I’ve been thinking about…emerging trends in portfolio construction

Kenneth R. Solow, CFP®Pinnacle Advisory Group, Inc.PortfolioConstruction Conference 2006

Caveats

This presentation is U.S. centric. The phrase “New Paradigm” belongs to Bob Veres.This presentation reflects the perspective of Pinnacle Advisory Group, Inc. as a Private Wealth Manager.

What is the “old paradigm” of portfolio construction for Registered Investment Advisors?

Equities outperform other asset classes over time. Risk premia are stable and positive.Non-correlated asset classes reduce portfolio risk.Time diversification is the best method of preserving capital.Market timing is impossible.

What is the “old paradigm” of portfolio construction?

Value tilts and small cap tilts add value.Active management by using money managers to invest various asset classes can add value.*Systematic rebalancing adds value.

* Still very controversial among U.S. institutional investors

The New Paradigm (NP) What if…..

Equities don’t always outperform other asset classes over long periods of time and risk premiums are “time varying?”Correlations can spike in bear markets adding surprising volatility to portfolios?Time diversification is a worthless concept in the real world for most retirees?Market timing is necessary and expected by our clients?Traditional style constraints become irrelevant?

Average equity returns are not always returned over 20-year periods.

Source: Crestmont Research, Net total returns including market gains, dividends, & transaction costs of 2%.

Expanding and contracting P/E multiples characterize secular market cycles.

Secular Market DJIA Returns (ex-dividends)

Source: Crestmont Research

12

10

8

6

4

2

60 65 70 75 80 85 90 95 2000 05

12

10

8

6

4

2

40

30

20

10

40

30

20

10

Core* Consumer Prices

Ann%Chg

Ann%Chg

U.S. S&P 500Price-To-Earnings Ratio

* Excluding food and energy.

LONG-RUN OSCILLATION BETWEEN P/E RATIOS AND INFLATION

© BCA Research 2006

?

Inflation and P/E multiples over long time periods.

2

1

0

-1

60 70 80 90 2000

2

1

0

-1

40

30

20

10

40

30

20

10

Liquidity Index

Tight Conditions

Easy Conditions

© BCA Research 2006

U.S. S&P 500Price-To-Earnings Ratio

P/E RATIOS AND LIQUIDITY

Liquidity and P/E multiples over long periods of time

Will Inflation Depress Multiples Going Forward?

Short-term or cyclical market moves within the last secular bear market.

16

14

12

75 80 85 90 95 2000 05

8

4

0

EBIT MARGINS* (LS)REAL GDP (RS)

% Ann%Chg

*EARNINGS BEFORE INTEREST AND TAXES AS A % OF NON-FINANCIAL CORPORATE SECTOR GDP NOTE: BOTH SERIES ARE SHOWN AS 4-QUARTER MOVING AVERAGES

MARGINS ARE CYCLICAL

© BCA Research 2006

Profits are Cyclical

Business Cycles three components-BCA

S&P 500 20-Year Real Returns from Earnings Peaks

S&P 500 Real Returns - 20 Year increments post peak

SP500 CPI Real SP500Peak Month Peak Yr. End Yr. Annualized Annualized AnnualizedDec 1950 1970 7.823 2.355 5.468March 1955 1975 4.201 3.448 0.753March 1959 1979 3.073 4.499 -1.426March 1966 1986 5.044 6.29 -1.246March 1973 1993 7.238 6.15 1.088Sept 1977 1997 12.087 4.95 7.137June 1984 2004 10.552 3.05 7.502Dec 1988 0731/2006 9.057 2.994 6.063Sept 1997 0731/2006 3.434 2.628 0.806

Mean 6.95 4.04 2.91

March 2006, Financial Planning, “Test Your Tactical IQ”

1.Fully invest the stock allocation. The “New Economy” really does exist.2.Underweight stocks versus the benchmark. Little to no chance of getting avg. historic returns over the next twenty years. Find a better idea.3.Adjust my portfolio modeling software for lower returns, but make sure that client’s don’t think I’m market timing.4.Trick question. The value of my client relationships has nothing to do with stock market returns.

If the stock market were to reach a forward P/E of 28, which portfolio construction strategy would you pursue?

Predictions, Forecasts, and Guarantees

Random House Webster’s Dictionary defines forecast as, “to predict, by observation or study; however it is most often used of phenomena that cannot be accurately predicted: Rain is forecast for tonight.”

Ben Bernanke, U.S. Federal Reserve Chairman, July 19th Congressional Testimony

“The lags between policy actions and their effects imply that we must be forward looking.”

Bill Gross, Managing Director PIMCO , Investment Outlook, August 2006

“ …..tricky business this forecasting. Even when posing as a long-term oracle as Francis Fukuyama did when he wrote his famous The End of History and the Last Man in 1989, the world can zig and zag and stone you intellectually faster than you can say Islamic radicalism. I shall don sufficient armor and prepare to be stoned.”

NP Advisors CAN Predict the Future!

SAA Prediction: A 60-40 portfolio construction will deliver a 5% premium over inflation over time.

