Investment Strategy - The Virtuous Cycle - Winter 2014

Exchange Capital Management, Inc.
Ann Arbor, Michigan
(734) 761-6500
INVESTMENT STRATEGY..
BWinter 2014
The Virtuous Cycle
It’s often hard to pinpoint why a stampede begins. Something as simple as a tumbleweed
blown into a herd can lead to a full-blown flight of animals that eliminates everything in
its path. Among the various species of animals, those most prone to stampede behavior
include cattle, elephants, blue wildebeests, walruses, wild horses, rhinoceros…
…And humans.
As intelligent as humans are, and as keen on individualism as they might be, humans are
often no better than cattle when it comes to herd mentality. We start running for tech
stocks, then we start running from houses. It’s hard to explain why sometimes, but the
result is clear: A trail of tears.
The point here is not that stampedes happen, or even that a stampede is about to occur.
Rather, it’s to get readers thinking: If we don’t know how a stampede starts, then how
can we tell when one has ended?
A stampede is nothing more than a vicious feedback loop - a "vicious cycle." The
“virtuous cycle” is, of course, the exact opposite of the vicious cycle. The calmer things
become, the more calm people get, ushering in further calm. All of this can arise from a
situation previously defined by a vicious cycle – such as a stampede, or a large-scale
deleveraging caused by a nasty financial crisis.
The question is: If we can’t pinpoint how a stampede starts, then how do we know what
will cause it to end? Is it as simple as looking around and saying “hey – these cattle
aren’t stampeding anymore?”
In 2013, the S&P 500 returned close to 33%. Since the bottom of the 2008 Financial
Crisis, this return has totaled nearly 200%. As we examine the economic and investing
environment around us, we ask: “Is the stampede over? Has the vicious cycle ended?
Has a virtuous cycle commenced?”
We think so.
Chris Georgandellis, CFA
PORTFOLIO MANAGER
Hcgeorgandellis@exchangecapital.com
Investment Strategy Committee
Thomas J. Costigan, CFP
Kevin D. McVeigh, CFA
Michael R. Reid, CFA
Is the stampede over? Has the
vicious cycle ended? Has a
virtuous cycle commenced?

Exchange Capital Management | INVESTMENT STRATEGY
Winter 2014 Exchange Capital Management, Inc.
Page 2 Ann Arbor, Michigan
(734) 761-6500
The Party is Well Underway
The fact is that The Stock Market Party is pretty much in full swing at this point. Some
have been partying all along, while others have been wagging fingers from afar. “Shame
on you,” they say. “Plus, the party was never predicated on reality anyways. The fun
you had was all a façade; fundamentally there was never a reason for the party to begin
with.” Pfft.
Investors are having a blast – good music, good friends, good conversation, fun times all
around. Invariably, you have the occasional concerned partygoer who points out that
“the party cannot last forever.” Obviously, it cannot. Does it mean that the club is going
to burn down, killing everybody inside - or that there will even be a disorderly rush to the
exits, crushing the unfortunate partygoers? Probably not.
Having been to more than one party, we will concede this: When the drinks are free,
everybody looks good. Take away the free drinks (you would never take away all the
drinks) and some partygoers just won't have that same appeal. We would expect nothing
less from more than a couple darlings of the market in the coming months as long term
asset puchases by the Federal Reserve taper down.
The After Party Will Be in the Developed World
In our Summer 2013 Investment Strategy piece (“Sit Tight”), we noted to investors that
“With emerging market investment opportunities abroad looking less and less enticing by
the day, we have re-focused our attention on domestic sources of potential value.” Since
then, emerging markets have underperformed the United States by almost 9%. We
expect that trend to continue.
The reality is that the “easy money” has already been made in the emerging economies of
the world. Foreign investment, coupled with internal improvements, has helped bring a
new level of prosperity to countries such as Brazil. With this comes the heightened
expectations of a population burgeoning with newly minted members of a rising middle
class.
Where investors might have made money investing in a simple factory and earning
outsized returns, the focus will shift to quality of life, a nebulous concept which
invariably eats into returns. Given the traditional risks that remain in developing
economies, investors are likely to seek safer – if not more modest – returns in Western
and developed Pacific economies.
"Overvalued" is not the same as "Unsustainable"
The idea that something can be expensive is not a strange one. What is strange is the idea
that expensive things must experience precipitous declines in price "just because."
While we cannot put our finger on it, at some point the notion that something was
overpriced began to imply that the only solution to the mispricing was a severe re-pricing
– “a crash,” if you will. At $4.50, a venti latte at Starbucks is pretty expensive - you don't
get much extra value out of paying full fare. However, that doesn't mean that the price of
lattes is unsustainable, or that the price of lattes must fall precipitously to $1 before one is
worth buying again.
The reality is that there still exists real demand for venti Starbucks lattes, just as there is
real demand for stocks in developed economies.
Take away the free drinks, and
some people just don't dance
as well anymore. We would
expect nothing less from more
than a couple darlings of the
market in the coming months.

