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When Reflection Leads to Inflection Quarterly Newsletter Q1 2014 January 2014

When Reflection Leads to Inflection

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January 2014. When Reflection Leads to Inflection. Quarterly Newsletter Q1 2014. Q1 2014. S&P 500 Index at Inflection Points. Q1 2014. S&P Price and P/E Ratio. Source: Standard & Poor’s, FactSet, Robert Shiller Data, J.P. Morgan Asset Management. Q1 2014. - PowerPoint PPT Presentation

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When Reflection Leads to Inflection

Quarterly Newsletter Q1 2014

January 2014The end of a year and beginning of a new one invariably leads people to reflect on the past and contemplate the future. In fact, doing so is big business. Just look at the entertainment industry with its awards season consisting of the Grammys, Oscars, and Emmys or the sporting world with its pre-season polls. Money managers are no different in this respect and can actually be some of the worst culprits. Performance reviews, market re-caps, and economic forecasts are common phrases this time of year, as e-mail inboxes become cluttered with write-ups from managers masquerading as historians and prophets. While these sorts of pieces have their place, they can sometimes miss the forest for the trees. 1S&P 500 Index at Inflection PointsQ1 2014

Admittedly, having just celebrated my half-century mark on this earth and 27th year in the business, I have been in a somewhat more reflective mode than usual. Even so, the beginning of this year, in particular, calls for a renewed focus on the now. There have been times in my career that I was certain were inflection points in the markets: the summer of 1987, fall of 1999, and March of 2009. Now is another one of those times.

2S&P Price and P/E RatioQ1 2014

Over the past few years, the Fed has embarked on a road of unprecedented monetary experimentation which resulted in ultra-low interest rates and record corporate earnings. It has had the effect of markets on steroids as asset prices have been inflated to record levels. This is starting to change, however, and many of the factors that have propelled stock prices higher and bond yields lower have quietly begun to subside. Market multiples are rising, economic indicators are changing course, and the Fed is finally tapering. So as the Motion Picture Association of America looked back on 2013 and made their Academy Award nominations, we found it incredibly ironic that the two films receiving the most nods were American Hustle and Gravity. Could 2014 be the year when an American hustle of a different kind comes to an end and gravity brings security prices back down to earth?

3S&P 500 Shiller Cyclically Adjusted P/EQ1 2014

Source: Standard & Poors, FactSet, Robert Shiller Data, J.P. Morgan Asset Management

Those playing devils advocate may argue, and rightly so, that multiples are not foolproof predictors of future market performance and that they can be clouded by short-term fluctuations in the economy and investor sentiment. For that very reason, Robert Shiller, the famed Yale professor, came up with his cyclically adjusted price-to-earnings ratio (CAPE). Shillers CAPE smoothes short-term fluctuations by dividing the current market price by trailing 10-year average inflation-adjusted earnings. At 25.4 times adjusted earnings, CAPE is well-above the 19.1x average since the 1950s, and within shouting distance of the 27x level seen at the October 2007 market peak.3 4Shillers Cyclically Adjusted P/E Ratio 1881-2014Q1 2014

(1929) The Great Crash and the Beginning of the Great DepressionDot Com Collapse (2001)50

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(1982) Black Monday(2005) Global Financial CrisisCurrent CAPE Level: 25.35x

According to John Mauldin, Not only does todays CAPE of 25.4x suggest a seriously overvalued market, but the rapid multiple expansion of the last few years coupled with sluggish earnings growth suggest that this market is also seriously overbought. 3

5Earnings Growth Without Commensurate Sales GrowthQ1 2014Reported EPS Sales Per Share0% 50% 100% 150% 200% 250%25%231%Source: Bloomberg Data

In order for profitability to surge, despite rather weak revenue growth, corporations have resorted to four primary weapons: wage reduction, productivity increases, labor suppression and stock buybacks. The problem is that each of these tools create a mirage of corporate profitability which masks the real underlying weakness of the overall economic environment. The problem, however, is that each of the tools used to boost EPS suffer from diminishing rates of return over time

The chart above dates back to the 2009 lows and validates the claim that earnings have grown without a commensurate rate of growth in top line sales. Stocks during this period have appreciated by roughly 170% but the point is that in order to achieve such spectacular earnings growth without a commensurate growth in sales it is necessary to reduce costs and in so doing increase margins. All the data we have looked at in the first part of this article suggests that is exactly what corporations have done and of course that brings us back to the issue of diminishing returns going forward.

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S & P 500 EPS GrowthQ1 2014

7S&P Positive and Negative Preannouncements Q1 2014

EPS GuidancePrice

8Q1 2014US Unemployment Rate

9Q1 2014While on par with renting nationally, buying is no longer cheaper for 175 of 277 largest metros

10Q1 2014Home Ownership Rate

11Q1 2014Fed Funds Rate and FOMC Interest Rate Projections

Source: Federal Reserve, FacSet, JP Morgan Asset Management

12Q1 2014Fed Balance Sheet

Source: Federal Reserve, FacSet, JP Morgan Asset Management

13Margin Borrowing CPI Adjusted and S&P 500 IndexQ1 2014

14Q1 2014S&P 500 during FOMC Action

Source: Bloomberg, Doubleline Capital

15Q1 2014Emerging Markets Currencies versus the US Dollar

16Q1 2014Developed World Markets versus Emerging Markets

17S&P 500 Index at Inflection PointsQ1 2014

Technology Innovation BubbleLending Innovation BubbleFed Innovation Bubble?QE3 EndFed Tapering June 2013Source: S&P, First Call, Compustat, FactSet, JP Morgan Asset Management

18Q1 2014What Is Our Strategy for 2014?Fixed IncomeKeep bond maturities short to maintain liquidityImplement Quality Barbell StrategyEquityMaintain patience for buy list stocks to reach entry pricesBuy on market dipSeek opportunities in stocks that have been through trauma and now have clean bill of health

19Disclaimers & FootnotesRegistered Investment Advisory services provided by Doucet Asset Management, LLC, which is independent of Institutional Securities Corporation (ISC).

Securities are offered through Institutional Securities Corporation (ISC) 3500 Oaklawn Ave. Ste. 400, Dallas, TX 75219, (214) 520-1115, Member FINRA & SIPC.

Chris L. Doucet is a Registered Representative of ISC.

This presentation is for information purposes only. Nothing in this presentation constitutes an offer to sell or a solicitation of an offer to buy any interest in any security, or in any investment vehicle managed by Doucet Capital, LLC, Doucet Asset Management, LLC, Institutional Securities Corporation, or any of their employees or affiliates. Nothing in this presentation constitutes professional or financial advice, or recommendations to purchase or sell a particular security.

Past performance does not guarantee future results.

Doucet Asset Management, LLC does not offer tax or legal advice. Please consult your tax advisor for recommendations regarding your specific situation.

Certain information discussed in this presentation may constitute forward-looking statements which can be identified by the use of forward-looking terminology such as may, will, should, expect, anticipate, target, project, estimate, intend, continue or believe, or the negatives thereof or other variations thereon or comparable terminology.

This presentation does not constitute an offer to buy or an offer to sell securities. Due to various risks and uncertainties, actual events or results or the actual performance of any of the investments discussed herein may differ materially from the events, results or performance contemplated by such forward-looking statements. Although Doucet Asset Management, LLC believes that the expectations reflected in such forward-looking statements are based upon reasonable assumptions at the time made, it can give no assurance that its expectations will be achieved.

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