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The Strong U.S. Dollar Could Pressure S&P 500 Earnings

Summary U.S. dollar is strengthening against a basket of foreign currencies. How a stronger dollar could affect S&P 500 company earnings. Sectors that are exposed to foreign exchange currency risks. The quickly appreciating U.S. dollar could begin to weigh on corporate earnings, especially among large-cap S&P 500 stocks and related exchange traded funds with significant overseas exposure. The SPDR S&P 500 ETF (NYSEArca: SPY ) , which tries to reflect the performance of the S&P 500 index, has increased 11.5% over the past year but is down 1.9% year-to-date. The stronger USD is expected to diminish profits for large companies that do business overseas, and some strategists contend that the strengthening currency and low energy prices could constrain quarterly S&P 500 earnings growth to just 3%, compared to previous calls for a 7% rise at the start of October, reports Eric Platt for Financial Times . The PowerShares DB U.S. Dollar Index Bullish Fund (NYSEArca: UUP ) has increased 13.1% over the past year and rose 2.6% year-to-date. The appreciating greenback, which has been rallying against a basket of foreign currencies since July, could pressure the S&P 500 where foreign sales make up over two-fifths of total turnover, with 261 companies in the index generating over 15% of revenues overseas. Deutsche Bank calculates that for every 10% increase in the USD against major currency baskets, the S&P 500 earnings face a potential decline of “slightly over $2,” or each 10 cent drop in the euro from about $1.2 could cut $1 from S&P 500 earnings. “The uncertainty in commodities, foreign exchange and interest rates across the curve is high, confounded by uncertainty in quantifying their influence on earnings per share and price-earnings,” David Bianco, strategist at Deutsche, said in the FT article. “We expect more cuts during fourth-quarter earnings season, especially for those with FX exposure.” For instance, GameStop (NYSE: GME ) has already blamed the “strength of the US dollar” for part of its slide in holiday same-store sales. On a sector-by-sector basis, observers believe the technology, materials and energy sectors will likely be the most affected by a stronger dollar as each sector generates over half of revenues abroad. Year-to-date, the Technology Select Sector SPDR (NYSEArca: XLK ) fell 5.0%, Materials Select Sector SPDR (NYSEArca: XLB ) decreased 1.5% and Energy Select Sector SPDR (NYSEArca: XLE ) dipped 2.4%. Cantor Fitzgerald analysts have warned that companies with “material international exposure,” such as Google (NASDAQGM: GOOG ), Facebook (NASDAQGM: FB ), Amazon (NASDAQGM: AMZN ) and eBay (NASDAQGM: EBAY ), could report reduced earnings forecasts if the “trend is sustained.” XLK includes GOOG 6.4%, FB 4.0% and EBAY 1.6%. SPY holds GOOG 1.6%, FB 0.9%, AMZN 0.6% and EBAY 0.3%. SPDR S&P 500 ETF (click to enlarge) Max Chen contributed to this article .

A Red Flag On The S&P 500 Index

Summary The U.S. Economy is growing at an above trend pace over the last 2 quarters. Despite this there has been recent volatility in U.S. equity markets and there was a shift in sector performance. Nonetheless the trend in the S&P 500 remains intact with a 3 month outlook on the S&P 500 at 1170. A Red Flag On The S&P 500 I love the beach. Almost every weekend I would go on afternoons and take a swim. I would build sand castles and often times swim in the water and if I were hungry I would go by the local kiosk and eat some delicacies such as “Bake & Shark” or “pholouri”. Those were fun times. Even now when I get an opportunity I would spend some of my vacation days by the beach relaxing on the sand. But every time by the beach wasn’t always pristine. On some days there would have been rough waters or areas of roughness by the bay. The lifeguards would put up these red flags by the areas that were not safe for swimming. The red flags were a warning for swimmers so that drowning would be prevented. On the Friday 16th January 2015 close of the U.S. equity market, I observed a red flag on the S&P 500 Index. While the U.S. economy has been moving at an above trend pace over the past couple of quarters and the risk premium for investing in U.S. stocks are at 1-year lows, there has been a shift in sector performance, showing that the S&P 500 Index is becoming defensive. As such a new asset allocation is recommended. While still being overweight in U.S. equities by having a position in the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), a heavy overweight position in the health care sector is recommended, through the Health Care Select Sector SPDR Fund (NYSEARCA: XLV ). Slightly overweight positions are proposed in the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) and the Utilities Select Sector SPDR ETF (NYSEARCA: XLU ) . Neutral positions should be observed in info tech through the Technology Select Sector SPDR ETF (NYSEARCA: XLK ) and the Consumer Discretionary Select Sector SPDR ETF (NYSEARCA: XLY ). Finally underweight positions in the energy sector through the Energy Select Sector SPDR ETF (NYSEARCA: XLE ), the materials sector through the Materials Select Sector SPDR Fund (NYSEARCA: XLB ) and telecoms through the SPDR S&P Telecom ETF (NYSEARCA: XTL ) are also recommended. The table below illustrates the recommendations. Chart 1 – Recommended Portfolio Allocation Versus S&P 500 Index as at Jan 9 th 2015 (click to enlarge) Source: Cerebro Recommendation using Microsoft Excel By looking at the allocation the portfolio is prepped for rough waters. On a weekly basis the portfolio metrics utilized to derive the portfolio allocation will be analyzed to determine whether another shift in asset allocation is required. Economic Activity Over the past couple of quarters the U.S. economy has been operating at an above trend pace. Latest figures show that U.S. GDP grew 2.7% year over year in the 3rd quarter of 2014, 0.4% higher when compared to the previous comparable quarter. U.S. GDP growth is also moving above its 4 quarter moving average of 2.6%. Chart 2 – U.S. GDP Growth (Y-o-Y %) as at Sept 2014 (click to enlarge) Source: Bloomberg The U.S. has been one of the leaders of growth from the developed economies and this trend is expected to continue, with its consumers obtaining a stronger purchasing power due to a strengthening U.S. Dollar. One of the more visible aspects of an appreciating U.S. Dollar was the decline in WTI Crude Oil. The over 50% decline in oil should bode well for the U.S. consumer. The uptrend in growth is also expected to continue as the slack in the U.S. labor market recedes. Chart 3 – U.S. Unemployment Rate (%) as at Dec 2014 (click to enlarge) Source: Bloomberg The U.S. unemployment rate stood at 5.6% at the end of the year, below the 12 month average of 6.2% and it is the lowest rate over the past 5 years. The “weather” in the U.S. appears to be just fine. Things appear to be going so well in the U.S. that the Fed ended its Q.E. program in October 2014. Also analysts expect the Fed to be raising its benchmark rate by the 3rd quarter of 2015. The Fed has continuously reiterated that it is data dependent and it will not make a move in rates unless the data corroborates the move. This is why the rate increase is expected 6 months ahead because the inflation data does not reflect a hike in rates. Over the month of November, U.S. CPI had the largest decline since December 2008. The retreat was attributed to the precipitous fall in fuel. U.S. CPI fell to 1.3% year-over-year in November 2014. The less volatile core CPI fell 0.1% year-over-year to 1.7%. Energy costs fell 3.8% versus a month earlier, led by a 6.6% decline in gasoline. While rent, medical care and airline fares rose, it was negated by the largest drop in clothing costs in 16 years and the largest fall in prices in used cars & trucks in September 2012. The declining energy & transportation costs will help both companies and consumers, improving the expectations for an increase in the S&P 500 Index in the short to medium term. Chart 4: 5-Year Chart of U.S. CPI (Y-o-Y %) as at Nov 2014 (click to enlarge) Source: Bloomberg Relative Asset Allocation & Sector Rotation Metrics By looking at the performance of bonds, stocks and commodities, a next move in the asset class performance of stocks can be forecasted as all these assets are related. Table 1: Total Returns of SPY, the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) & the PowerShares DB Commodity Index Tracking ETF (NYSEARCA: DBC ) ETFs Over Various Time Periods as at Jan 16 th 2015 Source: Bloomberg Chart 5: 6-Stage Business Cycle Source: StockCharts Based on the total returns of the ETFs above, the commodities are in a bear market while stocks and bonds are performing positively. Based on the above data it can be said that we are in stage 2 of the business cycle, with stocks and bond prices expected to continue to increase. Given that U.S. yields are expected to decline, stocks remain favored over bonds with the earnings yield of the S&P 500 at 5.58% as at January 16th 2015 while the U.S. 10-Year yield is at 1.84%. The difference between the 2 asset classes is 3.74%. On average, over the past year, the S&P 500 made a daily low when the difference or spread was 3.49%. Another point to note is that on average, over the past 12 months, the spread when the S&P 500 made a daily high was 3.09%. Thus one can deduce that the S&P 500 is closer to making a new low than a new high and that this low would be made soon (and perhaps around the 2040 to 2015 price zone). A daily price high can be deduced when the spread between the S&P 500 earnings yield and the U.S. 10 Year yield nears or is less than 3.09%. It can be construed that investors are not prepared to invest in U.S. equities as the risk premium (the value attained for buying such a risky asset as U.S. equities) for investing in U.S. equities heads below 3.09%. While the “weather” appears good, the waters are rough and it triggered a red flag. This red flag was derived from the shift in sector performance over the last couple of weeks. The tables below denote the shift. Table 2: S&P 500 Sector Total Returns Over Various Time Periods as at January 9 th 2015 Source: Bloomberg Table 3: S&P 500 Sector Total Returns