(734) 761-6500
An overpriced market can simply move sideways while the economy improves. It can
rise even while an underlying economy picks up steam. Over time, this will cause that
market first to be “fairly valued,” then “undervalued.” A market need not crash, and an
economy need not enter a recessionary state, for capital markets to correct.
In the meantime, individuals will probably give themselves a heart attack trying to time
these moves. As we stated in our Summer 2013 Investment Strategy piece (“Sit Tight”),
we recommend remaining invested, while keeping what is essentially a store of dry
powder in the form of cash to be put to work when favorable market opportunities
present themselves. We cannot outguess the intermediate turns of the market, and you
shouldn't fool yourselves into thinking you can, either. Having ready funds to "buy the
dip" will be a continuing strategy for 2014.
Do Not Underestimate "The Wealth Effect"
As previously discussed, we know not why recessions start – why a virtuous cycle
transforms into a vicious one. Cycles explain some of this – those who were previously
feeling wealthy no longer feel so; they cut back on spending, bringing down the wealth of
others, repeat.
Stock owners – who represent a large portion of the wealth of the United States and
indeed the world – in many cases find themselves much better off as 2014 commences
than they did just a year ago. The strong equity returns of 2013, coupled with rising
home prices and lower household debt levels, have helped in the formation of a
psychological base of financial security that is likely to pay economic divdends in the
years to come.
Does that mean people are about to go out, on leverage, and get that Ferrari they’ve
always wanted? Probably not, but what it does mean is that those who psychologically
were on the mental “cusp of poverty” might find themselves a little further from the edge
than they previously had been. That means that instead of waiting for the 40% off sale,
they are just fine with the 25% off sale.
Beware the Shadows in China
One might mistake our comments thus far as unabashed cheerleading. To answer your
question, "Yes: there are risks out there."
The Great Information Wall of China continues to confound some of the best efforts of
those interested in determining the true economic state of the Chinese economy. Of most
recent concern is the state of China's "shadow banking system," which is a general term
for the non-bank financial intermediaries which provide services similar to traditional
banks, but lay outside of the traditional system of regulated depository institutions.
The system of shadow banking in China has grown precipitously in recent years, due
both to the need for credit and because of the tight control maintained by the Chinese
government over traditional banking. This credit has found its way into highly
speculative ventures all over China, and has the government treading lightly in its efforts
to rein in credit growth.
As noted, it is hard to pinpoint the trigger that transforms an economy that was once
experiencing a virtuous cycle into a vicious one. Something as simple as a "run of the
mill" economic slowdown might be enough to take a leveraged economy into a severe
recession characterized by a financial crisis.
Stock owners are 30 %
richer...those who
psychologically were on the
mental "cusp of poverty" might
find themselves a little further
from the edge than they
previously had been

(734) 761-6500
Should the Chinese economy's growth slow further, many Chinese investors and
speculators could find themselves on the wrong side of liquidity, precipitating a vicious
credit cycle and possibly a financial crisis of the sort seen in Western economies in 2007-
2009.
How this might affect the global economy is hard to say. However, just as China was in
a strong position in 2008 to weather the Western financial crisis, the West is in a much
better position today to weather what might be a Chinese financial crisis. The main risk
here is that, in the case of a Chinese recession - severe or otherwise - Western economies
follow into recession as well.
The Stock Market is a Leading Indicator
It's said that the stock market takes all of the information people know about the future
and distills it down to a price today. What is the stock market telling us today? Well, the
price isn't declining - so it's not saying "the future is looking worse." The price is rising,
and consistently at that. To us, prices seem to be saying "the future is looking brighter."
When people suspect that future prospects are brighter than those in the present, they
invest - and prices rise. The virtuous cycle.
The United States is currently in the midst of an energy boom. The Energy Information
Administration released a study last month indicating that the United States is on track to
produce nearly 10 million barrels of oil a day by 2016 (the U.S. produced 7.5 million
barrels per day in 2013). By comparison, Saudi Arabia produced 9.8 million barrels per
day in 2013. Hydraulic fracturing and deepwater exploration & drilling have helped
unlock decades of reserves of both petroleum and natural gas. Coupled with plentiful
coal stocks, the prospect of American energy security looks brighter than ever.
Corporate balance sheets have recovered from the worst of the 2000's excess, which
culminated in the near-insolvency (and actual bankruptcy) of many firms in 2008-2009.
Households are in better shape as well - U.S. household debt service ratios are holding at
a 30-year low of 10% - better than even the 1981-84 and 1993-1995 pre-boom periods.
Total U.S. household net worth is now at an absolute all-time high of just under $80
trillion, surpassing the 2008 high of $69 trillion.
Manufacturing and trade inventories are at multi-year lows. Light vehicle sales are right
at the 20-year average. Housing starts are rising, and real capital goods orders have been
rising and are now above their 20-year average.
Things could be worse.
When people suspect that
future prospects are brighter
than those in the present, they
invest - and prices rise. The
virtuous cycle.

