What Would Make Us Worry

Ten years ago this month, the stock and bond markets collapsed after Lehman Brothers filed bankruptcy. For one day, 10 years ago, AT&T could not issue commercial paper that matured the next day. Investors were too afraid to lend AT&T money for one day. The S&P 500 declined over 55% from its highs during this period. The following companies either went bankrupt or were forced to restructure, Fannie Mae, Freddie Mac, General Motors, Chrysler, AIG, Wachovia, Merrill Lynch, Citicorp and Lehman Brothers. It was a scary time to be an investor. Local banks called in loans trying to raise money to help with their balance sheets. Virtually all future building projects were stopped. For an investor, it was a horrible time psychologically to live through. We want to congratulate all of you for making it through that period. Your account at Trend has been virtually 100% invested in stocks during this period. Ten years later the S&P 500 is at record highs. Your confidence in the world economic system not collapsing has been profitable.

We say all of that to remind you what a difference 10 years makes. Mark said it was the worst market he had ever seen (Mark started at Merrill Lynch in 1983). The bad news is we don’t think bear markets have been outlawed. We will enter another bear market at some point. We just don’t think we will see another “run on the bank” like 2008 for quite a while. Twenty percent declines in stocks can and will happen at any time. The bear market in 2008-09 hit the banking system. When the banking system gets hit, you are faced with the possibility of more than 50% declines in stocks. As we look at the banking system in the U.S today we think it looks very healthy. A healthy banking system keeps our fears low of repeating 2008.  

We want to highlight a letter we wrote to our clients almost six years ago. Here it is if you would like to read it:

https://www.trendmanagementinc.com/new-blog/2017/1/26/lets-fear-fear

 The interesting thing about that letter is we were sort of embarrassed to write it. We were predicting a big bull market in stocks. At that time, it wasn’t fashionable to say the stock market was going up. It was more fashionable to say the rally is over and we are going to experience another devastating bear market like 2008. At the time we wrote the letter the S&P 500 was at 1,425. Today it is around 2,900. Betting on all stocks going up made sense to us in 2012. Today it is a little less clear.

Let’s talk about one of our big predictions that has yet to happen. It may never happen. We think we are right on this one, even though our timing has not been great.

In March of 2016, we wrote that the U.S. dollar is going much lower, commodities are going much higher and emerging markets will benefit from this. Commodities have rallied about 10% since then but emerging market stocks and the dollar have been a mixed bag. Instead of declining as we predicted, the dollar is up 2% versus developed country currencies. Against emerging market currencies, the dollar is up 10%. Emerging market stocks have gone up but they have not done as well as American stocks. This has hurt our relative performance versus the S&P 500 the last two years. 

We continue to believe that the dollar is at risk of a very large decline. There are two big factors that have held the dollar up that we didn’t see coming in 2016. One is the U.S. continuing to increase its production of oil. The other is the currency market’s reaction to this trade war. 

We flat-out didn’t think oil production in the U.S. would make it to 10 million barrels a day. It is now 11 million barrels. The U.S. oil fracking industry is continuing to grow even though drilling for new wells is half of what it was at its peak. Something must give here, and we think it’s oil production declining. The increased oil production lessens our need to import oil, which is positive for the dollar. The U.S. is sending less money overseas for oil, which helps our currency.  Should oil production roll over, that would help our prediction of a lower dollar and higher commodity prices. 

The other factor in holding the dollar up is the Trump trade war. We have been predicting a trade war going back almost 7 years. It’s here now. There is an economic school of thought that in a trade war you buy the U.S. dollar as money comes from outside the country to build factories here. Those factories being built increase the demand for dollars.  At best we think that’s a short-term phenomena.  We aren’t big believers of this theory, but that theory has been winning versus our view. We think the more likely scenario is that our inflation in this country accelerates versus the rest of world causing our currency to decline. The currency markets hate inflation and I think ours will pick up versus everyone else’s. We are at full employment. We see wage growth accelerating above 3% in 2019. The Fed’s mandate is 2% inflation. When President Trump started this trade war he gave U.S. workers a better chance to increase their wages. We believe they will take advantage of it. When they do, we are concerned how the market will react to this.

We see the S&P 500 as being 15% to 20% over valued. We view commodities as being 50% undervalued.   To invest in this view, we have placed around 20% to 25% of your account in stocks we think will benefit from commodities going up and the dollar going down. We have three stocks that we don’t plan to sell based on our inflation views, BGC Partners, CenturyLink and Berkshire Hathaway. There could be more but those are the three we want to mention now. For older accounts these three positions represent around 30% to 35% of your accounts value. For now, lets say that our three core holdings plus our commodity/dollar investments represent 55% of our average accounts assets. Of the 45% that is left over, around 10% of that is in cash. This leaves us with 35% of our portfolio that we think is at a greater risk of a market decline should our view of inflation occur.  Should we decide to lighten up on stocks due to market concerns, this will be one area we look at. There has been only one time in the last 10 years when we raised cash due to market concerns, January of 2015. The cash level we raised back then was 20%. We reinvested that money back in the markets in August of 2015. We are not making a market call at this time, just alerting you to the possibility that we could do this in the future.

The average dividend yield of BGC Partners and CenturyLink is 8%. If we enter a bear market, those yields will help support the stocks. Berkshire Hathaway doesn’t pay a dividend, but it increased the price it’s willing to pay to buy back their stock this quarter. We view that as a form of a dividend and we think it would support the stock should times get tough. Berkshire Hathaway also has over a $100 billion in cash looking for a home.  That always helps in bad markets.

The question we get asked the most often is “Describe THE MOST LIKELY bearish scenario that causes you to get worried.”. Fair enough, here it is. If this market plays out like the bull market’s of 1999 and 2007, commodities will have to go up enough to cause the Fed to tighten more than the economy can stand. The most likely culprit of higher inflation is the price of oil. Oil prices went from $11 a barrel in January of 1999 to $32 by March of 2000. That was the end of the dot-com bubble and the economy entered a recession. In January of 2006 oil was at $60. By January of 2008 oil was at $100 (on its way to $150). The economy entered a recession in 2008. We think some combination of Fed tightening and higher oil prices (or the CRB index) could cause problems for this market. The average consumer in the US has very little excess cash flow. When the price of oil goes up, so do your car mileage costs, heating costs, airplane tickets, UPS shipping costs etc. The rising costs of everyday food and energy will keep the average consumer from spending it somewhere else. Hence the recession happens. 

If the key factor in the Fed’s decision to raise rates is rising inflation, then having money in inflation stocks should be the last area of the stock market to rally before this bull market is over. You can consider it a late economic cycle indicator. If the price of commodities never goes up, then theoretically the Fed could print all the money they want forever. In other words, the next 10 years would look a lot like the last 10 years. We view this as a low probability but it’s possible.  Commodity stocks won’t be as good an investment as owning the general market would be in a low inflation world, but they will do OK. If inflation comes back, these stocks will do much better than the general market or cash. 

If our scenario on inflation plays out like it did in 1999 and 2008, we would have the opportunity to raise cash by either selling the commodity plays if they go up a lot or selling the general market stocks if they didn’t. We will have to wait and see how this one plays out. No cycle ever repeats itself the exact same way on Wall Street, and we are sure this one wont either. Stay tuned.

If you have any questions on this feel free to give us a call (417-882-5746). Our holiday party is on December 20th this year. The time is 6-8 p.m. and it’s still at Highland Springs. We will send you an official invite in November.


Sincerely




Mark Brueggemann IAR                                Kelly Smith IAR                       Brandon Robinson IAR

Durable Goods Decline

In past letters we have written about a coming trade war with our economic partners and how we plan to deal with it. In this letter we will write about some of the problems the United States is facing in trade and how we think they might be solved. We will also give you some details about a new stock we bought called Banco Macro.

Trade war

It has been our view for the last 10 years that we will get into an economic trade war with the world. We think that trade war is here and it’s going to last awhile. The primary target of that trade war will be China. We want to show you in graphical form one problem the U.S. is facing.

Screen Shot 2018-10-13 at 9.22.55 AM.png

The chart above depicts our trade deficit with the world excluding industrial materials (this index excludes oil). The United States is running the world’s largest trade deficit ever in industrial goods. To try to fix this problem the Trump administration placed a 25% tariff on $50 billion of Chinese imports. Trump is considering an additional 10% tariff on another $200 billion of Chinese imports ($250 billion total).  Currently the United States only exports $133 billion to China while importing $521 billion. This trade deficit of $388 billion is what Trump is upset about. If Trump decides to place a tariff on another $200 billion of imports from China, it will be interesting to see what China does. China only imports $133 billion from the U.S., which means China can’t match Trump dollar for dollar on tariffs. Something will have to give.

