October 7, 2016 Fourth Quarter Items for Consideration

We hope that this letter finds you well. As we enter the final quarter of the year, one that is sure to be very
interesting for a great number of reasons, we thought it would be appropriate to give an overview of some of
the items on which we are and will be focusing in the coming months. Wed love to hear your feedback.
US equity markets have been unable in the last eighteen months to regain the head of steam gathered in the
earlier stage of this now seven and a half year old bull market. As of the date
date of this letter, the S&P 500 Index*
is trading just +1.08% higher than the interim peak set in late May 2015 that we have mentioned in the past
several letters. In that same period of time the Dow Jones Industrial Average* and MSCI All Country World
Index* are down by -0.25% and -6.01%,
6.01%, respectively, despite near or below zero interest rate policies around
the world and continuing central bank asset purchases intended to stimulate economic activity and support
asset prices.
So we must ask ourselves as participants in these financial markets, and more importantly as risk managers
entrusted with the safekeeping of our clients hard earned savings, what potential opportunities and pitfalls
should we presently have our eyes on that might drive market direction
direction in this fourth quarter and beyond.
What follows is a list, in no particular order, of just a few of the most pressing issues that occupy our thoughts.

Global Monetary Policy Effectiveness Central banks have recently been signaling acceptance of the fact that
they are running out of effective tools to support the global economy. For the past eight years, the major
central banks of the world have been utilizing every tool at their exposure, and indeed have been inventing
new tools along the way, in an
n effort to stimulate sustainable organic economic growth following the global
financial crisis.
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We have discussed at length in prior letters, all of which are archived on our website
www.UlmanFinancial.com,, the degree to which global interest rates have
have been pinned to the floor, and in
many cases below the floor in order to reduce the costs to households and businesses to service existing debts
and stimulate banks to lend and households and businesses to borrow and spend. Additionally, central banks
balance
alance sheets have been exponentially expanded through asset purchase programs in an effort to strengthen
banks balance sheets and support asset markets.

From the Wall Street Journal, October 4, 2016 (emphasis added):

Over the past couple of months, the capital
capital markets have been especially antsy on the topic of the limits of
monetary policy. A report this morning suggesting that maybe one key central bank is feeling the same way
sent the euro surging
According to Bloombergs report, the [European Central Bank] would start winding down its bond buying by
$11 billion a month, ahead of the programs currently scheduled end in March 2017. If that is the case, it
would be similar to what the Federal Reserve did with its QE3 program
Also on Tuesday, two ECB officials did publicly make comments casting doubt on the value of negative
interest rates. That follows on actions the Bank of Japan took last month that were widely interpreted as a
subtle abandonment of its own negative rates policy
In September the ECB disappointed the market by not choosing to expand its QE program, counter to
expectations it would do just that. The wider question for the markets is this: are central banks getting weary
of their own monetary policies?
Market participants
ipants now place a two/thirds likelihood that the Federal Reserve will raise rates at one of
their two remaining FOMC meetings this year, in an attempt to continue their ever so gradual
normalization of interest rate policy. We are not so sure about those odds considering the recent
reduction in 2016 and 2017 growth expectations, which we will touch on below. However, if the markets
expectations prove to be correct, an increase in the Fed Funds rate will be a US Dollar strengthener and
has the potential to rile equity, bond and commodity markets as occurred following the 0.25% hike in
December 2015.

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Global Debt > Slow Growth > More Debt Despite the mountain of unprecedented monetary stimulus,
many respected institutions are trimming their outlook for economic growth in 2016 and 2017.

From NPR, October 4, 2016:

In its latest forecast, the International Monetary Fund says it sees global growth essentially moving sideways
this year, with flat to slower growth in richer countries offsetting higher growth rates in emerging economies
such as India
The IMF cut its economic outlook for the U.S. to 1.6 percent growth this year, down from 2.2 percent, citing
weak business investment and lower demand for goods. It also cautioned the Federal Reserve to hold off
raising benchmark interest rates until it sees clear signs that wages and prices are firming durably.
From Bloomberg, October 5, 2016 (emphasis added):
Eight years after the financial crisis, the world is suffering from a debt hangover of unprecedented
proportions. Gross debt in the non-financial
financial sector has more than doubled in nominal terms since the turn of
the century, reaching $152 trillion last year, and its still rising, the International Monetary Fund said. The
figure includes debt held by governments,
nments, non-financial
non
firms and households.
Current debt levels now sit at 225 percent of world gross domestic product, the IMF said Wednesday in its
semi-annual
annual Fiscal Monitor, noting that about two-thirds
two thirds of the liabilities reside in the private sector. The
rest of it is public debt, which has increased to 85 percent of GDP last year from below 70 percent
Slow global growth is making it difficult to pay off the obligations, setting the stage for a vicious feedback
loop in which lower growth hampers deleveraging
deleveraging and the debt overhang exacerbates the slowdown, said the
Washington-based fund
Financial crises tend to be associated with excessive private debt in both advanced and emerging economies,
economies
the fund said. In addition, research has shown that high debt is linked with lower growth, even when a crisis
is avoided The IMF flagged the euro area and China as economies where its particularly important for
deleveraging to occur.

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Continuing Earnings Recession By the time you receive this letter the third quarter earnings reporting
season will have begun. Consensus expectations are for aggregate S&P 500 corporate earnings to have fallen
by -2.0%,
2.0%, which would mark the sixth consecutive quarter of year-on-year
year
year earnings declines.

As earnings fall and equity

quity prices remain in roughly the same range, as we have seen since this earnings
recession began in Q2 2015, the relative valuation assigned to those equities increases. The trailing twelve
month (TTM) price/earnings ratio of the S&P 500 is currently at 19.6, more than 20% above the 10-year
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average of 16.1. As we pointed out in our April letter, when compared to corporate earnings calculated using
the Financial Accounting Standards Boards generally accepted accounting principles (GAAP) the trailing
twelve
lve month PE ratio balloons to 25.9.
Trailing twelve month P/E is just one
valuation metric used to determine whether a
stock or collection of stocks is undervalued,
fairly valued or overvalued.
We have
reviewed quite a few of these in past letters,
most of which point to the current market
environment as one of the most overvalued in
market history.
Because of the financial
engineering that corporations often engage in
to meet or beat each quarters earnings
projection, it can be helpful to review those
variables that are less susceptible to being
gamed. On the left is a chart of the current
median price to sales ratio of the S&P 500,
which greatly eclipses that of the 2000 and
2007 market peaks.
Potential for US Recession The National Bureau of Economic Research defines a recession as a significant
decline in economic activity spread across the economy, lasting more than a few months, normally visible in
real GDP, real income, employment, industrial production, and wholesale-retail
wholesale
sales.
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While we claim no innate talent for predicting recessions, it is important to monitor the coincident indicators
that in the past have been particularly effective in warning that recession is imminent. This is especially
important to investors and financial decision
decision makers as bear markets (equity market contractions of greater
than 20%) historically occur in and around recessions. We submit the following charts without comment other
than to ask, looking at this data would you predict that we are likely approaching
approaching the next recession or that we
are on the cusp of the organic economic expansion that would enable the Fed to safely normalize interest
rates?

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Potential European Banking Crisis While a different situation to that of Lehman Brothers in 2008, there
t
is a
concern in global markets that the instability of many of Europes largest banks has the potential to trigger a
de-risking
risking of portfolios as the perception of counter-party
counter
risk increases.

Ever since the European Central Bank implemented negative

negative interest rate policy (NIRP) there has been
concern about the financial sectors ability to remain profitable and hence their ability to support the broader
economy in those regions. In just the last few weeks, European banks have announced plans to shed
she over
20,000 jobs in an effort to control costs. Add to this the increasing number of Non-Performing
Non Performing Loans, in the
Italian banking sector specifically, and investors have been increasingly unwilling to ignore the risks. This
ongoing turmoil in the European
ean banking sector, where many of the regions largest financial institutions have
seen their stock prices cut by more than 50% this year alone, has investors concerned that the failure of one or
more systemically important banks would require a public bail-out
bai out at a time when populism and antianti
establishment sentiment is reaching a zenith.
US Presidential Election Uncertainty No matter which
candidate wins the election on November 8th, it will be an
historic outcome. If the race remains tight in the closing
weeks, the uncertainty will keep financial markets on edge.
If the outcome is other than polls predict, a la the Brexit
referendum, markets would most certainly react negatively.
It is highly likely that the next president will be facing a
recession in their first term, given that the average period of
economic expansion since the end of the Great Depression
has been 59 months and this current expansion is already
beyond 85 monthss old. As discussed earlier, extraordinary
monetary policy appears to have reached the end of its rope
and it doesnt seem likely that the Fed will have enough time
to hike rates sufficiently to face the next recession on its own.
A strong fiscal stimuluss package will be necessary. As
indicated in the infographic to the left, there may not be a
whole lot of room for fiscal maneuvering either.
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Underfunded Pension Fund Liabilities This item is a

