INVESTING DURING UNCERTAIN TIMES

Good evening everyone and thank you for coming to our presentation. Before I start, I would like to thank all of you for making the personal sacrifice in order to make our lives a lot easier and safe, day in and day out. This is a virtue that should never be taken for granted. This event is titled;”INVESTING DURING UNCERTAIN TIMES” for two reasons: 1) these are “Uncertain Times”.  In the next two worst months on record- September and October, in financial markets, and just prior to one of the most contentious elections in U.S history, some uncertainties, in my view will have to clear out first in order to avoid some risk and then attempt to take advantage of any market weakness should it happen. 2) I believe that all of you sitting here tonight take enough risk on the job every single day when you leave home. I also believe that the last thing on your mind at this point is to double up this risk with your families’ egg nest at retirement. Although, unfortunately even if I would love to do so, I can’t promise to any of you that I can avoid risk, but what I can promise is to at least help you all to better understand that risk, how to handle it and possibly to try and take advantage of it. For example, if we would have had this meeting say, in the beginning of this year, maybe we could have had an opportunity to take some advantage of the last February stock market decline of 20% in order to be able today to outperform this market by a factor of five.

Some of these uncertainties include the following; First, one of the most polarized and closed elections on record will come to an end. Second, the Federal Reserve’s Board will likely decide on the direction and magnitude of the next Fed Funds’ Rates. Third, investors will likely start drawing conclusions about an expected slowdown in the Chinese-Second largest, economy in the world, and lastly, the other two largest developed economies in the world; Europe and Japan will have to come to grips with their stagnating economies and the limits of their monetary policies that are available to stimulate these economies.

When investing during uncertain times of extreme market volatility, investors many times get caught off guard by either investing too soon or too late. Committing assets to the market way too soon could result in short term unrealized losses. On the other hand, sitting on the side lines a bit too long could result in a long term opportunity loss. Any way you look at it, you might get hurt.

One relatively simple solution to this pending problem for reducing the impact of volatility risk is to implement a bi weekly ¹dollar cost averaging strategy whereby fixed dollar amounts are constantly being put to work during up and down markets in order to eliminate difficult market timing decisions, reduce the average cost of shares purchased; and therefore, to provide investors with potentially the best average entry point into the market. ²Numerous studies have confirmed that this strategy also results in better long term returns. For example, a Fidelity study looked at how several different strategies would have performed from January 2000 to January 2004, a period that included a dotcom bust and the start of a subsequent recovery. The study found that the best results came from steadily investing $500 every month into an S&P 500 stock portfolio. This dollar cost averaging strategy even outperformed a strategy that started putting all its new money into cash in April 2000, at the height of the market bubble. Strategies that shifted into cash either after the market had declined 20% or at the market bottom did even worse.

One more Example: Dollar Cost Averaging versus One Lump Investment from 10-11-2007 to 10-11-2012
Exhibit 1.

Another way to attempt to capitalize on violent market selloffs and subsequent recoveries requires, in my view some in depth understanding of the present uncertainties and their effects on financial markets, the current stock and bond markets valuations, a well-defined strategy of what to buy and what to avoid and the overall likelihood of a recovery in the first place.

When it comes to pointing out some of the “UNCERTAINTIES” that currently exist in the market place, investors should naturally pay attention to the pending U.S elections. The favorable market candidate at this point appears to be the Democratic nominee due to her perceived known policies of the past 20 years in government. On the other hand, the lesser favorable market candidate at this point appears to be the Republican nominee due to his unknown record in government. However, the reality is that as long as control over the house of representative and the senate is split between both parties, the next president’s influence over government policies and the economy should be limited, in my view.

Some other “UNCERTAINTIES” should include the following:

1. The Direction of the Fed Funds Rates which are the rates that banks charge one another. Is the Federal Reserves’ Board going to raise these rates this year? And if they do raise rates this year by how much and how many times? ³Although, U.S. economic data has picked up recently, slightly weaker-than-expected jobs report in September of 151,000 new jobs, reported unemployment rate of 4.9%, a decline in the Institute of Supply Management (ISM) to 51.4 in August from 55.5 in July, ⁴disappointing contraction in retail sales of a decline of 0.3% month-over-month, flat Producer Price Index in August, a decline in Industrial production of 0.4% month-over-month in August, flat business inventory in July, 2,143,000 continuing claims for unemployment in the past four weeks,⁵ lack luster increase in Consumer Price Index of only 0.2% month-over-month in August, and year over year increase of just 1.1% only confirm inconsistent lift in growth at best,⁶ especially when economists in 10 institutions expect an anemic 1.7% U.S expansion this year and not much better in 2017.⁷ In fact, at this moment there is a 22 percent chance the Fed will raise rates when it meets in September and 57 percent probability of a move by December according to data compiled by Bloomberg. In my view, regardless of the outcome for an interest rate increase or confusing Fed members that offer conflicting views, and in one case providing differing opinions in the same week by the same member, if the U.S economy can’t handle additional 0.25% to 0.50% fed funds rate then we are in trouble.
2. Potential slow down in the second largest economy of China. That prospect alone already caused last year a bear market in commodity prices such as a decline in oil prices from over $100 a barrel to $26 a barrel. In addition, a possible cool down in overheated real estate market coupled with bad bank loans could cause some contraction in the Chinese Purchasing Managers Index and possibly worldwide negative effects on financial markets. However, in my view, although China continues to be an important contributor to U.S economic growth.⁸ For example, in 2015, U.S goods exports to China totaled $113 billion, down from the previous two years, but still the third largest U.S goods export market behind Canada and Mexico.⁹ This alone, only represents a 0.63% of the entire U.S Gross Domestic Product of $18 Trillion.
3. The other two largest developed economies in the world; Europe and Japan are testing the limits of their monetary policies. As of today, about $11 Trillion of government debt in these continents is paying negative rates of return. Markets are losing confidence in the ability of central banks to boost inflation because there is a limit to how much quantitative easing programs can accomplish.¹⁰ In Japan, for example the BOJ is considering delving deeper into negative interest rates. If anything, in my view this current situation should make the U.S market look more attractive on a relative basis. The U.S employment picture and its positive GDP growth rate outlook of merely 1.7% percent should be a better home for investable assets yielding flat to negative rates for as far as the eye can see.

Additional uncertainties might include political polling ahead of the Italian constitutional referendum which can lead to additional European countries exiting the European Union, and naturally the upcoming third quarter earnings pre-announcement and reporting season.¹¹ Some market strategists believe that corporate earnings will probably stop going down beginning this quarter, after six consecutive quarterly drops, mainly as energy stocks begin to recover from their disastrous 2015 declines.

STOCK MARKET VALUATIONS

¹²The market’s price earnings ratio has risen markedly to 18.5 times. That’s up from the P/E of 16.1 times in 2015. Also, this current bull market has lasted; thus far 7 years, which is one of the longest runs on record, ¹³especially when considering that the average bull market normally lasts 68 months or about 5 to 6 years. As discouraging as this data might sound; we also however, need to remember that never before central banks around the world experimented with negative interest rates to the tune of $11 Trillion and/or zero to 0.25% Fed Fund rates at home for the past 7 years. Therefore, in an interest rate environment of negative to zero rates in most of the world, the U.S stock market selling at 18.5 times earnings in its 7th year run, might not look anymore that expensive on a relative basis.

BOND MARKET VALUATIONS

As treasury yields approach all-time lows and the U.S bond market is in its 34th year of declining interest rates of which European and Japanese bonds are now paying negative interest rates, it makes some sense to conclude that bonds are not cheap by any stretch of the imagination.

Exhibit 2. US Treasury, 10-year Yield, source: Bloomberg.

THE SOLUTION

Understanding that some uncertainties during unusually weak months exist and being ready to take advantage of these uncertainties is a solution in itself. This is because Uncertainties cause Volatility which in all likelihood could turn into a buying Opportunity. One relatively simple solution discussed earlier is an investment discipline that includes dollar cost averaging irrespectively of up or down markets. However, not less important are additional lump sum investment contributions that are attempted to take advantage of any market dislocations should they happen.

Exhibit 3. 10 and 20 years one lump sum asset growth with additional dollar cost averaging discipline during stock market dislocations.

HOW DO WE PUT THIS STRATEGY TO WORK?

Our firm endorses a top-down value discipline that seeks to identify globally undervalued markets, economic sector, and specific individual bonds and stocks that sell at deep discounts to markets’ bond face values and multiples respectively. For example, our team will look for sectors and companies that sell at price earnings ratios ex-cash of 14 or better. Our team will also try to identify companies with pristine balance sheets, preferably no debt, that pay dividends, grow their dividend and buy back their own shares.

