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PORTFOLIO MANAGER COMMENTARY
Third Quarter 2014
Market Review
“In order to achieve superior results, an investor must be able – with
some regularity – to find asymmetries: instances when the upside
potential exceeds the downside risk. That’s what successful investing is
all about.” -Howard Marks, Oaktree Capital Management
John Goode
Managing Director, Portfolio Manager
“Fewer than half of U.S. adults are working full-time. Why? Slow
growth and the perverse incentives of ObamaCare.”
Mortimer Zuckerman
“The Full-Time Scandal of Part-Time America”
“If there is risk for equities, it will come first from the bond market
because it is fixed-income that has been sedated the most, not just by
the Fed (Federal Reserve) but all the global central bank incursions into
the domain of publicly-traded securities.”
David Rosenberg, Chief Economist & Strategist, Gluskin Sheff
“In times of change, learners inherit the earth, while the learned find
themselves beautifully equipped to deal with a world that no longer
exists.”-Eric Hoffer
A Different Rulebook for the Administration’s Political
Business Model
From time to time, television and other commentators analyze the
Obama Administration using words such as “detached,” “naïve,”
“unfocused” to conclude that the President doesn’t know what he’s
doing and/or he’s surrounded by people with inadequate skills to
advise him properly. Our belief is that the President and his advisors
know exactly what they are doing.
The starting point for our own analysis is the 22nd Amendment to the
Constitution and the words uttered five days before the President
took office in 2009, namely that “we are only five days away from
fundamentally transforming America.” We take this to mean reducing
income inequality and focusing on policies consistent with “social
justice” objectives are guiding principles for the Administration.
The Administration’s perception, in early 2009 and today, is that the
U.S. economy has unfairly allocated incomes and wealth over time
and that a primary objective of the federal government must be to
redress this grievance on behalf of the poor and middle classes. The
urgency of this mission has a hard edge to it such that “reparations”
rather than “redistribution” often seems a more appropriate word.
The 22nd Amendment to the U.S. Constitution states that a President,
under normal circumstances, can only serve two terms in office or
eight years. This length of time is insufficient to permit “fundamental
MARKET REVIEW
transformation” because the legislative process (Congress) and the inherent checks and balances in our
Constitution provide time constraints on the rate of change which is possible. If one is serious about fundamentally
transforming the U.S. economy, an alternative political business model must develop which permits the fastest
possible enactment of laws and regulations. As a result, a primary political objective for the Administration seems
to be achieving one-party rule with the Executive and Legislative branches of government being controlled by
the same party with lopsided majorities in both the Senate and House of Representatives being on-board with
policies consistent with “fundamentally transforming” the U.S. economy. If this condition can’t be achieved then
the machinery of government must be controlled, manipulated and directed in ways that simulate the results that
presumably would follow from one-party rule.
One-party rule was in place from January 20, 2009 until the elections in November 2010 because the Democratic
Party controlled the Presidency and both houses of Congress. However, the overriding goal during this period
was the enactment of the Affordable Care Act1. This was passed on Christmas Eve of 2009 without any bipartisan
support. For many, this process seemed closer to “imposition” than legislation and the backlash in the country
returned the House of Representatives to Republican control in January 2011. With much political capital having
been expended in getting the Affordable Care Act signed into law, the Administration now faced divided
government which required a shift in its political business model. If the legislative process would no longer permit
timely enactment of desired legislation, alternative methods would have to be developed to by-pass the legislative
process and even the Constitution in the name of “fundamental transformation.”
The policies and approach in the years since the 2010 mid-term elections have incorporated the following.
• The President can never stop campaigning because the objective of one-party rule has not yet been achieved.
Even when crises have arisen, shortly thereafter he has returned to the campaign trail. The emphasis is always
on “victory” rather than building a “consensus.”
• The Senate considers virtually no bills emanating from the House of Representatives for several reasons, one of
which is that legislative dysfunction enhances the Executive branch narrative that the “pen and the phone” are
the only ways to confront a do-nothing Congress.
• The Executive Branch, with the approval of the Attorney General, has chosen to enforce some laws while
making it clear that others, in effect, are null and void. This presents opportunities for Executive Orders or new
regulations to modify or supplement existing laws without Congressional oversight.
• Regulatory bodies have been mobilized as quasi-legislative entities and increased regulation has been
used to restrict the private sector and the market economy in favor of government mandated policies,
including picking winners and losers in areas such as alternative energy. Regulatory agencies and the federal
bureaucracy (unelected), through their rule making and regulatory pronouncements, have become the “new
Congress.” Recently Operation Choke-Point in the Justice Department apparently has been used to deny
certain companies and industries access to banking privileges. In effect, this represents a punitive tax on these
companies and their viability as continuing entities is in question.
• Recess appointments have been utilized to avoid the time consuming Congressional approval process
especially when candidates for regulatory bodies, such as the Federal Labor Relations Board, may be
controversial. If regulatory bodies are to become effective replacements for the legislative process it is
essential that they be staffed with people willing to adopt the necessary policy initiatives.
• The objective of achieving a robust economic recovery has taken a back seat to policies that are designed
to reduce income inequality. The Simpson-Bowles Commission report several years ago sought to reform
our tax code by lowering marginal tax rates, broadening the tax base, thereby increasing tax receipts, and
driving a faster rate of growth that presumably would benefit all citizens. This was rejected out of hand by the
Administration because it apparently believed that if Simpson-Bowles were to succeed, it might validate the
existing distribution of wealth and income in the U.S. This possibility was anathema to the Administration and
Simpson-Bowles, a bipartisan effort, failed to pass the political litmus test of the Obama Administration.
• Tax rates on people with incomes over $250,000 have been ratcheted up, 180 degrees out of phase with the
proposals inherent in Simpson-Bowles. The optics associated with higher, rather than lower, marginal tax rates
were important for the Administration because it strongly believes that higher marginal tax rates are more
consistent with reducing income inequality than classic tax reform measures. It does not matter that that
higher marginal rates represent headwinds for the economy and the growth rate of GDP2. As shown in the last
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PORTFOLIO MANAGER COMMENTARY
Third Quarter 2014
few Market Reviews, the economic recovery in the current business cycle is the weakest in the last 80 years,
including the one coming out of the Great Depression. Ed Yardeni, of Ed Yardeni Research, has indicated that
during the current economic cycle, ended June 30, 2014, real GDP growth increased 10% vs. an average of 21%
(cumulative) for similar periods of time in business cycles since World War II. This shortfall in comparison to
previous business cycles amounts to more than $1.7 trillion! We continue to believe it will be easier to reduce
income inequality if GDP growth for the U.S. economy is more robust. Income inequality has worsened in the
last five years during a time when GDP growth was anything but robust.