It has been our position (and still is) that THIS trade war will be inflationary and not deflationary. Most economists disagree with us on this issue. They site the passage of the Smoot-Hawley bill in 1930 as proof of what happens economically in a trade war. That bill restricted trade using tariffs. Those tariffs are blamed for causing the depression. We agree that the Smoot-Hawley bill helped accelerate the depression but it’s more complicated than that. We like to remind those same economists that Richard Nixon and Paul Volker placed a 10% tariff on ALL imports (not just Chinese) coming into the U.S. in August of 1971. That trade war was the beginning of a 10-year run of inflation, not deflation.

How can you have two similar economic actions but dramatically different results? The answer is that focusing on just one variable (trade) is too simplistic. Here are a few of the questions that need to be answered to compare the two periods. 

• Was the Fed printing money or restricting money? 

• Was the banking system extending credit or calling in loans? 

• Was the collateral banks held increasing in value or decreasing? 

• Was the country starting the trade war a net creditor in trade or debtor? 

• Was the world on the gold standard? 

• Did the country that has a trade surplus get it by suppressing the consumption of its citizens? 

We won’t elaborate on all these points. However, we will review the responsibilities of being a creditor nation on the gold standard during the Great Depression.  

In 1930 the United States was on the gold standard (we are not now). This meant that every dollar issued by the government had to be backed by a certain amount of gold. Going into the crash of 1929 most countries were on the gold standard. The United States ran a huge trade surplus with the world (similar to what China is running today). It has been estimated that the United States and France in 1930 controlled over 60% of the worlds gold supply. They got most of that gold by running large trade surpluses with the rest of the world. Most of that gold was in the U.S. When the United States decided to restrict trade using the Smoot-Hawley bill, it also restricted the world’s ability to get access to gold to pay back their debts. The Smoot-Hawley trade war made it very difficult for debtors to get gold through trade to pay their creditors back. Today we don’t have that situation.

If we were in a similar situation with China today, the Chinese would have the ability to demand we pay them back in gold or some asset that our federal reserve can’t print. They can’t do that. Hence the U.S. could at any moment as a debtor country simply print $2 trillion and give it to the Chinese. In 1930 debtor countries could not print gold so it restricted their ability to create inflation. Today we don’t see that restriction. This is a big difference in why we think this trade war is more like 1971 that 1930.

The Chinese aren’t stupid. They are aware the U.S. could just print dollars to settle our debts. Accepting those dollars from the United States isn’t as great a deal as it was in the previous 20 years. Lately, China has been trying to buy our companies with their trade surplus rather than invest it in our treasury bonds. The problem with that idea is this administration will not allow them to buy out American companies. The Trump administration at every turn is blocking Chinese acquisitions of U.S. companies. The Chinese can buy our bonds but not our companies.

To make matters worse for the Chinese, in 2018, our Congress decided to cut taxes and increase spending. Those actions will cause the U.S. to run the largest peacetime budget deficit in modern history (around 6%). We are not only restricting what the Chinese can do with their U.S. dollars; we are making them less valuable by creating another trillion-dollar budget deficit.  

At some point in this trade war China will have some tough decisions to make. We don’t think three years from now China will have a $400 billion surplus in trade with the U.S. How will China replace that lost income? There are no other countries willing or able to replace the U.S. as a net trade debtor. Therefor, China will have to replace that lost demand by printing more money in China to stimulate their GDP. Its citizens’ consumption as a percentage of GDP has dropped from 50% a decade ago to around 35% today. In the U.S. it is around 70%. That will have to change. If you can’t sell to the U.S., you must sell to your citizens. 

Make no mistake about it, the game of world trade won’t be the same after this is over: new rules, new winners and new losers. We have placed our bets on who some of the winners will be. We think inflation will increase and stocks will do better than cash. If China decides to sell its U.S. treasuries it will cause rates in the U.S. to go up (which will slow down our consumption), but it will also FORCE China to increase their consumption to offset that. It will also cause the value of China’s currency to go up, which is one of Trump’s goals. It also will matter who buys those bonds. Will it be our Fed or the private market? We won’t know those answers until it happens (if it happens).

We think Trump has the stronger hand in this fight. We like to use this analogy to help prove our point. If a company’s largest client fires it to make a certain product in house, who initially suffers from this? It’s the company that lost the business (China) that suffers and not the client (USA). To survive, the company will have to take measures such as firing workers, cutting salaries and looking for new work. That takes time to do. We think this is the position China will be in soon. Fortunately for China, a government has the luxury of printing money to create work and pay its bills. A private company does not have that privilege. That helps. We think when they print more money it will help increase the odds of worldwide inflation. 

Every day brings a new press release on trade.  We can’t write about all of them. If you have any more questions on this topic call us. We are following the ebbs and flows of this fight very closely.

New stock: Banco Macro

We bought a new stock this quarter, Banco Macro. This is the first time we have bought an individual bank outside the United States. Banco Macro (BMA) is an Argentine bank. The country of Argentina has been an economic basket case this century. Its currency has declined from 3 pesos to the dollar to 28 pesos to the dollar in the last 10 years. The previous president was more of a socialist than a capitalist and she horribly mismanaged the economy. We really like the new president and hope he wins re-election. That said, we want to point out how well Banco did financially under both styles of government. During the previous presidency BMA had a return on equity of 25%, during the current presidency it has averaged over 28%. A good bank has a return on assets of around 1%. We own Wells Fargo and its ROA is around 1.25%. BMA averaged 3.85% under the previous presidency and 4.58% under the current pro markets administration. These are fantastic numbers. Most U.S. banks are leveraged 10 to 1. BMA has its leverage under 5. When you put it all together you get a stock with a 400% higher return on assets while using half of the leverage trading at half the price a U.S. stock would trade at. The dividend yield at the time we bought it was 3.6%.

So why did we only buy a one percent position? The political risk still scares us. Even though BMA has done well in both administrations, it’s still a wild card. What could happen politically five or 10 years from now? Should the stock decline into the 50s, we may add another one percent.

BGC Partners spinoff

We want to give you an update on BGC Partners (BGCP). Sometime this year the stock is going to split its real estate and financial business into two separately traded stocks. The real estate division is called Newmark Group. The finance division will continue to be called BGC Partners. We mention this because the stock exchanges are going to treat the spinning off of Newmark as an “ex-dividend” exchange. What that means to you is someday you will look at your account and see you own BGC Partners and Newmark stock. We place the value of Newmark at about $6 per BGC share. If BGC Partners stock price was trading at 12 on Monday and it spins off Newmark on Tuesday, you will see your BBC stock drop from 12 to 6 because of the dividend. Don’t be alarmed; this is how ex-dividend spinoffs work. The value of the two stocks in totality on Tuesday when added together would be 12. We don’t want you to be surprised to see BGC Partners drop 50% in one day because of the ex-dividend.

At today’s prices we think the new BGC Partners would trade around 6 bucks and have a 52-cent dividend (dividend yield 8.7%). We find that an attractive yield. We think we will hold onto both stocks after the Newmark spinoff. We do expect both stocks to go up. It is possible we might add to our BGC position after the split if it should drop versus Newmark.

Outlook

The equity markets are slightly up for the year. Our managed accounts are slightly down for the year. We think the markets are going to be more volatile than they have been the last three years. This volatility won’t be a lot of fun to watch on a day-to-day basis. The markets are trying to sort through the Trump trade war and what it means. We think its inflationary and negative for the dollar. The markets are betting the opposite of what we think which has hurt our performance this year. We will continue to work hard on this subject and keep you informed on what we think is the subject for 2018 and 2019.

Sincerely




Mark Brueggemann  IAR                        Kelly Smith IAR                      Brandon Robinson IAR 


6 Months of Low Volatility

“The stock market has just finished one of its least volatile six months in its history. A 5% market correction has not occurred in over 250 days. This won’t last. A normal, 10% correction might happen very fast, and be very scary.” Trend Management report July 1, 2017. 

We were eight months early in predicting when the return of volatility would occur. The market just had a scary 12% correction in February that brought some fear back into investors’ minds. Volatility is back and it’s going to be with us for a while. Buckle up. We will outline in this letter how we plan to deal with what is a more normal market now.

On February 6, the Dow Jones was down about 1000 points before the market opened. We took that opportunity to buy a 2% position in Goldman Sachs at the open. We filled at $242 and it closed that day at $258 (it’s now $252). Our confidence in buying Goldman that day was based on two things. The first was that it hit our buy price. The second was that we didn’t think the decline in the market that week was based on fundamentals. Wall Street had been gambling again, and they got caught on the wrong side of a bet. 

