If it walks, talks and looks like a Bull Market…then it must be a Bull Market! Or perhaps, like the wolf in sheep’s clothing, could it be a Bear Trap?

1. 1
Year-End Investment Comment
December 2013
2014 Asset Allocation
Fundamentally, our views have evolved but not dramatically changed from a quarter ago. Our
analysis does suggest that valuations have deteriorated in most areas, except for emerging
market equities. Yet, we feel more careful calling for caution, as the very forces that moved
markets in 2013 could very well continue to work their “magic” in 2014
Current Previous
December-2013 October-2013
CASH & CASH LIKE
Cash & Cash Like 1.0 0.0
FIXED INCOME
U.S. Fixed Income Inv. Grade (1.2) (1.0)
U.S. Fixed Income HY (0.3) (0.2)
EAFE Fixed Income Hedged (0.7) (0.3)
EM Debt (0.1) (0.6)
EQUITIES
U.S. Equities (0.4) (0.3)
EAFE Equities 0.3 0.9
EM Equities 0.0 0.0
ALTERNATIVES
RV Hedge 0.0 (0.2)
Event Driven 0.0 0.6
Global Macro (1.0) (1.0)
Directional Hedge (0.1) 0.0
Managed Futures (0.6) (1.2)
REAL ASSETS
MLP 0.2 0.2
Global REITS 0.3 (0.1)
Commodities (0.3) (0.8)
Asset Class Underweight Overweight
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(10.0) (7.5) (5.0) (2.5) 0.0 2.5 5.0 7.5 10.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
(3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0
Neutral
Note: This table depicts the current consensus opinion of WE Family Offices’ Strategic Investment
Committee regarding portfolio asset allocation. The portfolio asset allocation recommendations in
the table above are made by WE Family Offices LLC and not by Brunel Associates.

2. 2
2014 Investment implications
i. Higher than normal cash reserves remain warranted, both to dampen downward price
movements and provide ammunition for buying opportunities
ii. Fixed income investments appear most likely to disappoint for as long as they have an
exposure to interest rate risk. Thus, keeping duration to a minimum and tactically
allocating to: Investment Grade Munis, High Yield Munis, Emerging Markets and
Mortgage-Backed Securities
iii. Equity valuations do not appear to be cheap, tactical allocations to: European
Equities and Emerging Market Equities - Mexico, EM Consumer, Asia (ex-Japan) -
should be considered
iv. Trading strategies such as global macro and managed futures offer opportunities to
hedge certain portfolio risks, but they can be significantly whipsawed when markets
gyrate in a directionless manner. Caution continues to be prescribed regarding these
strategies and managers.
v. Income Producing Real Assets – MLPs – Though they may have suffered from the
perception that they were interest sensitive investments (as they are often bought for
income) their likely future exposure to the need to transport hydrocarbons from the place
they are extracted to the place where they are consumed should provide long-term
potential
vi. Illiquid strategies, may offer meaningful opportunities, specifically within the following
strategies: Distressed European assets, Distressed European real state, as well as
private market opportunities within the energy space
Market Summary (Year-End 2013)
Calendar year 2013 opened on a high note. As New Year's Day drew to a close, and after tense
negotiations the previous December, the U.S. Congress and White House struck a deal to
maintain the majority of the decade-long Bush tax cuts in exchange for a reversion to prior tax
rates on the nation's highest incomes. The revenue generated was not as noteworthy as the
psychological effect of eliminating a powerful political issue that had been a centerpiece of the
2012 presidential election. Once off the table, the Markets responded. Whether measured by the
first handful of days or the entire month of January, equities gave notice to a very good year. And
indeed, despite a few hiccups along the way, setbacks were relatively shallow, followed by new
records in the major indices confirming the broad based rally.
The first-half of the year was off to a quick start, leading to a superb first-quarter, the Dow Jones
and S&P 500's best showing of the 21st century. As we moved into spring and summer,
turbulence in the form of higher interest rates was the principal culprit of a swoon in stock prices.
By summer's end, the Market had become totally obsessed with Federal Reserve monetary policy
and whether a super accommodative stance would be peeled-back at all. The anticipation of a
reduction in bond purchases by the Fed coupled with geopolitical risks in late summer was enough

