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MARKET REVIEW AND ECONOMIC OUTLOOK
2014
“I have always considered a bet on ever‐rising U.S. prosperity to be very close to a sure thing……..who has ever benefitted during the past 237 years by betting against America………America’s best days lie ahead” – Warren Buffet, Berkshire Hathaway 2013 Year‐End Letter to Shareholders
The first quarter of 2014 ended on a positive note, with the major U.S. stock market indices logging their 5th straight
quarterly gains. The S&P 500 was up 1.81% for the quarter, closing at a new all-time high. The market index pulled
back almost 7% in January, marking the 19th drop of 5% or more in the current bull market. However, the pullback
never entered the official “correction” territory of a 10% decline, an occurrence last seen in the 3rd quarter of 2011.
There were two relatively big stories in the quarter, with one being Putin’s invasion of Crimea and subsequent standoff
with Ukraine. While geopolitical events can be inherently difficult to handicap on a short-term basis, the U.S. markets
seemed to take these developments in stride as the major indices moved to new highs. Unfortunately, there have been
bad things happening in the world since the founding of our country, but the U.S. economy has always found a way to
chug forward through crisis after crisis. With our usual caveat that markets don’t go straight up forever, and we
eventually will experience another real correction, we don’t believe this situation will be any different.
The second big story of the quarter was the appointment of Janet Yellen to replace Ben Bernanke as Fed chairman.
While the chairman of the Federal Reserve Board of Governors does have considerable influence over monetary
policy, there are seven members on the board, and Janet Yellen has been one of the seven for a decade (the last four
as vice-chair). The most likely outcome of this situation is that there will be very little change in Fed policy, a belief that
the market seems to share based on the lack of market reaction to the change in Fed leadership.
One of the most stunning developments of the year came in early April,
April when Greece issued 5-year bonds at a
shockingly low rate of 4.75%. This is the same country that effectively defaulted on their debt two short years ago and
hit their bondholders with massive losses of principle. It’s the same country that is still relying on bailouts from the rest
of Europe to stay afloat. We have written in recent newsletters about our concerns in the so-called high-yield or junk
sectors of the bond market, and this new deal from Greece does nothing to quell those concerns. Investors who are
scrambling to find yield in the bond market are accepting a risk level that is higher than the major U.S. stock indices, in
return for an annual yield that is less than half of the 10-11% that stocks have historically provided over the long term.
An investor who put money into the S&P 500 (U.S. stocks) at the beginning of 2008 (which would have been historically
bad timing), has now seen their portfolio grow to new highs. An investor who put money into Greek bonds at the
beginning of 2008 could have experienced a permanent loss of capital exceeding 50%.
What’s been very interesting about the market’s ascent over the last 5 years is the fact that this continues to be one of
the most unloved bull markets in history. Five years ago there was a very sharp division in opinions about how the
economic crisis would play out, and investors were divided into two camps. One camp (which Bowling belonged to)
believed that eventually the resiliency of the U.S. economy would kick in, capitalism would prove once again to be the
best (not perfect, but best) economic system thus far invented, and investors were best served by sticking with the
financial markets. The second camp bought into the doom and gloom prognosticators who were predicting the end of
western civilization as we know it.
It’s beginning to look more and more that the camp that bought into the worst-case-scenario back in 2009 has
permanently impaired themselves, either professionally or personally. It’s increasingly possible that 2009 will prove to
be a multi-generational low that will not be seen again in our lifetime (or ever for that matter). Investment advisors who
missed the recovery are now in a very, very delicate predicament: either admit to your clients that you have been wrong
or cling to your forecast of doom and gloom.
This predicament has led to the rise of increasingly obtuse ways to frighten people. The latter part of 2013 saw what
some market technicians call the Hindenburg Omen that was supposed to predict a market crash. This particular omen
is a group of obscure technical indicators that must occur in certain combinations and in a particular order. Just reading
about how this indicator is put together is laughable, but there it was on Forbes.com in August of last year. Of course, it
didn’t come true, nor did the several other Hindenburg Omens triggered during the current bull market.