bit of a longer term issue, but one that should be
informing asset allocation decisions today. As a result
of the ultra-low
low yields on the safest of investment
vehicles, the long term obligations of pension funds,
insurance companies and endowments have been
increasingly forced to use more risky investments
investment to hit
their annual growth targets. As depicted on the left,
the type of portfolio composition necessary to generate
the 7.5% average annual rate of return many long term
investors have built into their growth models requires
almost twice the amount of risk as was necessary ten
years ago and almost three times the risk exposure as
was necessary twenty years ago.
With valuations stretched on virtually all financial
asset classes, largely as a result of the reach for yield
caused by central banks reliance
relian on abnormally low
interest rates, history suggests that the next decade will
be characterized by rates of return dramatically lower
than the long term average.

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Other items that have our immediate attention

include, but are not limited to:
- Possibility of a Hard Brexit as
proposed by UK Prime Minister Theresa May,
in which the UK and EU sever all formalized
trade relations. Sincee the Brexit referendum
the British Pound has faallen to a 168 year low.
- Continued
ontinued capital flight and currency
depreciation in China, where the Yuan has
fallen to a six year low against the US Dollar
and a basket
et of international currencies.
currencies
- Further
urther deterioration of relations
between the US and Russia amid a worsening
humanitarian crisis in Syria.
Syri
While the above items combine to paint a rather bleak picture, it is imperative that we as investors not bury
our heads in the sand. With the 7--year inflation-adjusted
adjusted return forecast from famed investor Jeremy
Granthams GMO showing few places to protect
pr
assets, let alone generate positive real returns, one might be
tempted to take their ball and go home. Our recommendation instead, and that of some of the worlds most
respected wealth managers as discussed in our last letter, would be to increase your
your allocations to those safe
haven assets to which funds have always flowed in times of economic panic: US Treasuries, gold and cash
denominated in US Dollars.
US Treasuries and gold, like all traded asset classes, are subject to volatility and have in fact experienced a
good deal of volatility
lity in recent weeks. They have still, however, outperformed domestic and global equities
year-to-date.
date. Cash has the ability to protect you during a market downturn and gives you the option to dollar
cost average back into risk assets once they have been repriced to more historically attractive valuations. As
important as preservation of capital during a downturn is preservation of the psychological willingness to
assume risk at that point in the future when history proves it is most beneficial to do so. That is the service we
are attempting to provide.
Please feel free to share this newsletter and do not hesitate to call or email with any questions or comments or
to schedule a face-to-face
face portfolio review.
Sincerely,
Clay Ulman

Jim Ulman

CBU@UlmanFinancial.com
410-557-7045 ext. 2

JWU@UlmanFinancial.com
410
410-557-7045
ext.1

*The Standard & Poors 500 Index (S&P500)

P500) is a capitalization-weighted
capitalization weighted index of 500 stocks designed to measure performance of the
broad domestic economy through changes in the aggregate market value of the 500 stocks representing all major industries. The
Th Dow
Jones Industrial Average (Dow) is a price-weighted
weighted index of 30 significant stocks traded on the New York Stock Exchange and the
Nasdaq. The Bloomberg Commodity Index is a broadly diversified commodity price index for the global commodities market
distributed by Bloomberg Indexes.

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Indices such as the S&P 500 Index, the Dow Jones Industrial Index and the Bloomberg Commodity Index, and any others listed above,
are unmanaged and investors are not able to invest directly into any index. Past performance is no guarantee of future results.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or
recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor
prior to investing.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies
promoted will be successful.

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