Making Sense of Economists, Politicians and

the Federal Reserve

Presentation by

Bob Pugh, CFA, CFP®

to the

The AAII Baltimore, Maryland Chapter

April 11, 2015

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Making Sense of Economists, Politicians and the Federal Reserve

This slide show, presentation, related discussion, and all other materials provided are to be considered general educational information rather than investment advice for any individual or group of individuals. Specific investment advice for any individual or group of individuals must be based on a detailed evaluation of their personal needs and circumstances.

Nothing in this presentation should be considered a recommendation to buy or sell any securities.

Investors should research the various asset classes and available securities to find those that are most suitable to their specific needs. While this presentation and related discussion may refer to specific ETFs and other securities, other products in the same categories are available from other providers. Investors should ensure that the product(s) they select suit their specific needs.

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Making Sense of Economists, Politicians and the Federal Reserve

Bob Pugh, CFA, CFP® Brief Biography

President, Insight Wealth Management. Inc., an independent Registered Investment Adviser in Gainesville, VA, providing fee-only

wealth and investment management, and financial planning services to individuals, families, businesses and non-profit organizations since 2005. Member of the Schwab Advisor Services network of select independent advisors for custody and brokerage of client assets.

National Association of Personal Financial Advisors (NAPFA) – Registered Financial Advisor (www.napfa.org), member of the Financial Planning Association (www.fpanet.org), CFA Institute (www.cfainstitute.org) and the National Association for Business Economics (www.nabe.com). Member of Mensa, and former Testing Coordinator for the Metropolitan Washington Mensa chapter (www.mwm.org).

President of the CFA Society of Washington, DC, 2005 to 2007, and Eastern Region Presidents Council Representative, CFA Institute, 2009 to 2011.

Over twenty-five years of experience as an economist, financial educator and analyst, portfolio manager, and personal financial planner in the private and public sectors. Experience includes serving as an economic analyst with the Central Intelligence Agency, director of investment research at another firm, and senior financial analyst in municipal government.

Graduate degrees in global political economy from The Johns Hopkins University, School of Advanced International Studies, and in financial economics from the University of North Carolina at Greensboro

Full-time and adjunct faculty member experience with numerous colleges and universities, including nine years as a member of the Practitioner Faculty in Finance with The Johns Hopkins University’s (JHU) Carey School of Business, and with the JHU School of Medicine, teaching graduate-level courses in investment analysis, portfolio management, and corporate finance, and continuing education in the Business of Medicine program. Currently teach the full Level III CFA Exam review courses for the CFA Society of Washington, DC and the World Bank.

Community Volunteer, including serving as President of the Prince William Symphony Orchestra for four years, Lay Speaking Minister in the Virginia United Methodist Conference, and over twelve years of service with the Virginia Cooperative Extension’s Personal Finance Program in Prince William County. Recently appointed by the Prince William County, Virginia Board of Supervisors as a Board Member of the Health Systems Agency of Northern Virginia.

Contact information available at www.insightwealth.com

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Overview

1. Monetary Policy and Implications for Investment Strategy

2. Economic Outlook

3. Relative Valuations in Various Markets

4. Politics

5. Black Swans

6. Questions (for sure) and Answers (maybe)

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Overview

First and foremost – I lied. No one can make sense of economists (they don’t know if they’re lying or not), politicians (they, well anyway we need say no more regarding lying) and the Federal Reserve (they try not to lie but are often incomprehensible, even to other economists)

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Forecasting and Prediction are Futile Endeavors

“Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications. Nationwide banking and widespread securitization of mortgages make it less likely that financial intermediation would be impaired than was the case in prior episodes of regional house price corrections.”

Alan Greenspan, June 9, 2005

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Forecasting and Prediction are Futile Endeavors

If Alan Greenspan can’t get it right, what chance do we have?

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Risk Management - Asset Allocation

Asset allocation (cash equivalents, fixed-income,

equity and alternative classes) is the most important tool to manage risk and return in a portfolio

Combine asset classes with low correlations

Must be based on forward-looking analysis, not historical relationships and trends

Most benefit occurs over longer time horizons

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Risk Management - Diversification

Diversify not only security holdings, but asset class exposure

Diversification eliminates risk exposure to individual securities, and

leaves only risk and return exposure to the market or sectors

Either hold an adequate number of individual securities or invest in index funds

For those who think security selection adds value, do it within the framework of asset class exposure

Diversified exposure to asset classes allows investors to benefit from the interaction of those classes in a portfolio to improve its risk and return performance

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Monetary Policy and Equity Returns

Why does monetary policy matter to investors?