3. 3
for caution to reappear. However, selling spurts were limited to five-percent or less for the most
part, and for a second consecutive year, the Dow and S&P failed to witness a 10% correction,
rare indeed in the post WW II era.
The second-half was punctuated by the Fed's surprise decision not to begin tapering its stimulus
package due to economic uncertainty and uneasiness with Washington politics. That combination
appeared less threatening as year-end approached. For even though the federal government did
suffer through a partial shutdown, the residual effects mostly proved to be minimal, thus closing
the fourth-quarter on seemingly stronger footing than was the case on October 1st at the
beginning of the said shutdown.
Across the pond, European bourses picked-up steam in the spring after a slow start to the year.
The catalyst, as had been the case since the global crisis, was the European Central Bank
reducing the overnight cost of money in the face of the Continent's hard recession. This in turn
was followed several months later by a second cut after a sharp decline in headline inflation. The
bright spot was by the time the ECB cut rates a second time, the economy was officially out of
recession and stabilizing, though growth remained very uneven throughout the Euro-zone. Over
in the United Kingdom, the year opened literally in identical fashion, but began to show signs of
recovery sooner, thus helping both its equities and currency as the year progressed.
Japan was off-the-charts for a while in 2013, the full effects of a new prime minister stirring hope
that this time, finally, policy actions would be taken to change the trajectory of growth and inflation
in a nation mired in slow-motion quicksand for better than a decade. PM Abe brought a radically
different approach to tackle Japan's economic misfortunes. In rapid succession and through
cooperation with the Bank of Japan, bond purchases dwarfing steps taken by the Fed and meant
to create inflation from deflation caused a sizable rebound in stock prices through the early months
of the year, past the beginning of the fiscal-year in April, before subsiding, then retreating and
later recovering once again.
Emerging Markets sang a different tune. For the first time since the late 1990's equities
underperformed on a relative and absolute basis vis-á-vis developed markets. A combination of
weaker global demand hurt exports and therefore slowed economies, in some cases below
growth in developed countries. However, lower GDP did not mean lower inflation therefore
eliminating any real interest rate advantage. Foreign capital flows vital to the space turned from
noticeable to a wave and created a vicious cycle of lower prices and increased outflows, especially
right before and after mid-year, as the Federal Reserve contemplated a reduction in its bond
stimulus program. The Fed's subsequent announcement in mid-September not to taper provided
short-term relief, but in general, was not sufficient and did not reverse the pattern set much earlier
in the year.
Specifically, Treasuries seemed to be on cruise-control early, justifying a yield under 2% because
the economy was not lighting a fire, had remained subdued, and below the 2% mark. The early
forecast was for tax increases along with budget spending cuts to hold back any potential return
to trend-growth. However, as Q1 moved into Q2, the mood had become excessively bearish on
the growth front and began to price in even higher prices & lower yields. The view was not precise
but with the Fed on QE forever, or so it seemed at the time, risk-on stayed on course and little
potential for a change in course was anticipated.
All that changed in mid-May when Fed chairman Ben Bernanke ahead of a regular scheduled
meeting stated the central bank may see it appropriate to withdraw a degree of excess liquidity
sometime over the next few meetings. It began a series of steps, like dominos falling, and most

