summer intern project - grace chmiel

Stability Investment Solutions Diligence Client-centric

A Psychological Analysis of the Current

Investor Sentiment and Positioning

Presented to:

Global Allocation Fund

Steve Auth & Team

Presented by:

Grace Chmiel

Summer Intern: Investment Management - Global Equity

Department

Distributor Information/Disclosure/Product Code or Tracking Number

Key Question

Did the '08-'09 bear market so scar investors

that their "normal" balancing of risk and reward

was semi-permanently thrown off balance?

Institutional Sales Material. Not to be reproduced or shown to the public. (control through Header/Footer option) 1

Bottom Line

Investors are psychologically scared from the 08/09 Great Recession. Without recognizing the psychological impact the Great Recession had, investors rely on traditional economic approach to analyze current market trends which – by definition includes human judgment to make decisions – thereby blurring the investors lens to foresee a positive end market.

They have Psychological Constraints:

Heuristics

Over confidence

Narrowing framing

Much more sensitive to losses than gains

Aversion to ambiguity

Fear of regret


If “yes,” then we should observe…

1. The traditional "Wall of Worry" which fuels bull markets should last longer than usual

2. "Animal Spirits" which drive economic activity should take longer to recover

3. Portfolio management models built on extrapolating past risk reward relationship may miss

estimate future market returns

4. Government officials responsible for the economy (eg the Fed) should be likely to take

longer to raise rates/tame the recovery

5. Equities should be likely to remain under fair value or normal value vs bonds for longer than

usual

6. Investors should be slow to re-allocate into equities



American Association of Individual Investors

The Traditional “Wall of Worry” which fuels bull markets should last longer

than usual

AAII survey measures the percentage of individual investors who are bullish,

bearish, and neutral on the stock market for the next six months

The Savvy Investor knows to pay attention to general market conditions like “irrational exuberance” and the “wall or

worry”

Like Warren Buffett once said: “We simply attempt to be fearful when others are greedy and to be greedy when others

are fearful.”

The first sign of this: Sentiment Surveys are reporting Investors are leaning Bearish on the stock market for the next six

months


Even in recent weeks, investors continue to sway neutral/bearish


than usual

But are they doing what they are saying?

Shift to Bear Sentiment


5.88%

16.04%

1.02%

51.56%

24.30%

1.14%

2007 4.85%

14.56%

3.42%

47.70%

26.63%

3.36%

2013

Investors are doing what they are “saying.”

Current Bull Market show significant asset allocation changes relative to previous bull markets


than usual

5.36% 6.37%

0.77%

63.17%

20.45%

3.88%

Asset Allocation 1998

Cash

Domestic Bonds

International Bonds

Domestic Equity

International Equity

Other


Based on “averages”, this current 2009 Bull Market should expect a recession soon

Example: In the past 11 business cycles between 1945-2009, as defined by NBER, the average trough to trough lasts 69.5 months. Since NBER defined end of Great Recession in June 2009 – it’s been 60 months – 9.5 months away from next expected recession (on average)

Traditional “Animal spirits” have dissipated due to contagious bear ideas

"Animal Spirits" which drive economic activity should take longer to recover



Bear Markets: Average % drop in S&P 500

• Little Bear : - 21.51%

• Big Bear: - 49%

• 08/09 Crash: - 57%

84.70% 89.00%

111%

170%

185%

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

140.00%

160.00%

180.00%

200.00%

Little Bear Big Bear Big Bear (excluding'37)

2013 August 2014

% Move off Low on S&P 500 5 Years Out of Bear Market - - - - - - - - - - - - - - -


-66%

-48%

-10% -4%

26%

38%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

1929 - 1933 1937 - 1938 1973 - 1974 2001 - 2001 2007 - 2009 Little Bear

Where were the Big Bear markets 5 Years Out compared to previous high in S&P 500?

% abv/blwPrevious Highon S&P 500


This suggests we have

room to grow


3.17%

4%

1.80%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

Little Bear Big Bear 2013

GDP Growth Rate 5 Years Out

GDP Growth Rate

* Zarnowtiz Rule: deep recessions follow steep recoveries


5 Years Out after Big Bear

GDP Growth Rate

1937 5.10%

1943 17%

1979 3.20%

2006 2.70%

Government Officials responsible for the economy should be likely to take

longer to raise rates/ tame the recovery


4.67%

11%

0% 0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

Little Bear Big Bear 2014

Average Fed Funds Rate 5 Years Out

Fed has learned from its mistake from the Great Recession and it is

maintaining a low interest rate for a longer period of time

The lack of fiscal policy has hurt GDP growth

Portfolio Management Models built on extrapolating past risk reward relationship may

miss estimate future market returns

The past 10 years were far from “normal”

Great Recession was about 2 standard deviation increase in volatility

One standard deviation increase in volatility was associated with a 0.5% reduction in annual growth

(Ramey and Ramey, 1995)

Lower consumer spending (Romer 1990)

Investment and hiring (Bloom 2009)

Trade (Handley and Limao 2012, Novy and Taylor 2012)

Exposure to exogenous variations in energy and currency volatility depresses investment, hiring and advertising

Uncertainty increases in R&D spending

Firms less sensitive to business conditions drivers like demands, prices and productivity

High uncertainty can reduce the impact of stimulus policies like interest rate and tax cuts

INSTITUTIONAL Sales Material. Not for Distribution to the Public. 12

As of June 2, 2014.

