate funds to mitigate downside risk. We realize that the quarterly was lengthy this time around but given all of the reports that came out about index and U.S. equity returns last year, we felt it was important to spend a little more time digging into the details. The global index returned between two and four percent last year (depending on which one you use) and the S&P 500 was up 13.69%. Many of the managers we use underperformed the market capitalization weighted index last year as they see many of the same risks we see when viewing a rally 72 months long. The investment du jour right now is index funds because it is widely believed they beat active management in a bull market. While we take exception to this statement for many reasons as many of these reports use arbitrary time frames, or argue that a fund has to beat the index every year to achieve its goal; our main reason is behavioral. According to Rob Isbitts’ study last year¹, during the past two bear markets, the S&P 500 index beat only 34% and 38% of its active management competitors.  It has been our experience that when the market falls people do not hold onto their index funds and, therefore, never achieve index-like returns. We are focused on reducing downside risk so our clients stay invested and don’t chase returns to the detriment of their long term returns. The financial planning module we use focuses on a globally diversified portfolio to depict a thirty year cash flow for our clients. Our conviction is that this perspective is more stable and important than short term investment returns: of which, one year qualifies. Please call with any questions (as long it is not after Midnight). Sincerely, Richard Raby, AAMS   ¹http://www.marketwatch.com/story/index-funds-beat-active-90-of-the-time-really-2014-08-01

Chart 1	Chart 4
Chart 2	Chart 5
Chart 3	Chart 6

General Compliance Disclosures Statements made via this letter are the opinions of Creative Financial Group (“CFG”) and its advisors, and are not to be construed as guarantees, warranties or predictions of future events, portfolio allocations, portfolio results, investment returns, or other outcomes. None of the information contained is intended as a solicitation or offer to purchase or sell a specific security, mutual fund, bond, or any other investment. Readers should not assume that the considerations, suggestions, or recommendations will be profitable, suitable to their circumstances or that future investment and/or portfolio performance will be profitable or favorable. Past performance of indices, mutual funds, or actual portfolios does not guarantee future results. Future results may differ significantly from the past due to materially different economic and market conditions; investments in securities or other financial products involve risk and the possibility of loss, including a permanent loss of principal. Investments are not FDIC insured and have no bank guarantee. Creative Financial Group (“CFG”) is a division of Synovus Securities, Inc (“SSI”), member FINRA/SIPC. Prior to January 1, 2011, CFG was a separate registered investment adviser affiliate of SSI. Investment products and services are not FDIC insured, are not deposits of or other obligations of Synovus Bank, are not guaranteed by Synovus Bank and involve investment risk, including possible loss of principal amount invested. Synovus Securities, Inc. is a subsidiary of Synovus Financial Corp and an affiliate of Synovus Bank. Investment products and services provided by Synovus are offered through Synovus Securities, Inc, Synovus Trust Company, N.A., GLOBALT, Inc. and Creative Financial Group. The registered broker-dealer offering brokerage products for Synovus is Synovus Securities, Inc., member FINRA/SIPC. Investment products and services are not FDIC insured, are not deposits of or other obligations of Synovus Bank, are not guaranteed by Synovus Bank and involve investment risk, including possible loss of principal amount invested. Synovus Securities, Inc. is a subsidiary of Synovus Financial Corp and an affiliate of Synovus Bank. The U.S. Securities and Exchange Commission adopted new oversight rules designed to help and protect all investors. These rules generally reflect a reaction to the Madoff and custody scandals, but they do require that we, like all investment firms, adopt new policies and procedures related to verification of your accounts. As such, we request that you take time to compare your account balances and statements from NFS and to contact us if you do not receive those quarterly statements and/or that the values are materially different.” Cost basis reporting If you buy and sell a security in a taxable account on or after the effective date, NFS will report cost basis for the sold security to you and the IRS on Form 1099-B. If you have a mix of covered and uncovered positions in the same security, NFS will report cost basis to you and the IRS for any covered position that is sold. NFS will apply the FIFO (First In, First Out) default method unless you inform us of a different method. Your cost basis method for all transactions must be final by settlement date. If you choose to change the default method, you can do so by notifying your Financial Consultant. Use of Indexes