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1% on 10­year Note?January 13, 2015 David R. Kotok, Chairman and Chief Investment Officer

“What if the Fed doesn’t raise rates at all this year? There’s certainly a good amount of volatilitypossible with the ECB meeting Jan 22, the Greek election Jan 25, and the FOMC announcement Jan28.” – Don Rissmiller, Strategas, Jan. 11.

Don’s question is a valid one, notwithstanding the recent headline numbers from the employmentreport. My colleague Bob Eisenbeis has examined the composition of the Fed’s policymaking body, theFederal Open Market Committee (FOMC). He thinks a slight move up in rates will come beforeyearend. There is no need for me to repeat any of that here. For Bob’s discussion see his recentcommentary at www.cumber.com .

My view is similar to Bob’s and it is the consensus within our firm. I would add that I believe themarkets suffer from dysfunction when the interest rate is zero or very close to zero. As we see it,getting the policy rate up to 0.50% is a way for the Fed to restore market function. At one­half of onepercent, cash earns something instead of nothing. Above zero, choices may be made in the very frontend of the money market curve. Zero does the financial markets and the economy a disservice. Ourfriends in other jurisdictions such as the Eurozone are learning that the hard way.

But what happens to the longer rates once the Fed moves from zero to something else? Willbenchmark long­term rates rise or fall? Some argue for higher rates. They have been doing so foryears, and they have been consistently wrong. Maybe the move to lower longer rates is alreadyanticipating the Fed will move away from zero?

Friend and fishing buddy Gary Shilling has been on the correct side of the bond yield outlook foryears. He says the bond rally that started on 1981 is not over. In his January Insight Gary reaffirmedhis position:

We expect a further rally in Treasury prices with the 30­year yield dropping … to 2%, perhaps by the end of2015. If the 10­year note drops to 1%, as we forecast, the total return would be 12.4%. These may seemlike big gains…. But that’s what happens when yields are low. We believe that “the bond rally of a lifetime”marches on.

Could we see a 1% 10­year Treasury note yield? Maybe. And the sooner the Fed moves away fromzero, the sooner we will know where the market clears and at what yield. It is quite possible thatwe’ll see a short­term rate of 0.50%, an intermediate­term rate between 1% and 2% (it is alreadythere), and a long­term Treasury rate close to 2.0% and between 2% and 3% (it, too, is alreadythere).

Look around the world at 10­year yields in various countries on December 31. In the Eurozone,benchmark Germany was at 0.54%. Netherlands was 0.68%, Austria was 0.71%, France was 0.84%,Italy was 1.88%, and Spain was 1.61%. In Switzerland (which pegs its currency to the euro) the yieldwas 0.37%.

Elsewhere in Europe but not in the Eurozone, Sweden was at 0.94%, Norway was 1.55%, and theUnited Kingdom was 1.76%. And in the country with the highest amount of QE and the largest debt­to­GDP ratio, Japan, the 10­year yield was 0.33%.

Compare these yields with the yield of the 10­year US Treasury benchmark note on December 31. Itwas 2.17%. That’s right, the world’s reserve currency, denominated in the strengthening US dollar, ina country that has ceased QE and is shrinking its federal deficit, was yielding more than the others. Ifyou were sitting abroad and allocating bond monies globally, which bond would you select for yoursovereign­debt global fund? Note that nearly all highest credit quality yields are lower today thanthey were at year end.

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It seems to us that the US Treasury note is the world’s best government bond idea. Is it any wonderthat the bond market rally in Treasury securities continues? And is there any near­term action thatwill change this? It seems the answer is no. Gary Shilling’s courageous and consistent forecast maybe right.

So what is a bond investor to do?

At Cumberland, we elect to use spread product and not Treasuries. We do our own credit researchand make our own individual bond selections. We include Munis (taxable and tax­free) as an option.After 40­plus years, we think we know a little bit about how to examine credit and how to read bondindentures and interpret covenants. And we do some tactical hedging because we do not know whenthis market forecast will change. We are glad that we did not abandon the bond market.

Translate this outlook to the stock market in the United States. Suddenly the stock market doesn’tlook as expensive as many think. Sure the median p/e for an NYSE stock is the highest ever in thepost­war period and has exceeded 1962, 1998 & 2005. (Hat tip to John Melloy @ CNBC whoforwarded Jim Paulsen’s chart.) That reference is worrisome. And sure the ratio of total stock marketvalue in the US compared to US GDP is higher than any other time except for the tech stock bubblepeak 15 years ago. That, too, is worrisome. But those references were in times when the yields onriskless debt were much higher. What about now?

Let’s use a low earnings estimate of about $125 for 2015. At an S&P 500 price of 2250, the earningsyield would be close to 6%, the p/e would be 18. Using a 2% yield for the riskless 10­year Treasurynote, the equity risk premium would be 4 percentage points; @ 1% the equity risk premium would be5. Both are way above the historic equilibrium of about 3%. And S&P dividend yields wouldapproximate the yield on the riskless 10­year note and exceed the yield on cash, even if the Fedraised rates before the end of this year.

Within the US stock market the numbers above reflect the markdown of the energy sector and itsearnings. And they support the notion that the most compelling sector to own is the utility sector,which happens to be Cumberland’s largest overweight in its domestic US ETF portfolios.

In sum, we expect higher volatility in 2015. It has to be so when interest rates are this low and whenthere is a vast gap among various countries, their currencies and their central bank policies.

But higher volatility is bidirectional. It will terrify investors on the downside and exhilarate them onthe upside. 2015 is likely to offer both.

It is going to be an interesting year.

David R. Kotok, Chairman and Chief Investment Officer

Cumberland Advisors is registered with the SEC under the Investment Advisors Act of 1940. All informationcontained herein is for informational purposes only and does not constitute a solicitation or offer to sell securitiesor investment advisory services. Such an offer can only be made in states and/or international jurisdictions whereCumberland Advisors is either registered or is a Notice Filer or where an exemption from such registration or filingis available. New accounts will not be accepted unless and until all local regulations have been satisfied. Thispresentation does not purport to be a complete description of our performance or investment services.

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For a list of all equity recommendations for the past year, please contact Thérèse M. Pantalione at 856­692­6690,ext. 315. It is not our intention to state or imply in any manner that past results and profitability is anindication of future performance. All material presented is compiled from sources believed to be reliable. However,accuracy cannot be guaranteed.

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