May 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. All the action in April took place in the precious metals market as gold broke long-term support ($1,523) triggering significant selling by over-leveraged investors and late-comers to the gold bull market. An important low may have been set on 16th April at $1,322, which should mark the end of the 2-year correction in precious metals. Meanwhile, equities continue their impressive run but should be in the process of forming an important high later this year. Investor sentiment is at an optimistic extreme, aggregate corporate earnings are 30% above the long-term trend, company valuations are expensive relative to their 10-year average and margin debt has returned to levels last seen in 2007. While we have yet to receive a sell signal to move to a defensive position, now is a time to be cautious and not increase exposure to stocks.


Equity Market Update

Equity market cycle count

The S&P 500 peaked on 24th March 2000 at 1,527. At the time, investors valued the US stock market at a forward price/earnings multiple of 23 times. A severe bear market followed and stocks fell by -47% by October 2002. With assistance from the Federal Reserve, the US economy recovered and another cyclical equity bull market began. By October 2007, the S&P 500 reached 1,565 and this time traded at a more reasonable forward P/E multiple of 15 times. However, despite the improved valuation, analysts' earnings estimates proved overly optimistic. The global property and equity bubbles popped shortly thereafter and stock prices crashed again, this time by -55% in seventeen months. Central banks intervened once more, cutting interest rates to zero and firing up the printing presses. Yet again, stock markets responded. Today, as we break above 1,600 on the S&P 500 again, investors are valuing US stock prices at close to 14 times next year's net earnings. Investor sentiment has turned full circle. Institutional fund managers have not been this positive on their outlook for US stocks in over 20 years. I expect the boom-bust cycle to repeat once the momentum move currently underway exhausts itself.


S&P 500 has made no progress now for 13 years.

Another gauge of bullish sentiment is clear from the front cover of a recent edition of Barron's, a weekly-published New York financial newspaper and must-read for many on Wall Street. Barron's pictured a bull on a pogo stick bouncing over a bear on their front cover last month, as they advertised the results of their semi-annual Big Money poll of professional investors. In that survey, 74% of respondents were either bullish or very bullish on the prospect for US stocks. As a comparison, 54% were bullish in 1999 and 46% were bullish in 2006 at the prior two stock market peaks. Only 7% are pessimistic today. The timing or prior Barron's surveys was prescient, but for reasons that will not excite the bulls.


Barron's Big Money poll says 74% of professional investors are bullish or very bullish on the prospect for US stocks. (54% were bullish in 1999 and 46% in 2006).

Equity investors take note. Stock markets continue to rally and the Active Asset Allocator model continues to hold a 60% position in stocks for now. However, the risk of at least a medium-term correction is now quite high. Smart money is selling into this momentum move. Leon Black for example, owner of one of the most successful private equity firms in the world, The Apollo Group, reported last week that the current environment represented a fantastic opportunity in which to sell into and he was "selling everything that is not nailed down". Apollo has sold $13 billion worth of businesses in the last 15 months. Black noted that "the market is pricey.... priced for perfection."

Seth Klarman, founder of The Baupost Group, is another world class investor who operates under the radar. Klarman summed it up very well in a recent investment update to clients:

"While economist David Rosenberg at Gluskin Sheff believes government actions could be directly or indirectly responsible for as many as 500 points in the S&P 500, or 30% of its current valuation, traders have confidence in Ben Bernanke because betting that his policies will drive equities higher bas been a profitable wager. Bernanke, likewise, is undoubtedly pleased with these speculators for abetting his goal of asset price inflation, though we all know that he will not call them first when he decides to reverse direction on QE. Then, the rush for the exits will be madness, as today's "clarity" will have dissolved, leaving only great uncertainty and probably significant losses. Investing, when it looks the easiest, is at its hardest. When just about everyone heavily invested is doing well, it is hard for others to resist jumping in. But a market relentlessly rising in the face of challenging fundamentals – recession in Europe and Japan, slowdown in China, fiscal stalemate and high unemployment in the U.S. – is the riskiest environment of all."