SECOND QUARTER 2014 MARKET OUTLOOK
After the Hindenburg Omen didn’t pan out, parts of the financial press turned their attention to the so-called 1929 chart,
which compared the stock market’s recent rise to that of the market heading up to the market crash in 1929. The
rationale for this had nothing to do with any type of financial or economic analysis; it was simply an observation of the
similarity of stock market charts between 1929 and 2013. By contorting the scales for the two time periods, and laying
the two groups of data on top of each other in a line chart, it was suggested that the stock market charts were very
similar
i il and
d that
th t we were heading
h di
f a 1929-style
for
1929 t l market
k t crash
h that
th t was supposed
d to
t happen
h
i February
in
F b
off 2013.
2013
Despite the absurdity of such a simplistic approach, and the fact that nothing about our economy and financial system
today looks anything like it did 85 years ago, this chart got quite a bit of play in the financial press in the first quarter of
2014.
When the 1929 comparison didn’t pan out, USA Today joined the fray in early April, claiming that we could be a mere
37 trading days from a 1987-style market crash. As with the 1929 comparison, USA Today’s only basis for this was a
comparison of stock market charts. We at Bowling have taken a look at these two charts, and the only similarity we
can see is
i that
th t both
b th charts
h t are going
i up. Considering
C
id i the
th fact
f t that
th t the
th stock
t k market
k t is
i up approximately
i t l 255,553%
255 553% (that
(th t
is not a misprint!) since 1928, it’s not exceedingly difficult to find chart comparisons to the recent bull market. What’s
interesting is that the only comparisons that seem to make the headlines are the ones most likely to scare investors.
All of the preceding are examples of what would be called technical analysis, which is more or less a study of stock
market chart and data patterns. As with staring at the clouds on a beautiful spring day, with this type of analysis you
can more or less see what you want to see. There is a concept called data mining, which basically means that if you
look hard enough at historical patterns, you will eventually find something to prove whatever you want. It’s our belief,
as has
h been
b
proven true
t
over time,
ti
th t this
that
thi type
t
off analysis
l i is
i simplistic,
i li ti nott rigorous
i
i any way, and
in
d simply
i l does
d
nott
work.
If you don’t believe us, take a look at the Forbes list of the 100 richest people in the U.S., which was updated in January
of 2014 (you can easily find it through Google). As you peruse this list, what you see are people that mostly achieved
their wealth through ownership in a business enterprise, either directly or through the stock market. At the top of the list
you see Bill Gates, who got rich through his ownership position in Microsoft stock, and Warren Buffet, one of the
world’s great long-term investors. You see people like Michael Dell (Dell computers), Larry Ellison (Oracle) and the
W lt family
Walton
f il (Wal-mart),
(W l
t) who
h allll gott rich
i h by
b owning
i stock
t k in
i the
th company they
th run. What
Wh t you don’t
d ’t see on the
th list
li t are
technical analysts, economists, market timers, and media pundits.
The Stock Market’s Going Up on Nothing……Except Corporate Earnings, Dividends, Increasing Book Values,
Housing, and Unemployment
There is a well-documented behavioral bias called anchoring that all investors must face. This concept basically refers
to the tendency of most investors to let past events bias their expectations for the future. This tendency tends to be
magnified when investors have been wrong in their past assumptions.
assumptions Rather than accepting past investment
decisions for what they are, whether good or bad, many investors look for excuses to rationalize mistakes they have
made. This manifests itself into thoughts such as “I’m not wrong, just early”, and “if it weren’t for that meddling Federal
Reserve!”
One comment we hear quite regularly, both in the media and in our personal lives, is the concept that the stock market
has been going up on “nothing”. This is almost always stated, not as a question, but as a certainty. It’s usually
something along the lines of “we all know the market is going up on nothing” or “it’s only a matter of time before the
market goes back down
down”. It
It’ss always posited by someone who has been out of the market,
market and has missed the stellar
gains of last year. This type of behavior is a way to rationalize the choice they made to sit on the sidelines last year.
The financial markets however, are capitalistic and have a much shorter memory. Stock market prices are the
equilibrium of trillions of investment dollars, with each investment being a reflection of an investor’s available
information and future predictions. The market is constantly trying to predict where the economy (and corporate
earnings) will go, not where it’s been. Simply relying on a return to the recent past is a very poor investment
strategy.
IIn reality,
li the
h market
k has
h rallied
lli d to new all-time
ll i
hi h because
highs
b
earnings,
i
di id d and
dividends,
d corporate America’s
A
i
b k
book
values (the accounting value of a firm’s assets) have also moved up to all time highs. This can be summarized in the
following chart.
