In the summer we wrote to you with expectations that a continued slow growth of the market was most likely with a higher probability for continued improvement. Our recommendation was much different than the more popular “major market correction” view that was everywhere in publications. The idea that the market must correct at 17,000 did not materialize for the Doomsayers.

Now with the market exploring 18,000 the correction rhetoric has started again. It will probably be difficult to pass the 18,000 mark cleanly, just as it took some time to get over the 17,000 hurdle. We still see a higher probability of continued improvement in the market than a correction. This is based on an overall fair value in the market of 104.8%. Perfect Fair Value (PFV) is 100.0% which means we are 4.8% above perfect fair value. This is well within the range of fair value which is 120% to 80%.

The sectors that make up the market are telling a much different story than what we saw earlier in the year. Previously, most sectors were well within their fair value ranges. Today we have two sectors that are undervalued enough that they present an opportunity to overweight the sector, and one sector has moved into a range where it is time to lighten the allocation. The over/under weighting that can take place in the portfolio is shown in the Domestic Sector Weighting table. We have added some color to the table so let me take this opportunity to explain how to use the table and the new colors.

The table has five columns. The first column is the market ticker of the security that represents the stocks that compose the sector. For example, the third sector in the list under the title row is Energy. The energy sector is created from companies that operate within the energy market such as Conoco and Exxon. It also includes offshore management companies such as TransOcean. Eighty-one percent (81%) are oil and gas enterprises and 19% are equipment and service providers. Each of the companies is included in the index according to their size, or what is sometimes called “market cap weight”. This means Exxon carries more weight in the index than TransOcean because it is bigger. The index is created this way so that it represents the same weightings as what is in the market. You can find out more about these sector securities by referencing

The second column provides the name of the sector. The third column is the weight of the sector in the overall market. You can think of this as the importance of the sector to the overall market. In our example, Energy represents 8.6% of the U.S. domestic stock market. Just below that, you can see Financial stocks represent 16.3% of the market. Financials are twice as large in the U.S. market as Energy. You can begin to get a feel for why the mortgage crisis impacted the U.S. market in 2008 so dramatically; 16% of the market was in question

In a perfect fairly valued market, Energy stocks would represent 8.6% of a U.S. stock portfolio. If the stocks started to become overvalued, where the stock price was higher than what earnings reflect, you would want to lower the “weighting” because overvalued stocks have a higher probability of slowing down, or if the overvalue is very high, the stocks will correct to the fair price. The opposite is true if stocks become undervalued, they have a higher probability of correcting to fair value thereby adding value. Sectors can be adjusted by weighting just like securities. If a sector is becoming overweight you will want to reduce the allocation to the sector, and if it is underweight, you will want to increase the allocation.

In the case of Energy, it is currently under fair value and represents an opportunity to add value in the future because earnings represent a higher value than current market prices reflect. In the current environment, this is being caused by a global increase in oil supplies that is driving prices down. Many investors are placing a lower value on these securities and selling at discounted prices. Today that is true, but what about the future? Has energy demand gone down for the future? No, in fact the projected demand for energy has continued to show remarkable stability and China and India will be using as much energy as the U.S. by 2030. Energy demand is still robust and may even accelerate now that supply is no longer a constraining factor.

The difference depends on your investment horizon. If you are a trader, the next few days would be your investment horizon and you would be selling energy stocks because the probability of lower energy prices is still high. We might even see West Texas Crude or Brent Crude prices drop to the high $50s. However, if your investment horizon is more strategic than tactical the energy sector presents an opportunity. This is the fourth column. Energy is undervalued enough that we are suggesting the sector be increased above a market weight. The market weight is 8.6% and the adjusted weight is 11.6% which is 3.04 percentage points higher than the market weight.

The opposite is true for Healthcare where there are more stocks that are currently over fair value. In this case, we are suggesting the sector be underweighted by 1.57 percentage points to 12.8% from a market weight of 14.4%. The Healthcare sector has moved a bit ahead of itself because everyone is excited about how the demand for healthcare is expected to be strong. It will be strong, but the expectation has just gotten ahead of reality.

You can see all of the market weights and recommended weights for a global portfolio in the larger table on the front page. The larger table also shows you how the weights change from a highly conservative portfolio which we call “Stable” to a highly aggressive portfolio which we call “Opportunity”. This does not mean there is no opportunity in the Stable allocation, it just means the values within the Stable portfolio do not vary as much as the Opportunity portfolio.

We have also added some new features to the market and sector charts beginning with this issue. First, the chart has a higher resolution to make it easier to see and also read some of the very important information on the chart. If we take a look at the overall market chart you can see the title in the upper left hand. The price of the security over time is in blue with the scale on both the left and right side for easy reference.

From time to time we will add comments such as the one you see regarding earnings and sales growth. The market has reacted well to earnings increasing above the average of 6% to a high level of 10%. This is positively supported by a sales growth level of 4%. This combination increased the market fair value estimate from 16,654 to 17,574. The fair value estimate is displayed on the graph in the note holder shown here.If the note holder is green there has been an increase in fair value, if red there has been a drop in the estimate. Gray represents no change. This will allow us to show a continuous time line of fair value estimates rather than just the single representation in earlier charts.

A yellow box has also been added to the chart which shows the fair value range. The range is 130% to 80% of fair value. Positions above the box are overvalued and positions below the box are undervalued. You can see the overall market is just ahead of fair value. The text note to the right provides an opportunity to add information that might be significant to the chart.

Looking at the Energy sector chart you can clearly see the degree to which the sector has moved into under fair value (below the fair value box border). There are numerous opportunities starting to show

up in the Energy sector. Thirteen of the top twenty stocks that are classified as undervalued are energy stocks. The range goes from major energy providers such as Ensco and Halliburton to offshore management companies such as Transocean. Even Occidental and Marathon are ranked amongst the top 40.

Energy is not the only sector that shows potential valuations. Consumer Discretion is showing potential for an over weighting by 1.2 percentage points to 13.0% from a market weight of 11.8%. This is not a high as Energy, but anything greater than a 1.00 percentage point +/- is considered noteworthy.

The only underweighting in the market currently is Healthcare. Expectations were high for healthcare stocks throughout the latter part of 2013 and most of 2014. It appears the costs associated with healthcare services delivery has increased to the point where earnings are not as robust as earlier expected. Expectations are still high, but possibly a bit too high. We are suggesting a slight 1.6 percentage point reduction in healthcare to 12.8% rather than a market weight of 14.4%.

I hope you enjoy the new tables and graphs in the report. You will be seeing more of them in the Annual Economic and Market Review of 2015.




DOWI, - Dow Industrial

DOWI, – Dow Industrial

XLY - Consumer Discretion Select Sector

XLY – Consumer Discretion Select Sector

XLP - Consumer Staples Select Sector

XLP – Consumer Staples Select Sector

XLE - Energy Select Sector

XLE – Energy Select Sector

XLV - Healthcare Select Sector

XLV – Healthcare Select Sector

XLF - Financial Select Sector

XLF – Financial Select Sector

XLI - Industrial Select Sector

XLI – Industrial Select Sector

XLB - Materials Select Sector

XLB – Materials Select Sector

XLK - Technology Select Sector

XLK – Technology Select Sector

XLU - Utilities Select Sector

XLU – Utilities Select Sector