Over Various Time Periods as at January 16 th 2015 Source: Bloomberg The health care, consumer staples and utilities all became leaders, indicating that the market is defensive, despite the S&P 500 Index having a larger than average risk premium. This move in sector performance complemented the move in the VIX, a measure of volatility for the S&P 500, which made a daily high of 23.34, which is below the 1 year October 2014 high of 31.06. Chart 6: Daily VIX Candlestick Chart as at 16 th Jan 2015 (click to enlarge) Source: Bloomberg Despite the shift in total returns of the sectors, when the returns are weighed versus the S&P 500, which smoothens the data, the shift is not so drastic. Chart 6: S&P 500 Sector Relative Rotation Graph as at January 16 th 2015 (click to enlarge) Source: Bloomberg From the relative rotation graph above we can see that info tech and health care are the leaders while telecom, materials & telecom are the laggards. Utilities & consumer staples are neutral with positive momentum while financials and consumer discretionary are also neutral, with negative momentum. By marrying the two concepts, total return sector performance & sector relative rotation, the recommended sector allocation in chart 1 was derived. Technical Analysis Based on the chart analysis as well as the risk premium in the S&P 500, support is seen around the 2040 to 2015 price region, with the S&P 500 expected to reach 1170 over the next 3 months. Chart 7: S&P Index 500 Candlestick Chart as at Jan 16 th 2015 (click to enlarge) Source: Bloomberg

Generating Alpha With A 2015 Model Portfolio

Summary 2015 will be a volatile year, and only the great stock pickers will come out significantly ahead. Don’t look for the needle in the haystack. Just buy the haystack! Taking the Jack Bogle approach might be the best way to mitigate risk and avoid unnecessary volatility. The first (and only) email request sent to SAFoundationalResearch@gmail.com was a request to create a model portfolio against the S&P 500. The weightings below are what we recommend for 2015: S&P 500 Recommendation Equity Sectors Weight Weight Difference Consumer Discretionary 12.0% 12.0% 0.0% Consumer Staples 9.9% 10.9% 1.0% Energy 8.3% 10.3% 2.0% Financials 16.5% 18.0% 1.5% Heathcare 14.5% 16.0% 1.5% Industrials 10.4% 8.9% -1.5% Information Technology 19.7% 19.7% 0.0% Materials 3.2% 3.2% 0.0% Telecom 2.3% 0.0% -2.3% Utilities 3.2% 1.0% -2.2% We fundamentally believe that 2015 will be a volatile year, and only the great stock pickers will come out significantly ahead. That being said, this portfolio will take the Jack Bogle approach and will strictly purchase SPDR ETFs. “Don’t look for the needle in the haystack. Just buy the haystack!” – Jack Bogle Some other rules for this $100,000 model portfolio: Opportunity to rebalance quarterly (but not required) Must be within +/-3% of the sector benchmark Must be at least 80% invested at all times Recommended $100,000 Model Portfolio Ticker Price as of Jan 2, 2015 Number of Shares Consumer Discretionary Select Sector SPDR ETF (NYSEARCA: XLY ) 72.15 166 Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) 48.49 224 Energy Select Sector SPDR ETF (NYSEARCA: XLE ) 79.16 130 Financial Select Sector SPDR ETF (NYSEARCA: XLF ) 24.73 727 Health Care Select Sector SPDR ETF (NYSEARCA: XLV ) 68.38 233 Industrial Select Sector SPDR ETF (NYSEARCA: XLI ) 56.58 157 Technology Select Sector SPDR ETF (NYSEARCA: XLK ) 41.35 476 Materials Select Sector SPDR ETF (NYSEARCA: XLB ) 48.58 65 Utilities Select Sector SPDR ETF (NYSEARCA: XLU ) 47.22 21 Cash 244.31 244.31 After this article, Foundational Research will post a series of articles for each sector and the respective industries. Below are some highlights on half of the sectors: Technology Sector Highlights We remain cautious on the technology sector, and recommend an equal weight. Although the sector, as measured by the XLK, has outperformed the broader market in 2015, much of that is due to AAPL, which accounts for more than 16% of the XLK index. We also believe the shift to cloud computing will have a negative impact on earnings for most large-cap technology companies, especially over the next few years, when the highest switching over/expenditure costs are expected. Valuations are also higher than they used to be, with overall tech trading at a 22% premium to the 5-year median P/E and a 70% premium to trough valuation, but the Technology sector still trades at a -9% discount to the S&P 500. Telecommunications Sector Highlights News flow continues to be almost exclusively negative in the telecommunications sector. Pricing is likely to continue to be a problem in wireless, and the wireline business is in secular decline. The negative pricing/promotion backdrop in wireless accelerated this past year. While the competitive condition may take a seasonal respite early this year following the holidays, the intermediate-term prospects in this regard is for more of the same, in our opinion. That is, more brutal competition. Energy Sector Highlights The downturn in crude oil prices and the prices for oil & natural gas-related stocks accelerated to the downside over the two