These are also businesses that should have a growth rate of about 20%, and Enterprise Value/EBITDA (Cash Flow) multiple of preferably 8 times or better (As opposed to the S&P 500 cash flow multiple of approximately 9.8 times).

WHAT TO BUY?

¹⁴Technology, a classic growth sector in the S&P 500 index, now has the lowest price/earnings multiple ex-cash, despite its strong growth prospects and despite having one of the highest free cash flow yields and being the only sector in the S&P 500 index with net cash.

Exhibit 4. Valuation Metrics by Sector as of June 2016, source Merrill Lynch.

¹⁵The valuation level of technology stocks is now 20% below historical levels, even when excluding the technology bubble in 2000.

Exhibit 5. Relative Forward P/E of Technology vs. S&P 500, 1986-2016, source Merrill Lynch.

Technology also has one of the lowest dividend payout ratios (Dividends divided by Net Income) providing ample room for future dividend growth. ¹⁶For example, a company such as Apple that for the three months ended in June pays only 40% of its net income to shareholders versus keeping that cash on hand to reinvest in growth still has ample room to increase its dividend distributions.

Other sectors that can fit that bill include, but are not limited to:

Financials: for a potential rise in interest rates.

Health Care: if you believe that a Clinton presidency won’t lead to overly strict drug-price regulations. Merrill Lynch’s Subramanian says the group’s valuation is back to where it stood during the Bill Clinton health-care reform scare, back in the 1990s.

Energy: if you believe that oil appears to have stopped its free fall and price recovery should eventually follow.

High grade Individual taxable and tax free municipal bonds that trade on average at 150% over the taxable U.S treasury bonds (Historically, should only trade at 80% to 90% of 10-year Treasuries) as opposed to bond funds when predicting the end of the 34 year long bull market for bonds.

Exhibit 6. Sizing Up Sectors. Based on 2017 analyst earnings estimate through 09/01/2016, source Bloomberg.

WHAT NOT TO BUY?

If technology has one of the lowest dividend payout ratios, other sectors in my opinion with high-dividend payout ratios should be avoided. Additionally, the big fixed-income price appreciation of the past 34 years has now brought the dividend yield premium of defensive sectors such as utilities and consumer staples (PG, MO, KMB) over cyclical sectors to the lowest level in 20 years.

Exhibit 7. Dividend Yield Premium of Defensive vs. Cyclical Sectors.

In fact, low-volatility stocks have outperformed high volatility stocks by a huge margin since 2009 as this next chart demonstrates.

Exhibit 8. Low Volatility Factor Performance, source JP Morgan.

In general, bond and index funds that doesn’t provide direct ownership of the underlying individual bonds; and therefore, are extremely sensitive to up swings in interest rates.

What this all means to us as investors:

1. Defensive sectors such as utilities and consumer staples with flat to miniscule growth rates, selling at above market multiples of 20 times earnings or more, and have very high dividend payout ratios should be avoided.
2. Bond and index funds should be avoided, and
3. On a positive note, pronounced sector valuation divergence can create terrific buying opportunities for value investors seeking to buy growth at reasonable prices.

The following FOUR MAIN Investment Programs at TAMAR SECURITIES which are specifically designed for FIRST RESPONDERS allow us to execute our discipline:

SO, WHAT IS THE LIKELIHOOD IN THE FIRST PLACE FOR AN OVERALL MARKET RECOVERY SHOULD THE STOCK AND BOND MARKET CORRECT?

The last piece of the puzzle before putting any money to work should include a brief macro economic analysis as to the Likelihood of a stock and bond market Recovery subsequently to a market selloff. In general, from an asset allocation standpoint investors are now faced with an incredible scarcity of attractive asset allocation choices. In particular, the fixed income class is expensive and doesn’t compensate investors, in my view, for the long term interest risk they assume.¹⁷ However, U.S stocks in general look more attractive because their ¹⁸earnings yield, the inverse of the P/E ratio, is now 4.9%-way over the 10-year Treasury yield of 1.7%, and they now pay in dividends more than the yield on the 10-year Treasury. With the exception of short period in 2011/2012, this is something we have not seen in almost fifty years. This is happening at a time when the labor market is showing strength as also evident when U.S initial jobless claims hit new lows, as seen in the next slide.

Exhibit. 9 U.S Initial Jobless Claims, source Bloomberg.