Wall Street loves to place bets on just about anything. The latest rage is betting on how volatile the markets are going to be. Wall Street created a product called the CBOE Volatility Index (VIX) that allows you to bet on the implied volatility of the market for the next 30 days. Starting in late 2016, this bet became a one-way street. Most of the money was betting on no volatility. For a while they were right. We figured this out in April of 2017 and wrote the above quote in July. We knew that when the first signs of volatility picked up, it would cause a total market rout as these positions unwound. We weren’t disappointed. To throw gas on the fire, academia has been writing white papers about how stocks that show low volatility, and smooth path dependency (don’t ask) will outperform the S&P 500. Money started flooding into these smart beta, low volatility funds in 2017. It was destined to end badly, and it did. 

There was a fund created called the Inverse Volatility Index Exchange Traded note. On February 1, it was trading at $125. On February 6, it was trading at $7.35. In four market trading days it lost 95% of its value. There was close to a billion dollars “invested” in this fund. The fund was set up to bet on market volatility. If the market wasn’t volatile you made money and it went up. If it became very volatile they would wipe you out and close the fund. On February 5, the market volatility that day caused a stop order to be filled and the fund was closed. By closing the fund, investors could not recoup the 95% loss they just took. 

This fund wasn’t the only one doing volatility trading. It was simply the most public. We will soon find out who owns this stuff when Wall Street gives their report. We have a theory who it is, and it’s not our U.S. financial companies this time.

The chart above is an index we created of four of the largest derivative bank dealers in Europe. We think somebody in this group is going to fess up to experiencing some problems. We think the most likely suspect is Deutsche Bank (DB). It just so happens they reported terrible earnings on February 2, and the market blew up later that day. They also warned again about their business on March 22. The market lost 5% right after that talk. We think there is a correlation between the two events. DB is over 20 times leveraged which is twice the leverage of a U.S. bank. Over half of their $1.7 trillion balance sheet is in something that is not a loan. A gamble so to speak. We think when they warned on February 2, it started “a run” on their positions that hasn’t ended yet. We have been looking to buy market breaks from “bad European bank” news for the last few months. The economy is good worldwide. Earnings for our stocks have been good. We think the recent volatility reflects gamblers getting caught on stupid trades. This isn’t new, but it usually takes time to work its way out. At some point, Europe will have to address this issue, and not kick the can down the road. We think that time is within months as opposed to years.

We have owned US Gypsum (USG) as a way to play the housing recovery. Our average cost is below $10. In the last week of March, Knauf made an offer to buy the entire company at $42 per share. Knauf owns 10% of USG. Warren Buffett owns another 30% of USG. Mr. Buffett agreed to sell his stock to Knauf if the USG board said that was a fair offer. We think Knauf will have to raise their price to seal the deal and we aren’t sure what that price will be. When one of our stocks is involved in a takeover bid we usually sell half to decrease our risk. In this case, we sold half of USG at $40 per share. We will ride the other half and hope for a higher offer. We think the biggest risk we face in the midst of this deal is that the U.S. government may not allow a foreign company to buy a U.S. company. We think they will allow it, but it’s not a slam dunk.

Two of our better performing stocks this quarter have been Maxwell Technologies and American Public. Maxwell was up 4% and American Public 72%. These two stocks have been a drag on our performance for the last few years. We have mentioned in our letters that American Public is the cheapest stock we own. The biggest problems for them have been a poor regulatory environment and the budget sequester. Both of those are getting better. Once Wall Street saw that and believed it, they bid the stock up a lot this quarter. American Public is no longer the cheapest stock we own. There are a few mergers going on in this area. This has helped drive the stock up. We are watching this one closely to decide what to do next. 

Maxwell is our green play on the electrification of cars. The years 2018 and 2019 will be pivotal years for them (their words, not ours). If they execute, we should have fun. If they don’t, we will sell this stock. We hope they get it right.

Our growth stock system has three stocks in it, Data I/O, Skyworks and Profire Energy. All three reported good earnings, and we continue to hold them. As a reminder, our system is not reliant on the price of the stock, but the operations of the company. Skyworks and Profire went up after their earnings and Data IO did not. They each still have our highest ranking and we will wait and see how they do on the next earnings report.

We started writing about a coming trade war with China in 2010 and 11. We think it’s safe to say we are in one now. President Trump wants to put 60 billion dollars’ worth of tariffs on a long list of Chinese products. You can learn a lot about the president’s views by reading what his advisors have written about trade. President Trump’s lead advisor on trade is Peter Navarro. We suggest reading his books on trade to get a feel for where this is headed. Here are two of the titles of books he has written, The Coming China Wars (2008) and Death by China (2011). We sure don’t see a middle ground for negotiations in those titles. This is going to be a long ugly fight. We don’t think this will be going away anytime soon. 

Our trade deficit with China is pushing $400 billion or 4% of their GDP. This is not sustainable. When we started talking about this years ago, we thought this imbalance would be corrected in one of two ways. Either the U.S. would place a tariff on any import coming into the U.S., or our currency would decline to make our exports more competitive. We thought the most likely outcome would be a decline in currency. When we came to that conclusion two years ago, we bought gold, commodities, and Latin American stocks in your account. So far, this has worked out. We still see more upside to those trades. The Trump administration will continue to use tariffs or some form of border adjustment taxes (Vat tax) as a way to even the trade flows out. We don’t see either of these two trends slowing down soon.

We are going to introduce a third way to stop trade imbalances. It’s one we think is becoming increasingly likely in the next five years. Capital controls. What are capital controls? They occur when the government places restrictions on what you can do with your money. For 40 years, ANYONE has been able to take money in and out of the U.S. without restrictions. By anyone, we mean foreign governments, their citizens, or U.S. citizens. We are now thinking there is a 25% chance (up from 0) this ends within the next five years.  

When we ran trade deficits over the last 30 years, those countries took that trade money and sent it back to the United States as an investment. For the most part, they have bought our government bonds with that excess cash. China has over $3 trillion of foreign exchange, and Japan has over $1 trillion. Most of that money is invested in the United States bond market. There is a growing school of thought (Michael Pettis, Richard Koo) that if you limit a foreigner’s ability to send the money back, you stop the actual PHYSICAL trade deficit. If you are thinking this is never going to happen, consider the following: The Trump administration has blocked four transactions in which a Chinese company wanted to buy a U.S. company. The dollar amount of those busted acquisitions is over $100 billion. That’s a form of capital controls in our opinion. The U.S. is dictating what people can and cannot do with their excess dollars. The United States is exerting control. That’s a form of capital control.

China is an example of a country that has capital controls on its people. You can’t legally take $50,000 out of China if you are resident. In the 1960’s and 1970’s, the United States had restrictions on where U.S. citizens could invest their money outside the U.S. That ended with the demise of Bretton Woods in 1973. In 2012, the Brazilian government tried to limit the amount of money that could come into their country to stop “hot money.” An example within the U.S. that a real old timer will remember occurred in 1933. When Roosevelt became president, he took over all of the gold in the U.S. He made it illegal to own gold.  If you owned gold as a citizen, you were forced to sell it back to the government. There is precedent for capital controls in this country and others.

If we went to full blown capital controls in the U.S., we think studying the Argentine economy this decade might help. They instituted capital controls when their currency was four pesos to the dollar in 2011. When it ended, it was 20 pesos to the dollar. Inflation in Argentina was around 10% in 2011, and four years later, it was around 40%. They blocked their citizens from freely using their credit cards in foreign countries. That helped keep dollars in the country.  We don’t think something that extreme would happen here, but we think the trend would be correct. Our currency goes lower, and our inflation goes up. In that environment you don’t want to be a bond holder or own your currency. It is this scenario we are trying to figure out how to deal with if the probability goes from 25% to over 50%. 

If you have any thoughts on this, or questions about your account, feel free to call us at (417-882-5746).

 

Sincerely,

 

 

 

Mark Brueggemann IAR                   Kelly Smith IAR             Brandon Robinson IAR

 

2017 Was a Very Good One For Stocks.

Trend Management’s Year End Report 2017

2017 was a very good one for stocks. The strength in the stock market incurred little volatility. This is unusual. The stock market had the least number of pullbacks in the S&P 500 in twenty years, leading investors into a false sense of security, if not complacency.  A more volatile market in 2018 is not an if, but a predictable when we’ll again experience a market correction. 

The period from 1996 to 2000 is our blueprint for what might happen in this cycle.  Peaceful, profitable 1995-1996 was very similar to 2016-2017.  During both periods, the Federal Reserve raised interest rates, yet the stock market continued to go up. Alan Greenspan, then-chairman of the Federal Reserve, gave a speech on December 5th, , 1996, calling the stock market “irrationally exuberant.” 

At the time, the S&P 500 was at 750. Under our current valuation system, we calculate the stock market  in 1996 was about 15% overvalued.  (We think it is similarly overvalued today.)  Four years after Greenspan’s speech, the S&P 500 was at 1500, for a gain of 100%.  Between 1996 and 2000, there were three corrections of 10% or more.  Contrary to Mr. Greenspan’s fears, the markets remained exuberant for another four years. 