SECOND QUARTER 2014 MARKET OUTLOOK
2007 Value
S&P 500 Operating Earnings Per Share
S&P 500 Dividends per Share
S&P 500 Book Value per Share (Year End)
S&P 500 Index Value (Year End)
$82.54
2013 Value
Percentage Change
$107.30
30%
$27.73
$34.99
26%
$529.59
$693.22
31%
1,468
1,848
26%
When you look at the table above, you can see that the stock market’s recovery and rise to new highs is, in fact, well
supported by earnings, dividends, and increases in book value. Operating earnings per share increased 30% between
2007-2013, and book value increased 31% Dividends increased 26% over this time horizon, which is right in line with
the S&P 500 index gain of 26%. To suggest that the stock market’s rise is irrational chooses to completely ignore the
cold, hard facts.
Things like the unemployment rate and the housing market aren
aren’tt as directly linked to stock prices as are the above
metrics. However, indirectly they are crucial, as jobs tend to lead to home ownership, which in turn leads to consumers
buying all of the stuff they need for their house. The U.S. job market continues to show slow improvement, with U.S.
payrolls at all-time highs and the unemployment rate nudging down to 6.7% in the first quarter (significantly below the
official unemployment rate of 10.0% in October of 2009). For the week ended April 10th, unemployment claims
reached their lowest level since May 2007.
One thing we will concede to the naysayers, however, is that despite all of the improvements noted above, economic
conditions in the U.S. (or world for that matter) remain far from ideal. The jobless rate, while improved, is still higher
than what is considered “normal” in a healthy economy, and the underemployment rate is much higher. An alternate
measure of the unemployment rate that includes the under-employed and those who have quit looking for jobs is
estimated to be closer to 12%. We all know recent college graduates who are having difficulty getting their careers
started and taking temporary jobs that don’t require a college degree. If you talk to business owners, virtually no one
would say the economy is humming right now.
However, from purely a market standpoint, the slack in the U.S. labor market and U.S. economy is actually reason for
optimism. Despite all of the hemming and hawing in the financial press, in the long run stock market prices are driven
by corporate earnings. Earnings are a function of both demand for a company’s products and its ability to efficiently
produce enough of its product to meet that demand. We believe that the slack in the U.S. economy and labor market
provides plenty of room for consumer demand to pick up, and gives U.S. corporations the resources to meet that
demand.
Velocity of Money and Fed Policy
It’s not uncommon to hear those that have missed the last several years of market gains to blame their predicament on
th Fed.
the
F d The
Th criticism
iti i
h been
has
b
th t the
that
th Fed
F d has
h been
b
“ i ti money”” through
“printing
th
h quantitative
tit ti easing,
i
which
hi h in
i turn
t
i
is
creating “artificial” demand which will eventually lead to hyperinflation and the return of the gold standard. The problem
with this logic is that it focuses only on the supply of money, and completely ignores the velocity of money through our
economy.
SECOND QUARTER 2014 MARKET OUTLOOK
The money velocity chart, which is taken directly from Federal Reserve data, shows the velocity of money in the U.S.
economy over the last 55 years or so. The money supply referred to would include liquid assets such as checking
accounts, savings accounts, money market funds, and short-term CDs. The velocity of the money supply is essentially
telling us how many times the average dollar changes hands over the course of the year. When confidence is high,
dollars tend to change hands relatively quickly as we buy and sell goods and services to each other. When confidence
is low, people tend to hoard their cash which lowers the velocity of money.
As you can see from this chart, the velocity of money through the U.S. economy has been at modern-era lows for the
last several years. To counteract this historically low velocity of money, the only choice the Fed has had the last
several years is to increase the quantity of liquid money (aka quantitative easing). To be absolutely clear, it’s virtually
impossible to have hyperinflation and dollar devaluation at these historically low levels of money velocity.
As economic factors like GDP growth, unemployment, and the velocity of money improve, the Fed will gradually back
off of its quantitative easing program.
program If done successfully,
successfully the net result would be to keep the economy on a relatively
even keel, creating neither hyperinflation nor deflation. There may be bumps in the road as the Fed backs off from the
unprecedented monetary stimulus we have seen over the last several years, but betting against the Fed is a losing
proposition in the long run.
