Asset Allocation

September 30, 2014

Inside this Issue
Q3/14 Update 1
Current Asset Class Weighting 4
Asset Class Descriptions 5













Q3/14 Update
Equities have posted very strong returns since the 2009 lows, with the S&P 500 Index
(S&P 500) and S&P/TSX Composite Index (S&P/TSX) up 192% and 98%, respectively,
on a price basis. Given the strong gains some believe that the market top is near, with
some forecasting weak equity returns in the years ahead. While the equity markets
could be susceptible to near-term weakness, especially in light of the fact that the US
Federal Reserve (Fed) is ending its asset purchases in October, the longer term
outlook remains supportive for equities. As such, we maintain our overweight
recommendation in stocks relative to bonds. Below we outline our current asset
allocation calls, which include our preference for stocks over bonds, developed
market equities over emerging market equities, corporate bonds over governments,
and government bonds over cash.
Overweight Equities
The strong equity gains since 2009 have been driven by a combination of improving
fundamentals and accommodative central bank policies. The Fed has implemented
three rounds of quantitative easing (QE) since 2008, with the Feds balance sheet
more than tripling from roughly US$800 bln at the start of the financial crisis to
US$4.6 tln currently. The Feds policies and expanding balance sheet have been very
supportive to the equity markets. As evidence of this we note that the correlation
with the S&P 500 and the Feds expanding balance sheet has been a very high 0.97
since 2009. With the Fed expected to end QE in October this does remove a support
for the equity market, but provided the US economy continues to improve, the stock
market should be able to withstand the normalization of Fed policy.
In our view, the normalization of Fed policy is a sign that the US economy is
recovering from the financial crisis and may now be strong enough to stand on its
own, without the need of aggressive Fed liquidity. The recovery of the US economy
has significant consequences for both the equity and bond markets. For the equity
markets, stronger economic growth would likely translate into stronger corporate
earnings. For example, S&P/TSX earnings look to have bottomed following a
challenging 2013 and continue to trend higher. Looking at forward earnings estimates,
they are pointing to 10% earnings growth over the next 12 months. We believe
further upside in equity prices is likely to be driven by earnings growth rather than
multiple expansion, which has been the dominant driver of gains in recent years.
Looking at equity valuations, while they are no longer cheap they are not excessively
expensive, in our opinion. Currently, the S&P/TSX is trading at 19.4x trailing earnings
and 2x price-to-book (P/B), which equates to just a 2% premium to their long-term
averages. Similarly, the S&P 500 is trading at 17.9x trailing earnings (a 9% premium to
its long-term average) and 2.7x P/B (a 5% discount to its long-term average). While
valuations are above their long-term averages, they remain below levels typically seen
at major market tops, implying the potential for further expansion. Our base case
view is that stocks will rise in line with their earnings growth over the next 12-18
months; however, we cannot rule out further multiple expansion in this cycle.

Asset Allocation: Q3/14 Update
September 30, 2014 | Page 2 of 5







While equities are trading at modest valuations premiums to
their long-term average it is important to emphasize that
equities look attractive relative to bonds, which is an
important factor in our overweight recommendation. One
way to contrast valuations between stocks and bonds is to
calculate the current equity risk premium (ERP) embedded in
stocks and determine whether that premium is warranted
given economic and market conditions. A simple approach to
calculating the ERP is to compare the earnings yield (inverse
of the P/E) for an equity index, in this case the S&P 500, and
subtract that from the yield on government or corporate
bond yields. Currently, the earnings yield of the S&P 500 is
5.50% while the 10-year Treasury yield is 2.50%, resulting in
an ERP of 3%. We note that over the last half century the ERP
has averaged 0.25%, which implies that equities currently
appear cheap relative to bonds. We believe that over time
the ERP will contract, with the government bond yield rising
and the earnings yield on the S&P 500 declining. If correct,
this would result in stocks outperforming bonds.
We Expect the ERP to Contract over Time

International and Emerging Markets
From the late-1990s to 2008, the emerging markets (EM)
were the place to be. Over this period the iShares MSCI
Emerging Market ETF (EEM-US), our proxy for EM, trounced
the returns for the S&P 500. However, since 2010 the S&P
500 has outperformed the emerging markets, which we
expect to continue. First, on a relative basis the developed
markets, particularly the US and Canada, are showing
stronger economic momentum than EM. For example, India
and China GDP growth has slowed materially in recent years,
which is having a negative impact on EM growth. Second, as
we saw in late 2013, EM is often at the mercy of Fed policy
changes, as their currencies often depreciate in response to
Fed tightening, which then leads to foreign capital outflows.
With the Fed looking to end QE in October, this could be a
potential headwind for EM. Finally, from a technical
perspective the S&P 500 remains in a strong relative uptrend
versus EM, which is showing little signs of ending. All told, our
preference is for the developed markets, with the US market
being our top pick. Given the strength of the US dollar and
weakness in the commodity complex, we see the S&P 500
outperforming the S&P/TSX in the coming months and would
encourage investors looking for international exposure to
look at our neighbors in the south.
We See the S&P 500 Continuing to Outperform the
Emerging Markets