No one, including us, knows how excited investors will be during any bull market, or can pinpoint the market’s exact top.  However, we think there are seven signs in most bull markets that indicate when the party is getting out of control, the market is topping out, and more caution is warranted.  In 1999-2000, one indicator after another flared red, and eventually, the market went bad.  Fast-forward to today, and no indicators have yet turned negative.  If they do, the market could still go up.  The market could also go down, before any indicators flare red.  Will that cause us to sell all our stocks? No, but it would signal time for caution.  

The money the world’s central bankers have printed over the past decade is going to go somewhere, and it’s our job to figure out where that is. Stocks will continue to be the main investment we make for our clients, but not the only one. We want to remind you that being cautious doesn’t always mean be in cash.

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We have written previously about why we have gradually invested in commodities. The chart above does a great job of illustrating how cheap commodities are, versus stocks. We are close to setting record lows on this index. If a chart is worth a thousand words, this one will save us a lot of typing. What the chart doesn’t convey is when commodities will start to out-perform stocks (the line moves back up). It also doesn’t note whether stocks go up, but commodities rise more, or stocks tank and commodities fall less. It does indicate there is value in owning stuff, versus stocks. It is our opinion, before this bull market in stocks is over, stuff will have a good, upside run, and we hope to profit from it.  We are actively looking for ways to invest more money in this area. Investments to date have worked out, and we would like to own more.

We started rolling out the growth stock system this quarter. We now own Skyworks Solutions, Data I/O, and in a few accounts, Profire Energy.  Profire sells burner management systems for the oil and gas industry, and the float is very small.  We have been cautious on how much we can buy, without disturbing the price of the stock.  Profire is also working on a system to lower the cost to transport oil and gas in pipelines. 

Skyworks gets 40% of its revenue from Apple, and we think this revenue stream is secure for now. What is exciting for Skyworks’ future is it appears to be a prime beneficiary of the move to 5G and the Internet of things (IOT).  5G stands for fifth generation wireless connectivity for mobile devices. What’s exciting about 5G is its wireless capacity to replace cable TV.  Verizon, AT&T, Sprint, and T-Mobile will also roll out this service in late 2018. This is the first serious competition to the cable bundle we have seen. 5G will not only benefit Skyworks, but also CenturyLink. Competition is coming to the last mile and we think it’s a good thing for our accounts.

Data I/O is a particularly interesting stock. It has a market cap of $100 million. It initiated a system to make semiconductors more secure from data hackers. It also develops hack-resistant chips for self-driving cars.  We have researched the system and think it has a chance to be a big winner, if Data I/O executes. It has announced customer wins with EBV Elecktronik, Maxim, and Renesas. This quarter, its revenue growth was 45% over the previous quarter, last year. Let’s hope that trend continues.

CenturyLink pays a dividend of $2.16.  At today’s price of $17.33, it represents a dividend yield of 12.46%. We think that yield is secure. We understand, when a stock has this high a dividend yield, the market is saying the dividend is going to be cut. We don’t agree. One of us is wrong. We hope it isn’t us. In the last month, seven CenturyLink insiders bought stock in the open market. We hope they are right.

We continue to like BGC Partners.  Sometime this year, it will spin-off to shareholders its real estate division, Newmark Group. When that occurs, the price of BGC’s stock will decline to reflect the spin-off. We have not decided whether to keep the Newmark stock, but will continue to hold our BGC stock.  At today’s price of $15.18, BGC yields 4.8%. We think that yield will continue after the spin-off. We will continue to update you on this in our next reports.

There is new tax law in 2018.  Here is a brief take of what we see in this legislation.  On the corporate side, the winners appear to be companies that spend a lot of money on capital expenditures (capex). These companies will now be able to write off 100% of their capex in the year they spend the money. This is a huge incentive for beneficiaries, primarily steel and telecom, to  spend more money to juice the economy.  

The potential losers are companies that gamed the tax system to lower their U.S. taxes on their intellectual property rights. These companies are mostly the large technology stocks, like Google, Apple, and Microsoft.  They placed their intellectual property in low tax havens like Ireland, and the Caribbean. We have read that the tax savings on this strategy was around 10% to 13%. We think that loophole has been closed, and it will affect a lot of high-tech companies.

We think the stock market has rallied this quarter on the perception the new tax law will spur record earnings.  Bank of America has issued a report projecting a 10% boost to its earnings.  Should that occur, it will help close the gap between today’s overvalued market and its historical mean.   The tax law will give stocks a short-term earnings increase, when first quarter stocks report at the new rate.   We will analyze these reports very carefully to identify what other things are in the legislation we aren’t yet aware of today.   

We won’t make investments in your account based on what may or may not happen as a result of new tax legislation.  Our continued focus is on the sustainability of our companies’ businesses, and if they execute on their business plans.  

We hope you had a happy 2017.  We will do our best to make 2018, a profitable year.  If you have any questions about this letter, or about your account, please give us a call (417-882-5746)

 

Sincerely,

 

 

 

Mark Brueggemann IAR                            Kelly Smith IAR                     Brandon Robinson IAR

Trends Have Caught Our Attention

TREND MANAGEMENT 3RD QUARTER REPORT 2017

The S&P 500 started the quarter at 2423, and closed at 2519.  A 3.93% gain. The Value Line composite, representing how the average stock is performing, went from $523.19 to $539. A gain of 3.05%. Those two statistics indicate the average investor is buying more established stocks, than smaller ones. This ongoing trend has caught our attention. 

Go to our website, trendmanagementinc.com, to review our twenty-year, audited track record for an account we manage. We feel it fairly reflects how our accounts have performed during that time-frame.  There have been many ups and downs in the stocks we own, which happens, when the average holding period per stock is over seven years. 

During Trend Management’s first decade, we made minor changes on what type of value stocks we would buy.  The approach was: Mark looked for struggling stocks in underperforming industries and bought them.  The company’s quality was secondary to how cheap the stock was. 

In 2008, Kelly and Brandon came in, and that style began to change. We started to analyze how cheap a stock was, and how solid a business it was.  A big step for us was our ability to numerically define a good business, and we’re confident it has added value to our portfolios. 

About three years ago, we introduced a macroeconomic view of the world, investing in commodities, including ETFs, gold stocks, and Latin American index funds.  We thought they were too cheap, versus all other asset classes. They have worked out, so far. 

Looking back at all the stocks we have owned during the last twenty years, it is safe to say there were some good decisions and some bad ones. Analysis involved brutal discussions between the three of us (four, when McCoy is in the office) speculating how much more money we would have gained, had weowned X, instead of Y.  Yes, we beat the S&P 500 over the last two decades. We want to do even better. One area we have shied away from is buying growth stocks rather than value stocks. Why?

Value versus growth.  Would you rather own a stock you think will make 9% a year, where its earnings don’t grow?  Or is it better to buy one to earn 6% today, but projected to grow rapidly?  We had to develop a mathematical way to judge what determinate growth rate of earnings to assume, and for how long. 

It took nine months to solve the issues of what to pay for growth, and what current earnings minimum we will accept. We read and reread nearly a dozen books on this subject to educate ourselves on the issues. Brandon Robinson and Brandon McCoy did a great job figuring out how to follow four-thousand stocks of interest, on a quarterly basis. 

We also let cash build up in your accounts, having sold IBM, and not reinvesting. We continue to expect receiving a big cash dividend from Level 3 this quarter, (October) when the Centurylink merger is done.  

We plan to allocate up to 20% of your account’s assets in these growth stocks. The maximum initial purchase size of each stock will be 1%, or no more than 2%, of the value of your account. This means we could have up to twenty stocks in your account. It allows us to buy more, to lower our cost basis, should the market correct. 

The markets today are at record highs, and so are our accounts. Other than the first half of 2015, we have been fully invested in stocks for ten years, holding minimal cash and bonds.  We relied on the S&P’s historic earnings yield to determine the stock market was cheap.  We also thought, and still do, that bonds are way overpriced.  We were confident, the world’s Central Banks printing money for a decade would result in rising stock prices. It is altogether more difficult to invest in 2017, than it was in 2009-2016. 

These facts complicate going all-in with our new system. If the earnings of the companies grow at their current rates, it won’t matter, long-term, what the S&P 500 does.  These guys will grow through it. Companies with earnings’ growth are eventually rewarded with higher stock prices. However, first-year growth stocks have less margin for error, compared to value stocks. 

There will be more turnover in this part of your account, than there has been in your value stocks. To compensate for not buying stocks as cheap as our value stocks, we will have less patience with a stock, if it messes up. Bet on growth, and if it doesn’t happen, it will be time to look elsewhere.  Which means we might hold some growth stocks for three months or fewer.  Hold one for less than a year?  We didn’t like its earnings report, and sold out. That money will be reinvested in the next qualifying company.  A growth stock held for eighteen months indicates a sustained winner and a higher stock price.  Our goal is to ride the winners and sell the losers.