Liquidity in the markets

Interest rates

Discount rate for cash flow valuation

Cost of borrowing, thus earnings

Economic stimulus or contraction, thus earnings

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Monetary Policy and Equity Returns

Quantitative Easing – Fed purchases long-term bonds, mostly mortgage-backed securities and Treasuries. Already stopped further increases of holdings.

Normal Policy Tools – Primarily open market operations that involve injecting or removing liquidity by trading short-term securities.

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Federal Funds Rate

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Monetary Base

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Excess Reserves

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Impact of Fed Policy on S&P 500

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“Don't Fight the Fed: Interest Rates and their Impact on the Stock

Market” by Sam Stovall, AAII Journal, May 2009

Central Bank Policy Impact on Exchange Rates

Currency of country with relatively rising interest rates tends to appreciate

Return in foreign market consists of foreign market return plus change in exchange rate

If dollar is appreciating, foreign investments lose value for U.S. investors

U.S. Federal Reserve will begin tightening, sooner or later

European central bank recently embarked on its version of quantitative easing and monetary expansion

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Central Bank Policy Impact on Exchange Rates

Appreciating dollar will reduce return to U.S. investors

Europe and other international markets coming out of recession and, combined with central bank easing, could represent good investment opportunities

Solution – hedge currency exposure

Hedging can be done through some ETFs and mutual funds

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Monetary Policy and Sector Rotation

For more detail on impact on specific sectors, see

“Don't Fight the Fed: Interest Rates and their Impact

on the Stock Market,” by Sam Stovall, AAII Journal, May 2009

“Is Fed Policy Still Relevant for Investors?,” by C. Mitchell Conover, CFA, Gerald R. Jensen, Robert R. Johnson, CFA, and Jeffrey M. Mercer, Financial Analysts Journal, Volume 61, Number 1, ©2005, CFA Institute

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Monetary Policy and the Bond Market

Fed tightening on the short end of the yield curve could reduce long-term interest rates, or have little or no impact on them

Tightening reduces concerns about inflation and thus can ease pressure on long-term nominal interest rates

Monetary policy most effective on the short end of the yield curve

Long-term interest rates are more a function of economic factors rather than Fed policy

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Three- to Five-Year Corporate Bond Yield

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Seven- to Ten-Year Corporate Bond Yield

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Economic Outlook – NABE Forecasts

Review March 2015 Forecasts from the National Association for Business Economics

Role of Economic Forecasts in Developing Expectations Used for Investment Planning

Consider them as “expectations” for planning purposes rather than predictions

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Economic Outlook – Real GDP

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Economic Outlook – Changes in Non-Farm Employment

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Economic Outlook – Unit Labor Cost

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Economic Outlook – Capacity Utilization

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S&P 500 Operating Earnings P/E Ratio

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Average 1989 to 2014 – 18.72

March 31, 2015 – 18.38

Currently at long-term average and not significantly high in historical terms

Market not over- or under-priced but about average

Source: S&P Dow Jones Indices, S&P 500 EARNINGS AND ESTIMATE REPORT, April 2, 2015

Geographic P/E Comparisons

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S&P 500 Index – 19.07

S&P Developed International Markets Ex-US Index – 18.67

S&P Emerging Markets Index – 13.77

Election 2016

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House of Representatives – Very Likely Republicans Maintain Control

Senate – Likely Republicans Maintain Control with Smaller Majority

President – Could Go Either Way

Election 2016

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Hillary Plus Republicans Controlling House, but Not Senate

More of the same as under Obama, but Hillary more business-friendly than Obama. Better for markets. Looser financial regulations.

Republican President Plus Democrats Controlling Senate

Gridlock with little change, but perhaps somewhat more business-friendly than Obama. Better for markets.

Election 2016

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Republicans Win White House and Control Both Houses of Congress

Significant change • Obamacare repealed

• Loosing industries – health insurance companies, for-profit hospitals, pharma

Winners include defense, finance, others

Generally Better Business Climate

Black Swans

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Events that are not high probability but would have a high negative impact

Usually difficult or impossible to foresee

Geopolitical War in Middle East

Major terrorist event

Financial Greek default

Major bank(s) failure

Other Regional or Global Catastrophes Pandemic

Climate or weather disaster

“Honey Boo-Boo” renewed for another season

Questions?

Bob is available for a free, no-obligation

initial consultation and portfolio review, or to answer your questions about this presentation and help you with the available resources.

Insight Wealth Management, Inc.

7250 Heritage Village Plaza

Suite 101

Gainesville, VA 20155

www.insightwealth.com

bob@insightwealth.com

(703) 753-6082

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