WEALTH MANAGEMENT
April 30, 2015
by Brian Andrew & Doug Ramsey
Opportunities in Global Markets
ON THE RECENT STOCK MARKET STRENGTH
By: Doug Ramsey
We’ve described ourselves as reluctant bulls with our quantitative discipline driving our equity exposure. We look
at economic data, sentiment and other data to create the Moving Trend
FIGURE 1
Indicator (MTI) and what’s carried it is a momentum-type convergence,
which in turn has driven the market. Most stocks participated fairly
uniformly, which argues for market strength to continue. When most
stocks are participating, odds are you will see higher highs. Internal
strength tells us there should be higher highs ahead, but it is hard to see
much beyond 4-6 months.
Source: Leuthold Weeden Capital Management
We see a couple early signs of potential problems. Transportation stocks
have been a leading indicator of trouble for stocks. When this average
starts to slow down, it isn’t a good sign. Over the last few years, these
stocks have been on a tear – especially airlines – but they have recently
turned. If we see further deterioration, that will be an official yellow
flag. Additionally, high yield credit market spreads started to widen last
summer, and when this happened in June of 2007, it led to trouble. Just
4 months later the stock market
FIGURE 2
peaked. We’ve now had 10
months of widening spreads in
the high yield market, which is
a warning sign.
ON CURRENT EQUITY VALUATIONS
Stocks are considerably more expensive than Wall Street analysts say when
using normalized earnings. Professor Robert Shiller suggested normalizing
earnings by smoothing out earnings over ten years and then calculating a
Profit Earnings Ratio (P/E) using this smoothing of highs and lows. Our
preference is to take five year normalized earnings to look at where the market
is priced.
Using the five year measure, we had a bull market top in 1983 at just 11.3
times normalized earnings; but at the top of the tech bubble in 2000, the
market topped out at 32.1 times. Take all of the bull market tops since 1950
and the average P/E ratio for the S&P Index with smoothed earnings is 28
times. We’re currently at 22 times. If markets were to roll over today, it
Source: Leuthold Weeden Capital Management
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WEALTH MANAGEMENT
April 30, 2015
would be at a pretty normal point. We argue that force of
momentum will push at least the S&P Index and the Dow
Index higher for at least four to six months.
In the U.S. equity markets, the median stock P/E ratio
is 21 times earnings, which is more expensive than the
median stock values in October of 2007 or in 2000. U.S.
Stocks are about 10% more expensive than we were at
the last two bull market tops. In addition, the earnings are
benefiting from far-and-away record profit margins, with
typical net profit margin now at a record of over 10%.
ON FORECASTING THE ECONOMY AND ENERGY
It is well known that the stock market is a leading indicator
of the economy. When we look at business cycle peaks,
when the U.S. economy tops out, what does the stock
market do in the 12 months leading up to that peak? In the
past 11 of 12 tops, stock prices have been down, with an
average decline of 9%. The only exception is in 1980 when
stocks were flat. The stock market anticipates downturns
and is rarely taken by surprise by an economic decline.
FIGURE 4
The good news is valuations around the
world are not quite as high. If we look at
the MSCI USA Index for U.S. equities,
prices are at 22.5 times earnings. The
rest of the developed world trades at
only 17 times earnings looking at the
MSCI World Ex U.S. Index. There
may also be value to be had in the less
developed world. The MSCI Emerging
Market Index is at 12.2 times earnings or
almost half of the U.S. index value. This
suggests developed Europe and emerging
markets stocks may perform well over the
next two to three years. Europe has real
structural challenges, but those markets
should do better than the U.S. indices.
FIGURE 3
Page 2
Source: Leuthold Weeden Capital Management
In contrast, few people forecasted the large drop in energy
prices at the end of 2014. Fortunately, our models have
kept us out of energy over the past year; but now the
energy sector is shaping up to be an interesting value play.
Supply is the issue. We have seen a lot of spending in
commodity oriented pockets of the economy, creating a
commodity production boom not just here, but globally.
The capital spending of commodity producers in 2001
was $15 billion; in 2012 it was $120 billion. The level of
capital spending is still quite high and it seems there is still
more excitement than fear. Even though the price of oil is
down sharply, we don’t see a lot of angst. So, we wouldn’t
be surprised if there was another $15 to $20 (per barrel)
downside to oil prices.
Source: Leuthold Weeden Capital Management
36
Managing Cycles
Page 3
ON PORTFOLIO CONSTRUCTION
FIGURE 6
By: Brian Andrew
We want to offer a view on portfolio construction given
the ideas presented by Doug and others that inform our
thinking. We find investor manager styles, like markets,
move in cycles, so it becomes critical to identify where
you are in the cycle as an investor. Decision making
should not be binary – ‘I like the market or I don’t like the
market,’ buy or sell. In downturns, the normal reaction is
to sell out of the market rather than looking at how to stay
in the market and become more defensive.