To compensate for the market’s higher levels, we dollar-cost average these stocks into the portfolio, buying at least one stock a month. The first is a tech stock, Skyworks Solutions, that manufactures chips for cellular phones. Apple represents 40% of Skyworks’ sales, and is ramping up for next year’s roll-out of 5G cell-phones and TVs.   The stock was $112 at its high.   We waited for a correction, and paid $100.32 on September 27th.  

On some of the accounts, we are waiting for the merged CenturyLink/Level 3 dividend, probably arriving at the end of October, before we implement the growth stock system.  At the current price for CenturyLink, the stock will yield 11.2%. Jeff Storey will run the combined company, and we think he is one of the best CEOs in America. 

Maxwell Technologies continues to frustrate us.  In April, it negotiated to sell 20% of the company to a Chinese investment firm, at $6.32.  Maxwell planned to use those proceeds to develop a longer-lasting car battery.  CFIUS, a government agency that regulates foreign acquisitions of U.S. companies, rejected the deal. 

Maxwell then decided to do a convertible bond, with a strike price of $6.35.  Issue a convertible bond on Wall Street, and traders will buy it for the 5.5% yield, and short the stock. In three days, Maxwell stock went from $6.20 to $5.00. We will continue to closely follow Maxwell. 

For the year, our accounts are up, on average, between 8% and 10%. The biggest winners are:  Apple, up 34%, BGC Partners, up 41%; Royal Gold, up 35%; and Latin American stocks up 27%. Biggest losers:  Exxon, down 9%, and Omnicom, down 13%.  

This split performance between the good and the bad reminds us, it’s still a market of stocks, and not a stock market. There will always be stocks going in opposite directions to the market.  It’s our job to take advantage of it, when we can. 

The Holiday party is going to be on December 21st at Highland Springs. Feel free to stop by anytime between 6 and 8. You will get an invitation after Thanksgiving. 

If you would like a copy of our ADV and privacy disclosures please let us know. Feel free to call us with any questions you may have. 

Sincerely,

 

 

Mark Brueggemann   IAR                 Kelly SmithIAR              Brandon RobinsonIAR

 

Dont get to comfortable

TREND MANAGEMENT'S SECOND QUARTER REPORT 2017

It was a profitable first part of the year for your account. The stock market continues to drift higher, with very little volatility.  We don’t expect it to continue, indefinitely.

 We sold IBM this quarter in all our managed accounts. We lost confidence in IBM’s successful transition to the cloud and data analytics.  Up until the first quarter of 2017, there were positive signs IBM was turning around its business. Each quarter, it released its gross margin percentage for its sales. Gross margin percentage is the percentage of each dollar in sales retained after suppliers are paid.  For most companies, the gross margin on a quarter-to-quarter basis is very stable. That was not the case with IBM. We were shocked when it posted its lowest gross margin in a long time.  IBM’s explanation for it wasn’t convincing.  

We interpreted a declining gross margin as competitive pressures on the products IBM sells.  It may be losing the data analytics business to Google and Amazon. Although Watson, its artificial intelligence product, is fantastic, significant revenue from it is farther away than we originally thought. When a company must discount its prices to sell its products, yet sales continue to decline, you have a real problem. IBM has a real problem.

 When we buy a value stock, we try to acquire it at about half its market price.  This allows leeway regarding the direction of earnings.  We initially bought IBM with its pretax earnings at around $21 billion.  In this case, we were way wrong about the direction earnings would take.  Last year, IBM’s pretax earnings were $13 billion, and may be worse this year. The margin of safety we thought we had has eroded.  Based on the last quarter, there’s little evidence it can fix its problems quickly. We hope it can, and does, but won’t reenter this stock anytime soon. 

Happily, our methodology proved right, regarding Apple. It, too, was bought at about half the market price, and its pretax income was $51 billion. We thought the market was too pessimistic, expecting Apple’s earnings to crater. Today, its pretax income is $61 billion—a significant increase.  Our reward for optimism was the stock rising, from $57 to $145. Had Apple not grown its pretax income, but stayed at $50 billion, we’re confident the stock would still have made it to around $100. 

Apple does face future challenges in the consumer cell phone sector, but later this year, its new, ten-year anniversary phone should boost earnings.  Apple’s consumer brand-loyalty will be hard for any competitor to overcome.   

A quick update on a few of our other stocks. We still expect the Level3 merger with CenturyLink in the third quarter. CenturyLink is dealing with class-action lawsuits regarding alleged, unethical billing practices. At this time, we don’t view this as a material event. 

BGC Partners will spin out an IPO to real estate division shareholders. We don’t have the financial details, so stay tuned. 

Maxwell is apparently fixing its issues in China, which we view as a positive. 

Bank loans have declined of late, which won’t help our bank stocks’ earnings in the short term. We think uncertainty about potential new tax laws has slowed commercial lending. 

We want to point out, American consumers’ balance sheet is getting healthy again. The chart on the next page represents the equity U.S. homeowners have in their houses. From it, we can derive an indication of how consumer spending might trend in the future. Increasing homeowners’ equity translates to eventual increases in consumer borrowing. 

 

Screen Shot 2017-08-24 at 8.56.32 AM.png

The stock market has just finished one of its least volatile six months in its history.  A 5% market correction has not occurred in over 250 days. This won’t last.  A normal, 10% correction might happen very fast, and be very scary. 

Market complacency shatters quickly in the age of the Internet. On June 9th, market leaders declined 5% in about two hours, before coming back up. We mention this to let you know, we haven’t forgotten about bear markets at Trend. We have been fully invested in the stock market for ten years, with the exception of raising 20% percent cash, in 2015. That money was reinvested in the second half of that year, when the market took a big hit. 

Today, we have over 5% in cash that will grow when Level3’s merger pays a $26.50 dividend this quarter. Add that cash to investments more impacted by which way commodities go,  (DJP, RGLD, ILF, NUE, XOM) than by the Dow Jones, and we might have over 30% of our portfolio in cash or stocks less correlated to the Dow. 

We are not inferring another 2008-09 is about to occur. What we do emphasize is, investors are too calm and happy, and it won’t last. We have a long list of stocks to buy, if the market drops. Some prices are over 20% away; some are much closer. Our job now is to wait for our price. Stocks on the list are not tied to commodity prices, which we think can grow, even if the economy entered a recession.  

 The bond market lately is giving some indication we are headed for one, despite the fact it correctly predicted two of the past seven recessions. Bond investors don’t have a crystal ball, either. Commodity prices have also been weak, which indicates global demand isn’t as robust as we want it to be.  Both are signals earnings in the second half of 2017, may not be as great as the consensus thinks they will be.

 We will try and navigate whatever the world throws at us, and plan to be profitable doing it. We have many scenarios in our heads, but no clear winner predicting how the economy plays out. If there is a recession, it won’t be like the Great Recession. The system is now in much better shape, than it was then.  The bond and commodity markets are alluding to the economy needing some sort of boost. We have assumed it would come from fiscal stimulus, but not sure it will happen this year. We will keep you up-to-date on these developments in future letters.

 

Sincerely,

 

 

 

Mark Brueggemann IAR                   Kelly Smith IAR                       Brandon Robinson IAR .

Macro Events and the Economy

First Quarter 2017

The last few years, we have spent a lot of time talking about macro events and the economy. We don’t have anything new to add this quarter, so we’ll give a quick update on some of our individual stock holdings.

Warren Buffett bought Apple stock this quarter, at a price (our guess) of around $115-$120. We first bought Apple stock for our clients in 2013. It was trading around $57, and currently at $141. We are a little surprised Buffett now owns 17 billion dollars’-worth of a technology stock. He used to insist he didn’t invest in technology, because he didn’t understand it. What changed between 2013 and 2017? 

His confidence in Apple might relate to the coming revolution in mobile-pay technology.  Apple has the fastest, most secure Smartphone app for debit-/credit-card transactions. Mark has fallen in love with Apple Pay, because it is faster than cash for buying stuff.  Casey’s, Jimmy John’s and Best Buy are a few among many retailers that accept Apple Pay.  Mark has timed his Apple Pay purchases at Jimmy John’s at four seconds or less—very impressive.  A thumb-print authorizes transactions, and the store never has access to customer credit-card numbers—very secure.  Apple Pay does require an iPhone, but the app takes it from a portable computer, to a potentially integral part of all debit- and credit-card transactions. 

Warren Buffett’s knowledge about the credit card industry dates back to the American Express stock he’s owned for nearly a half-century.  He has been invested in Visa and MasterCard for years.  For Buffett to buy Apple’s stock indicates his belief the iPhone creates a moat, distinguishing it from other Smartphone manufacturers.  Buffett coined and popularized the term, economic moat, defined as a business’s ability to maintain and protect its competitive edge over its competitors.  

