December 2014 Quarter Review

GKV Capital Management
Economic and
Investment Outlook
Fourth Quarter 2014
2014 Year End Review
Managing Expectations
Dealing With Unpredictability
Market Expectations in 2015
GKV Capital Management
A note from:
PETER VOGEL
The bull market continued through 2014, however, it gave
several deceptive moments of ending in a sharp downward
correction. Although the S&P 500 index advanced by 12% last
year it was not a smooth ride. The Ukraine crisis, geopolitical
tensions, collapsing oil, diminishing growth around the world
except in the United States and the termination of the Federal
Reserve bond buying program, and even an Ebola outbreak
caused periodic episodes of selling during 2014.
Because the bull market was into its fifth year of recovery from
its nadir in March 2009, the brief stock market paroxysms described above caused us twice to modestly increase cash reserves and decrease common stock exposure in portfolios. Twice we were wrong. On several occasions the
stock market very swiftly fell by more than 5% last year, but it remained resilient and
recovered these losses in equally swift ascensions. For long-term investing, patience
and selection are critical variables to achieve investment success. In the short-term
timing is an additional critical variable. Preservation of capital is a primary investment objective in our portfolios. During the two short but sharp stock price collapses
in the first few quarters of 2014 we decreased common stock investments by about
10%. This action proved unnecessary and the reinvesting of these funds back into
equities caused a reduction for the year in our common stock investment performance each time by about 2%.
In 2007/2008 our quick determination of a change in economic and financial fundamentals allowed us to preserve client assets and to dramatically outperform the S&P
500 index in 2008. The increasingly pervasive high-frequency trading in the stock
market has resulted in sudden, overly exaggerated stock price spasms, and twice in
the first three quarters of 2014 we were fooled into believing these quick drops in
prices were perhaps the harbinger of more long term adverse economic and financial changes. This was not the case, but our modest realignment of stock portfolios
last year caused us to underperform the major stock market averages.
Although our goal is to achieve performance commensurate with the major indices,
this objective is superseded by the need to preserve capital and minimize risk. With
this philosophy we will usually underperform a surging bull market but outperform a
stable to declining one.
If you wish to further discuss our financial outlook and how it pertains to your personal situation, please do not hesitate to contact me at [email protected].
President and Chief Investment Officer
GKV Capital Management is an independent registered investment advisor.
For more information about us please call (805) 497-2616 or visit gkvcapital.com
Page 2
4Q14 Data Points
DJIA YTD
7.5%
S&P 500 YTD
11.4%
NASDAQ YTD
13.4%
Int-Term
Bond YTD
4.4%
10-Year
Treasury Yield
2.2%
S&P 500 LTM 2.0%
Dividend Yield
S&P 500 EPS
2015 EST
$131.14
S&P 500 P/E
15.9x
Fourth Quarter 2014
Fourth Quarter Review
Looking at the year-end results, 2014 was another positive
year for investors. However, beneath the surface investors
experienced a rollercoaster ride with two major sell-offs
that threatened to wipe out all of the gains for the year.
After a sharp sell-off in July and again at the end of September, the major indices pushed forward resulting in gains of
11.4% for the S&P 500, 7.5% for the Dow Industrials, and
13.4% for the Nasdaq Composite.
It was for us, a difficult year for investment in stocks. The
strong run-up in equity valuations in 2013 assumed economic strength in 2014 and into 2015, and was influenced
positively by massive economic stimulus. Instead of accelerating growth, economic activity has been merely tepid with
a weakening global outlook. The U.S. has remained stronger
than the rest of the developed world, but we cannot carry
the entire global economy on our own. Additionally the Federal Reserve continued to reduce stimulus finally ending its
bond purchase program.
consumer spending. U.S. GDP grew by 5% in the September
quarter raising expectations that the economic recovery was
gaining traction. In the fourth quarter GDP growth increased
at an annualized 2.6% rate to bring the full year GDP growth
to 2.4%. The fourth quarter growth was driven by a strong
acceleration in spending on services and non-durable goods.
Corporate earnings throughout 2014 were generally positive
due largely to historically high profit margins. Companies
have remained lean throughout this recovery but there is no
Firm Wide Asset Allocation December 31, 2014
The market was driven forward largely by positive macroeconomic data, particularly by positive employment and
Source: GKV Capital Management
Ten Year Time Weighted GKV Performance of $100,000
Page 3
Source: GKV Capital Management
GKV Capital Management
room for increased profits without increased sales. In fact,
expectations of strengthening sales never really materialized in 2014 causing earnings forecasts to be reduced
throughout the year marginally. For example, earnings estimates on the S&P 500 for 2014 began the year at $121.48
and by December 31st had been revised down to $116.66.
While the revised forecast still reflects positive annual earnings growth, we are still waiting for the much anticipated
economic reacceleration.
