September 2018 Investor Letter

Strategy Performance

 
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Investment Philosophy and Approach

The Active Asset Allocator investment strategy is designed to deliver a consistent level of positive returns over time with a strong focus on capital preservation. I follow a multi-asset investment approach, actively allocating between global equities, bonds, precious metals, currencies and cash. I always invest with the primary trend of the market and do not follow a benchmark. Instead, I manage the market risk for clients. This strategy has returned +9% per annum net of fees since inception with a lower level of risk than the average multi-asset fund. My active asset allocation approach is best illustrated in the following chart.

 
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Gold Trader focuses on capturing the strongest and weakest parts of gold's daily cycle, buying daily cycle lows, selling daily cycle highs and holding for 10-20 trading days, depending on the cycle count. This approach allows me to effectively manage risk. The strategy aims to capture +5%-6% profit per trade while risking 2%-3% each time, has a win rate in excess of 70% and is structured so that profits are TAX FREE for investors.

Executive Summary

This month I discuss stock market valuations particularly in the US and highlight some technical signs that suggest the equity bull market is running out of steam. Amazon for example has now outrun one of the market leaders of the dotcom mania, as the vertical ascent of its share price continues. While US equities remain in a bull trend, European and emerging market equities are lagging badly. Something has to give. In fixed income, as the US yield curve is close to inverting, I note that both fixed interest and inflation-linked bonds are set to rally once more. Meanwhile in precious metals, speculator and smart-money commercial trader positioning have reached extremes not seen since the bull market began in 2001. Gold and silver are preparing to launch.

Stock Market Update

US stocks are expensive. The Wilshire 5,000 captures the market capitalisation of all equity securities trading in the United States. Historically comprised of approximately 5,000 names, currently there are just under 3,500 equities listed in the Index. The Wilshire 5,000 Index has a market capitalisation today of approximately $29 trillion. The Index sports a trailing price/ earnings ratio of 26 times and a price/book ratio of 2.7 times, historically at the extreme end of the valuation range. The size of the US economy by comparison is approximately $20 trillion. So, the Wilshire 5,000 is now 1.4 times the size of the US economy, the most elevated since records began in the 1970's. As the Federal Reserve increases interest rates and withdraws billions of dollars from the financial system each month, it will be fascinating to watch the knock on impact on both equity securities and the US economy.

 
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As I watch Amazon, Apple, Microsoft and Google continue to rip higher week after week, I am reminded of a quote from Scott McNeely, CEO of Sun Microsystems back during the dot com mania of the late 1990’s. Sun Micro was one of the tech darlings back then and eventually reached a peak valuation of 10 times revenues, an incredible multiple, even for a high margin tech software company. A couple of years after the tech bust, McNeely made the following comment:

At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64?
— Scott McNeely, CEO Sun Microsystems

Sun Micro rallied from approximately $5 in 1997 to $64 in 2000, a thirteen fold increase, before falling all the way back to $5 again a couple of years later.

 
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Amazon, by comparison is a low margin online retailer. AMZN had revenues of $178 billion in 2017 so not trading at the same lofty multiple of revenues as Sun Micro. The same cannot be said for its share price performance however. AMZN has rallied from $100 in 2010 to over $2,000 in 2018, a twenty-fold increase. What could possibly go wrong?

 
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While stocks are expensive, momentum remains positive and there has been scant evidence of any material selling pressure to date. The majority (68%) of US equities continue to trade above their long-term moving averages. So long as this trend persists, stocks should not experience a significant decline. However, if this trend reverses and market breadth starts to deteriorate (a drop on the next chart below 50) a more substantial correction would likely occur. I don't think we are too far away from that happening. Continued caution is warranted.

 
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Turning to Europe, stocks have been consolidating below multi-decade resistance for the last 24 months. I have written that a break out above 415 on the Eurostoxx 600 Index would be a bullish development and I would take a position in EU shares in the Active Asset Allocator if a break higher was confirmed. European shares have so far failed to muster the strength to break out and now appear to be losing strength and at risk of breaking down. I have marked on the next chart key periods when the Relative Strength Index (RSI) has traded below 50. Each time coincided with a sharp break lower in the Eurostoxx 600 Index. The RSI is at 40 today and EU shares are at risk of correcting.

 
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Germany has been the strongest performing economy in the Eurozone and the German stock market has also led since the bear market lows of 2009. The Dax Index should lead the charge higher if the STOXX Europe 600 is to break out to new all-time highs. The current head-and-shoulders topping pattern in German equities is concerning however and suggests that the next break could be lower. 

 
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Following a strong breakout to new all time highs in 2017, emerging market equities have reversed sharply lower in 2018 and are now threatening to undo much of the good work they achieved last year. Emerging market equities typically trade inversely to the US dollar and the recent rally in USD has driven the recent correction in EEM. EEM now trades below $42 and under the resistance zone marked on the chart. EEM will require a resumption in the USD decline before an uptrend can resume. If EEM cannot get back above $42, this will be considered a failed breakout and a bearish development for the medium-term prospects for emerging markets. 