We think the development of direct, electronic consumer transactions is just beginning, and Apple may be developing a moat. Two Smartphone operating systems exist, controlling over 80% of our phones.  Apple is one of them. We think this is a great situation for Apple to be in, and we will continue to hold the stock.

April marks the announced retirement date for Dan Tarullo. Who is Dan Tarullo? The Federal Reserve’s point-man, who oversaw supervision and regulation for the banks.  Tarullo was the guy who kept the big banks in line.  His departure will make it easier for banks to deregulate and increase their lending amounts.  Big bank opponents adored Dan Tarullo.  Big bank proponents loathed him. 

We anticipate Tarullo’s replacement to roll back myriad too-big-to-fail safeguards implemented after the crash. The industry will love it.  For a while, so will the economy. Retro-deregulation will allow the big banks to increase their leverage from nine times their equity, to more like thirteen times it.  Increasing their lending by 50% will fund a lot of good, and not-so-good projects. 

For those of you who’ve watched the movie, “The Big Short,” imagine we’re in year 2003, or 2004 of this new paradigm shift. It takes time for the banks to do dumb stuff, and we have time to evaluate what they are doing. Tarullo’s retirement will help BGC Partners, Wells Fargo, PNC, and USB, the most. We think the proverbial wind will be at their backs, for at least the next two years.

We haven’t changed our view that owning the dollar is a bad bet over the next five years. We have written in the past, for a lot of your investments, the direction of the Dow or the S&P 500 is secondary to which way the dollar goes. 

Investments that should do well if the dollar declines are Royal Gold, Nucor, IBM, Exxon, iPath Commodity index, (DJP) and all our Latin American exchange traded funds. Owning these investments is one way to start hedging your portfolios, should inflation return. If we head into deflation again, like we have been since the crash, these investments won’t do as well as owning an index fund. We believe the markets are in the early phase of transitioning from deflation to inflation. The dot.com collapse bottomed-out the stock market in 2003, but Latin American stocks rallied, with commodities spiking 600%. We hope it happens again.

We have not seen any meaningful opposition to Level3’s merger with CenturyLink. Our best guess is this deal will finalize in the third quarter. At that time, we will receive a dividend of $26.50 per share for each Level3 share you own. Level3 stock will then convert to 1.4286 shares of CenturyLink stock. The dividend yield on CenturyLink is currently around 9%. We consider that yield secure, if the Level3 merger goes through. There will be pressure on CenturyLink’s stock from the arbitrageurs holding it lower, until the deal is finished.  Once it closes, we think CenturyLink’s stock belongs in the 30s, and not the 20s.

Maxwell Technologies bought another Ultracap company to secure its dominant position in the market. We anticipate this deal helping Maxwell’s position in selling to the auto industry. American Public is still struggling with new enrollment trends. Regulatory relief would help with that. We are closely monitoring that area, and will keep you up-to-date. 

 

Any questions about your account, or any topics covered in this newsletter?  Please feel free to call (417-882-5746).

 

Sincerely,

 

 

Mark Brueggemann IAR                     Kelly Smith IAR                     Brandon Robinson IAR

 

 

 

Bye Bye Dan Tarullo

First Quarter 2017

TREND MANAGEMENT'S FIRST QUARTER REPORT 2017

The last few years, we have spent a lot of time talking about macro events and the economy. We don’t have anything new to add this quarter, so we’ll give a quick update on some of our individual stock holdings.

Warren Buffett bought Apple stock this quarter, at a price (our guess) of around $115-$120. We first bought Apple stock for our clients in 2013. It was trading around $57, and currently at $141. We are a little surprised Buffett now owns 17 billion dollars’-worth of a technology stock. He used to insist he didn’t invest in technology, because he didn’t understand it. What changed between 2013 and 2017? 

His confidence in Apple might relate to the coming revolution in mobile-pay technology.  Apple has the fastest, most secure Smartphone app for debit-/credit-card transactions. Mark has fallen in love with Apple Pay, because it is faster than cash for buying stuff.  Casey’s, Jimmy John’s and Best Buy are a few among many retailers that accept Apple Pay.  Mark has timed his Apple Pay purchases at Jimmy John’s at four seconds or less—very impressive.  A thumb-print authorizes transactions, and the store never has access to customer credit-card numbers—very secure.  Apple Pay does require an iPhone, but the app takes it from a portable computer, to a potentially integral part of all debit- and credit-card transactions. 

Warren Buffett’s knowledge about the credit card industry dates back to the American Express stock he’s owned for nearly a half-century.  He has been invested in Visa and MasterCard for years.  For Buffett to buy Apple’s stock indicates his belief the iPhone creates a moat, distinguishing it from other Smartphone manufacturers.  Buffett coined and popularized the term, economic moat, defined as a business’s ability to maintain and protect its competitive edge over its competitors.  

We think the development of direct, electronic consumer transactions is just beginning, and Apple may be developing a moat. Two Smartphone operating systems exist, controlling over 80% of our phones.  Apple is one of them. We think this is a great situation for Apple to be in, and we will continue to hold the stock.

April marks the announced retirement date for Dan Tarullo. Who is Dan Tarullo? The Federal Reserve’s point-man, who oversaw supervision and regulation for the banks.  Tarullo was the guy who kept the big banks in line.  His departure will make it easier for banks to deregulate and increase their lending amounts.  Big bank opponents adored Dan Tarullo.  Big bank proponents loathed him. 

We anticipate Tarullo’s replacement to roll back myriad too-big-to-fail safeguards implemented after the crash. The industry will love it.  For a while, so will the economy. Retro-deregulation will allow the big banks to increase their leverage from nine times their equity, to more like thirteen times it.  Increasing their lending by 50% will fund a lot of good, and not-so-good projects. 

For those of you who’ve watched the movie, “The Big Short,” imagine we’re in year 2003, or 2004 of this new paradigm shift. It takes time for the banks to do dumb stuff, and we have time to evaluate what they are doing. Tarullo’s retirement will help BGC Partners, Wells Fargo, PNC, and USB, the most. We think the proverbial wind will be at their backs, for at least the next two years.

We haven’t changed our view that owning the dollar is a bad bet over the next five years. We have written in the past, for a lot of your investments, the direction of the Dow or the S&P 500 is secondary to which way the dollar goes. 

Investments that should do well if the dollar declines are Royal Gold, Nucor, IBM, Exxon, iPath Commodity index, (DJP) and all our Latin American exchange traded funds. Owning these investments is one way to start hedging your portfolios, should inflation return. If we head into deflation again, like we have been since the crash, these investments won’t do as well as owning an index fund. We believe the markets are in the early phase of transitioning from deflation to inflation. The dot.com collapse bottomed-out the stock market in 2003, but Latin American stocks rallied, with commodities spiking 600%. We hope it happens again.

We have not seen any meaningful opposition to Level3’s merger with CenturyLink. Our best guess is this deal will finalize in the third quarter. At that time, we will receive a dividend of $26.50 per share for each Level3 share you own. Level3 stock will then convert to 1.4286 shares of CenturyLink stock. The dividend yield on CenturyLink is currently around 9%. We consider that yield secure, if the Level3 merger goes through. There will be pressure on CenturyLink’s stock from the arbitrageurs holding it lower, until the deal is finished.  Once it closes, we think CenturyLink’s stock belongs in the 30s, and not the 20s.

Maxwell Technologies bought another Ultracap company to secure its dominant position in the market. We anticipate this deal helping Maxwell’s position in selling to the auto industry. American Public is still struggling with new enrollment trends. Regulatory relief would help with that. We are closely monitoring that area, and will keep you up-to-date. 

 

Any questions about your account, or any topics covered in this newsletter?  Please feel free to call (417-882-5746).

 

Sincerely,

 

 

Mark Brueggemann IAR                     Kelly Smith IAR                     Brandon Robinson IAR

 

Let's VAT!

Trend Management, Inc. End of Year Report 2016

There is an oft repeated saying on Wall Street that when a market goes down suddenly We got caught with our pants down”. The opposite of that saying which is rarely heard is We got caught with our pants up”. Without a doubt the rally in the stock market caught our clients with their “pants up” and we are thankful. 2016 turned out to be a good year and it all happened in about six weeks. There are concerns to be monitored that we will talk about next.

Interest rates on the ten-year US government bonds have risen from 1.70% on the day of the election to 2.55% today. The “price” of money went up 50% in 7 weeks. This is a very strong move which begs the question why? We can point to two things that are election related that can account for it. One is easy to understand and the other one is not. Let’s start with the easy one.