Healthcare, biotech, utilities and consumer-oriented shares
outperformed in 2014. Energy companies declined sharply
in the fourth quarter as the price of oil fell through the floor.
The NYSE energy index declined 14% for the year.
While geopolitical headline risks seemed to have lessened in
the second half of 2014, global economic data has become
increasingly negative raising new concerns for global growth
prospects and how they might impact U.S. companies. More
important has been slowing global GDP growth coupled
with a strengthening of the dollar, which reached its highest
point in more than four years. While the strength of the
dollar is a positive reflection of the strength of the U.S.
economy relative to the rest of the world, it has a negative
effect on corporate profits for U.S. based companies exporting goods abroad and repatriating foreign profits.
rate environment in the long-term, our expectation is predicated on the long awaited acceleration in economic growth.
At the current rate, we should anticipate interest rates to
remain near current levels through the summer. The low
interest rates have had a very positive impact on significant
bond holdings in 2014 resulting in fixed income gains of
4.6% for the year.
The dramatic drop in the price of oil and energy prices in
general resulted in a 0.3% decline in consumer prices in November. Low inflation, a strong dollar and slow growth will
likely keep interest rates low.
For 2014, positive performance in stocks was largely limited
to the U.S. markets. Economic slowdown in China, continued malaise in Europe, and the expectation of rising interest
rates in the U.S. resulting in a strengthening dollar all contributed to a sell-off in international markets. The DOW
Global-excluding U.S. index posted a decline of 5.5% for the
year.
Our exposure to equities overall remains significant, closing
the year with 53% of assets under management in equities,
38% in fixed income and only 4% in cash. The remaining 5%
is in various real estate investments.
Interest rates remain low with a 2.2% yield for the 10-year
Treasury. While we continue to anticipate a rising interest
GKV Performance
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
GKV
Bonds
2.0%
4.5%
4.7%
-1.6%
9.9%
5.4%
5.0%
6.9%
2.5%
6.5%
Int Term
Bonds
1.8%
4.2%
4.7%
-4.7%
14.0%
7.7%
5.9%
6.9%
0.0%
4.4%
GKV
Stocks
5.7%
9.1%
17.4%
-36.4%
28.1%
5.23%
3.0%
8.1%
28.5%
5.0%
S&P 500
3.0%
13.6%
3.5%
-38.5%
23.5%
12.9%
0.0%
13.4%
29.6%
11.4%
GKV Total
Acct*
2.5%
5.0%
8.0%
-8.3%
9.2%
3.7%
3.2%
5.4%
12.2%
4.9%
10 Year Total
2004-2014 Annual
56.1%
4.6%
53.4%
4.4%
74.4%
5.7%
69.6%
5.4%
54.4%
4.4%
Source: GKV Capital Management, December 31st, 2014
*GKV Total Account Performance calculated after fees
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Fourth Quarter 2014
Managing Expectations
“The financial markets generally are unpredictable. So that one has to have different scenarios... The idea
that you can actually predict what's going to happen contradicts my way of looking at the market.”
- George Soros
“Generally unpredictable.” We find it hard to believe that
Mr. Soros fully believes the quote attributed to him
above. After all, what reasonable person commits vast
sums of wealth to something unpredictable? We suppose
it would depend on a broad or narrow interpretation of
what is meant by the word “generally.” While the quote
may be easily misinterpreted out of context, we are in
agreement with Mr. Soros. The markets are generally unpredictable and anyone stating that they “know” with any
certainty future investment returns doesn’t really know
anything. And while predictions, both ours and others, are
continually wrong, the overall long-term trend has been
consistent. Investors make money over time with patience and diligence.
Managing investments keeps you humble. Mistakes will
be made and the worst ones occur when you most think
you have everything all figured out. Our favorite example
in recent history is the spectacular failure of Long-Term
Capital Management in 1998. Run by ex-Solomon Brothers head of bond trading, John Merriweather, and with
two Nobel laureates on the board, Myron Scholes and
Robert Merton, the hedge fund completely unraveled,
losing $4.6 billion in less than four months. Initially very
successful, the hedge fund returned 21% in its first year,
43% the second, 41% in the third before going to zero. We
have to confess, it is more fun highlighting others’ more
spectacular mistakes to make you feel better about your
own less significant failures.
Value of $1,000 Invested at LTCM
Although the markets are generally unpredictable and nothing
can be known with certainty, we do have certain expectations
in regards to investment performance or there would be no
reason to invest at all. These expectations differ from one individual to another, but for the most part, investors expect to
make a positive return over time. There is always the risk of
loss, but the responsible investor should expect to be rewarded for their risk. To further define a reasonable expectation
without bringing mathematics into the picture, most investors
would claim that they expect at least a return commensurate
with other investors taking similar risk. In other words, it is
reasonable to expect to make 8% annually in the stock market
if everyone else is making 8% in the stock market.