Source: Macro Mavens.
Median Real Household Income
seasonally adjusted
January 2000 - January 2014
$58,000
$57,000
$56,000
$55,000
$54,000
$53,000
$52,000
$51,000
$50,000
Source: Sentier Research.
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MARKET REVIEW
• In an environment where fiscal and regulatory policies have been directed toward reducing income inequality
and promoting social justice objectives, virtually all the responsibility for growing the U.S. economy has
fallen to the Federal Reserve3 and monetary policy. Interest rates have been held at unusually low levels for
more than five years which has had the effect of increasing asset prices and actually causing greater income
inequality. The middle class includes older and retired workers. The ZIRP (zero interest rate policy) has caused
interest income to plummet for many of these people which has had an adverse effect on their incomes.
Although some of the above may be speculative, it does seem consistent with what is happening in Washington
D.C. It is our contention that the President and his Administration are not detached or naïve-they know exactly what
they are doing. Theirs is a laser-like focus on achieving one-party rule and with it the ability to move their programs
into law quickly so that “fundamental transformation” is achieved and hopefully preserved beyond their stay in
office. Weakening the two-party system permanently is consistent with the latter objective. There has been no
concerted effort, of which we are aware, to develop a Republican “Tip O’Neill” in recent years that might have led to
bipartisan support for needed legislation on a number of fronts.
The political business model being pursued, in our opinion, brings risks for investors especially now that we are in
the sixth year of a bull market for common stocks. These risks may not be immediate because, as we suggest below,
the stock market may still have “legs” but time is running out for dealing with the 800 pound gorilla in the room.
Federal Debt, Unfunded Liabilities & Total U.S. Debt — The 800 Pound Gorilla in the Room
Over the last 60-70 years, the business model employed by the U.S., Europe, and more recently China, has been
based on using increases in debt to drive the next business cycle. As the chart below shows, during each new
business cycle, over this period, it took more debt to generate an incremental dollar of GDP.
$1.10
Incremental Nominal GDP from each $1 of Debt (Left) vs.
U.S. Non-Financial Debt Multiple of GDP (Right)
1Q1962 to 1Q2014
2.6x
$1.00
2.5x
$0.90
2.4x
$0.80
2.3x
$0.70
2.2x
$0.60
2.1x
$0.50
2.0x
$0.40
1.9x
$0.30
1.8x
Dollar increase in
GDP per $1.00
increase in debt
(left axis)
$0.20
$0.10
1.7x
Total U.S. nonfinancial debt *
as a multiple of GDP
(right axis)
$0.00
($0.10)
1.6x
1.5x
2013
2010
2007
2004
2001
1998
1995
1992
1989
1986
1983
1980
1977
1974
1971
1.2x
1968
1.3x
($0.40)
1965
1.4x
($0.30)
1962
($0.20)
* Total debt is household & business non-financial debt + Federal debt held by the public + state &
local debt
Source: US Federal Reserve Flow of Funds data, Stifel.
The declining returns to the increasing use of debt are strongly suggestive that there is a limit to the process.
Recently, the federal government has tried to deemphasize the private sector by dramatically increasing its presence
in the economy and capital markets. The Great Recession, which began in 2008, created the need and desire in the
private sector to deleverage rather than continue its historic role in driving the next economic recovery. Although
the private sector has deleveraged, this has been offset by increases in government debt such that overall debt has
continued to increase. Federal debt has risen from $11 trillion when the Administration took office in January 2009
to a level approaching $18 trillion, not including in excess of $75 trillion of unfunded future liabilities. The current
path is unsustainable when projected into the future by the Congressional Budget Office (CBO). The U.S. has a few
years at most to begin addressing this problem because if it does not, then the poor and middle class will suffer the
most. If this were to happen, worrying about income inequality and social justice would become moot.
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Third Quarter 2014
The following chart shows how entitlement spending has been increasing as a percentage of federal spending
since World War II. Currently, 68% of annual expenditures are mandated with discretionary spending making up
the other 32%. As recently as
1990, discretionary spending
was 53% of the federal
budget and in 1970 it was
approximately 67%.
If we adjust the percentages
for current and future budget
deficits projected by the CBO,
77% of tax receipts currently
are directed to mandatory
expenditures such as Social
Security, Medicare and
Medicaid. Ten years from
now, the CBO projects that a
mere 7% of tax receipts will
be available for discretionary
purposes. Clearly something
will have to give in the next
decade.
The principal problem with this
trend is that the past crowds
out the future. In recent years
there has been much rhetoric
regarding the need to rebuild
the infrastructure in the U.S. or
make a greater commitment
to education and yet the
country is faced with meeting
ever larger entitlement
commitments made in the
past when apparently there
was no consideration given
to the demographic effects
retiring baby boomers would
have on these expenditures.
As a result, there is less
left over for discretionary
purposes. Many states also
face the same competition
for resources to fund current
and future needs in the face
of mounting expenditures for
past promises. In California,
costs associated with pensions
and interest on the State’s debt are growing robustly whereas spending on the University of California system and
education in general has been declining-consistent with our assertion that the past is crowding out the future.
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MARKET REVIEW
Source: www.governforcalifornia.org
Current high and rising debt levels in the U.S. need not lead to the crisis suggested above because this nation
knows what to do to prevent it. It is time to dust off proposals made by the Simpson-Bowles Commission several
years ago, and implement some of the necessary mid-course corrections that should produce much better
outcomes for all income groups, but especially the poor and middle class, than the current economic trends would
suggest. The fixation on achieving one-party rule, with the objective of reducing income inequality and promoting
“social justice,” will be for naught if Washington continues ignoring the “800 pound gorilla” in the room.