Seth Klarman – Founder, The Baupost Group


Next, I want to highlight an interesting study from US-based investment manager Sitka Pacific that examined historic valuation contractions in the S&P 500 and corresponding inflation changes in the United States during all of the previous bear markets since 1900. They identified a consistent pattern in the way valuations have tended to decline during long-term equity bear markets. The chart below shows how the market’s P/E ratio, based on the last 10 years of average earnings, has declined during previous bear market cycles (light blue line) and during the current bear market (dark blue line). If the current long-term bear market in equities runs true to course, we could have another 60 months or 5 years of P/E contraction before we reach the final bottom.

The green lines on the chart measure the change in the Consumer Price Index (CPI) from the beginning of past long-term bear markets, and during the current one. Price inflation has tended to be relatively modest during the first half of long-term bear markets, only to accelerate during the second half. We could be at an inflection point in the current cycle where the inflation curve is about to accelerate higher. I have found this framework of past cycles of falling valuations and rising inflation quite useful when framing my overall market views. It has defined the second half of every long-term bear market since 1900 and I expect it to define the second half of the current bear market (although it doesn't feel like a bear market just now), once this momentum move higher in stocks runs its course.


Is the outlook for inflation set to accelerate?

The cyclically adjusted Shiller P/E (CAPE) for the S&P 500 (price divided by ten-year average inflation-adjusted earnings) continues to show that stocks are quite expensive relative to the past 100 years of data. The CAPE currently trades at a lofty 22.3 times historical earnings, a level similar to previous valuation peaks in 1901 and 1966. For comparison purposes, historical troughs in the CAPE came in 1920 at 4.8 times, 1932 at 5.6 times, 1942 at 8.5 times, 1949 at 9.1 times and 1982 at 6.6 times. We are obviously a long way from trough valuations levels today which makes investing in the stock market such a difficult proposition.

Cyclically adjusted P/E ratio still trades at 23 times.

Finally, a note on the technical trend indicator (TTI). I developed the TTI, a market trend indicator, a few years ago to help investors stay on the right side of long-term trends in the equity market. I use the TTI as one of the bases for the asset allocation changes I make in the Active Asset Allocator model and it has worked out quite well to date. For example, despite my scepticism of the sustainability of the current global stock market rally, the Active Asset Allocator Model continues to hold a fully invested position of 60% stocks, and that is thanks to the TTI. The indicator comprises eight sub-components of price, volume and breadth that capture the overall health of the stock market. Equities cannot rally or decline in a meaningful way without the TTI following suit. It is not a perfect timing tool but quite effective for capitalising on the meat of long trending moves. Certainly if the stock market was to break lower and not look back, it would take a week or two for the TTI to catch up. However, market top formations usually take many weeks or months to complete, which makes the TTI so useful.

Stock markets… and the TTI… are accelerating higher right now. Accelerations in either direction are typically ending patterns in markets. When bull and bear markets accelerate higher or lower, retail (dumb) money is chasing the move and typically arriving late to the party. Once the latecomers are 'in', it usually marks the top, as there are no buyers left. Then bids suddenly dry up and the market rolls over and does not look back. That is the way markets tend to work. The TTI should protect you from getting caught up in any long protracted declines. 

The Technical Trend still favours a fully invested position of 60% stocks.

As noted earlier in this report, stock market sentiment remains sky high. The Hulbert Stock Sentiment Index (below left) shows an overbought equity market. 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.

Equity markets accelerating higher now.... Accelerations tend to be ending patterns.

Bond Market Update

You get paid one basis point per annum to lend money to Angela Merkel for two years.


You only get paid one basis point – one hundredth of one percent – per annum to lend money to Angela Merkel for two years. Last month, you had to pay her 5 basis points/year just to take your money! There is something very wrong with that situation. Ten year yields on government bonds across the world are at generational lows. A quick scan of numerous fixed income charts reveals that an important low (in yields) may be in the process of being made in the many of the government bond markets of the developed world. You will shortly be able to check out these charts for yourselves and much more on my new website, which I hope to launch next month..... Stay tuned. Bull markets have to end some time and yields can't go down forever. Nominal government bond yields are already well below the rate of inflation today. If a rising trend in inflation is on the cards over the next few years, then long-term government bonds could be quite a poor investment. Investors should only choose bonds with a short term to maturity, as they are less sensitive to interest rate movements. Bonds should only be used as a tactical investment; somewhere to shelter during periods of turmoil in stock markets.