Underweight Government Bonds
A key factor in our underweight recommendation in bonds is
our belief that bond yields will move slowly higher as the
economic recovery continues. Our proprietary bond
forecasting model, which estimates fair value for the
Government of Canada (GoC) 10-year yield, is currently
suggesting fair value of 3.40% compared to its current level of
2.15%. Based on our expectations for economic growth and
output from our bond model, we see the potential for the
GoC 10-year yield to rise to a range of 3.25% to 3.50% in
2015. If correct, this would result in a 9% to 11% loss for the
GoC benchmark 10-year bond over the next 15 months. As
such, we recommend an underweight in government bonds.
Our Bond Model Suggests Fair Value is 3.40% for the
GoC 10-Year Bond Yield

1
2
3
4
5
6
7
8
9
'99 '01 '03 '05 '07 '09 '11 '13
S&P 500 Earnings Yield
US 10-Year Treasury Yield
%
1
2
3
4
5
6
7
'04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14
S&P 500 (SPY) Relative to Emerging Markets (EEM)
200-day MA
S&P 500
underperforming EM
S&P 500
outperforming EM
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
'97 '99 '01 '03 '05 '07 '09 '11 '13
CAD Bond Yield Model
GoC 10-Year Yield
%
"Fair value" is
3.40%

Asset Allocation: Q3/14 Update
September 30, 2014 | Page 3 of 5







Overweight Credit
Within bonds our preference continues to be with corporate
credit, particularly higher quality issues as we get later into
the business/market cycle. Currently, Moodys Baa bond
index, which we use as a proxy for North American corporate
credit, is yielding 4.82%, representing a spread over the 10-
year Treasury yield of 2.29% or 229 basis points (bps). The
long-term average spread for this corporate bond index has
been 200 bps, with typical lows in the spread between 125 to
150 bps. This suggests the potential for further spread
tightening. Additionally, corporate balance sheets are the
strongest they have been in decades, with high cash balances
and low debt-to-total-equity ratios. For example, US
nonfinancial corporations are currently sitting on roughly
US$1.9 tln in cash, while companies in the S&P 500 have a
net-debt-to-EBTIDA ratio of 1.60x the lowest level since
1990 based on our available data. Given the strength of
corporate balance sheets and the potential for further spread
tightening, our clear preference is for corporate credit over
government bonds.
Corporate Spreads Are Above Their Long-term Average
Suggesting the Potential for Further Tightening

Underweight Cash
We are currently underweight cash given low nominal yields
and negative real yields, after adjusting for inflation.
However, given the recent decline in the S&P/TSX, which did
result in some intermediate term technical damage for the
Canadian equity market, we are monitoring the equity
markets closely and should we see important technical
supports being broken, we would consider trimming our
maximum overweight position in stocks and raise some cash.
This would be more of a tactical move, as the long-term
outlook for equities remains constructive, while cash yields
remain very low.


Conclusion
As outlined above, we remain constructive on equities given
an improving North American economy, the prospect of
stronger corporate earnings, and attractive valuations when
compared to low-yielding bonds. We have made no changes
to our asset allocation calls in Q3/14, but given the recent
short-term weakness in the S&P/TSX we are monitoring the
equity markets closely, and should we see important
technical levels on the S&P/TSX be broken, we could make a
tactical call to reduce our maximum equity overweight and
raise some cash. For now, we are maintaining our maximum
overweight in equities given improving fundamentals and
supportive technicals.

Ryan Lewenza, CFA, CMT
SVP, Private Client Strategist


0
100
200
300
400
500
600
700
'62 '67 '72 '77 '82 '87 '92 '97 '02 '07 '12
Credit Spreads (Moody's Baa Index - 10-Year Treasury Yield)
Long-term Average

