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August 8, 2014

Dear Clients and Friends:

 

The Fiduciary Rule

As part of the Dodd-Frank legislation enacted after the most recent financial crisis, the Department of Labor (DOL) and the Securities & Exchange Commission (SEC) were charged with promulgating rules that would place a fiduciary duty on providers of financial advice. The DOL would propose rules for advisors working with retirement plans, such as 401(k)s, and the SEC would propose rules for other advice providers, most commonly brokers and registered investment advisors.

What is a fiduciary? Stated simply, a fiduciary is a person placed in a position of trust to act in the best interest of another party. It is obvious to us that any individual holding out as an advisor, whether to retirement plan participants or to investors in general, should be held to a fiduciary standard. Such is not currently the case. While recent legislation has called for rules that would correct this situation, we are no closer today to investor protection than we were before the crisis. The securities and insurance industries have a significant stake in making sure that any new fiduciary rules are so watered down as to make them meaningless. They want business as usual. Brokers and insurance agents have a fiduciary duty to their employers, not their customers. If they had to comply with the rules that made them fiduciaries, their whole way of business would have to be revamped. This has caused a regulatory standoff with no relief in sight.

The advisors at Schiavi + Dattani have acted as fiduciaries since the firm was founded in 1983. To us, there is no other way to truly provide unbiased financial advice.

 

Investment Return Expectations

Estimating future returns is an important part of the investment process. Unfortunately, many investors use long-term historical averages in setting return expectations, without considering key factors that help to determine prospective returns.

From 1926 to 1999, the compounded annual return of the S&P 500 was 11.3%. However, from 1926 to 1979, it was only 9% and from 1980 to 1999, it was 17.9%. The divergence in returns during these two periods depended heavily upon one major factor, valuation.

Valuation equals the price an investor pays for a given earnings stream, or P/E. As we have written before, a point in time P/E is fairly meaningless, but a cyclically adjusted P/E (CAPE), which averages an earnings stream over a 10-year period, is considered one of the most reliable indicators for forecasting future return possibilities. The results are clear: the higher the starting CAPE value, the lower therange of return outcomes, and the lower the starting CAPE value, the higher the range of return outcomes.

To re-emphasize, CAPE will help to provide a range of outcomes, but should never be viewed as being able to somehow determine a precise outcome. Investors go through periods of time when they are willing to pay more for each dollar of earnings and times they are willing to pay less. Over time, this averages out, but from one point to another, there can be significant divergences from the average CAPE, which, incidentally is around 16.5. In other words, on average, investors are willing to pay 16.5 times each dollar of earnings for a basket of stocks.

The current CAPE of the S&P 500 stands at 25.1, which we have only experienced in a handful of years, mostly in the late 1990s. See chart below:

 

These are the average returns of initial investments at various levels of CAPE of the S&P 500:

 

The current CAPE level of 25.1 suggests meager portfolio returns for U.S. equities over the next decade. This is not a prediction, but a high statistical probability, based on historical data.

The additional fly in the ointment is that U.S. profit margins (i.e. corporate profitability) are at levels that have been previously unsustainable. If these margins revert to their mean (average), it would put additional downside pressure on U.S. stock returns.

While the U.S. market has historically traded at a premium to other countries around the world, currently this premium is at high levels. Holding a globally diversified portfolio is always a prudent strategy. Given the valuation level of the U.S. market relative to others, this cannot be underemphasized.

See CAPEs from various countries below:

 

Source: Zerohedge

To summarize, the starting valuation matters significantly in forecasting a range of returns. The average return or recent performance contains very little or no value in forecasting a range of future returns. CAPE has been a good historical metric, and it currently indicates modest returns going forward in the U.S. market. International markets are priced more favorably, and client portfolios are exposed to benefit from this.

Q & A with the Manager of Ironclad Funds

The Ironclad Managed Risk fund is recommended as a compliment to core equity and core fixed income investments. The fund’s primary strategy is to sell put options to generate income.

We posed the following question to the fund’s manager, Rudy Aguilera:

There are times when Ironclad Managed Risk (IRONX) will underperform a stock/bond mix, as has happened recently.  Can you go into scenarios when the fund will underperform and outperform a standard 60% stock and 40% bond mix?