Past performance is no guarantee of future results.

This chart is for illustrative purposes and not representative of a specific investment.

S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States.

EPS = Earnings Per Share

P/E = Price to Earnings

March 24, 2000

$1,527.46

$56.13 EPS

27.2x P/E

6.79% 10 Year Treas

Implied Target P/E 14.7x

Overvaluation 85%

August 25, 1987

$336.77

$19.55 EPS

17.2x P/E

8.78% 10 Year Treas


Overvaluation 51%

March 6, 2009

$666.79

$61.00 EPS

10.9x P/E

2.055% 10 Year Treas


Undervaluation 78%

October 4, 2011

$1,074.77

$96.57 EPS 2011E

11.1x P/E

1.67% 10 Year Treas


Undervaluation 81%

June 4, 2012

$1,266.74

$104.44 EPS 2012E

12.1x P/E

1.44% 10 Year Treas


Undervaluation 83%

INSTITUTIONAL Sales Material. Not for Distribution to the Public. 13

Current Valuation

May 29, 2014

$1,920.00

$117.00 2014E EPS

16.4x P/E

2.40% 10 Year Treas


Undervaluation 61%

Equities should be likely to remain below fair value or normal value vs bonds for longer

than usual


0

100

200

300

400

500

600

700

0-1yrs

1-2yrs

2-3yrs

3-4yrs

4-5yrs

5-6yrs

6-7yrs 7-8yrs

8-9yrs

9-10yrs

10-15yrs

15+yrs

# o

f M

anag

ers

# of Years with Fund

22.25%

24.67%

20.55%

12.56%

10.57%

7.05%

2.35%

% of Total Mangers by # Years with Fund

>2 yrs

2-4 yrs

4-6 yrs

6-8 yrs

8-10 yrs

10-15 yrs

15+ yrs

1/3 of Managers of have been with a

Fund for 6+ years

# of Managers Organized by # Years with Fund

Investors should be slow to re-allocate into equities

…Because of the lack of cognitive diversity

Cognitive Diversity allows investors to rebalance the thrown off “risk and reward” by

adding unique perspectives that would otherwise be absent. It also takes away or least

weakens, some of the destructive characteristics of group decision making.

Appendix

Bear Market 5 Years Out

(12-31-19xx) % down in S&P

500 % Move off Low 5

Years Out %Move off Low

(Cycle Peak)

% abv/blw Previous High 5

years Out GDP Growth Rate 5

Years Out Yield on 10yr Note 5

Years Out

P/E Fed Funds Rate 5 Years Out 5 Years Out

1929 - 1933 1937 -84.80% 169% 322% -66% 5.10% N/A 10.5 N/A

1937 - 1938 1943 -54.50% 25% 145% -48% 17% N/A 12.6 N/A

1945 - 1946 1949 -28% 70% 90% 23% 8.7% N/A 7.5 N/A

1948 - 1949 1954 -21% 158% 96% 105% -0.6% N/A 12.6 1%

1957 - 1958 1963 -20.50% 62% 84% 7% 4.4% 4.1 18.8 3.5%

1960 - 1961 1965 -28% 84% 105% 31% 6.5% 4.7 17.8 4.3%

1965 - 1967 1971 -22% 40% 83% -6% 3.30% 5.9 18.0 4.9%

1969 - 1970 1975 -36% 30% 73% -25% -0.2% 7.76 11.8 7.5%

1973 - 1974 1979 -48% 74% 125% -10% 3.20% 10.3 7.4 15.5%

1981 - 1982 1987 -26% 141% 228% 139% 3.50% 8.85 14.0 8.5%

1987 - 1988 1993 -33% 93% 114% 30% 2.70% 6.6 21.3 3%

2001 - 2001 2006 -49% 89% 101% -4% 2.70% 4.71 17.4 6.75%

2007 - 2009 2013 -57% 170% 185% 26% 1.80% 3.04 19.1 0%

Average -37.57% 86.22% 130.50% 14.68% 3.42% 7.3 14.1 6.11%

Big Bear (x < - 40) -59% 89% 173% -32% 4% 7.5 12.0 11%

Little Bear

(-40 < x < - 20) -26.81% 84.70% 109.13% 38.03% 3.17% 7.1 15.2 4.67%


NBER defined 11 recessions between 1945- 2009 On Average: • Contraction – peak to trough: 11.1 m • Expansion – previous trough to this peak: 58.4 m • Trough from previous trough - 69.5 m • Peak from previous peak – 68.5 m

Since NBER defined end of Great Recession in June 2009 – it’s been 60 months – 8.5 months away from

next expected recession (on average)


3.98

19.63

5.28

62.01

3.60 1.68

Federated Asset Allocation 1998

Cash

Domestic Bonds

Internation Bonds

Domestic Equity

Internation Equity

Other

1.97

16.82

5.40

31.45

40.36

3.39

Federated 2013

2.79

22.83

1.82

33.72

35.73

0.74

Federated 2007

Appendix

*Federated average Tenure Manger : 7.09 years

summer intern project - grace chmiel

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