We take our responsibility very seriously. Most of our clients
will not have the time or the capability to recover from significant losses. We are always nervous about protecting our clients and yet we have to take risk in order to grow assets.
While we have gotten used to making minor investment mistakes over the decades we are continually learning new lessons and striving to face our shortcomings. Our approach to
taking risk is to manage that risk so that in the case of a failure
the outcome is not cataclysmic. In any endeavor, you must
survive to be able to learn from your mistakes. As a teenager
you learn to drive and to the consternation of every parent,
you learn the biggest lessons through some close calls. As long
as you survive to learn the lessons, you become a better driver. The average career on Wall Street is short lived. Some
managers, like Long-Term Capital management have cataclysmic failures. Most have mediocre performance. Some have
trouble being wrong and have difficulty evaluating the requisite risks. This business is a struggle, but it’s that challenge
that gets us in the door every day.
We take a conservative approach to managing portfolios and
to manage risk we diversify our clients’ assets generally between stock and bonds, and at times in real-estate investment
vehicles. We further diversify portfolios in various industries
or in the case of bonds with different issuing entities and maturities. At the close of 2014, firm wide, 38% of clients’ assets
were invested in bonds, 54% in equities and 4% in cash. Each
of these major asset classes have different characteristics and
carry different risks and expectations. By utilizing a blend of
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GKV Capital Management
these security types we are able to reduce the volatility of a
portfolio. Therefore, our total results, stocks, bonds and
cash combined, tend to perform somewhere between the
major stock indexes and the major bond indexes.
S&P 500 Annual Performance
Although the markets are unpredictable there are certain
reasonable expectations for returns based on long-term
performance results. As the disclaimer goes, past performance cannot predict future returns, but it can and should
serve as a guide. Looking at the S&P500 since 1958, stocks
in the index have yielded an annual return of 7.1% excluding
dividends. As the chart on this page shows, the volatility of
the index is tremendous making the market “generally” unpredictable. The standard deviation over the period is
16.6%, meaning that two-thirds of the time the market will
be up 8.5% +/- 16% and a full one-third of the time it will be
up or down even more!
By contrast, the bond market has produced stable returns,
4.7% over the last 10 years with considerably lower volatility
as measured by the standard deviation during the period of
3.2%. Two-thirds of the time bonds have returned between
1.5% and 7.9% in the last ten years. While this is materially
Stocks vs. Bonds—Returns and Volatility*
lower than the S&P500 return of 7.7% over the same period,
the sleepless nights have been far fewer. Investment professionals will point out that with the specter of rising interest
rates, bonds may produce sub-par results in the coming decade, however our point is that we are using various security
types to reduce volatility and manage risk. We have been
steadily reducing our fixed income holdings as interest rates
have bottomed.
As a portfolio manager, we expect our returns for equities to
be roughly commensurate with the major stock indexes. We
expect our bond portfolio to perform roughly in line with the
major relevant bond index. We expect the blend of stocks and
bonds to yield a less volatile long-term gain that is likely to
trail the stock indexes when they are up significantly and to be
far better than the stock indexes when they are down. For
example in 2008 when the S&P500 declined 39%, our accounts, after fees, declined only 8%. The stocks we held in
2008 declined 36%, which is a little better than the index but
because we held few stocks, our overall performance was far
superior. Conversely, in 2013, when the S&P500 was up 30%,
our accounts were up 12%. The stocks we held in our accounts
gained 29%, again we matched the index, but because our
accounts were not 100% stocks, our total account performance was lower. We are managing assets to protect wealth
and grow assets responsibility over time.
Looking at the last 10 years, we find that the reduced volatility
came at a very small price to performance. The compound
annual growth for all GKV managed accounts was 4.4% after
fees, from December 31st, 2004 to December 31st, 2014. Over
the same period, the S&P500 gained only 5.4% and the Barclays Intermediate-Term Index gained 4.4%. The complete 10
year data is available on the chart on page 4 of this report.
The historical statistics can tell us a lot about the market and
should be used to guide our expectations. We are striving to
manage assets in a responsible manner and avoid the mistake
of trying to swing for the fences and chase unreasonable returns.
All this is not to say we are infallible and don’t make mistakes.
To the contrary, 2014 was a tough year for us as our equity
investments underperformed the major indices. Across all
accounts, our equity portfolio was up 5% versus 11% for the
S&P500. In our effort to protect capital we reacted to swings
in the market too hastily. While not a disaster, we are disappointed nonetheless. We expect 2015 to be another challenging year with slow growth in the U.S. and slower growth globally. The prospect of increasing interest rates and a strengthening dollar may put further pressure on stock valuations and
corporate earnings.