Donald Trump has proposed spending a trillion dollars on infrastructure projects over the next 10 years. That spending at a time when we have unemployment at 4.6% will drive up the cost of wages for your average worker. Construction jobs pay well. This will draw labor away from other low wage paying jobs. The bond markets fear of rising wage inflation from higher wages helped push interest rates up. That’s reason one. The second reason also involves employment but is more complicated. We have talked about it for the last few years. We are headed into a trade war with China and it’s going to be controversial.

Donald Trump has repeatedly said he wants to bring jobs back to America. One tool he has threatened to use is place tariffs on goods coming into the country. We wrote in the past about how Paul Volcker and Ricard Nixon did this in 1971. We thought a 10% or more universal tariff on imports was a possibility and it still may happen. However, we think it is more likely the new administration will change the tax code to achieve much of the same result.

There are two types of taxes countries use to get most of their money from corporations, corporate income taxes and a Vat tax. The United States only uses a corporate income tax which is a tax on the profits a corporation makes. The WTO calls this a direct tax (this matters and we will say why later) because the corporation writes their check directly to the Government. The other tax is a vat tax. It’s considered an indirect tax because you don’t write your check DIRECTLY to the government. Vat stands for Value added tax. The vat is considered a tax on the profit companies make on each step in the manufacturing process of a product. It is not considered an income tax. If you pay $100 for components to make a product and then sell the finished product for $150, there will be a tax of 17% on that $50 dollar gain if you are located in China or another WTO country. There would be a 16% vat tax if you made it in Mexico. The WTO has ruled that a vat tax is not a direct tax. Why does that matter? Confused yet? Keep reading.

There are 164 countries in the WTO and 163 of them have a vat tax. Only the Unites States does not. This becomes important when you realize what the WTO allows you to do when you have a VAT tax and you export or import products. If you are a corporation in China and sell something to the United States, the Chinese government will allow you to rebate that 17% VAT tax back to the Chinese manufacturer. The Trump Administration compares this to an unfair tariff or tax. The WTO will not allow you to rebate your income taxes which are viewed as not eligible because they are a direct tax. That ruling excludes US companies from being able to get a rebate on their corporate income taxes when they export. To make things more difficult for anyone trying to sell into China, when an American product comes into China, they will impose their vat tax of 17% on your product. The Trump administration is saying that the difference in the cost of a product through these Vat taxes rebates and assessments is 34%. Their math is you give a Chinese producer a 17% rebate and then charge a USA manufacture 17% to export into China. That’s 34%.

Because the United States is the only country who doesn’t have a vat tax, all products coming into the US are not assessed a 17% tax like they are assessed in China or elsewhere. This is the area that we think the new administration is going to try and change. We think they may follow the Paul Ryan plan which says if you export a product out of the United States you do not recognize the sale in your revenue. Hence, you won’t pay any corporate income tax on the export sale because the IRS will say there “was no sale”. If they can do this, they will be converting a direct tax into a REBATABLE indirect vat tax. The lack of corporate income tax (direct tax) you pay would be equivalent to what foreign countries do when they rebate a vat tax to their manufactures. There are more complicated examples but we will stop here.

Our point in bringing this up is to state the obvious, if the Trump administration does this it will increase the demand for products to be manufactured in the United States by raising the cost to ship products into the USA. Not paying taxes on USA exports will also lower your cost of production when you export out of the USA. This is their intent. We believe this change in taxes will cause higher inflation and interest rates. The tradeoff will be more US jobs. The consumer will also spend more money for their I-phones, clothing and anything imported into our country.

You will soon be reading about Senators in Congress from both parties who hate this idea because they are “friendly” to the retailers who have outsourced the making of these products they sell to overseas manufacturers. Whether it be Target, Home Depot, Amazon or Wal-Mart they will fight this. They will claim it is a regressive tax on the poor and not fair to those on limited incomes. We think Trump will win this battle but that prediction is not cast in stone. We will keep you up to date on this in later letters.

Two stocks we own that would most benefit from this new policy are Berkshire Hathaway and Nucor. Nucor’s ex CEO is the one who helped Trump pick the new commerce secretary, Wilbur Ross. Wilbur’s view on trade can be found in this article which we are linking below. 

https://assets.donaldjtrump.com/Trump_Economic_Plan.pdf

Those views are similar to what we wrote about above. Berkshire owns a huge number of US manufactures that are also like Nucor. We think that is one of the reasons Berkshire’s stock made all time new highs this year. We are also looking at smaller manufactures in the US to invest in should the tax code change. We will keep you updated on this issue through our letters.

Level 3 is merging with CenturyLink and we think it’s a good deal for us. This deal was announced on Halloween and is a little complicated. CenturyLink is going to pay each Level 3 shareholder $26.50 in cash on the date of closing. At closing, each share of Level 3 you own will be converted into 1.4286 shares of CenturyLink stock. At the end of this transaction Level 3 will own 49% of the new entity and CenturyLink will own 51%. The company is predicting that this deal will close in the third quarter of 2017 after passing regulatory and antitrust scrutiny.

The new CenturyLink stock will pay a dividend of $2.16 per share which at today’s prices for CenturyLink ($24.09) works out to a dividend yield of 9%. We view that dividend as secure if the merger goes through. The combined company would control 100% of any new long haul fiber or empty conduits in the United States. Should the demand for long haul bandwidth needs grow as we expect, that’s a great position to be in. What could go wrong?

CenturyLink is one of the old regional bell operating companies that was part of AT+T in 1986. They were called US West and they were the incumbent carrier in 14 states. This is good news because they have lots of local fiber which is very valuable. It is also bad news because they have a lot of “old technology” and software tied to that fiber. That software is going to be rewritten and “merged” with Level 3’s. That is never a risk-free event. Level 3 got a head start on this type of integration by rewriting their software five years ago. This will make it easier to put CenturyLink’s data on Level 3’s fiber. That said, it’s not going to be a risk-free deal and some bumps could happen as they do this. Both companies say the integration will take three years.

Level 3 is a large position for our clients. The payment of $26.50 in cash per share is a return of 40% of our investment back to us. We cannot stop them from giving us the cash, It’s part of the deal. That payment will raise the cash levels of our accounts. We are looking at other things to do with that money. Until the deal closes, we will just have to wait until we get it. Stay tuned.

As we write this letter our average account this year is up about 15%. On the day of the election we were up around 3%. A question we have been receiving a lot lately is “when do we get out”? We view some sort of pull back as inevitable in 2017. Will this pullback be like the one in 2008? We don’t think it will be. Most investors and pension managers totally missed this move and are sitting on too much cash. When you miss a move like this you have two predominant choices, get fired for staying in cash or get invested in stocks. We think job security factors will win out. Portfolio managers will buy more stocks. 

We think the herd mentality of “getting invested” will prevail for a while. The public has not been active in stocks and most pension plans have invested significant money in alternative assets classes like hedge funds, long-short funds and private equity. These alternative asset classes have done poorly versus just owning stocks. We think there will be a rethink of that approach in the first quarter of 2017 with managers selling alternative assets and buying plain old stocks.

That said, are stocks over valued today versus history? The answer would be yes by about 10%. Are bonds over valued versus stocks? Yes. Will investors sell bonds and buy stocks? We think so. Will earnings go up to make stocks cheaper if the new corporate tax rate is 20% versus 35%? Yes. Will placing a “vat equivalent” tariff on imports into this company increase earnings for most US companies? Yes. Because we answered yes more than no, we are willing to give this market some more room to run. Keep in mind we will be receiving cash from Level 3 sometime this year which will build up our cash positions.

As you can tell, there are more moving pieces going into this year than any year we can remember. We have a game plan to attack it but that plan will depend a lot on what happens in Washington. Feel free to call us with your views. We will do our best to navigate what is going to be an interesting year.

Sincerely

Mark Brueggemann IAR       Kelly Smith IAR       Brandon Robinson IAR

Fiscal spending is among us

Trend Management, Inc. Third Quarter Report 2016

On February 24th, 2015, the S&P 500 closed at 2115. On September 26, 2016, the stock market closed at 2151, gaining 1.7% over the prior nineteen months. That may seem like a boring market, but we know it wasn’t.

During that time-frame, we had two, 10% corrections in the S&P 500. Six, straight quarters of declining earnings helped increase the pressure on stocks. The U.S. economy has not entered a recession, but has slowed some. We expect the upcoming election to generate some stock market volatility, over the next thirty days. Political uncertainty usually increases investors’ anxiety, and this year is no exception. We have stated in the past, the United States president is the second-most powerful person, relative to the stock market. Most powerful is Federal Reserve chair, Janet Yellen.

Investors have been on edge, since the world watched asset values evaporate in 2008. To ease concerns, central bankers in Europe and Japan have, and continue to print a lot of money to help raise asset prices. Until two years ago, the U.S. printed around $4 trillion to lower interest rates, in the hope it would increase the value of stocks, bonds, and real estate. In hindsight, we can say the strategy worked.