The Importance of New Business Creation
The capital markets exist to transfer capital from those who have abundant savings to those who have a new idea
or product and need access to funding so they may start a business. Unfortunately, much of what goes on in
the capital markets today is closer to a “casino environment” than one dedicated to funding new businesses and
creating jobs. Several years ago, a Market Review contained a chart from the Kauffman Foundation which showed
that 100% of net job creation over the last 40-50 years has been attributable to startup companies. Unfortunately,
recent trends suggest the number of new companies being created is going in the wrong direction.
We agree with the Kauffman Foundation about the importance, even primacy, of start-up companies as engines
of growth and the best examples of the economic multiplier at work. Many times investors and others think of
successful new companies such as Facebook and Google when the idea of startup companies is discussed. The
following probably is more representative of what happens more broadly in the U.S. economy.
I grew up and spent my first 17 years in the farming community of Fowler, which is located in California’s Central
Valley, 10 miles south of Fresno on Highway 99. When I was there its population was about 2,000 and it has now
mushroomed to 6,000! In 1969, three brothers and a partner decided to start a packing operation for table grapes,
raisins, tree fruit, and nuts. The early years were difficult and the partner decided to drop out. Eventually the
business model took hold and operating results moved in a very positive direction. Today the company’s customers
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Third Quarter 2014
include Costco, General Mills, Kellogg, Kraft, Mondelez, Kroger, Walgreens, CVS, Dollar General and many other
household names. However, the most significant result from the company’s growth was the creation of 400 good
paying jobs. This is a very significant figure given the size of Fowler’s population. Why shouldn’t this type of activity
be celebrated, including in our tax code?
Our feeling is that people who start businesses should face only nominal taxes on the assets they create,
something on the order of 5-10%. For companies that are private, special provision should be made for allowing
intergenerational transfers rather than subjecting them to estate taxes that often require liquidation or sale. Above
all, there should be distinctions in our tax code and the federal regulatory rule books for smaller, privately held
companies when compared to larger, publicly traded enterprises. The tepid growth in GDP this business cycle
has occurred because small businesses have faced unique headwinds emanating from Washington D.C. that have
limited hiring and investment in this important and critical segment of the economy.
The Underappreciated “Crown Jewel”
The crown jewel in the U.S. private sector is the venture capital community which is unique and whose presence
differentiates our private sector from all others in the world. Senator Elizabeth Warren of Massachusetts has
argued that companies built by venture capitalists or by ordinary investors owe much, if not all, of their success
to government expenditures on research and infrastructure development. We acknowledge that these are very
helpful but Warren misses the point. If the argument “You didn’t create it” has merit, then central planning and
socialist countries, whose bureaucracies meddle in asset allocation decisions and for whom “crony capitalism” is
a way of life, should have equally robust venture capital communities-but they don’t! A successful venture capital
community has something that no government can provide and that is the creative spirit combined with long
hours honing a skill-set.
Malcolm Gladwell’s book Outliers traces some of the factors that make for venture capital successes. Specifically,
he points out that people like Bill Gates, Steve Jobs, Scott McNealy and others committed many hours to learning
their crafts. Gladwell suggests that 10,000 or more hours of such preparatory commitment is what it takes, but the
message is clear. Building a successful company takes more preparation than having an MBA, a degree in electrical
engineering, or a high IQ. A successful startup company often requires considerable time, by its managers, in
the technological and business “trenches” which involves trial and error and necessary mid-course corrections,
activities that government bureaucrats and Senator Warren do not appear to understand or appreciate. For them,
wealth creation from forming a new and successful company is a given-it just happens! The increased wealth and
additional jobs new businesses create are taken for granted and the appropriate political response for them seems
to be finding all the ways government can devise to separate the successful entrepreneur from his or her capital.
The charts below suggest that venture capital startups, like median middle class incomes, have weakened since
2006. Business startups from 1978 through 2006 were 175-200+ in number for each 100,000 of population.
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MARKET REVIEW
Source: Mauldin Economics.https://www.mauldineconomics.com/outsidethebox/money-how-the-destruction-of-the-dollar-threatens-the-global-economy
Since 2006, the figure has fallen to about 125. The second chart above shows that successful startup companies
have been declining while at the same time the number of failures has been increasing. The net effect of these
trends makes the fall in new startups even more concerning. For some it is tempting to blame these trends on the
Great Recession but the truth is there is no real advocacy of venture capital in the Administration because few, if
any, of its bureaucrats have ever been deeply involved in it. It is difficult to champion something with which one is
unfamiliar or which often is associated with the top 1%. It is equally difficult for the Administration to support our
traditional venture capital community when it believes that government should play a growing role in resource
allocation such as the Energy Department’s funding of Solyndra, Abound, and a number of other federal adventures
into venture investing.
Each month the National Federation of Independent Business (NFIB) surveys its small business membership and
asks them for the most important problems facing them. Taxes has been a consistent number “1”, but not far behind
is Government Regulations
and Red Tape.
If creating conditions for
a more robust economy
was its primary goal, the
Administration would be
dealing with concerns
involving taxes and
regulations but we suspect
these are seen as “positives”
from its standpoint. Higher
taxes and increased
regulation are consistent with
agendas to limit the role of
the private sector in favor of
a greater one for the federal
government There is a strong
distrust of market forces
and individual incentives in
much of the Washington
establishment.
Source: www.NFIB.com.
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Third Quarter 2014
Technical Market Considerations
The current bull market is one of the longest on record and it is understandable that investors may be questioning
whether we’re nearing a major market top. There are a number of things that seem to support this idea. One of
Warren Buffett’s favorite charts compares GDP in the U.S. with the value of all common stocks.
Source: Ned Davis Research.
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MARKET REVIEW
Source: Macro Mavens.
As can be seen above, the aggregate value of all U.S. stocks is in excess of 140% of GDP, a high figure over the years.
MacroMavens’ Stephanie Pomboy adjusts this comparison to include corporate debt (enterprise value=value of all
stocks plus corporate debt). Enterprise value is now more than 200% of GDP, the highest such figure on record.
Margin debt often reaches its highest levels near major market peaks and the chart below shows that margin debt
recently hit new historic highs.
Source: www.dShort.com.
