April 2013 Investor Letter

Model Portfolio Update

Past performance figures are estimates only and may not be a reliable guide to future returns.

Executive Summary

The Active Asset Allocator Model remains fully invested with 60% equities, 20% bonds and 20% gold, a position that has been maintained since June 2012. The risk of a medium-term peak in equities is increasing. The S&P 500 is close to setting new all-time highs (above 1,576), last seen in October 2007. We should get there shortly and the smart money may use it as an opportunity to unload their shares to optimistic retail investors who are always too bullish at market tops and too bearish at market bottoms. This time should be no different. Investor sentiment is frothy. Confidence is high. There is still no technical evidence yet to warrant moving to a more defensive position but I remain on alert for clues of a trend reversal.

Equity Market Update

We are on week 19 of the current investor cycle. Investor cycles typically last 20 weeks on average, rising for a minimum of 10 weeks during bull markets but less than 10 weeks during bear markets. So, the current cycle has been quite powerful but is now stretched and likely close to correcting. As noted last month, stock markets have been rallying since March 2009, so the current bull market is four years old. Bull markets on average last 3.8 years. Equities have been propelled higher by record levels of liquidity supplied by central banks to the financial system. However, a significant amount of 'quantitative easing' has now been priced in to global stock markets.

The recent news from Cyprus that depositors will lose up to 10% of their savings as part of a troika-led bailout of their insolvent banking sector is a game changer. So far, equity markets have shrugged at this news. However, in time, we will look back and view the events unfolding in Cyprus as a turning point in the Eurozone financial crisis. Until now, depositor savings have always been sacrosanct. (Cyprus has a €100,000 bank guarantee scheme but no funds to back it up). Depositors want no risk and typically lend to banks in return for a low, risk-free rate of interest. This relationship is based on a level of trust; a trust that has now been broken. Perception is that Cyprus is a unique, self-contained event. Reality, once it sets in, will be quite different.

Changes to investor psychology take time to have an impact. Once confidence in the banking sector is lost, it is very difficult to restore. The case for owning gold has just become stronger. Hedge fund manager and mentor Bill Fleckenstein put it very well recently when he said:

"Oftentimes, events come along that change the psychology, the fabric of trust, or affect the business cycle and go unrecognised simply because such things take time to play out, or one event impacts another and then another…. Just because there was no 'implosion' yesterday when the markets got a chance to react to the Cyprus bank plan does not mean that it will not have many more consequences down the road. Psychology is an extremely important component of the whole investment landscape. The willingness to suspend disbelief regarding inflation and the monetization of debt here, in Europe, and everywhere else for that matter is a big reason stocks and bonds are where they are. When one considers what people have been willing to look past (or disregard), it is clear that it wouldn't take much sobering up to cause a whole litany of problems."

The EU and ECB have sent a strong signal to Eurozone depositors that can now not be retracted. Deposits held in Eurozone banks should no longer be considered as riskless investments. If there is so much trouble over Cyprus, what will happen when Spain has to deal fully with the losses in its banking sector? Contagion risks to peripheral Eurozone countries have just stepped up a notch. These risks have yet to be discounted by a remarkably confident contingent of equity investors. Margin debt is now close to its prior 2007 peak. Investors are borrowing to invest in stocks at a rate not seen since 2007. Are memories really that short? Leveraged equity investors have been right with their positions so far, but there is an eerie similarity to prior periods of irrational exuberance. Corporate margins also appear to be peaking just as investor sentiment becomes overtly bullish. Market commentators continue to call for higher stock prices in the months ahead. Stocks look cheap because the next twelve months earnings are at record levels. Corporate margins always mean-revert over time. The best time to buy stocks is when profit margins are turning up from depressed levels, not when they are turning down from record highs.


Newsletter writers have rarely been more bullish in their outlook for stocks than at the present time. John Hussman of the Hussman Funds recently made the following observation:

"Last week Investors Intelligence reported that the percentage of bearish investment advisors has declined to just 18.8%. The last time bearish sentiment was below 20%, at a 4-year market high and a Shiller P/E above 18, was for two weeks in May 2007…. The next instance before that was two weeks in August 1987…. The next instance before that was for three weeks in December 1972, which was immediately followed by a 50% market plunge… The instance before that was in February 1966, which was promptly followed by a bear market decline over the following year. You get the picture."