4. 4
importantly forced a reevaluation on the working premise and expectations charted for the
remainder of the year. No longer was a super aggressive monetary policy guaranteed for the year.
The one caveat consistently expressed by the Fed is as long as long-term inflation expectations
are well-anchored, additional time can be bought to secure a stronger domestic economy.
Throughout the year, Washington, not the capital but Capitol Hill was on the minds of the Fed and
Wall Street. The only bit of good news was as the year drew to a close political headwinds
appeared to be diminishing – a two-year budget agreement was achieved – and though not
expected to turn into tailwinds, it was seen as better news.
By the beginning of September EM debt in general had declined substantially in value and
became oversold, which led to a brief respite. Additionally, in mid-September, the Federal
Reserve clearly surprised markets with a decision not to taper its bond program, even by a little
bit! That became the moment in the year’s second-half. Afterwards, most every risk-on asset
immediately improved, be it EM debt, external and in local currency, crude oil, or Gold. The
second part of that story is the relief was just that only for a brief spell; the previous pattern
returned to the fore, though not with the same intensity as prior to the Fed’s announcement.
Going forward, the questions become, how aggressively will the Fed taper, and, more importantly,
what will be the market’s reaction? In other words, how much has been factored-in? Will Emerging
Market debt suffer losses comparable to last year’s, or will foreign flows return? History is not
always a good guide, so even though in recent years EM assets have bounced back, sharply at
times, there is no assurance a repeat will be in the works as a New Year begins.

5. 5
Excess liquidity creation
Continuing to update the same two charts that we presented in our last two letters we can see
that the intuition we had last quarter came to pass. In the second chart, which shows normalized
monetary base to GDP ratios, Japan did overtake the E.U. As expected, government policy has
focused on expanding the monetary base to finally stop Japan’s deflationary expectations; this is
working as deflationary fears were erased from the latest official economic commentary, but it did
cause a much higher rate of monetary expansion than in the E.U. There, the ECB, though
prepared to provide liquidity when needed, has made a determined effort to “sterilize” excess
money and thus control its monetary base, as it still lives under a mandate that puts inflation
control ahead of any other goal. Thus, the U.S. is still the unchallenged leader in terms of excess
money creation, followed by Japan, then by the E.U.
While this U.S. liquidity generation has undoubtedly contributed to significant wealth creation in
the financial sector of the economy, one can honestly wonder how the plot will conclude. Clearly,
in the short term, those who worry about massive inflation appear somewhat misguided:
significant overcapacity of all major global input sources – labor, energy and materials – most
likely limit those risks. Yet, the scope for inflation in goods or services that are either not globally
traded or tradable – healthcare or education, for instance – or whose markets are dependent on
the richest fringe of the population – exceptional real estate or art – is certainly present. In fact,
the evidence would suggest that inflation has been rampant in those latter two segments. The
one question which is still unfortunately unanswered – and will likely remain so given the dearth
of politically unbiased commentators – is whether that monetary creation has led to any materially
higher economic growth. If it has, one can feel that the ills which went with such unabashed
liquidity creation might have been necessary evils. If it has not, one can only bemoan the profound
misallocation of capital which artificially low interest rates and distorted economic rewards can
inflict on an economy.
0
100
200
300
400
500
600
700
Mar-99 Aug-01 Jan-04 Jun-06 Nov-08 Apr-11 Sep-13
U.S., E.U. and Japanese Monetary Base Indices
100 = March 31, 1999
Japan
U.S.
E.U.

6. 6
The one thing which is clear, as illustrated in the chart below, is that currency markets have shown
a preference for the Euro against the Dollar, while the Yen has continued its downward drift
against both the Dollar and the Euro. Interestingly, these patterns fit with relative rates of monetary
creation. One of the stated goals of the Japanese authorities was to stop the appreciation of the
Yen and bring it down to more “reasonable levels” in order to regain some of their lost
competitiveness vis-à-vis dollar-linked or – pegged currencies. The appreciation of the Euro is
more puzzling given the obvious structural challenges facing the European Union. In short, one
can only conclude that markets continue to prefer currencies from countries – or groups of
countries – whose central bank shows a modicum of monetary discipline!
Recent U.S. economic contradictions
0
50
100
150
200
250
300
350
400
Mar-99 Aug-01 Jan-04 Jun-06 Nov-08 Apr-11 Sep-13
U.S., E.U. and Japanese Monetary Base to
Nominal GDP Ratios (Normalized pre 2Q 2008)
Japan
U.S.
E.U.
60
65
70
75
80
85
90
95
100
105
110
Dec-11 Jun-12 Dec-12 Jun-13 Dec-13
Euro and YenVersus the U.S. Dollar
(100 = December 2011)
Japan Euro