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Third Quarter 2014
Part of the reason for this is that the Federal Reserve has held interest rates at very low levels for more than five
years, which has encouraged investors to use their holdings of common stocks as collateral. Nevertheless, margin
debt levels reflect the late-stage status for the stock market this cycle.
Another interesting valuation metric comes from the Holt Advisory Service. Holt’s discount rate indicates whether
the companies in its research universe are cheap (a higher discount rate) or more expensive (lower discount rate).
Source: Credit Suisse HOLT.
This indicator also is influenced by the Federal Reserve actions to maintain artificially low interest rates. The only
time the Holt discount rate was meaningfully lower than the current 4.3% figure was during the Internet and
technology bubble in 2000. We find this and the indicators discussed above cautionary for the stock market but
they are notoriously poor timing tools. Late stage bull markets may remain at relatively high valuations for extended
periods of time and go higher than anyone might expect.
In our experience, in every approaching bear market dating from the late 1960s, market breadth breaks down
prior to the stock market peak and the “thinning process” we described in the last Market Review becomes more
extreme. Historically, Lowry’s buying power-selling pressure charts show pronounced increases in selling and falling
demand (buying) for common stocks prior to important market peaks.
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MARKET REVIEW
Source: Lowry’s.
Lowry’s OCO (operating only companies) cumulative advance-decline chart remains in a well-defined uptrend. Prior
to the 2007 peak for stocks, this chart began declining six months in advance of the peak. The buying power-selling
pressure chart also doesn’t show the type of pattern one would expect if a market peak was imminent. Selling has
been declining rather than increasing as it usually does prior to important tops for the stock market.
In recent Market Reviews we have referred to Lowry’s study of the “thinning process” that occurs in late-stage
bull markets. Included below are the percentages of stocks that have confirmed each new high for the S&P 5004
because their share prices are within 2% of their own 52-week highs. Lowry’s maintains a database of 1800 stocks.
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Third Quarter 2014
Source: Lowry’s. Past performance is no guarantee of future results.
This figure must be related to the percentage of stocks in Lowry’s 1800 stock database that measures the number
of companies that are already in their own bear markets, defined as a stock price more than 20% below its 52-week
highs. Although the “thinning process” is evident in the Lowry’s numbers, it is not advanced sufficiently enough to
signal a bear market immediately ahead.
Merrill Lynch keeps track of market strategists and the percentage of stocks that they feel appropriate in an
asset mix that includes bonds and cash. In 2000, strategists believed that 70% stocks was the appropriate equity
allocation near the market peak and the figure was approximately 65% in 2007 at the peak that year. Strategists in
these previous cycles were quite bullish at the market tops.
Currently the figure is 51% which is a relatively low equity allocation figure during the last 30 years. This occurs at a
time when the returns on bonds and cash are at or near historic lows making market strategists’ relatively subdued
enthusiasm for stocks even more compelling. Strategists, like many investors, seem to be climbing their own “wall of
worry” which may be a near-term market positive.
We believe the stock market continues to have “legs” and that the liquidity and interest rate environment remains
supportive of meaningfully higher stock prices. In addition GDP for the second quarter came in at 4.2% which seems
a breakout of sorts for the economy. If the stock market continues working its way higher and meaningful gains
result over the next six months, it may become time for investors to consider de-risking their portfolios including
raising additional cash. Currently, we feel investors have additional time before they embark on this course of action.
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MARKET REVIEW
Common Stocks
What does history say about potential stock market returns in the next 6-9 months? The following chart comes from
analysis done by the Leuthold Group.
The Stock Market's Annual & Presidential Cycles Combined:
S&P 500 Annualized Total Returns, 1926 To Date
Post-Election Year
Mid-Term Year
Pre-Election Year
Election Year
24.7%
Nov-Apr
12.9%
Nov-Apr
8.4%
Nov-Apr
9.4%
May-Oct
5.8%
May-Oct
11.0%
8.7%
May-Oct
Nov-Apr
1.1%
May-Oct
We are here.
© 2014 The Leuthold Group
Source: Leuthold Group.
Past performance is no guarantee of future results.
It suggests the very best period for stocks, during the presidential cycle, is late in the mid-term election year
(now/2014) through the first four months of the pre-election year (2015). We point out that 2013 was a much better
year than history would have suggested and returns approaching 25% by April of next year probably are unrealistic.
However, as pointed out in our Technical segment, stock market strategists seem relatively subdued where stocks
are concerned and the cumulative advance-decline charts for stock remains in a healthy uptrend. We continue to
feel that the stock market may do relatively well over the next six months.
Recently Francois Trahan of Cornerstone Macro generated a chart showing his interpretation of the free cash flow
trend for the U.S. consumer. He derives free cash flow by taking consumers’ incomes and then subtracting energy
and food costs as well as interest expense associated with mortgages and other consumer debt obligations.
Source: Cornerstone Macro.
As the chart above shows, there has been continuing improvement in Trahan’s consumer free cash flow in recent
years which is consistent with a low probability of recession. The U.S. consumer could be doing even better if the
Administration was being more proactive in generating faster economic growth. Nevertheless, existing trends
support our belief that meaningfully higher equity values may lie ahead.
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The Markit figures on new orders and inventories for U.S. manufacturing companies also suggest better times lie
ahead for U.S. companies and for GDP growth.
Source: Mauldin Economics.https://www.mauldineconomics.com/outsidethebox/geopolitics-and-markets
*PMI: Purchasing Managers Index is a composite index of 400 purchasing managers throughout the US.
Leuthold Group Sector Valuation Analysis
We have believed that the sectors to emphasize are those that are more economically sensitive such as Consumer
Discretionary, Financials, Technology, Energy, Industrials and Materials. The more defensive sectors are Health Care,
Utilities, Staples, and Telecommunications. Health Care has been our favorite within the defensive sectors. Recently
we came across some interesting work by the Leuthold Group which used sector median metrics to compare a
sector’s relative valuation to the S&P 500. Metrics used included relative P/E5 based on 5-year normalized EPS,
relative price/cash flow, and relative price/book value. These were then combined into a single sector relative
valuation composite.
