Model Portfolio Update
We are approaching the latter stages of this four year bull market in stocks and it has been quite a ride. The multi-year equity market rally has done its job. Investors have stepped back from the brink and have returned to the market in their droves, buying equity funds at a record pace in recent months. The model portfolio remains defensively positioned with an asset mix of 20% equities / 50% bonds / 20% gold / 10% cash. While the short-term performance of the model portfolio has been impacted, the current position is warranted given that stocks remain expensive, sentiment is at a bullish extreme and my technical indicators are advising caution.
Please feel free to add your comments and questions at the end of this report and I will reply to all as best I can.
Equity Market Update
Investor sentiment is back to levels that have marked stock market tops in the past and valuations are also stretched - the S&P 500 currently trades at 19 times 2012 net reported earnings. Stocks are more expensive now than they were at the previous peaks in 2000 and 2007. Today, there is over $8.0 trillion invested in US equity mutual funds and equity ETFs, which is 3.5 times more than the amount invested in cash, a new all-time record looking back over the past 30 years. The last time investors were buying stocks with such abandon was May 2007. At the peak in August 2000, the ratio was 3.1 times. We are not in a new secular bull market for stocks, so I expect this ratio to top out shortly, along with the stock market. Investor appetite for stocks should start to decline in the near future. Now is not the time to be fully invested.
Hand in hand with the above measure of investor confidence, we also see a strong desire among stock market participants to embrace risk once again. The Risk Appetite Index comprises a mix of indicators that track investor risk appetite including credit spreads, stock and currency volatility and the relative performance of different stock market sectors. We have seen a big rise in risk-seeking behaviour in recent months.
Last month I discussed some initial signs of technical deterioration for stocks as measured by the Advance / Decline Line. That weakness continues today so I want to include an updated chart in this month's Investor Letter. A quick recap first: the Advance/Decline Line graphically displays the relationship between the number of stocks in rising trends versus the number of stocks in declining trends. In a healthy bull market, you should expect to see the majority of stocks in rising bullish trends (rising A/D Line). However, late in every bull market, the number of stocks participating in each rally falls (falling A/D Line) until such a time that the trend peaks and reverses. We experienced a negative divergence in the A/D Line for months prior to the stock market peak in 2007 as fewer and fewer stocks participated in the rising trend. We are seeing the same behaviour today.
In August for the first time in over a year, my technical trend indicator tipped over into the red, breaking support at the long term moving average. While the technical trend has recovered somewhat in recent weeks, any additional sustained selling will tip the long-term moving average into a downward trend. Investors should take note of this early warning signal that the uptrend in the stock market is deteriorating.
Bond Market Update
In May of this year, the Federal Reserve hinted that they may consider tapering their purchases of US Treasury and mortgage backed securities in an effort to bring this $85 billion/month QE experiment to an end. That was enough for skittish bond investors to sell. The 10 year yield on US Treasuries promptly doubled (almost) from 1.6% to 3.0% in four short months. In September, Bernanke backed off of his grand plan, but US Treasury yields have only backed off by a mere 0.40%. The bond market has started to sense that something is wrong and Bernanke is worried. He knows he will have to start the taper some day. The Fed just can't just keep on printing $1 trillion/year without something bad happening.
So what does this mean for bond investors today? Well, return expectations should remain low for starters and short term-bonds should be favoured over long-term bonds. High quality government and corporate bonds should be the preferred choice where possible. After a doubling in interest rates in recent months, chances are that interest rates won't travel much further north from here in a highly leveraged global economy. In any stock market correction, bonds will continue to provide short-term shelter and the risk of capital loss in a high quality short-term bond will be a lot lower than the risk of loss from an equity investment, no matter the quality. It is for this reason that bonds remain a core holding in the model portfolio.
Gold Market Update
The gold conundrum continues. Following an epic 11-year run, gold reached a peak of $1,921 in September 2011 and has been in correction more ever since. The bull market for gold is not over, so we should expect $2,000 and higher (possibly much higher) at some point in the future once the current correction ends. Gold bottomed in June 2013 at $1,180 and has been rallying sporadically since, trading at approximately $1,300 at the time of writing. The bull market is doing its job, throwing off the majority of holders. Even the long-term gold bulls are jaded with the market action.
I continue to believe that gold is building a strong base and in its own good time, when least expected, gold will resume its bull market. During the last gold bull market of the 1970's, gold corrected in price from $200 to $100, a -50% decline before surging higher to a peak of $850 in 1980 as inflation ran wild. While no two bull markets are ever the same, I am expecting a strong second half performance by the precious metals as investors finally lose faith in the paper currency system and trust is restored in the ultimate foreign currency. Patience will be rewarded.
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