Asset Allocation: Q3/14 Update
September 30, 2014 | Page 4 of 5







Current Asset Class Weighting


Asset Class Weightings
Profile Cash Bond Can. Equity Intl. Equity U.S. Equity Alternative
Income & Capital Preservation 40% 40% 20% 0% 0% 0%
Conservative 15% 65% 20% 0% 0% 0%
Moderate 5% 47% 15% 15% 15% 3%
Growth 0% 20% 20% 10% 40% 10%
Global Equity 0% 0% 20% 20% 45% 15%
General Asset Class Ranges
Cash Bonds Equities Alternative
Income & Capital Preservation 40 75 15 40 0 20 0
Conservative 15 30 60 65 10 20 0
Moderate 5 10 45 65 25 45 0 5
Growth 0 5 15 40 50 70 10 15
Global Equity 0 0 80 85 15 20
Profile Descriptions
Description
Income & Capital Preservation
Virtually any loss is unacceptable. Investors primary objective is to achieve a return that keeps pace with inflation. Fixed
income and cash make up the largest portion of holdings.
Conservative
Losses can be tolerated, but erosion of regular income payments cannot. Stability of coupon or dividend is the primary
concern as many investors will employ this income for cost-of-living expenses. Bonds tend to make up the largest proportion
of holdings.
Moderate Some higher risk positions tolerated but these are typically offset with blue-chip dividend paying equities or low-risk bonds.
Growth
Willingness to take speculative bond and equity positions though growth portfolios are typically biased towards equities.
Strong earnings growth or high yields usually take preference over valuations. Some defensive constraints may be employed,
but even these may be removed for highly risk-tolerant investors.
Global Equity
A willingness to ignore home-country bias and allocate holdings internationally. International equities typically receive
weightings equivalent to or greater than domestic securities. These investors recognize that Canada represents only ~3% of
global equity markets and are willing to source investment opportunities outside our borders.
Income & Capital
Preservation

Conservative


Moderate


Growth


Global Equity


Cash
40%
Bonds
40%
Can
Equity
20%
Cash
15%
Bonds
65%
Can
Equity
20%
Cash
5%
Bonds
47%
Can
Equity
15%
Intl
Equity
15%
US
Equity
15%
Alt
3%
Bonds
20%
Can
Equity
20%
Intl
Equity
10%
US
Equity
40%
Alt
10%
Can
Equity
20%
Intl
Equity
20%
US
Equity
45%
Alt
15%

Asset Allocation: Q3/14 Update
September 30, 2014 | Page 5 of 5







Asset Class Descriptions


Major Asset Class Descriptions
Cash Bonds Equities Alternatives
Characteristics
Liquid assets. Generally,
straight cash or securities
with one year or less
remaining to maturity. Bank
balances, money market
funds and 30- to 90-day
bonds would all be proxies
for cash.
Debt instruments that are promises
from governments or corporations
to pay a series of coupons and
return principal to investors at
maturity. Bonds, like equities, are
priced and traded and therefore
investors can realize profits or
losses on their investment prior to
maturity.
Shares of publicly traded
companies. Equities are a claim
on the future cash flows and
profits these companies are able
to generate.
Alternative assets can
encompass a broad range of
investments including real estate,
gold, commodities, hedge funds
and private equity. Alternative
strategies also include hedging
and short-selling.
Strengths
Often ignored during
periods of rising equity
markets, cash is a critically
important defensive asset
during periods of declining
prices. The standard
deviation for cash and
equivalent assets tends to
be low and cash is seen as
a store of wealth in
anticipation of better
investment opportunities.
For investors able to wait to
maturity, highly rated bonds such
as AAA-rated bonds can provide
very predictable returns. Bonds
usually have lower standard
deviations than equities, and
corporate bonds provide more
protection than equities in the event
of bankruptcy.
Historically, long-term returns on
equities have been superior to
returns on fixed income
investments (see periodic table
on page 3). Investors are
entitled to all company issued
dividends. Equities tend to be
liquid and are easily priced.
Generally, equities will rise in
inflationary environments.
There are periods where bonds
and equities are highly correlated.
Alternative assets can provide the
needed correlation in these
instances. Alternative assets
often allow allocators to target
returns based on highly specific
economic conditions and can be
used to hedge against unlikely,
but potentially disastrous, market
events.
Weaknesses
Cash pays little or no
interest. Held for long
periods, cash is almost
always a losing investment
due to inflation and/or bank
fees.
Defaults are more common for
lower rated issuers and therefore
loss of income or principal is a risk.
Bond prices are interest rate
sensitive, so while volatility is
typically less than for equities, it is
still present. Historically, returns for
bonds have been lower than
equities. Unlike equities, bond
payouts typically do not increase
over time.
Equities are more economically
sensitive than other asset
classes. Deflationary
environments are usually difficult
for equities. The standard
deviation for equities is higher
than other asset classes, which
means investors are more likely
to experience steeper losses
under some market conditions.
Weightings to alternative assets
are generally kept at low levels
(510%). Overweighting
alternative assets may increase
portfolio risk. Investing in
alternative assets often requires a
highly specific skill set (option
trading knowledge, for example).
Pricing of alternative assets can
be difficult.
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