"Our benchmark (CBOE Put Write Index) has a nearly 30-year history of outperforming equities with significantly less risk, but there are times when equities experience a parabolic rise accompanied with exceedingly low volatility. You can expect IRONX to underperform during these periods. However, this underperformance is transitory as volatility, like a rubber band, cannot be pulled too far below its long-term average without snapping back.

Last year, the realized volatility in the stock market was approximately half its long-term average. There have only been three other years with a more extreme risk/reward relationship (1958, 1995 & 1954). Consequently, it comes as no surprise that a fund designed to manage risk would underperform in such an environment.

IRONX is best viewed as an alternative engine of return, which can bring stability to portfolios throughout the markets ups and downs. No one knows when those ups and downs will occur, but preparing for the inevitable volatility allows clients to rest easier knowing they are on track to meet their financial goals.

It is also worth noting, IRONX is exposed to a different set of risk factors than a traditional stock/bond mix. For this reason, IRONX is an appealing alternative with stocks at record highs, bond yields near record lows, lackluster economic growth and increasing geopolitical risks.

I have included a table below showing the relative performance of our benchmark in different economic environments over the past 28 years."

 

7/1/1986

 

S&P

 

CBOE

 

 

12/1/2013

 

500 TR

 

Put Write Index

 

Difference

 

 

 

 

 

 

 

1986

 

-1.80%

 

2.00%

 

3.80%

1987

 

5.30%

 

-2.50%

 

-7.80%

1988

 

16.60%

 

19.70%

 

3.00%

1989

 

31.70%

 

24.60%

 

-7.10%

1990

 

-3.10%

 

8.90%

 

12.00%

1991

 

30.50%

 

21.30%

 

-9.10%

1992

 

7.60%

 

13.80%

 

6.20%

1993

 

10.10%

 

14.10%

 

4.10%

1994

 

1.30%

 

7.10%

 

5.80%

1995

 

37.60%

 

16.90%

 

-20.70%

1996

 

23.00%

 

16.40%

 

-6.60%

1997

 

33.40%

 

27.70%

 

-5.70%

1998

 

28.60%

 

18.50%

 

-10.00%

1999

 

21.00%

 

21.00%

 

0.00%

2000

 

-9.10%

 

13.10%

 

22.20%

2001

 

-11.90%

 

-10.60%

 

1.30%

2002

 

-22.10%

 

-8.60%

 

13.50%

2003

 

28.70%

 

21.80%

 

-6.90%

2004

 

10.90%

 

9.50%

 

-1.40%

2005

 

4.90%

 

6.70%

 

1.80%

2006

 

15.80%

 

15.20%

 

-0.60%

2007

 

5.50%

 

9.50%

 

4.00%

2008

 

-37.00%

 

-26.80%

 

10.20%

2009

 

26.50%

 

31.50%

 

5.00%

2010

 

15.10%

 

9.00%

 

-6.00%

2011

 

2.10%

 

6.20%

 

4.10%

2012

 

16.00%

 

8.10%

 

-7.90%

2013

 

32.40%

 

12.30%

 

-20.10%

 

 

 

 

 

 

 

Annualized Return

 

10.00%

 

10.40%

 

0.40%

 

 

 

 

 

 

 

Standard Deviation

 

15.50%

 

10.40%

 

-5.20%

 

The PutWrite Index (PUT) vs. the S&P 500 (SPX TR) in the 1990s (1/1/1990-12/31/1999)

 

The PutWrite Index (PUT) vs. S&P 500 (SPX TR) in the 2000s (1/1/2000-12/31/2009)

Source: Rudy Aguilera

 

Children and Grandchildren Consultations – A Gift of Unbiased Advice

A parent never stops caring about the path his or her children are on. The level of caring and responsibility for a child is overwhelming at first. It does seem to decrease with time as they grow more independent, but the caring never really stops. What you care about does. Caring about academic progress is replaced by caring about career progress. Caring about them having enough lunch money is replaced by caring about whether they can afford that new home, or if they can afford to send their children to college.

As we have stated before, we care about what you care about. Clients who recognize a need for their adult child or adult grandchild to receive some unbiased financial advice can suggest an hourly consultation with us. Sometimes that is all it takes to put someone on the path to financial security. Let us know if we can help.

We continue to work daily to earn your trust and confidence.
 

Best Regards,

Vincent A. Schiavi, CFP®, CPA/ PFS                Ravi P. Dattani, CFP®, CPA
President                                                             Vice-President

 


INDEX

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