7. 7
Though one can take – and many have taken – some solace in several economic news releases
in the U.S., a more detailed analysis of the data suggest that a more nuanced stance may be
more justified.
Starting with real GDP, for instance, there is little doubt that the 4.1% reported rate of growth in
the third quarter of 2013 was decidedly better than any number since the fourth quarter of 2011.
However, how good is the news, really?
The two charts above track two of the most important contributors to real GDP growth, domestic
private consumption and private capital spending, excluding changes in inventory. Together,
these account for 84% of GDP! The first graph entitled “Personal Consumption Expenditures”,
depicts private consumption and illustrates that it has been stuck in below par growth: it is
currently growing at barely more than half its long-term average. This is not surprising when one
looks at the chart just below: personal income is also growing at lower than its long-term average,
-6%
-4%
-2%
0%
2%
4%
6%
8%
2000 2003 2006 2009 2012
Personal Consumption Expenditures
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
2000 2003 2006 2009 2012
Private Capital Spending (ex-Inventories)

8. 8
and in fact is stuck in the lower half of most observations. We will revert to this thought when we
consider employment statistics.
The chart entitled “Private Capital Spending” on the previous page, looks at fixed capital spending,
adjusted for changes in inventory levels. Though it has bounced back from the recessionary lows,
it now looks to be more in a down– than in an up-trend. Half of this aggregate is comprised of
residential and non-residential constructions, while the balance includes equipment and
intellectual property products. An analysis of the growth since the onset of the 2008 recession
confirms that the story is still not all that great: construction spending is still below pre-recession
levels, while the average growth of spending on equipment and software are at low levels, 1.1%
and 2.0%, respectively. Further, as illustrated in the chart, recent data suggest that fixed
investment growth is on a downtrend! Note that changes in inventories accounted for 72.5% of
the GDP growth in the third quarter! These can be intentional, as business builds inventories to
deal with rising demand, or unintentional and the result of disappointing sales. If the latter, which
circumstantial evidence suggests might be the case, they will have to be worked down!
The really good news, which few people mention, is that exports are growing at a pace that is at
least twice as fast as imports. With net exports still a negative for the GDP as a whole, the
tendency for exports to outperform imports is excellent. Some of this must be credited to the
growing domestic oil and gas production which is slowing imports of hydrocarbons; this does not
look like a trend which should soon reverse unless extreme views within the ecologist movement
prevail or if the current export ban on domestically produced oil remains. The balance of the
slowing import growth is less good news as it is well known that imports tend to track domestic
consumption. Thus, weak consumer spending growth naturally begets weak import growth; this
could reverse as and when consumer spending starts to return to its long-term growth norm. This
may not take place any time soon, though, as consumers seem to be reasonable and to seek to
maintain a more conservative savings rate, as illustrated below.
-6%
-4%
-2%
0%
2%
4%
6%
8%
2003-Jan 2005-Sep 2008-May 2011-Jan 2013-Sep
Personal Income Monthly Growth Patterns