Fear of Success
One other comment we hear bantered about quite a bit is the concept of new stock market highs actually being a
negative event and a reason for concern. There is a perception by some that the historically bad decade stocks
experienced between 2000 and 2010 is somehow the “new
new normal
normal”, that after several hundred years of progress the
stock market and economy have reached their upper bounds, and stocks will eventually succumb to gravity and give up
the recent market gains. The idea of new highs being bad for the market is patently false, conflicts with market history
over the last 100 years, and is another manifestation of the anchoring bias mentioned previously.
The reality is that new highs in the stock market tend to lead to more new highs, and it’s not unusual to see years and
years of new highs following a decade as bad as what we experienced from 2000-2010. In the decade leading up to
1952, the Dow Jones Industrial Average logged exactly zero new all-time highs. In the subsequent 14 years, the Dow
logged 279 all-time
all time highs.
highs Between 1966 and 1982,
1982 the Dow logged only 27 new highs,
highs but then between 1983 and
1999 it logged 492 (an average of almost 29 per year!).
More recently, the S&P 500 logged only 8 new all-time highs between 2000 and 2012, but then logged 50 in 2013. Like
many other things in life, these things tend to go in cycles, and stock market cycles can last for quite a while. Based on
history, the reality is that we may be due for an extended period of all-time highs over the coming decade. Will we
repeat the 279 all-time highs experienced in the Dow from 1952-1965, or the 492 logged between 1983 and 1999?
Only time will tell, but it certainly wouldn’t be unprecedented.
One thing we do know is that strong stock returns in a given year stack the odds in an investor’s favor the following
year. Since 1924, there have been 22 calendar years during which the Dow Jones Industrial Average rose more than
20%. If you look at each of the years following these strong returns, 69% of the time the market posted another gain.
What’s more, the average return following one of these very strong years is actually half a percentage point higher than
the overall average since 1924.
.
BOWLING PORTFOLIO MANAGEMENT LLC 4030 SMITH ROAD SUITE 140
(513) 871-7776
WWW.BOWLINGPM.COM
CINCINNATI, OH 45209
This report is provided for informational purposes only and should not be construed as a recommendation for the purchase or sale of any
security nor should it be construed as a recommendation of any investment strategy. There is no guarantee that any opinion, forecast,
estimate or objective will be achieved. Certain information has been obtained from sources that we believe to be reliable: however, we do
not guarantee the accuracy or completeness of such information. Opinions and estimates offered constitute our judgment and are
subject to change without notice, as are statements of financial market trends, which are based on current market conditions.
Q1
2014
BOWLING PORTFOLIO MANAGEMENT LLC
LARGE CAP EQUITY COMPOSITE
ANNUAL DISCLOSURE PRESENTATION
Year
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Cumulative*
Annualized*
Gross of
Fee
Return
19.05
15 01
15.01
15.85
12.72
-38.36
27.67
13.54
-2.21
16.44
42.25
2709.38%
13.68%
Net of Fee
Return
17.85
13 88
13.88
14.79
11.70
-38.95
26.51
12.55
-2.99
15.61
41.11
1996.44%
12.42%
Russell
S&P 500
1000 Index
Index
11.40
10.88
6 27
6.27
4 91
4.91
15.46
15.79
5.77
5.49
-37.60
-37.00
28.43
26.46
16.10
15.06
1.50
2.11
16.42
16.00
33.11
32.38
1306.20% 1241.77%
10.70%
10.50%
Number of
Portfolios
398
472
541
613
528
500
469
438
233
230
Annual
Composite
Dispersion
1.37
1 14
1.14
1.12
1.20
1.08
1.05
0.31
0.55
0.47
0.38
Composite Assets
End of Period
($Millions)
233.4
311 1
311.1
392.3
460.7
242.0
279.3
285.1
283.5
187.3
185.4
Percent
of
Firm Asset
75.6
78 1
78.1
75.0
75.7
65.4
69.3
70.2
73.5
46.7
41.1
•Cumulative and annualized performance is calculated since inception (01/01/88) through 12/31/13______________________
PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS.
Bowling Portfolio Management LLC claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared
and presented this report in compliance with the GIPS standards. Bowling Portfolio Management LLC has been independently
verified for the periods January 1, 2006 through December 31, 2013 by Ashland Partners & Company LLP and for the period January
1, 1988 through December 31, 2005 by Deloitte & Touche, LLP.
Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a
firm-wide basis and (2) the firm’s policies and procedures are designed to calculate and present performance in compliance with the
GIPS standards. The Large Cap Equity composite has been examined for the periods January 1, 2006 through December 31, 2013
by Ashland Partners & Company LLP and for the period January 1, 1988 through December 31, 2005 by Deloitte and Touche, LLP.
The verification and performance examination reports are available upon request.
1.
2.
3.
4.
5
5.
6.
7.
8.
9.
Bowling Portfolio Management LLC (“Firm”) is an investment management firm serving both tax-exempt and taxable clients,
offering a variety of investment management strategies. The Firm is an SEC-registered investment adviser and is dedicated to
the practice of professional investment management
management. Bowling Portfolio Management
Management, Inc
Inc. was founded in 1982 and began
managing equity accounts January 1, 1988. Effective July 1, 2001, Bowling Portfolio Management, Inc., became Bowling
Portfolio Management, an independently operated division of The Renaissance Group LLC (“Renaissance”). Effective
December 31, 2004, the Firm became a stand-alone entity and was no longer a division of Renaissance. The composite of
Large Cap Equity portfolios was created July 1, 1994.
The Large Cap Equity Composite includes the portfolios of all tax-exempt clients for which the Firm has full discretionary
authority to manage in a diversified portfolio of large cap equities. Portfolios below $50,000 are excluded from the composite.
Beginning January 1, 2012 all taxable accounts are excluded from the composite.
Performance results are calculated both gross and net of management fees. Gross returns include the reinvestment of income
and are gross of the firm’s management fees; they are reduced by transaction costs and administration fees. Net returns reflect
the deduction of actual management fees. Beginning January 1, 2004 the composite contained bundled fee accounts which pay
a fee based on a percentage of assets. This fee solely includes brokerage commissions. The percentage of composite market
value of these bundled fee accounts at the end of each period is as follows: 2004: 19%, 2005: 8%, 2006: 2%, 2007: 2%, 2008:
2%. Beginning July 1, 2009, all fully discretionary, large cap equity accounts participating in a wrap or bundled fee program were
removed from the composite. The fee schedule is as follows: 2% of the first $500,000, 1% of the amount above $500,000, and a
flat 1% on all accounts above $1,000,000. Varying terms may be negotiated. Performance is expressed in U.S. Dollars. Aftertax results may vary from the returns presented here for those portfolios that are subject to taxation.
Annual composite dispersion is calculated using the asset-weighted
standard deviation of gross results for those accounts in the
.
composite for the entire year.
Th
The b
benchmark
h
k ffor th
the Fi
Firm’s
’ L
Large C
Cap E
Equity
it St
Strategy
t
iis th
the R
Russellll 1000 IIndex
d which
hi h iis an asset-weighted
t
i ht d iindex
d off llarge
U.S. based companies that includes income but does not have any expenses. Prior to January 1, 2014, the benchmark for the
Firm’s Large Cap Equity Strategy was the Standard & Poor’s 500 Index which is an asset-weighted index of large U.S. based
companies that includes income but does not have any expenses. Effective January 1, 2014 the benchmark changed to the
Russell 1000 Index due to the fact that it was now the selection universe for the product and therefore a better comparison. Prior
to September 30, 2005, presentations included the Standard & Poor’s 500/Barra Value and the Standard and Poor’s 500 indices.
The Standard & Poor’s 500/Barra Value is no longer included in the presentation as the index is no longer available.
A complete list and description of the Firm’s composites is available upon request. From January 1, 2008 through January 1,
2014 the composite was named the Large Cap Core Value Composite. From January 1, 2005 through January 1, 2008, the
composite was named the Large Cap Equity Composite. Prior to January 1, 2005, the composite was named the Large Cap
Value Composite.
For all periods presented, the composite contains non-fee paying accounts. The percentage of composite market value of these
non-fee paying accounts is less than 1% at the end of each period listed, 2004 through 2011. The percentages for the other
periods are as follows: 2012: 1.2%, 2013: 1.9%.
Policies for valuing portfolios, calculating performance and preparing compliant presentations are available upon request.
3 Year Annualized Ex-Post Standard Deviation for the composite is as follows: 2011: 18.82%, 2012: 16.85%, 2013: 14.59%.
3 Year Annualized Ex-Post Standard Deviation for the benchmark is as follows: 2011: 18.70%, 2012: 15.09%, 2013: 12.26%.