¹⁹Yet, as yields are hitting new lows fresh yearly data from the U.S Census Bureau showed recently that median, inflation adjusted household income rose 5.2% to $56,516 in 2015, the highest level since $57,423 in 2007, when the recession began. The rise in median income was due mainly to an increase in yearly employment of 1.4 million men, and 1 million women. However, even with a 7.3% gain from its post-recession low of $52,666 in 2012, median income was still 2.4% below its inflation-adjusted peak of $57,909 in 1999.

Exhibit. 10 Source: Bloomberg-U.S. Census Bureau Median Household Income. 12/31/2015.

Also, the Atlanta Fed Wage Growth Tracker, which covers workers who have been employed for one year or more, increased to a record 3.6% wage growth in June. This trend can be interoperated as inflationary; and therefore, dangerous for fixed income investments and for interest- rates sensitive segments of the equity market.

Exhibit. 11 Atlanta Fed Wage Growth Tracker, source Bloomberg.

Coupled with moderating productivity gains, as shown next, below the 1% level can lead to additional rising labor costs and inflation.

Exhibit. 12 U.S Nonfarm Business Labor Productivity, source Bloomberg.

This is all happening during a time when cash at both the consumer and the corporate level continues to rapidly approach $11 trillion, as seen in the next slide. This has the potential to back stop stock and bond market declines should it happen.

Exhibit. 13 Federal Reserve U.S Household and Nonprofit Organizations, Total Deposits and Currency, source Bloomberg.

²⁰Additionally, corporate cash pile of non-financial companies rated by Moody’s held 41.68 trillion of cash as of the end of 2015. Not surprisingly, the top five cash holders included all technology names such as Apple, Microsoft, Google, Cisco and Oracle of which our TAV portfolios hold three out of these five. These companies for the first time held $504 billion, equal to 30% of the total non-financial corporate cash balance and up from $404 billion or 25% of the total no-financial cash in 2014.

This is all very important, as the combination of tight labor market and record high cash piles can reinvigorate economic growth and raise inflation expectations.²¹ In fact, rising growth expectations and inflation can actually be positive for equities for as long as, in my opinion, the 10-year Treasury yield is below 4%. In general, there should be a positive correlation between rising yields and rising stock markets. However, above the 4% level the relationship becomes negative. This is because, in the beginning stages of an economic recovery when interest rates go up slowly and consumer confidence increases, stocks are perceived less risky by investors; and therefore, typically appreciate in value more so than the negative effect of interest rates on earnings and investments.

This powerful potential combination of record cash accumulation and increased confidence in economic growth can also jump start a powerful spending cycle. For example, new home sales of single-family homes are already recovering this year.

Exhibit. 14 U.S New One-Family Houses Sold, Annual Total ASSR, source Bloomberg.

And this is happening at a time when U.S Household Net Worth is rapidly approaching $90 trillion, already surpassing the prior peak of approximately $68 trillion in September 2007.

Exhibit. 15 Federal Reserve U.S Household Net Worth, source Bloomberg.

In summary, in my view risk can’t be avoided. However, if analyzed properly risk can be quantified, better understood, hopefully minimized, and if prepared for appropriately taken advantage of. I also believe that it is unwise to apply more of the same risk you take on the job to your retirement assets. It is important, in certain situations to transfer that risk to a professional for the same reason that I won’t even dare to put off a fire myself or take the law into my own hands. You all deserve, like anyone else in the market place, to have more than just few broad funds in order to capitalize on any market dislocation should it happen. Fortunately, the department allows you to have Self Directed 457 Deferred Compensation Plan with Schwab Institutional which is also our firm’s preferred custodian. I will urge all of you here tonight to get prepared for any unresolved market uncertainties and to at least set up this account.

For the purpose of better understanding current market conditions, I do think that the current pending uncertainties are transitory in nature. Therefore, it is my view that any market correction at this point should be looked at as a buying opportunity. On a relative basis, the U.S market seems to be the “best house” in a “bad neighborhood”. And, in today’s context of somewhat positive and improving general macroeconomic environment at home of stronger labor market, high cash balances, and fewer available alternatives for investments, growth equities with a pristine balance sheet, strong cash flow generation, sustainable dividend payouts and relative low multiples look attractive. Also, in my view due to higher inflation and interest rate prospects, bond and index funds as well as defensive, interest rate sensitive equities, should be avoided. I believe that it’s not a question of “if” but “when” the end of the 34-year super cycle for bonds will come to an end.