The Leuthold analysis in some cases supports our emphasis on economically sensitive sectors but it does come up
with some surprising results as well. Included below is a summary of the Leuthold findings from most attractive (#1)
to least attractive (#10). The Leuthold Group found that Technology and Health Care were the top groups based on
its work with Energy coming in third. The surprises were the #4 and #10 spots, Staples and Materials. We continue
to believe most of the Staples companies
© 2014 The Leuthold Group
Sector
Relative Valuation
we have reviewed are selling at prices
Leuthold GS Score
Score
The top four
that reflect full value. Materials is the
ranked
Sector Composite
(1990-to-Date Pctl.;
least attractive sector for the Leuthold
sectors in the
Ranking
Lower = Cheaper)
Leuthold GS
1
20
Group and yet we are finding a number of Information Technology
Scoring
Health Care
2
19
framework
compelling values in the group. A number Energy
3
14
also happen
of leading companies in the Materials
Consumer Staples
4
21
to be the four
Financials
5
37
cheapest
sector have reduced their projected
sectors on a
Consumer Discretionary
6
82
capital expenditures and it seems clear
historical
Industrials
7
33
relative
that free cash flow generation will be an
Telecom Services
8
36
valuation
9
36
important objective going forward. Charts Utilities
basis.
Materials
10
89
showing the Leuthold sector relative
Source: Leuthold Group.
valuation work are included below.
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MARKET REVIEW
Source: Leuthold Group. Past performance is no guarantee of future results.
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Third Quarter 2014
More Specific Areas of Investment Focus
More specifically, the following are some of the themes, trends, and business areas we favor for individual stock
selection.
• Larger companies seem to be much better values currently. Smaller companies have consistently outperformed
since 2000, a very long relative bull market. However, over the last six months, smaller companies have
underperformed larger ones consistently.
Source: Leuthold Group.
The Leuthold Group relative P/E ratio chart above highlights
the relationship between small and larger companies. Small
cap companies were selling at historically cheap levels in 2000
and since then their relative P/E levels compared to those
for larger companies are near all-time highs. The other chart
from Empirical Research indicates that larger companies were
expensive as recently as 2010 (85th percentile) vs. the situation
today when their relative value is in the 10th percentile
indicating larger companies have been cheaper, on a relative
basis, only 10% of the time in the past.
In addition, Empirical Research’s studies show that larger
companies currently enjoy better profit margins, on average,
than smaller companies, their free cash flows are higher, and
their capital spending has been more subdued as well. The
latter suggests that returning capital to shareholders in the
future may be a higher priority for the larger companies.
Source: Empirical Research Partners.
Past performance is no guarantee of future results.
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MARKET REVIEW
Source: Empirical Research Partners.
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Third Quarter 2014
• Financials historically have been good performers earlier in the market cycle but we believe this time around,
they may perform more like late-stage cyclicals. For example, only now are we beginning to see meaningful
loan growth at our nation’s banking institutions, an important segment with the Financials sector. Within the
Financial sector, which comes in at #5 on the Leuthold studies, we are particularly positive on companies with
significant involvement in mergers and acquisitions, so-called M&A activity.
Source: Macro Mavens.
One of the things that distinguished the stock market peaks in 2000 and 2007 was “froth.” In 2000, speculation
was centered in Technology and Internet companies and in 2007 housing drove the speculative juices in that
business cycle. We suspect that before this market cycle is compete, a trend or market focus will develop
that would compare with the leadership (froth?) in these previous cycles. One possibility would be that a very
strong M&A cycle develops and drives valuations higher for the shares of companies with substantial M&A
operations as well as the companies they represent in transactions.
• Everyone is aware that much of the developed world is getting older and in many emerging market countries
the middle class is growing at a very fast rate. Older people already may have the material things they need
and be more interested in new experiences. Others in rapidly growing middle classes in emerging economies
may want to explore the world they’ve only seen on television and in various advertisements. Commercial
aircraft manufacturers and their suppliers and cruise ship lines would seem well positioned to benefit from
these trends over the next 5-10 years. In the U.S. it also appears there may be pent-up demand for durable
goods such as automobiles.
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MARKET REVIEW
Source: Empirical Research Partners.
As the chart above shows, spending on durable goods is far below where it has been in previous business cycles. As
with commercial aircraft, suppliers to the automobile industry could be interesting as well.
• There are reasons why the capital expenditures have been the weak this business cycle when compared to
those that preceded it since World War II. Many production facilities have been outsourced to places like
China, India, and Mexico and operations in these countries have become responsible for what historically
showed up in U.S. capital expenditures. However, some of the weakness may be due to the fact that many
companies have had concerns about the strength of the U.S. economy in the next few years and this has
limited their willingness to hire new employees and spend on capital additions. Many companies have elected
to direct capital to share buybacks, dividend increases, and debt reduction as their capital allocation priorities.
Source: Gloom, Boom & Doom Report – Marc Faber.
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PORTFOLIO MANAGER COMMENTARY
Third Quarter 2014
With the stock market dramatically higher than a few years ago, share buybacks make less sense and we
suspect competitive and other forces will lead to higher spending on capital equipment. We continue to
believe many companies, including the larger ones in the Technology sector, are compelling ways to participate
in an improving capital expenditure cycle. As pointed out above, according to the folks at the Leuthold Group,
Technology is the number “1” ranked sector based on its valuation criteria.
• In the sixth year of a bull market it seems reasonable to conclude that capital gains opportunities over the
next few years may be more constrained than in the last few years. As such, dividends and dividend growth
may become more important within the context of total return (capital gains + dividend yield). We continue
to believe stocks yielding 2.5%-3.25% that can grow their dividends in excess of future inflation are more
attractive than “bond-like” higher dividend yields whose future growth may trail inflation. The charts below
show the large buildup in non-financials’ cash positions over the years and the payout ratio since the 1960s,
which is about as low as it has ever been, suggesting that dividends might be able to grow faster, in the next
five years, than earnings. Share repurchases may be less attractive going forward because equity values are
elevated at this time. Could there be a substitution effect away from buybacks in favor of increased dividend
payments? We think this may be likely.
Source: Ned Davis Research.
Source: BCA Research. Past performance is no guarantee of future results.