quarters. Demand continued to suffer from weak economic conditions and/or slowing economic growth, particularly in the eurozone and China. At the same time, investors were spooked by ongoing strong oil production growth from US unconventional basins and the recovery of disrupted output from Libya. There was also the risk that the sanctions on Iran might be reduced or eliminated, potentially opening the way for increased production (approx. +500,000-700,000 barrels/d). Finally, OPEC was not able to come to an agreement to cut production to balance the market, leading to a sizeable drop in oil prices the day after Thanksgiving. We believe that the share prices have over-reacted to the crude oil price drop. Historically speaking, whenever energy stocks have lead decline for six months, they then lead for the following six months. “This time is different” often leads investors astray. Industrial Sector Highlights We are concerned that reductions to oil & gas capital spending budgets will have an outsized impact on the machinery and electrical equipment industries. There appears to be an expectation that better consumer spending trends following cheaper gasoline prices will spur further capital spending from the consumer discretionary sector. This may be the case, but we’d expect any pickup in capex from the discretionary sector to take time, while the cuts from the oil & gas complex will be more immediate. Additionally, sales into the oil & gas complex are among the most profitable for our companies, and will be difficult to replace (even if there is a pickup in consumer discretionary capex). Consumer Discretionary Highlights The market weight recommendation on the consumer discretionary sector reflects a more balanced view of the tailwinds and headwinds facing the group over this year. Fairly significant 2014 underperformance in the group has led to more reasonable relative valuations of late, and that, coupled with falling gas prices (a potential benefit to the consumer) and easing top line/margin comparisons in F15 have resulted in a more balanced risk/reward. That being said, many near-term macro data points remain mixed (i.e. jobs, housing, food commodity costs) and could keep a lid on overall earnings growth, which prevents a more constructive view on the group, for now. Material Sector Highlights Downstream is the new upstream. While we retain our neutral recommendation on the complex, we favor downstream/processed/refined-related commodity companies that benefit from the decline in upstream pricing. The perfect storm of increased production, stemming from higher prices, followed by slowing demand growth has resulted in a backdrop where many upstream commodities are in “oversupply.” The stronger United States dollar is only adding fuel to the fire. We would remain positioned in those commodities that benefit from falling inputs and oligopolic behavior. Our two preferred commodities are steel and aluminum, with the former capitalizing on falling iron ore prices, and the latter on falling power prices. We would avoid copper and iron ore where we have yet to see price support, as the cost curve continues to decline. Consumer Staples Highlights The third-quarter earnings results certainly did not encourage us to change our view. The operating environment remains challenging for packaged goods companies, especially so for food companies, yet the consumer staples sector continues to make new highs. Investors seem to continue to seek out yield, and probably even more so, stability, as we move toward year-end. Category growth remains sluggish in developing markets, and has slowed in emerging markets. The currency headwinds have intensified for many companies. Domestic attempts to drive volume with more promotions have not been as successful as in the past. The debate continues as to whether there has not been enough innovation or the consumer is still in a constrained in spending mode – we believe it has. Healthcare Highlights We continue to believe the Patient Protection and Affordable Care Act (ACA) will be a positive force in healthcare for the next 3-5 years, with some potential ramifications that need to be watched. As we approach year 2 of the expansion part of the law, Republicans have taken control of the Senate, and the Supreme Court has decided to review another case relating to the legislation. Scientific breakthroughs are creating a cornucopia of new biopharmaceuticals for unmet or poorly served medical needs. The demographics of the major industrialized nations, including North America, Europe, and Japan, are changing to larger populations of elderly patients, who are major consumers of drugs. Utilities Highlights We see nothing operationally wrong with the Utilities sector. The reach for yield has caused share prices to increase. Without a capex increase, and with prices as high as they are, we believe they will not appreciate any further. The last time the Utilities sector lead the market over the course of a year, as it did in 2014, it only returned 1% total return the next year. Over the next few weeks, we will go in-depth on each sector, so please remember to “Follow” us to not miss anything!