(734) 761-6500
The Folly of Forecasting (or, "Here it Comes")
Now, ladies & gentlemen, the moment you’ve all been waiting for. May we present for
your reading enjoyment an instantly stale guess regarding the future, based solely on
incomplete data and a rear-view mirror:
A 2014 S&P 500 total return of 20%, resulting in a closing price of 2,180 on December
31, 2014. We see 2014 operating earnings at $132, and a P/E of 16.5, and a dividend
yield of approximately 2%.
We believe that, in 2014, revenues will take the reins from price/earnings multiples.
Whereas buoyed sentiment helped push the S&P 500 price/earnings multiple from 12.6 to
15.4 in 2013, investors will expect revenues in 2014 for confirmation (with continued,
though small, increases in forward price/earnings ratios).
Why 20%, and not something safer like 7%? Discerning readers - all with their own
opinions - will want to know. Our answer is simple: That investors, as prone to herd
behavior as any other, will overshoot - just as they always have.
While we're on the subject of predictions, we'd like to add one more. Investors as of late
have become used to fairly calm markets. It's been a long time since we've heard a 2%
decline in the S&P 500 characterized as a "plunge". Market volatility never disappears.
We caution investors against using psychological anchoring points like "10%" when
trying to protect profits. The market will test you - it will make you question every
aspect of your investment plan. The patient investor will learn to discern market and
economic volatility from true reversals in the underlying real economy.
26%
-10%
15%
17%
1%
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15%
2%
12%
27%
-7%
26%
4%
7%
-2%
34%
20%
31%
27%
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-10%
-13%
-23%
26%
9%
3%
14%
4%
-38%
23%
13%
0%
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30%
-17%-18%-17%
-7%
-13%
-8% -9%
-34%
-8% -8%
-20%
-6% -6% -5%
-9%
-3%
-8%
-11%
-19%
-12%
-17%
-30%
-34%
-14%
-8% -7% -8%
-10%
-49%
-28%
-16%
-19%
-10%
-6%
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
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2012
2013
S&P 500: Calendar Year Returns vs. Intra-year Declines
S&P Calendar Year Price Return S&P Intra-year DeclineSource: J.P. Morgan AM,
Exchange Capital Management
We caution investors against
using psychological anchoring
points like "10%" when trying
to protect profits.

(734) 761-6500
Addendum & Corrections:
In our Fall of 2013 piece ("The Great Deflation"), we included a chart of the S&P 500
total return vs. its price to earnings ratio, from 1871 to 2013. One of our readers asked us
to re-examine our presentation, which led to the discovery that we had made an error.
This error resulted in a reversal of colors on the chart (alternatively, an incorrect legend).
We have included the correct chart below.
Analyst Certification
Exchange Capital Management, Inc. is an SEC registered investment advisor located in Ann Arbor’s historic
Kerrytown district. Founded in 1989, the firm provides fee-based investment management and advisory services to
private clients & families, foundations, and financial institutions. The opinions expressed in this report are based on
information deemed reliable. All opinions are subject to change and should not be regarded as specific advice.
Investors should consult their own legal and tax advisors prior to taking any investment action.
From time to time Exchange Capital Management, Inc. may hold in discretionary client accounts, positions in some or
all of the securities mentioned in this report. Officers, directors and/or employees of Exchange Capital Management,
Inc. may hold a position in any of the securities mentioned in this report.
1
10
100
1,000
10,000
1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011
S&P500TotalReturnIndex
(1871=1,LogScale)
S&P 500 Total Return vs. Price/Earnings, 1871-2013
(Average S&P 500 P/E = 15.5)
S&P 500 Total Return, P/E BELOW 15.5 S&P Total Return, P/E ABOVE 15.5
Source: Robert Shiller,
Exchange Capital
Management

Investment Strategy - The Virtuous Cycle - Winter 2014

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Investment Strategy - The Virtuous Cycle - Winter 2014