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MARKET REVIEW
• As indicated in the Leuthold work, Energy comes in third on its relative valuation work. It is remarkable what
has happened in the U.S. as technological innovation has allowed domestic reserves to be produced in ways
unimaginable just a few years ago. The chart below shows the profound changes that have taken place
in recent years, virtually all of it on private lands. The federal government has been a reluctant warrior in
supporting the growth in oil and natural gas production because the technological changes that made much
larger oil and natural gas production possible centered in the fossil fuels area rather than in alternative energy.
Source: Pring Turner Capital Group.
Source: Strategas Research Partners LLC.
22
PORTFOLIO MANAGER COMMENTARY
Third Quarter 2014
In 2013, world oil production increased 0.56 million barrels per day and yet the U.S. increase was double this
figure at 1.11 million incremental barrels per day of production which indicates the rest of the world combined
had a decline in production. This trend is bullish for the U.S. economy as a whole because it means we are
spending less on foreign oil which has a very positive effect on our balance of trade.
Source: Sanford C. Bernstein, company data.
Source: Sanford C. Bernstein, company data.
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MARKET REVIEW
Many energy companies have been spending more than 100% of their cash flows in recent years on
development and exploration activities. As a result, return on property, plant and equipment (PPE) has
consistently declined in the last five years for the average oil company. It will be important to focus on those
companies which are becoming more disciplined allocators of their capital going forward. In the energy area,
we also believe prospects for natural gas producers are positive because U.S. natural gas will find its way into
international markets in the next few years. Weather will continue to be the wild card where natural gas prices
are concerned.
• Homebuilders seem to be on many strategists’ and analysts’ buy lists but we believe one needs to be
selective in this area. The chart below shows the percentage of people 35 years of age and younger who are
homeowners. The figure has been declining substantially in recent years as home prices have escalated much
faster than incomes.
Source: Gluskin Sheff Research.
Low interest rates have not been enough to offset stagnant incomes and much less affordable housing due to
substantial increases for single-family home prices in recent years. Within the homebuilders group, there are
companies that serve stronger segments of the market which should be the focus. We continue to be wary of
those homebuilders whose products cater to the first time buyer.
As indicated in the last Market Review, non-residential construction seems to be gaining strength. On balance
we prefer commitments in the non-residential construction area to those in the residential area. Several
mortgage REITs which focus on the non-residential (commercial) area could be attractive for investors looking
for above-average income.
• Labor compensation has declined to a 60 year low relative to corporate profits and seems poised to begin
reversing this trend in the coming years. The chart below shows how dramatically labor compensation has
lagged corporate profits in recent decades. Some of this has been due to the ending of the Cold War and the
opening of large pools of low cost labor in places like China. The Bank Credit Analyst says that the current
relationship of corporate profits and labor compensation is a five standard deviation event if the period from
1950 to the present is considered. If there is any substance to this claim then labor rates may be poised to
increase substantially relative to corporate profits in the future. Very few investors are worried about labor
costs in making investment selections today. In our opinion, this consideration will become much more
consequential before much longer. Companies that produce labor-saving devices, including robotic production
tools, should continue to be rewarding in the coming months.
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PORTFOLIO MANAGER COMMENTARY
Third Quarter 2014
Source: BCA Research.
• Although we favor larger companies, as indicated previously, the U.S. dollar has been showing strength
recently. With Europe adopting its own version of Quantitative Easing, it seems that the Euro will weaken
vs. the dollar in the next year and dollar strength could persist against this and other currencies. A stronger
dollar means that domestic earnings will be prized more than if the dollar was weak. Although we continue
to favor many multi-national and larger companies, it is possible that smaller companies may be perceived as
beneficiaries of a stronger dollar because their operations are more focused on the domestic U.S. economy.
However, this may be an intermediate trading possibility more than a return to the market leadership of
smaller companies between 2000 and 2013.
Source: Bloomberg. Past performance is no guarantee of future results.
• There are areas of the market that are suitable only for more aggressive investors with longer investment
time horizons. These include uranium producers and solar energy companies. We continue to believe uranium
producers will be outstanding performers over the next 3-5 years. Uranium prices have been very weak
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MARKET REVIEW
recently but they may be in the process of establishing a durable bottom. We have been early on this call and
possibly the next important move for the stocks will be in 2015-2016. Nevertheless, the number of new nuclear
facilities going up in China, India, and the Middle East suggest substantial demand growth in the coming
years for enriched uranium. We continue to believe Japan will begin returning nuclear facilities to production
although the pace has been slower than anticipated. Japan’s energy costs have escalated because much higher
energy sources have temporarily replaced nuclear, which also has caused its emission levels to worsen.
Source: The Ux Consulting Company, LLC; www.uxc.com.
The charts below show that costs for solar energy are coming down and grid-parity may not be too far off. It
appears that an oil price of $125-$150/Bbl. might make solar viable without subsidies. However, natural gas
prices are likely to remain substantially below oil prices on a BTU equivalent basis in the period ahead which
may affect this calculation. The real question facing solar relates to storage. For solar to become viable, it
needs to be produced at a competitive cost and most importantly, a means of storing it is necessary so that it
can be utilized when necessary.
Source: BCA Research.
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PORTFOLIO MANAGER COMMENTARY
Third Quarter 2014
Source: BCA Research.
Source: BCA Research.
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MARKET REVIEW
This summer I heard a presentation (“Using the Sun to Fuel our Lives”) by Professor Nate Lewis, a chemistry
professor at Caltech, who has been working on a system to produce electricity from solar and store it in the same
system. His team has been working on this for a number of years so success may not be just around the corner.
However, in the next decade, the storage problem may get solved. Of all the alternative energy sources, the Caltech
professor says the only one that really can scale to meet the world’s long-term needs is solar. We’re sorting through
solar companies to see the ones that may make sense longer term.
Emerging Markets
Emerging Markets relative to the S&P 500 peaked in 2010 and have fallen relative to this index by more than 30%
since then. Emerging Markets have also fallen, in relative terms, by a similar amount when compared to Global
Equities according to the Bank Credit Analyst.
Source: Macro Mavens. Past performance is no guarantee of future results.
*MSCI Emerging Markets Stock Index includes over 800 securities across 23 markets and represents approximately 11% of world market cap.