 
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China makes up 31% of the EEM ETF and therefore has a big influence on the overall direction and performance of the Emerging Markets ETF. The Shanghai Stock Exchange Composite Index is currently trading a touch under 2,700, down -25% from the January 2018 highs and -48% from the highs of 2015. The Index has not yet reached long-term support, which suggests EEM may have more downside ahead. Support for $SSEC would come in closer to 2,400, approximately -11% below current levels. I think we will get there and we will see then if China and the broader Emerging Markets Index can find a foothold and begin a longer-term rally. A break below long-term support would result in a more painful move lower for China and EM stocks and also potentially signal that the US dollar has more room to run higher. 

 
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For more information on my stock market analysis, please get in touch. You can reach me at brian@secureinvestments.ie or at 086 821 5911.

Bond Market Update

 
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US 10-year yields are currently trading at 2.88%, while shorter-term 2-year yields have surged higher, more than doubling over the last 12 months to 2.64%. The difference between 2 and 10 year yields has reached 24 basis points. The US yield curve is close to inverting. Typically, investors demand a higher rate of interest when locking up funds longer term, unless of course they are concerned about the future. Then demand for long-term debt drives bond prices higher and yields lower. When long-term bond yields drop below short-term bond yields, the yield curve inverts. It is a sign that all is not well in the financial system and we are almost at that point today. Once the yield curve inverts, and then normalizes, it signals recessionary times ahead and pain for equity investors. The conundrum today is that US stock markets are hitting all-time highs in many cases. Which market is correctly predicting the future, stocks or bonds? We are about to find out.

 
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Inflation-linked bonds (ILB's) in the US, EU and UK continue their steady climb higher. Unlike fixed interest rate government bonds where price moves inversely to changes in nominal interest rates, inflation-linked bond (ILB) prices are sensitive to changes in real interest rates, rather than nominal interest rates. This means that inflation linked bonds will rise in price and provide a hedge for investors against unexpected increases in inflation. Interest rates and government bond yields can rise, but as long as inflation rises at a faster rate, inflation linked bonds will increase in value. ILB's are under-owned and offer an excellent form of diversification and protection to investors in a rising interest rate and rising inflationary environment. ILB's are playing an increasingly important role in the Active Asset Allocator.

 
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For more information on my bond market analysis, please get in touch. You can reach me at brian@secureinvestments.ie or at 086 821 5911.

Gold Market Update

The gold cycle has proven quite challenging to read this year due to an investor cycle (IC) that has extended 8 months versus the more typical 5-6 month range. The IC finally bottomed in mid-August and I think a new IC is now underway. The recent market action looks and feels similar to the ICL of December 2015. Back then, gold spent four weeks building a based before launching higher. That is the pattern I am looking to repeat this time around. During the recent decline in precious metals, Gold Trader has been stopped out a couple of times but is currently positioned long in anticipation of a new IC emerging. Time will tell.

 
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Sentiment readings in the precious metals sector and current positioning by speculators and commercial traders certainly suggests a new IC is due. The Commodity Futures Trading Commission (CFTC) publishes a weekly report that summarises the current positioning of speculators and commercial traders across a broad range of commodities that trade on the Exchange.  The latest Commitment of Traders (COT) report shows that large speculators are currently holding a huge short position in gold of 213,259 contracts, 200% more than they held a few months ago and one of the largest short positions on record. Commercial traders - the miners and bullion banks - who are usually always net short to hedge their production, are 6,525 contracts net long today. Are you kidding me!! To give readers an idea of how extreme this position is, the last time the Commercials were net long gold was all the way back in 2001 when gold was trading at $250, before the bull market started. This is an extremely bullish setup for gold. 

 
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The setup is even more bullish in the silver market. Commercial traders are net long 14,613 silver contracts for what I believe is the first time ever, while the large speculators are net short 28,974 silver contracts, another extreme reading. While the COT charts are not a timing tool, the scene is set for the next leg higher in gold and silver to unfold.

 
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In my last investor update, I included a quote from Charles Gave of GaveKal Research. I found his article incredibly thought-provoking and believe his conclusion is worth repeating here again. Gave concluded:

Now, most people tell me that the renminbi cannot become a global currency as it has a closed capital account. The answer to that objection is simple: China has just to offer a conversion in gold to anybody who has too many renminbi. And indeed it is headed in that direction. In recent years the Chinese have bought all the gold they can lay their hands on, as have the Russians. So, the real economic struggle between the US and China may not be fought out over trade or technology, but end up as a monetary war. In this regard, watch gold as any significant rise in its price versus the US bond market will be a defeat for Washington; any fall in this ratio should be seen as a victory. In recent years we have been in a stalemate. I doubt that this situation will last.
— Charles Gave, GaveKal Research

The performance of gold priced in USD versus US long duration zero coupon bonds has suddenly became a lot more interesting. As Charles noted, in recent years, we have been in a stalemate, but he doubts that situation will last much longer. I hold a similar view. Gold appears to be forming a rounded bottom versus US Treasuries. I expect this chart will resolve in higher prices for gold versus US bonds and victory for China over the US longer-term.

 
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At Secure Investments, I advise individual clients on their pension and non-pension fund investment portfolios. To learn more about my Active Asset Allocator and Gold Trader  investment strategies, please get in touch at brian@secureinvestments.ie or 086 821 5911. If you are reading this via LinkedIn, why not visit Secure Investments and subscribe to get exclusive content for free. No spam, ever. Just great stuff.

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