NP Prediction: Buying the stock market when multiples are high will lead to less than average returns over secular time periods. Restrictive monetary policy & inflation will result in lower multiples.

Current Example of Possible Mispricing #1?

Current Example of Possible Mispricing #2?

2.0

1.8

1.6

1.4

1.2

1979 1984 1989 1994 1999 2004

2.0

1.8

1.6

1.4

1.2

S&P 600* / WILSHIRE 5000TrendTrend +/- Two Standard Deviations

*Russel 2000 shown prior to 1990, rebased to starting point of S&P 600.

© BCA Research 2006

If This Makes So Much Sense, Then Why Can’t We Talk About it?

Academics can’t tell us how to do it. Subjective decision making. Implication that all advisors can’t be equal as money managers.Terrible business model that implies significant additional expense.Unnecessary to grow business in robust FA market place.Business risk if clients misperceive the meaning of a forecast.

Market Valuation Methodologies

Discounted earnings, cash flow, dividendsP/E relative to historic meanEarnings yields relative to bond yields (Fed Model)Derivations of Fed ModelForward, trailing, normalized earningsOperating, GAAP, Core earnings

Market Cycle Methodologies: Consumer Spending as Leading Indicator

Real wagesHousing valuesInterest ratesOil and gas pricesHome equity extraction

Market Cycle Methodologies: Bond Market as Leading Indicator

Inflation indicatorsMoney supplyYield spreadsYield curveNew issuance

Three Methodologies For Constructing New Paradigm Portfolios

1. Outsource to larger more experienced firms, or follow outside research/asset allocation service with no in-house analysis.

2. Strategically own non-style constrained money managers.

3. Use in-house analysis to change portfolio construction based on valuation and market cycle.

“Strategic” NP Portfolio ConstructionBest 12-month return: 19.8%Worst 12 month return: -2.9%

3-yr Standard Deviation:Portfolio 3.65S&P 500 7.82

3-yr MPT Stats (vs S&P500)Alpha 4.3Beta 0.33R-Squared 51

3-yr % Ann. Returns thru 6-30-06Portfolio 10.08S&P 500 11.223 mo. T-Bills 2.3

Absolute Return Allocation

Long/Short Equity35%

Market Neutral Equity10%

Hedge Fund of Funds10%

Flexible Fixed Income

30%

Diversified Commodities

5%

T-bills10%

Client Expectation: Short-term- positive rolling 12-month return, Long-term – Beat T-Bill Return.

In-House Analysis NP Portfolio Construction: Early Cycle

Early Cycle Allocation

U.S. Large Cap25%

Cyclical Sector 15%

Cyclical Sector 25%

U.S. Mid/Small-Cap15%

Foreign Large Cap10%

Foreign Mid/Small-Cap5%

Emerging Markets5%

Bonds20%

Alternative Investments

10%

Cash0%

Benchmark: 60% Equity. Rotated to 70% equity, Emphasis on beta, small-cap, cyclical sectors.

In-House Analysis NP Portfolio Construction: Late Cycle

Late Cycle Allocation

U.S. Large Cap20%

Defensive Sector 15%

Defensive Sector 25%

U.S. Mid/Small-Cap5%

Foreign Large Cap5%

Alternative Investments

15%

Emerging Markets0%

Bonds35%

Foreign Mid/Small-Cap3%

Cash7%

Benchmark: 60% Equity. Rotated to 43% equity, Emphasis on Large-cap & defensive sectors, 42% fixed, 15% alternatives

Becoming an Investment Expert BCA Global Investment Strategy, BCA ResearchBCA Equity Sector Strategy, BCA ResearchThe Bank Credit Analyst, BCA ResearchJohn Kosar, Asbury ResearchJohn Mendelson, Stanford Research CompanyFrancios Trahan, Bear, Stearns & Co. IncLiz Ann Sonders, Charles Schwab and Co, Inc.John Roque, Natexis Bleichroeder, Inc.Jim Bianco, Bianco ResearchBrian Reynolds, MS HowellsBill King, M. Ramsey King Securities, Inc.Steven Roach, Morgan StanleyDick Berner, Morgan StanleyJohn Mauldin, InvestorsInsight Publishing, Inc.Jim Grant, Grant's Interest Rate ObserverGloom Boom & Doom report, Marc Faber LimitedKen Tower, CybertraderBill Gross, PIMCOPaul McCulley, PIMCOVan R. Hoisington, Lacy H. Hunt, Van Hoisington Investment Management CompanyEd Yardeni, Oak Associates, ltd.Business Week Magazine

Summary and Conclusion

Strategic asset allocation may not always be the best investment strategy.If advisors believe that risk premiums can vary, then other investment strategies may be appropriate.New trends in portfolio construction will evolve where forecasting is an accepted method for managing portfolio risk.Advisors will have many choices in determining how they will participate in NP investment strategies.

I’ve been thinking about…emerging trends in portfolio construction

Kenneth R. Solow, CFP®Pinnacle Advisory Group, Inc.PortfolioConstruction Conference 2006