Page 6
*S&P500 and Barclays Intermediate-Term Bond Index
Fourth Quarter 2014
Looking Forward
The economic outlook remains positive although there is
little to get excited about. With the reduction in stimulus to
propel stock valuations, we expect stock prices to track
earnings growth. Unfortunately, we are concerned about
corporate earnings going into 2015. Since the significant
recession in 2008, earnings have recovered nicely, driving
the stock market to new highs. The current recovery has
been unusual by historical standards in both its tepid
growth and long duration. We believe that the slower than
typical growth has made the longer than usual duration of
this recovery both possible and reasonable.
Corporate earnings recovered dramatically after the recession and have continued to increase in subsequent years
driving the equity markets higher. However much of the
earnings growth has come from increases in profitability
rather than growth in revenues. The growth rate of earnings
is slowing as we reach limits in corporate profit margins.
This coupled with weakness in the rest of the world has
prompted companies to reduce their earnings outlook for
2015.
S&P 500 Performance and Earnings Growth
what might look like an expensive market a reasonable value. Conversely, if the forecast is too rosy, then the market
isn’t worth what investors are currently paying and the value will adjust.
While it is entirely possible that revenue growth could accelerate with earnings improving as 2015 progresses, we have
been experiencing the opposite trend with continual reductions in estimated earnings. Until recently the reductions
have been slight. We remain positive for the overall outlook
for the U.S. economy and the prospects of individual companies, but given the trends in earnings, we think double
digit gains for the major indices will be difficult to achieve in
2015.
The S&P 500 closed the year at 2,051 which is 16.9x the
earnings forecast for the next twelve months based on the
latest revised earnings forecast of $121.31. We find this
valuation to be expensive. Consider that at the start of
2014, the S&P500 was trading at 16.0x the latest 2014 forecast of $115.77. We find little reason, given the slower earnings growth expectations in 2015 for the market to be trading at a premium to year-ago levels. A 16x multiple puts the
S&P500 at 1,941.
We expect individual stock selection to be critical for performance in 2015. We are focusing our attention in subsectors
of healthcare, technology, biotech, and select companies
with superior growth prospects. We expect to reduce our
exposure to stocks marginally to hedge the risk of a significant correction. We anticipate a positive 2015, but like 2014
the slow growth and reduced earnings expectations may
lead to significant volatility.
Since the close of the year, largely due to the dramatic reduction in the price of oil, we have seen a fairly dramatic
reduction in earnings estimates. From an initial 2015 forecast for the S&P500 of $137.19 made in March of 2014, the
current forecast has been reduced to $121.31, an 11.6%
reduction. This figure represents only 4.7% growth over the
current 2014 estimate of $115.77 which is hardly enough to
propel the stock market to dramatic new highs, in our opinion.
The earnings estimates and growth rates are important because they drive what investors should be willing to pay for
equities. If growth accelerates, greater future earnings make
Page 7
S&P 500 Earnings Estimate Revision History
Personal Portfolio Management
Southern California
125 Auburn Ct.
Suite 200
Westlake Village, CA 91362
Northern California
2950 Buskirk Ave.
Suite 300
Walnut Creek, CA 94597
GKV Capital Management is a registered advisory firm operating since 1975. We manage separate accounts for families,
charities and retirement. Four of the largest asset bubbles have
occurred in the last 25 years. Volatility has taken a significant
toll on investment assets requiring new strategies to protect
and grow wealth. As an independent portfolio management
firm making direct investments on our clients’ behalf, GKV
Capital has the flexibility and expertise to respond to the
changing investment environment to reduce risk, minimize
losses and grow wealth.
Phone: 805-497-2616
Fax: 805-379-3216
E-mail: [email protected]
Our Investment Philosophy
We take a dynamic view of the macro economy to determine expected returns
in the near-term of various asset classes. Within these classes individual investments are selected for clients’ accounts on an account by account basis.
We do not buy and hold, but seek to take advantage of changes in market sentiment and fundamentals to avoid losses and create opportunity. As an independent portfolio manager we have the flexibility to adjust investment exposure rapidly.
We make direct investments on behalf of our clients buying individual securities, generally stocks and bonds eliminating costly mutual fund fees. We are a
fee-only advisor, we do not receive commission and we do not sell any financial
products. Client assets are held at an unaffiliated brokerage firm.
GKV Capital Management is a registered investment advisor with the SEC under the 1940 act. This newsletter provides general investment information and is not
intended to provide specific financial, investment, legal, or tax advice. Any discussion of individual securities should not be taken as a recommendation for any reader
to buy or sell such securities. You should consult with your own advisor and/or do your own research before acting on any of our opinions, which we change without
notice. The data provided in this newsletter is believed to be reliable, but are not guaranteed as to accuracy or completeness. The value of the securities mentioned
herein may fall or rise and are not insured by any government or private company.
©2015 GKV Capital Management Company Inc.