Stock Market Layers
•
Top down vs. bottom up
•
Market cycle
•
Active vs. Passive
•
Valuation criteria
•
Stock selection criteria
•
Sectors/Industries
Source: Cleary Gull
ON THE ECONOMIC CYCLE
FIGURE 5
$250
Domestic
$100 Invested in March 2005
200
Standard & Poor's
500 Stock Index
150
100
Less 6 Best
Months
05
06
07
08
09
10
11
12
We begin by looking at where we
are in the economic cycle. With
Total
$216.12 8.01
the exception of commodities,
Less 1 Mo. $198.75 7.11
most asset classes have done
Less 2 Mos. $181.41 6.14
pretty well over the past couple
Less 3 Mos. $168.68 5.37
of years, with both U.S. stocks
Less 4 Mos. $157.65 4.66
and bonds up dramatically. Even
Less 5 Mos. $144.75 3.77
real estate has gone up fairly
Less 6 Mos. $130.49 2.70
dramatically. But how each asset
T-Bills
$114.48 1.36
class performs varies based on the
time in the cycle. If we review the
last five stock market declines of
15% or more, some patterns begin
to emerge. Before a downturn,
we see a relative outperformance
15
by intermediate bonds as an asset
class. After the downturn, we
see that they fall to the bottom in
relative performance and that intuitively makes sense.
But perhaps less obvious, small cap stocks underperform
in the three months before a drop while after the drop, it
is one of the best relative performers as an asset class.
Another similar cycle can be seen in the relative outperformance of growth stocks compared to value stocks
after a major downturn.
S&P 500
Ending 10 Yr.
Stock Index Value CAR
13
14
Source: Crandall, Pierce & Company
If we look at attempts at market timing, you can see on
this chart (Figure 5) of returns for the S&P 500 Index
over the last 10 years, there is an 8% return over that
period. If you missed just the one best month, the return
drops to 7.1%. If you missed just the top 6 months of the
120 months in this period, the return drops to 2%. Trying
to time the market by getting in and getting out doesn’t
make much sense. Instead, we make an effort to allocate
to different approaches or styles to manage downturns,
rather than selling out completely.
When we consider the variety of investment strategies
and different approaches, we see the market in various
layers (see Figure 6). Each of these layers can offer us
a method to express what we feel is happening in the
market at that time.
ON ACTIVE VS. PASSIVE MANAGEMENT
When the market is on an upswing, people get focused on
how well the S&P 500 Index has performed, and therefore
want to only use passive management. But here again,
it’s not just a binary decision, it’s not either/or. At Cleary
Gull, we use both actively and passively managed funds,
depending on the cycle. We ask ourselves whether we
passive by +0.99% on a three-year rolling basis, and it does so 78%
of the time. When relative breadth gets very positive, say at 60%,
then active beats passive by +2.35% and does so 100% of the time.
How often does this happen? Relative breadth above 55% has happened 32% of the time since 1991 and 23% of the time since the
start of our breadth data in 1927. Relative breadth above 60% has
happened 11% of the time since 1991 and 8% since 1927.
regimes that were favorable to either active strategies or indexing. Basically, when the market leadership is broad (as discussed
earlier) and equity returns are less correlated, that’s a macro
backdrop that tends to lend itself well to active management (i.e.,
the ability of the manager to pick winning stocks), all else being
equal. For instance, the early to mid-1990s was a period during which classic GARP (growth at a reasonable price) investing
WEALTH MANAGEMENT
April 30, 2015
Page 4
FIGURE 7
EXHIBIT 1: The higher the percentage of relative breadth, the greater the tendency for active to outperform passive.
In the late part of a market cycle,
we see a relatively big change
S&P 500 Total Return
in historic performance, where
AvP 3yr
3600
Relative Breadth
small cap stocks fare less well
than large cap stocks. Companies
1800
paying dividends have done better
in this stage. People begin to look
900
for Growth At Reasonable Prices
5%
0.9
4%
0.8
(GARP) strategies, which tend
3%
0.7
2%
to do better as people become
450
0.6
1%
concerned about earnings growth
0.5
0%
–1%
0.4
and decline in profit margins. In the
–2%
0.3
–3%
late part of a market cycle, breadth
0.2
–4%
0.1
tends to be wide, with more stocks
–5%
–6%
0
outperforming the index; and, as
Dec-90
Dec-95
Dec-00
Dec-05
Dec-10
we have seen, active managers start
Source: Haver Analytics, Morningstar, Fidelity Investments
AvP 3yr = excess return of active over passive during rolling 3-year periods. Source: Haver Analytics, Morningstar, Fidelity Investments, as of Jul. 31, 2014.
to do better as breadth opens up.
2
should be using more of one or the other at a given time
in the markets, based on market breadth.
Relative breadth
AvP 3-yr. excess return
S&P 500 Total Return
MARKET REGIMES
There are many layers to the stock market and many
different strategies designed to take advantage of
valuation differences. Our job is to understand economic
and market cycles and to inform our thinking about how
to construct a portfolio using those different strategies.