9. 9
Theory teaches us that changes in a nation’s savings rate are often explained, at least in the short
term, by confidence within the job market. Thus, though one can argue that the Fed’s quantitative
easing – and the wealth effect it is meant to trigger – has helped bring down that savings rate
from the highs induced by the 2008-09 recession, it is equally clear that certain fears have been
rekindled. It is too early to tell whether this relates to an employment situation which is not nearly
as good as advertised or to fears of the impact on disposable income of rising health costs; yet,
the timing of the spike six months ago and recent steady increases suggest that employment
prospects are more material than health cost fears which only surfaced recently.
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
2000-Dec 2004-Feb 2007-Apr 2010-Jun 2013-Aug
Personal Savings as a % of Disposable Income
(3 month moving average)
95.00
100.00
105.00
110.00
Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-11 Jul-12 Oct-13
Total U.S. Jobs Data
(100 = Jan 2005)
Recession
Non-Farm
Household

10. 10
The two charts above entitled “Total U.S. Jobs Data” and “Rolling 12-Month New US Jobs Totals"
look at the employment situation and illustrate the fundamental premises that this recovery, if not
“jobless” has created a lot fewer jobs than “normal;” more to the point, the situation has hardly
improved in the last several quarters. The first chart, which shows total employment according to
the two surveys used by the U.S. Bureau of Labor Statistics, illustrates that, five years into the
“recovery” there are still fewer people employed in the U.S. than before the onset of the recession.
The second chart displays rolling twelve month job creation totals; it shows that, using the
enterprise survey – which focuses on 160,000 large businesses – new job creations reached 2
million on a rolling twelve month basis in September of 2011 and have bobbed around that line
ever since; people pointing to this 2 million as a major milestone reached recently have not been
looking at the data for the last two years! The household survey – which is often said to be more
accurate, although more volatile, because it incorporates small businesses – is showing a more
pessimistic picture as the most recent data points suggest that employment growth has in fact
been flagging in the last couple of quarters.
The real worry in the labor picture is displayed in the chart below. The labor force participation
rate has been falling dramatically and shows no sign of turning around. Note that, though
fluctuating somewhat in response to levels of economic activity, the labor participation ratio –
which measures the share of the population in age and capacity of working that is working – had
oscillated in a very narrow range between 1990 and 2008: between 66% and 67%. The 2008
recession brought it down, as should be expected. However, it has not rebounded at all since
then. The red line in the chart provides some initial explanation. There has been no drop in
unintended partial unemployment during the recovery (this comprises individuals working part-
time and saying they do so because they could not find a full-time job). This fits with our earlier
analysis. The economic recovery has been somewhat anemic and thus unable to generate
enough new jobs: able-bodied people would love to work, but cannot find it. Unfortunately, the
survey asks for self-reporting of the reasons for being unemployed or partially employed. Thus,
one cannot evaluate whether other factors – beside a lack of opportunities – may be driving this
unintended partial employment rate. Similarly, we cannot assess why the labor participation rate
keeps falling while the ratio of unintentionally part-time employed individuals seems to have
stabilized. Commentators have speculated that well-intended political decisions to offer a rising
level of unemployment and disability benefits may be discouraging people from looking for jobs.
People would be reporting that they cannot find jobs, but in fact might only be looking in a half-
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
2010 2011 2012 2013
Rolling 12-Month New US Job Totals (millions)
Non-Farm - Establishment Survey
Household Survey

11. 11
hearted manner; also, they might prefer blaming their status on a lack of opportunity. While
plausible and in line with many academic expectations, this explanation cannot be supported from
the statistics provided by the BLS.
In short, the U.S. economic picture does not appear to justify the kind of excitement that has been
displayed by most analysts, particularly after the release of revised third quarter growth. That it is
no longer totally in the doldrums is a welcomed fact. That all cylinders of the economic engine –
save government; and that is a plus – seem to be contributing is also a fact. There is however
quite a gap between an economy which is moving ahead at half its historical rate and the onset
of a real economic expansion. The so-called “recovery trade” looks at this point more like a
justification of recent equity price movements than a true fundamental discovery! As we shall see
later, valuation distortions can arise because of the discrepancy between perceptions that the
U.S. economy is doing a lot better and the reality that it is chugging along at a lower than normal
pace.
Economic trends outside of the U.S.
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
60%
61%
62%
63%
64%
65%
66%
67%
68%
1990 1993 1996 2000 2003 2006 2010 2013
Labor Force Participation Rate
vs. Unintentional Part-Time Employment
Labor Force Participation RateLab
Unintentional Part-Time EmploymentUn