The cyclically adjusted Shiller P/E (CAPE) for the S&P 500 (price divided by ten-year average inflation-adjusted earnings) shows that stocks are not priced for long-term gains and are, in fact, quite expensive relative to the past 100 years of data. The CAPE is currently 22.8 times, a level similar to previous valuation peaks not troughs. 

Investor sentiment can and often does remain elevated for lengthy periods of time, particularly with such significant central bank support. This is why technical market timing tools are so useful. The technical set up for stocks remains positive as captured by my technical trend indicator. This indicator comprises a mix of market sensitive data that work together to keep investors on the right side of major market moves. The rising trend will likely break over the next few months and this will result in a recommendation to move to a more defensive position. I am on watch for warning signs of a trend change and will advise accordingly.


Technical Trend

In sentiment terms, the four-year equity bull market has had its effect. Investors are once again optimistic in their stock market outlook and only see blue skies ahead. The Hulbert Stock Sentiment Index (below left) suggests the rally is due to at least pause and consolidate. The Intermediate Term Indicator Score (below right) suggests there may still be room for stocks to rise, confirming the current bullish stance of my technical trend indicator.


Bullish equity sentiment is reaching extreme levels.

Bond Market Update

Record low government bond yields unsustainable.

With 10-year government bond yields for Germany, US, UK and Japan all now trading below 2.0%, it is very difficult to make a long-term bullish case for buying bonds. After all, when inflation is taken into account, real yields are negative across the board. A 1.0% increase in 10-year yields will result in an 8-10% capital loss on your 10-year fixed income investment. Investors should favour bonds with a shorter term to maturity, as they are less sensitive to interest rate movements. Bonds should now only be used as a tactical safe haven investment; somewhere to shelter during periods of turmoil in stock markets.

Sentiment today is neutral on government bonds following last month's rally. Bonds may catch a bid during the second half of 2013 if equity markets begin a multi-month decline, but the long-term case for owning government bonds, particularly long duration bonds remains rather weak.


Sentiment neutral

Gold Market Update

Gold has started to act better in recent weeks following a long and difficult 19 month decline from all-time highs. Sellers now appear to be exhausted. However, we have yet to experience a sustained period of buying pressure. That will come in time but first we need to see gold break and hold above the $1,650-$1,700 range. Buyers should step in once they become more confident that the almost 2-year decline is at an end. Odds are high that gold has made a significant low in the $1550-$1,590 range. I believe we are close to the next major move higher in this bull market that should take gold over $2,500 in the next 18-24 months.

Sentiment remains at levels similar to previous investor cycle lows. The Hulbert Gold Sentiment Index reflects newsletter writers' continued contempt for the sector as they recommend investors take a net short position in precious metals. Public opinion on gold is flat as a pancake. This should be music to the ears of gold bulls. After twelve consecutive years of rising prices, one would think that there should be a reasonable level of excitement and expectation for the sector but in fact the opposite is the case. Long-term gold holders will once again be rewarded for their patience as rising precious metals prices lift sentiment later this year.

Record low sentiment reached on gold

An interesting divergence is appearing in the gold mining sector. Despite gold mining stocks making lower lows recently, fewer stocks are falling this time around, a common occurrence near major trend changes. This non-confirmation is evident in the following chart. The McClellan Summation Index, which measures the number of stocks declining versus advancing, has not confirmed the recent price lows set by the mining sector. Also at the bottom of the chart, fewer stocks are closing below their long-term 250 day moving average. This also signifies that the record decline may be nearing an end. If this turns out to be the case, the entire gold mining sector may be indicating that a major turn is at hand.


Are we there yet?

We are at a defining moment in this bull market for precious metals. After rallying for 12 straight years, gold has started 2013 by declining -5% in euro terms. If the bull market is still intact, which I believe is the case, then the next significant rally should be around the corner. A close below $1,520 for gold will postpone the next major move higher for another while. We will know soon enough.



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