We feel it is very difficult to both be right often enough
and make money over time, all-in/all-out strategy; so we
use these different levers in portfolio construction to lean
in or lean out as we feel appropriate.
FIGURE 8
Early vs. Late Cycle portfolio
In this chart (Figure 7), the dark blue line represents
the relative breadth of the U.S. stock market and the
yellow line represents the rolling performance of active
strategies. You can see when there is more relative
breadth in the market, historically, the more likely active
managers are to outperform. This is an example of a
“layer” in stock market strategies we can utilize to your
benefit in putting a portfolio together.
Historically, active management of stock strategies
does better close to the peak of markets than through
the trough. When breadth is higher than 65%, active
managers have outperformed the index 100% of the time
and by an average excess return of 130 basis points.
ON DIFFERENT STYLES OF MANAGEMENT
Another lever we can utilize is the combination of
different management strategies in a portfolio. Again,
we do not use an all in/all out approach, but rather
lean a portfolio in the direction of a more favorable or
defensive positioning. An early cycle portfolio may
differ significantly from a late cycle stock portfolio. In
an early cycle portfolio, we have seen micro- and smallcap stocks do very well, as we saw in 2009. Particularly,
value in the small cap space does well in the early part
of a cycle. As momentum builds, passive starts to make
more sense as passive has done better than active in the
early part of a market cycle.
Early Cycle Portfolio
•
Deep value
•
Momentum, high growth
•
Micro and small capitalization
•
Move toward passive
Late Cycle Portfolio
•
Equity income and core value
•
Sustainable growth
•
Mid and large capitalization stocks
•
Active management
Source: Cleary Gull
Page 5
ABOUT THE AUTHORS
Doug is the Chief Investment Officer of The Leuthold Group, LLC, and Co-Portfolio
Manager of the Leuthold Core Investment Fund and the Leuthold Global Fund.
In addition to his CIO and Portfolio Management responsibilities heading both the
asset allocation and investment strategy committees, Doug maintains the firm’s
proprietary Major Trend Index, a multi-factor model which evaluates the underlying
health of the markets, both domestically and globally. He is also the lead writer for
The Leuthold Group’s highly regarded institutional research publications.
Doug Ramsey, CFA, CMT
Chief Investment Officer
The Leuthold Group, LLC
Before joining the Leuthold team, Doug was Chief Investment Officer of Treis
Capital in Des Moines, Iowa, where he managed equity portfolios and published
a quantitative equity research product. Prior to that, he worked at Principal Global
Investors. Doug is a Phi Beta Kappa graduate of Coe College in Cedar Rapids, IA,
where he earned a Bachelor’s degree in Economics and Business Administration. He
also played four years of varsity basketball at Coe, earning Academic All-America
honors in 1986-87. Doug received an MA degree in Economics from The Ohio State
University in 1990; he earned his CFA designation in 1996 and became a Chartered
Market Technician in 2003.
Mr. Andrew leads the investment research and strategy teams and is integral in
establishing the firm’s investment policies and identifying strategies across all asset
classes. Having worked as a Chief Investment Officer, Chief Operating Officer,
president, portfolio manager and analyst of fixed income and equity securities of
mutual fund and money management firms, he contributes to business and client
services practices.
Brian Andrew, CFA
President and Chief
Investment Officer
Cleary Gull
Mr. Andrew also chairs the firm’s Investment Policy Committee and serves on the
Equity, Fixed Income and the Complements Strategy Groups. He has provided
economic insight through monthly published pieces, webcasts, and other outside
media outlets. In addition, he has been active in public speaking forums in investment
management. Mr. Andrew received his Chartered Financial Analyst designation and is
a member of the Milwaukee and Chicago Investment Analyst Societies. He received
his B.S. in business and finance from the University of Minnesota and completed
the Harvard Business School/CFA Institute Investment Management Program.
He currently serves on the Advisory Board for the Marquette University Applied
Investment Management Program. He has also been active in varying capacities
on the boards of several municipal and not-for-profit organizations and currently
serves on the Advisory Board for the University of Wisconsin-Milwaukee, College
of Health Sciences.
WEALTH MANAGEMENT
April 30, 2015
ABOUT CLEARY GULL
Cleary Gull (www.clearygull.com) is an SEC-registered
investment advisory firm providing financial advice
through two operating divisions: Investment Advisory
Services and Investment Banking Services. Cleary Gull
is a wholly owned subsidiary of Cleary Gull Holdings
Inc. a privately held, employee-owned organization.
Our investment advisory team provides investment advice
with respect to over $2.1 billion of client assets for high
net worth individuals and families, entrepreneurs, pilots,
and not-for-profit hospitals and senior living communities
across the nation. We are known for our combination
of attentive service and sophisticated capabilities. With
our decades of experience in financial security strategies
we’ll help you face challenges that require a combination
of financial, legal and tax expertise. What’s more, we
work in conjunction with your other personal advisors
to create a seamless financial plan for your future and to
make sure you receive customized advice on such topics
as trust and estate planning, taxes and retirement benefit
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from $10 million to $200 million.
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