12. 12
The chart above displays the real GDP growth rates of Europe – defined here as Euro-Land and
thus excluding the U.K. – and Japan. For comparison purposes, these are shown with those of
the U.S. The main message is unfortunately not terribly pleasing: real economic growth has really
not recovered around the developed world and the U.S. remains the leading economic light in the
developed world! Japan continues to follow the stop-and-go pattern it has been experiencing
since the December 1989 bursting of its asset price bubble. It is still much too early to declare the
policy of Prime Minister Abe a successful one, although there admittedly are a few encouraging
signs. Europe remains in the doldrums, despite the still solid performance of Germany. The major
structural issues that plague southern Europe – France, Greece, Italy, Spain and Portugal – are
not being addressed. The largest economy of the lot, France, suffers from a total inability for any
political party to implement the changes that are badly needed: more efficient labor market, some
minimum acquiescence that free markets work better than government-driven ones and a
substantial reduction in the size of the public service sector. The appreciation of the Euro is – or
should be – a further worry for Europe looking forward; the fundamentally flawed structure of the
Union comes out vividly here. While Germany can easily compete in global markets at current
Euro levels, it is a much harder game for southern Europe. Thus, any recovery there must be
driven by domestic growth, and this requires policies which governments will not implement!
-10.0%
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
1996-
Q1
1998-
Q3
2001-
Q1
2003-
Q3
2006-
Q1
2008-
Q3
2011-
Q1
2013-
Q3
Real GDP Growth in Developed World
EuroZone Japan U.S.

13. 13
The developing world appears to be on a continued growth mode, held back by the monetary
policy tightening instituted by many governments in response to what they saw as runaway laxity
by the U.S. As these economies – save India – do rely on exports, tracking their currencies helps
anticipate future performance somewhat. Thus, Brazil and India should be benefiting from lower
currencies, while China and Mexico will need to compete within a stable to rising currency
environment.
U.S. Equity market valuations
Over the last several commentaries, we have been using a couple of equity valuation measures
that rely more on macro-economic data than actual corporate reporting. This does not reflect a
fundamental preference on our part, but rather is part of a plan of broadening the analysis to
include other major countries. We believe that there is more consistency in macro-economic
reporting principles than in terms of accounting practices. Further, while “listed” corporate
developments may appear to diverge from the broader macro-economic trend in the short-term,
rare is the country – only Germany comes to mind – where such discrepancies can persist for an
extended period of time.
Three graphs tell the story. The first, overleaf, creates a notional implied P/E for the S&P 500 by
dividing the actual level of the index at the end of each quarter by the reported GDP-based
corporate profits with inventory valuation and capital consumption adjustments for that same
quarter. Though still in the middle of the long-term historical range, it appears to be creeping up
and thus deserves watching, particularly when one focuses on the post-1982 environment and
mentally excludes the tech bubble at the turn of the century!
0
50
100
150
200
250
Jan-03 Mar-05 May-07 Jul-09 Sep-11 Nov-13
Developing Currencies Versus the U.S. Dollar
(100 = January 2003)
China India Mexico Brazil