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PORTFOLIO MANAGER COMMENTARY
Third Quarter 2014
Source: BCA Research. Past performance is no guarantee of future results.
We believe Emerging Markets are cheaper and relatively attractive when compared to U.S. stocks at this time.
Recently the Emerging Markets have begun to perform better than U.S. stocks for the first time in four years. We
believe this may continue.
Developments in China will be very important for the performance of Emerging Markets stocks in absolute and
relative terms over the next year or so. China is attempting to pivot from an emphasis on exports and massive
capital expenditures on infrastructure to one more focused on its consumer economy. The pivot in favor of its
internal economy will take time and the country will need to digest the large debt load built up over the last 15
years. As seen below, the Bank Credit Analyst projects 7% GDP growth for Chinese GDP over the next decade
which represents much faster growth than in the developed world, including the U.S., and many other emerging
economies.
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MARKET REVIEW
Source: BCA Research.
Fixed Income
Deflationary trends in Europe have caused 10-year government yields for Germany, France and Spain to fall to
1.05%, 1.37%, and 2.26% respectively which is one reason 10-year U.S. Treasury Yields, which reached 3% late in
2013, fell back to 2.35% recently. U.S. yields have recently recovered to 2.59%
Source: Cornerstone Macro. Past performance is no guarantee of future results.
The chart above shows how significant the divergence has been between German and U.S. yields. It is wider (U.S.
yields higher) than at any other time in the last 25 years.
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PORTFOLIO MANAGER COMMENTARY
Third Quarter 2014
The chart below shows the trend for 10-year Treasury interest rates since 1974. The Federal Reserve has held interest
rates at historically low levels for more than five years. By doing this, asset prices have become elevated, people who
have relied on income from certificates of deposits and other short-term securities have seen their incomes decline,
and the “hurdle rate” for investments has been lowered which means some of them wouldn’t have been made in an
environment of normalized interest rates. The longer the Federal Reserve maintains interest rates far below historic
norms, the greater the misallocation of resources in the economy will become. Our best guess is that the Federal
Reserve will begin allowing interest rates to increase in the first quarter of 2015. Although the initial increases may
be small, we continue to believe the risk-reward profile for most fixed income securities, including Treasuries and
High Yield bonds, is unattractive. Municipal bonds appear to be the best relative value in the fixed-income arena.
Source: Macro Mavens. Past performance is no guarantee of future results.
Source: Macro Mavens. Past performance is no guarantee of future results.
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MARKET REVIEW
Gold & Precious Metals
We feel that many investors should have positions in gold as an insurance policy to protect against economic and
political calamities. When this “insurance” is relatively cheap and investors aren’t really interested in purchasing it,
somewhat larger gold positions are justified. Conversely when advertisements, such as the ones for gold and silver
on television, outnumber those for erectile dysfunction, positions in gold should reflect this and be somewhat lower.
Source: BCA Research.
The chart above shows the profile of gold compared to inflation since 1875. In 1980 and in recent years, gold
prices diverged rather dramatically from the long-term trend for inflation. When this happened in 1980, gold prices
corrected and slowly eroded for about 20 years. The peak in gold prices at $1900/oz. in 2011 was an even bigger
deviation from the inflation trend than the 1980 experience. As such, it seems likely that gold prices may remain
under pressure for some time unless significant inflationary pressures reassert themselves.
Among the variables that affect gold prices are the U.S. dollar and its trend, the level and trend for interest rates,
and inflation. Currently the dollar is strengthening and this is a negative for gold prices. Although interest rates
are low and unlikely to move sharply higher in the next year or so, the next significant directional move may be
somewhat higher-not a plus for gold. Inflation remains contained and though we believe there may be some upside
surprises coming on this front, they will have to be significant to nullify the headwinds associated with a stronger
dollar and the potential for higher U.S. interest rates.
“Insurance” positions in gold may be appropriate with the majority being in gold bullion or coins held in
investors’ personal possession. The best relative value in gold mining companies appears to be in the junior gold
producers, which have fallen in price much more than the leading gold companies. The latter have heard from
their shareholders and will be reducing capital expenditures (exploration) in the future in an effort to reach at least
free cash flow breakeven. This suggests that these gold mining companies may be interested in acquiring other
companies with attractive gold assets, namely the junior gold miners, as a way to maintain and/or increase their
reserves.
It would not surprise us if gold prices, at some point, might decline $100-$150/oz.; however, we wonder whether
such weakness might generate large bids that might limit further weakness. The chart below shows that East Asia
and the Pacific, which includes China, India, Japan and many other countries, were only modest acquirers of gold
before 1995. Since then there has been persistent buying by Asian countries. The substantial purchases in 2013,
shown in the chart below, were made during a time of extreme weakness in gold prices.
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PORTFOLIO MANAGER COMMENTARY
Third Quarter 2014
Source: Mauldin Economics.
We suspect that China and others in Asia may use gold price weakness in the future to accumulate even
larger holdings.
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MARKET REVIEW
Things That Make You Go Hmmmmmmm……………
As the chart below shows, life expectancies have increased dramatically since 1600 and have roughly doubled
since 1800. It is likely this trend will continue in the future because of the amazing medical breakthroughs that
are being made.
Source: BCA Research.
Source: BCA Research.
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PORTFOLIO MANAGER COMMENTARY
Third Quarter 2014
The human genome was decoded only a few years ago and in 2001 it would cost about $100 million if you wanted
yours to be analyzed in this manner. Since then, the cost has come down each year and the Bank Credit Analyst claims
that today it costs only about $6,000 to determine what is contained in an individual’s gene makeup. Actually we think
this is conservative because Illumina Inc. has been able to accomplish this for $1,000 recently.
The ability to map a person’s genome relatively cheaply will facilitate personalized medicine by developing treatments
and medications that are specifically designed with a person’s own unique genetic makeup in mind. It seems clear
than in the short run, the next 25 years, breakthroughs will be necessary with dementia and Alzheimer’s so that the
quality of life will not decline as life is extended. Breakthroughs will come but the challenges are formidable. The
human brain contains 90-100 billion neurons and approximately 1 trillion synapses and the interactions taking place in
the brain are highly complex.