Sentiment on bonds today remains mixed. US Treasuries appear to be making a long-term top. It will be interesting to see how they trade on the next market decline. If treasuries fail to make new highs on the next sharp move lower in the stock market, the bond bull may have cast his last breath.



US Treasuries are in the process of forming a long-term top.

Gold Market Update

Gold bull market wounded but still intact.

First, some perspective. The gold debate is a rather emotive one with quite a diverse range of opinion. The bears will say that gold is just a 'barbarous relic' with little use in today's world. Gold pays no coupon or dividend and earns no income. It is just a price, which rises based on the greater fool theory. It is a peculiar market. One group of folks spend a fortune trying to find it and dig it out of the ground only to sell it on to another group who want to bury it again, paying storage costs and insurance to protect against theft. What on earth is all the fuss about? The bulls will counter that gold provides an effective hedge against central bank profligacy and the risk of financial contagion as well as its more traditional function as an inflation hedge.

When gold began its secular bull market in 2001 at $250, the bears hardly noticed. The run to $1,000 left them perplexed but disinterested. Gold then corrected in 2008 from just above $1,000 to $770 and the bears cheered; their consensus views finally vindicated that the gold bull market was over; but of course, it was not. When gold started rising again in 2009, disinterest turned to irritation and confusion for those of a bearish viewpoint. Why was gold rising in such a consistent pattern? Jim Grant of Grant's Interest Rate Observer provided the best answer in April 2011 when he said: "to me, the gold price takes the form of a very uncomplicated formula. All you have to do is divide one by 'n' and 'n' I'm glad you ask, is the world's trust in the institution of paper money and in the capacity of people like Ben Bernanke to manage it. So, the smaller 'n', the bigger the price. One divided by a receding number is the definition of a bull market."

Nothing has changed regarding the institution of paper money. In fact, the situation has deteriorated since 2011. More and more central banks are deciding to follow the lead of the Federal Reserve, turning to the printing press to weaken their currencies and stimulate their economies. They see no downside to their actions. Central banks are sowing the seeds of inflation and the next significant move higher in precious metals. So, the gold bull market is not over despite many (who did not participate at all in the 12 year run to date) now calling time on the most precious of metals. A good deal of technical damage was done in April and it will take some time to repair, but repair it will and gold will trade at new all time highs in the not too distant future.

Let's look back for a moment at what happened last month. On the evening of Friday 12th April in a thin (low volume) market, an enormous 400 tonnes of 'paper gold' was sold in the futures market in the space of 90 minutes, driving the spot price of gold down sharply. More aggressive selling occurred on Monday and long-term support levels at $1,520 gave way. Plenty of stops were triggered and gold plunged to a low of $1,322. I will leave it to the conspiracy theorists as to who placed those big orders in the derivatives market. I will just say that someone or some bank wanted to drive the gold price lower and they succeeded in the short-term.

Gold has now recovered approximately $150 but may re-test April's lows in the next 2-3 weeks; re-tests often occur in markets at major turning points. Alternatively, gold could just take off from here, keeping many who were shaken out during the recent decline from re-establishing a position. I feel strongly that we are now very close to the start of the next major move higher, which will mark the transition to the start of the bubble phase in the gold bull market. Sentiment in the gold sector is at the most lopsidedly bearish level as I have ever seen it. Gold bears are vitriolic in their commentary, partly because a bet on gold is a bet against the financial system and that does not sit well with many investors.

In terms of target prices in the short-term, step one on the road to recovery will be a close back above $1,620; step two will be a close above $1,800; and the third and final step will be a close above the current all time high of $1,923. Once gold breaks through $1,923, the sky's the limit. We will get there; it will just take some time. My final target for gold is much higher than today's price and I will reveal it in good time, but for now, we need to stay focused on the price action in the shorter-term so we can identify with some confidence when the current bout of selling has ended. In sentiment terms, we are still at all time lows since the bull market began in 2001. The Hulbert Gold Sentiment Index shows that newsletter writers continue to recommend a net short position in precious metals and public opinion on gold is at a bearish extreme. Patience will be rewarded.


Gold sentiment at a bearish extreme; at the lowest level since the bull market began in 2001.

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