14. 14
The second, above, looks at the reverse of this implied P/E ratio – an implied earnings yield – and
compares it with the yield of the constant maturity U.S. 10-Year Treasury bond, as computed and
provided by the St. Louis Fed. The main insight from that chart does not relate to equity valuations;
the data on the implied earnings yield is no more conclusive than in the first chart above. On the
other hand, U.S. Treasury yields appear considerably below historical levels. Thus, if it is true that
there should be some relationship between earnings yields – and thus P/E ratios – and long-term
interest rates, one should probably develop a measure of caution. It should suggest two
conclusions.
First, any measure of equity valuation that is based on interest rates should be roundly discarded:
it may well be that equities are cheap relative to bonds; but bonds are so visibly expensive that
equities could also be expensive, albeit a bit less than bonds! Second, if there is – as there should
be – some relationship between equity valuations and long-term interest rates, one should be
mindful of the reaction of equity prices as and when – not if – long-term U.S. interest rates climb
further.
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012
Implied S&P 500 P/E
0
2
4
6
8
10
12
14
16
18
0%
50%
100%
150%
200%
250%
300%
1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012
Implied S&P Earnings Yield vs. 10 Y Treasury
Yield
Implied Earnings Yield
10 Year Constant Yield U.S. Treasury

15. 15
The last graph, below, is based on the theory that P/E ratios should in part reflect profit growth
prospects. However, because we do not have access to historical forward looking equity profit
growth prospects, we have had to make a conceptual change. Using actual data for future profits
for some of the time and real expectations for the more current period would bias our analysis:
expectations can be wrong, both now and in the past! We postulate that future growth – if
measured over the intermediate term – should in part reflect some measure of recent intermediate
growth trends. Ostensibly, this is debatable as one can easily imagine that our analysis would fail
to show anything if there was a sudden structural change. However, we felt it best to conduct it
and show it, in order for our readers to make up their own minds.
Thus, in the chart above, the current implied P/E is adjusted by the average rate of nominal GDP
growth over the prior 36 months – we need nominal growth so that our analysis is not distorted
by change in inflation levels. The results are interesting from two points of views. First, it shows
that there has been a fluctuating but relatively steady valuation range and that its fluctuations
conform to rational expectations: valuations fell while inflation was rising rapidly and rose as
inflation – and interest rates – came back to more “normal” levels. Second, it suggests that though
not overpriced yet, equity prices appear close to bumping against the upper boundary of our band,
defined by the long-term average plus and minus half a standard deviation.
In short, we conclude that it is too early to cry wolf and argue that U.S. equities should be sold
simply on valuation grounds; yet, we note that they have become quite a bit more expensive in
the last couple of quarters and that both corporate profits and valuations are susceptible to
negative surprises when long-term interest rates return to the norm. Higher interest rates could
cause some slowdown in the interest sensitive part of the economy, while equity P/E’s normal
tendency is to move in the opposite direction to interest rates.
Investment implications
Fundamentally, our views have evolved but not dramatically changed from a quarter ago.
Ostensibly, we feel chastised by the fact that we underestimated the strength of the “tsunami of
liquidity.” Our analysis does suggest that valuations have deteriorated in most areas, except for
emerging market equities. Yet, we feel more careful calling for caution, as the very forces that
0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
80.0
1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012
Implied GDP Growth-Adjusted S&P 500 P/E

