January 2014 Investor Letter

Model Portfolio Update

Executive Summary

2013 turned out to be quite a strong year for stocks, rather subdued for bonds and downright difficult for precious metals. Our model portfolio captured approximately 50% of the stock market gains, as we were overweight equities until the end of June 2013. We switched to a defensive position in July and have maintained that stance ever since. In hindsight, we gave up some extra performance as equities continued their run through year-end. However, stock markets are now turning lower as we enter 2014 and we are well positioned. 2014 is shaping up to be a much more challenging year for investors. Capital preservation will be the name of the game and we aim to steer our customers through these volatile times with our tried and tested conservative approach. To learn more, please feel free to drop us an email or call Brian at 086 821 5911.

Equity Market Update

2013 turned out to be a fabulous year for global stock markets with the MSCI Global Equity Index returning +21% for the last 12 months. Our model portfolio captured approximately 50% of those gains, as we were overweight stocks until the end of June 2013. We moved to a more defensive position in July on the first big break lower for equities and the bonds we purchased performed quite well +2.5% for the July-December period. However, global stock markets recovered and tacked on another 10% through year-end, so our tactical switch proved overly conservative in hindsight. However, we continue to believe a conservative approach is the correct strategy in the current environment where stocks are expensive, particularly on Wall Street, overbought in the near-term and investor sentiment is running sky high. We advise caution and patience for now.

As we turn to 2014, what does the future hold? Well, the current bull market in stocks is approaching its fifth birthday and is already a full 12 months longer than the average bull market of the past one hundred years (4.8 years versus 3.8 years on average). In fact, we are currently witnessing the fourth longest stock market advance since 1932. Equities are expensive, overbought and overextended but the trend higher must be respected. What we are likely seeing here is a runaway move that will lead to a major stock market top - unless it has already occurred. The timing of the top is unknowable in advance, but I sense we are getting very close now, for a few reasons:

1) Everyone's bullish on stocks. Those holding a negative opinion are in a tiny minority. By any measure, optimistic sentiment has reached a record extreme. At a minimum, we are due for a stock market correction. We may or may not be at the end of this 5-year bull market run, it is too early to tell just yet but a +10% decline to reset sentiment is definitely overdue.

2) Investors are heavily committed. Margin debt levels - money borrowed to invest in stocks - have returned to those last seen at the end of the equity bull market in 2007 (and 2000 for that matter). Margin debt always rises during a healthy stock market advance but when it reaches an extreme like today and then turns lower, the risk of a significant stock market correction rises significantly. We are there now.


3) Market breadth is showing early signs of deterioration. The Advance-Decline Line measures the heart beat of the stock market. It is a great tool for capturing turning points, often tipping off investors ahead of time when the trend is changing. The A/D Line is calculated by adding together the difference between the number of advancing and declining stocks each day. When this indicator starts to decline for example, it signals that fewer stocks are participating in the market rally. The A-D Line typically turns lower ahead of the broader market.

Today, we see the A-D Line still making higher highs, but its progress has slowed significantly. The slope of the line is flattening and may begin to turn lower shortly. I calculate a second A-D Line for large cap stocks only and this indicator peaked in November 2013 and has been trending lower ever since.


4) Nobody's worried! The time to worry is when folks believe there is nothing to worry about! Certain branches of the Federal Reserve in the US calculate various different financial stress indexes which they then combine into a Financial Stress Composite. Some of the index components include stock prices, volatility, interest rates, credit spreads, leverage, liquidity, etc... When the Stress Composite, pictured below, exceeds +2, markets are in a period of extreme stress; -2 and stress levels are at an extreme low. A few days ago, the Composite reached a level of -1.21, the lowest reading on record. Each time in the past (68 times in all) the Composite approached a similar reading, the next 12 months return for the S&P 500 was  -6.4%!


5) Stocks are expensive. The S&P 500 now trades at 25 times the average of the last ten years of inflation-adjusted earnings, a rate similar to prior peaks (excluding the 2000 market top). Also, corporate earnings in aggregate today are at a historic peak relative to GDP and have a long way to decline back to their long-term average. So, price/earnings multiples (and stock prices) potentially have a long way to fall.

The stock market remains overvalued, overbought in the near-term and investor sentiment has reached an optimistic extreme. We therefore maintain our cautious stance with an allocation in the model portfolio of 20% stocks, 50% bonds, 20% gold and 10% cash.

Bond Market Update

The moment of truth will arrive shortly for the bond market. Historically, government bonds have always rallied during stock market declines, as investors run for cover away from high risk investments and towards lower risk investments. That trend has been in motion since government bond yields were at double-digit levels in the 1980's. Today, with 10 year bond yields only 1.8% in Germany and 2.8% in the US and UK, the trend lower in yields (and higher in prices) is coming to an end. However, I don't believe we are there yet and I expect government bonds to rally once again on the next big decline in stocks. Thereafter, it will be time to shorten the duration of the bonds we hold in the model portfolio and introduce a broader mix that will include shorter dated government bonds, some corporate bonds and some emerging market debt. For now, we continue to hold our defensive position as the defensive characteristics of government bonds continue to work in our favour.

As government bond yields fall (shown for the US government bond market in the example above) bond prices rise. In the next chart we can see that bond prices are rising and the technical indicators show that this rising trend has only just begun and has plenty of room to rally in the weeks ahead. Our model portfolio should benefit and capture this performance during the first quarter of 2014. Continued patience with this position will be rewarded.

Gold Market Update


As noted in our recent update on precious metals, it is looking increasing likely that gold is emerging from a difficult 2.5 year bear market. Gold bottomed in June 2013 at $1,179, rallied +22% and then declined to re-test the lows set over the Summer. So far, that re-test has been successful with gold bottoming in December 2013 at $1,181 and then rallying into the New Year. Gold is currently trading at $1,260.

Notable in the chart below, we can see that, in addition to the successful re-test of the lows, the momentum of the decline has also slowed (MACD), indicating that there are few sellers left to sell. The longer gold can hold above $1,179, the stronger the case that the bull market is about to resume. Of course, we need to see gold making higher highs in the months ahead to confirm the bullish case, but the current setup is a solid start.


The gold, silver and junior mining stocks are also confirming this bullish breakout in the precious metals and have already rallied 11%, 10% and 15% respectively year-to-date, while the broader stock markets are all in the red. More on that in the weeks to come.


To learn more about the full range of investment services available at Secure Investments, please contact Brian Delaney at 086 821 5911 or by email at brian.delaney@secureinvest.ie.