The Bank Credit Analyst (BCA) believes that eventually medical technology may be able to retard or prevent the
decline in the number of stem cells as we age and if this can be done the ramifications might be profound. Doing this
could extend life dramatically more than we can imagine. The analysts at BCA end with the rhetorical question, “will
death eventually become optional?”
Summary of Goals & Objectives for the Simpson-Bowles Commission
Several times in this Market Review we mentioned the Simpson-Bowles Commission and its approach to bringing
federal government finances into better balance and also providing a better foundation for faster GDP growth. We are
not going to discuss the Commission’s proposals, only to outline, in its own words, its guiding principles and values.
The Administration apparently finds these principles and values to be in conflict with its goals and the overarching
commitment to “fundamental transformation” of the U.S. economy. The objectives and goals of the Simpson-Bowles
Commission seem to us to be reasonable and compelling.
Our Guiding Principles and Values
“In establishing this Commission, the President (Barack Obama) gave us a two-part mission: to bring the budget into
primary balance (balance excluding interest costs) in 2015, and to meaningfully improve the long-run fiscal outlook.
Our recommendations accomplish both of these goals, while keeping the following core principles in mind:
We all have a patriotic duty to make America better off tomorrow than it is today. Americans are counting on
us to pull together, not pull apart, to put politics aside and do the right thing for future generations. Our country’s
economic and national security depend on us putting our fiscal house in order.
Don’t disrupt the fragile economic recovery. We need a comprehensive plan now to reduce the debt over the long
term. But budget cuts should start gradually so they don’t interfere with the ongoing economic recovery. Growth (our
emphasis) is essential to restoring fiscal strength and balance.
Cut and invest to promote economic growth and keep America competitive. We should cut red tape and
unproductive government spending that hinders job creation and growth. At the same time, we must invest in
education, infrastructure and high-value research and development to help our economy grow, keep us globally
competitive, and make it easier for businesses to create jobs.
Protect the truly disadvantaged. We must ensure that our nation has a robust, affordable, fair, and sustainable
safety net. Benefits should be focused on those who need them the most.
Cut spending we cannot afford-no exceptions. We must end redundant, wasteful, and ineffective government
spending, wherever we find it. We should cut all excess spending-including defense, domestic programs, entitlement
spending, and spending (deductions and loopholes) in the tax code.
Demand productivity and effectiveness from Washington. We must use fiscal restraint to promote reforms and
efficiencies that force government to produce better results and save money. We should insist on productivity growth
in government.
Reform and simplify the tax code. The code is rife with inefficiencies, loopholes, incentives, tax earmarks, and baffling
complexity. We need to lower tax rates, broaden the base, simplify the tax code, and bring down the deficit. We need to
reform the corporate tax system to make America the best place to start and grow a business and create jobs.
Don’t make promises we can’t keep. Our country has tough choices to make. We need to be willing to tell
Americans the truth: We cannot afford to continue spending more than we take in, and we cannot continue to make
promises we know full well we cannot keep.
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MARKET REVIEW
The problem is real, and the solution will be painful. We must stabilize and then reduce the national debt, or we
could spend $1 trillion a year in interest alone by 2020. There is no easy way out of our debt problem so everything
must be on the table. A sensible, realistic plan requires shared sacrifice and Washington must lead the way and
tighten its belt.
Keep America sound over the long run. We need to implement policies today that ensure future generations
have retirement security, affordable health care, and financial freedom. To do that, we must make Social Security
solvent and sound, reduce the long-term growth of health care spending and tackle the nation’s overwhelming
debt burden.”
John G. Goode
September/October 2014
TN14-381
© 2014 Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC and ClearBridge Investments are subsidiaries of Legg Mason, Inc.
All investments involve risk, including the loss of principal. Past performance is no guarantee of future results. Investors cannot invest directly in an index and unmanaged index returns
do not reflect any fees, expenses or sales charges. Fixed income securities are subject to interest rate and credit risk, which is a possibility that the issuer of a security will be unable to
make interest payments and repay the principal on its debt. As interest rates rise, the price of fixed income securities falls. Equity securities are subject to price fluctuation and possible
loss of principal.
Foreign securities, where permitted, are subject to the additional risks of fluctuations in foreign exchange rates, changes in political and economic conditions, foreign taxation, and
differences in auditing and financial standards. These risks are magnified in the case of investments in emerging markets.
U.S. Treasuries are direct debt obligations issued and backed by the full faith and credit of the U.S. government. The U.S. government guarantees the principal and interest payments on
U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may
not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply
to losses resulting from declines in the market value of these securities.
There are heightened risks associated with investments in high-yield securities, also known as “junk bonds.” High-yield bonds are subject to increased risk of default and greater
volatility due to the lower credit quality of the issues.
1 Affordable Care Act: A federal statute signed into law in March 2010 as a part of the Health Care reform agenda of the Obama administration. Signed under the title of The
Patient Protection and Affordable Care Act, the law included multiple provisions that would take effect over a matter of years, including the expansion of Medicaid eligibility, the
establishment of health insurance exchanges and prohibiting health insurers from denying coverage due to pre-existing conditions.
2 Gross Domestic Product (GDP): The monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually
calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.
3 Federal Reserve: The central banking system of the U.S., comprised of the Federal Reserve Board, the 12 Federal Reserve Banks, the Federal Open Market Committee, and the
national and state member banks. Its primary purpose is to regulate the flow of money and credit in the country. 4 S&P 500: The S&P 500, or the Standard & Poor’s 500, is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or
NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.
5 Price to Earnings Ratio is a valuation ratio of a company’s current share price compared to its per-share earnings.
ClearBridge Investments
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Past performance is no guarantee of future results. Copyright © 2014 ClearBridge Investments.
All opinions and data included in this commentary are as of
Sept. 30, 2014 and are subject to change. The opinions and
views expressed herein are of ClearBridge Investments, LLC
36
and may differ from other managers, or the firm as a whole,
and are not intended to be a forecast of future events,
a guarantee of future results or investment advice. This
information should not be used as the sole basis to make
any investment decision. The statistics have been obtained
from sources believed to be reliable, but the accuracy and
completeness of this information cannot be guaranteed.
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providers are responsible for any damages or losses arising
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