16. 16
moved markets in 2013 could very well continue to work their “magic” in 2014. At the same time,
we are not ready to throw all traditional indicators to the wind or to adopt the justifying rather than
analyzing approach that we are seeing in many – too many – commentators. That these have
proven right in the recent past does not prove that the analysis is correct. It just proves the old
adage that fighting the tape is a dangerous sport. We emerge from the last twelve months with
our share of wounds and feel one should always learn from one’s mistake; however, woe to he
or she who learns the wrong lesson!
We are thus firmly convinced by three main themes:
o Excess liquidity has been a very important – though not the sole – driver of equity
markets in the U.S. – and by extension, in the balance of the developed world. There
is no compelling reason to assume that this will stop in the short term. In fact, the
recent announcement by the Fed that it would only trim $10 billion off its hitherto
monthly $85 billion purchase of fixed income securities, suggests that we are nowhere
near the time when quantitative easing stops! There is room for equity prices to rise
further.
o Direct and indirect valuation factors suggest that equities could well experience a
setback at some point, which does not have to be in the too distant future. We suspect
that this will happen as and when markets feel that the path toward allowing the
economy to operate without the constant official creation of liquidity is clear, and thus,
the “inflection point” may come too close for comfort. At that point, there may be
material downside risk to equity prices.
o Trying to time whatever turning point is ahead of us does not seem reasonably
possible. Though we have heard commentators discuss and predict the actual quarter
during which this could happen, we view these as pure speculation. The truth is that
one can conjure up as many rationales for it happening next quarter as there are
against that same proposition. We feel that this should drive a strategic dichotomy
which many investors will have to face.
The major decision which investors should indeed make relates to the trade-off between the short-
and the long-term. It relates to whether not participating in a raging bull move is creating so much
discomfort that they feel they have to remain overweight in equities and thus have a portfolio
comprising more tactical risk than their investment policy. At the same time, retaining more tactical
risk than “normal” exposes investors to the near certainty that some of the gains they have made
and are still making will disappear. Unless one assumes – and this would appear to us a fool’s
errand – that one will be able to call the turn just in time, one is bound to have to decide to sell
after markets turn. How unpleasant will it be to take losses, which could be material if the turn is
sharp? Thus, an alternative strategy is to decide to avoid the potential worry with excess equity
risk and start to move to an underweighted position. This, however, cannot be done unless one
is explicitly prepared to see the portfolio underperform for as long as the equity rally continues.
Within these parameters, a number of themes emerge:
i. Higher than normal cash reserves remain warranted, both to dampen downward price
movements and provide ammunition for buying opportunities
ii. Fixed income investments appear most likely to disappoint for as long as they have an
exposure to interest rate risk. Thus, keeping duration to a minimum and tactically

17. 17
allocating to: Investment Grade Munis, High Yield Munis, Emerging Markets and
Mortgage-Backed Securities
iii. Equity valuations do not appear to be cheap, tactical allocations to: European Equities
and Emerging Market Equities - Mexico, EM Consumer, Asia (ex-Japan) - should be
considered
iv. Trading strategies, such as global macro and managed futures, offer opportunities to
hedge certain portfolio risks, but they can be significantly whipsawed when markets gyrate
in a directionless manner, caution continues to be prescribed to these strategies and
managers
v. Income Producing Real Assets – MLPs – Though they may have suffered from the
perception that they were interest sensitive investments (as they are often bought for
income) their likely future exposure to the need to transport hydrocarbons from the place
they are extracted to the place where they are consumed should provide some long-term
potential
vi. Illiquid strategies, as unpopular as they may be, may actually offer meaningful
opportunities, specifically within the following strategies:
o Distressed European assets, Distressed European real state, as well as private
market opportunities within the energy space present interesting opportunities
The environment is thus not devoid of opportunities, but it should be seen as somewhat
treacherous. In short, as mentioned in virtually all previous commentaries, the prudent investor
will seek to capture as many of the opportunities as might be available, but will be particularly
careful to define his or her real risk tolerance and need for higher returns, hopefully through a
cautious evaluation of his or her individual goals and the size of the assets needed to defease
them. For many, this may involve taking a wealth preservation strategy, remembering that wealth
is created in entrepreneurial ventures and protected in the public markets. For a few, this may
involve continuing to seek long-term returns and accepting the inevitable volatility, arguing that
one’s balance sheet strength and long-term horizon allows such relative aggressiveness. The
spectrum of possible investment stances is thus large, but the main focus should be on ensuring
that one is in the right position within this spectrum rather than being mesmerized with short-term
return opportunities.
___________________________
Santiago Ulloa
___________________________
Jean Brunel
This letter contains our current opinion, and does not represent a recommendation of any particular security, strategy, investment
product or manager. Our opinions are subject to change without notice. This letter is distributed for educational purposes only and
should not be considered as investment advice or an offer of any security or service for sale. Information contained herein has been
obtained from sources believed to be reliable, but not guaranteed. No part of this letter may be reproduced in any form, or referred to
in any other publication, without express written permission.