If inflation ever results, Europe’s and Japan’s central bankers will stop printing money, instead taking money from the system to slow the inflation. A withdrawal of money would cause stocks and bonds to struggle. 

 

The chart illustrates year-over-year change in the amounts of money circulating in the U.S. From the third quarter of 2015, circulation started to increase, with M2 at a new, three-year high this quarter. So far, the increase in M2 has led to wage gains over 2%, but overall inflation, as measured by consumer prices is at only 1.1% per year.

The Federal Reserve’s mandate is to hold inflation around 2%, and have full employment. We think those boxes can be checked. If inflation rises above 2%, we anticipate the Fed starting actions to slow down the stock and bond markets. We have bought commodities, gold stocks, and foreign stock markets we think will go up during this phase.

Both the Republican and Democratic parties indicate plans to dramatically increase fiscal spending. As we know, what politicians say, and what they do, may not be the same things. However, there appears to be a consensus to increase government spending as a percentage of GDP. If a big increase in fiscal spending passes Congress in 2017, it will trigger a greater acceleration in M2, than we have had so far. If it occurs, we predict the Fed tightening the market more than it expects. We know it is strange to say, when the economy picks up, it increases the likelihood of stocks struggling, but that’s how we see it. At that point, we’ll then discuss a greater cash position or owning fewer, cyclical stocks.

For now, we view the stock market as ahead of itself, but not horribly so. We think it is priced to earn between 4% and 5% per year, over the next ten years, but our stocks are priced to double that return. We consider our managed accounts as a market of stocks, not a stock market. In other words, companies we own and hold for long periods of time can withstand the overall market’s ups-and-downs. We will sell them, when they become over-valued, or do something we don’t like. That happened this quarter, with Microsoft.

Five years ago, we bought Microsoft for most of our accounts at around $27. In 2011, its business was fantastic. We sold it, this quarter, at $56.47. Why? The once-wonderful Windows franchise is being damaged by “cloud” technology, yet Microsoft is spending massive amounts of money to support its new Windows, as well as cloud infrastructure. Although we doubt its investment can be recouped in a timely manner, two things pushed us into the sell camp.

We forecast Microsoft stock’s future returns to be in the low, single-digits--before it spent $26 billion in cash for LinkedIn. We didn’t view the LinkedIn acquisition as a good use of Microsoft’s cash. It had already spent $8.5 billion for Skype, receiving little in return. Microsoft also bought Nokia for $7.5 billion, then a year later, wrote off $8.5 billion on its investment. That may be a new, modern-day record for blowing cash in an acquisition, but buying LinkedIn was the last straw. We wished them well, and moved on. 

Wells Fargo has been in the news, and the news isn’t good. We are big fans of Wells Fargo, but some proverbial heads are going to roll. Wells Fargo likes to cross-sell products to its customers. For example, a Wells Fargo checking account is considered one transaction. Add a credit card to the account, and it’s a second transaction. A loan would be a third transaction. Wells Fargo averaged six transactions per account, which was fantastic compared to their competitors. Until Wells Fargo pushed its cross-selling culture too far.

Approximately 5,300 Wells Fargo were fired over the last five years, for not reaching upper management’s aggressive transaction quotas, or for creating fraudulent transactions. Upper management was aware of the latter practice in 2013, but did very little to stop it. It’s doubtful the CEO will keep his job, and likely to also take a huge, monetary hit.

Opening accounts customers didn’t authorize is a form of identity theft. Some people experienced credit-rating downgrades, resulting from multiple credit card accounts they didn’t know they had. Wells Fargo was fined $185 million, and public perception of its banking practices is horrible. We estimate the ultimate damage to be in the $1 billion to $2 range.

Because Wells Fargo’s profits from fraudulent account transactions was small, we don’t need to reduce our earlier earning’s estimates. It averaged a $22 billion net income over the last three years. We were surprised Wells Fargo screwed up like this, but it can afford to pay a price, and it will. We still think it will earn over $22 billion in the future, before write-offs. For now, we will collect its 3.3% dividend yield, and see how systemic this event was. There will be more headlines to come, but we don’t consider this event a reason to sell Wells Fargo stock.

The last stock to update is American Public (APEI). This is the cheapest stock we own, and it continues to be a problem. APEI’s stock market valuation is $310 million. Of that, $125 million is cash sitting on the balance sheet. It has no debt. When you back out the $125 million, the market is valuing the company at $185 million.

In the past five years, APEI has an averaged net income of $39 million. If it continued earning $39 million per year for another five years, it could take its excess cash on the balance sheet and buy back the entire company. Although APEI qualifies as cheap, it isn’t predictable, which is the problem. 

Corinthian College and ITT, two for-profit education stocks, were put out of business by the current administration’s regulatory policies. Those companies had different business models from APEI, which we did not like. That said, today’s political climate has cast a shadow over the whole group. At this time, our confidence is low, regarding exactly when the situation will clarify for for-profit education companies.

The military is a strong, APEI niche market, but we were wrong in our analysis, and predicting its pretax profit. The logical question is, what do we do now? A stock four times cheaper than the market is great, but we aren’t sure which way the pretax will go. Another for-profit education stock, Apollo, (University of Phoenix) with a much bleaker future was bought by a private equity company, earlier this year. We think there is a decent chance APEI may also receive a buy-out bid. We don’t like to own stocks betting on an event like a buy-out, but it could be our exit.

In the meantime, we think APEI has ways to fix its own problems and make the stock go up. If we were APEI, we would jettison everything related to Title IV money. Downsize the organization and concentrate where it already has an advantage: military/law enforcement, and its nursing school business. Those specialties are very valuable online courses for the military, and for society. At the same time, we’d recommend taking the $125 million on the balance sheet and buying back one third of the company at these prices.

Whether APEI downsizes and focuses, and/or initiates a stock buy-back, we think the market will drive the stock to a more normal valuation (over $30). We do try to buy stocks twice as cheap as the market, because occasionally you run into a mess and need that margin of safety. So far, this stock qualifies as a mess. In the short-term, we consider the risk to the downside is limited, due to APEI’s large cash position and no debt.

We continue to believe the major, world economic trend investors will need to deal with is the dollar’s decline over the next five years. It will be led by an increase in the price of oil, and an exploding U.S. trade deficit. The premise and prediction guide managing our accounts.

Our Christmas party is later than usual, on December 22nd, from 6 p.m. to 8 p.m., at Highland Springs. There will be a buffet, and the band will play from 6 p.m. to 7:30 p.m. We will also be celebrating Brandon Robinson’s engagement to Jessica Young. Please join us in the festivities.

Sincerely,

Mark Brueggemann IAR        Kelly Smith IAR       Brandon Robinson IAR

Buh-Bye Britain

Trend Management’s Second Quarter Report 2016

Global stock markets were having a good year . . . until an election in Britain, the financial markets didn’t like. Our managed accounts are up for the year, but the last week of June was quite the roller-coaster.

The financial community is trying to figure out what it means for Britain to leave the EU. We do not feel Brexit is the start of another 2008 stock market debacle, similar to the result of Lehman Brothers’ bankruptcy. Unlike eight years ago, the system is awash in cash, growing $150 billion a month, as Japan and Europe continue printing a lot of money. Cash will temper the fear spreading in the market since the last week of June.

Brexit has caused a huge decline in bank stocks in Europe. Investors are debating whether another country will leave the Euro. We have always viewed England’s exit from the EU as not a huge deal to the world financial system. British banks borrow in pounds, and lend in pounds, and Brexit will not change it. That fact makes it easier for the banks to manage their balance sheets and limit systemic risk. British banks can weather a change in bank regulation from Brussels to London, because the currency will remain consistent.

Some may remember, during the last crisis, we predicted Greece would leave the Euro. So far, it has not, but we do believe Greece will be first to follow Britain’s lead, before the vote in Italy and Spain. Short-term, these elections will cause problems for investors to work through, but we foresee the end of the Euro is inevitable. In the past two-thousand years, there is no instance where a group of countries survived, who shared a currency, but did not share the money.

European bank investors fear Greece, Italy, or Spain, leaving the EU. If so, any money remaining in those banks will convert to new, respective Greek, Italian, or Spanish currencies. What each would be worth is a guess. For example, Euros now deposited in an Italian bank may convert to lira, when withdrawn. Would one theoretical lira be worth one Euro? Half a Euro? Less?

The last run on European banks was 2010-2012, and caused very sharp swings in U.S. stock markets. In 2010, three corrections of ten-percent or more related to Europe. We don’t anticipate an encore, but it probably won’t be a boring summer, either.

We own three, U.S. bank stocks. All have passed the Fed’s economic stress test, designed after 2009 to help identify financial system risk. Our largest bank stock position is Wells Fargo. It is not a large player in Europe, and we view their decline this year as a stock-buying opportunity. We also own positions in USB and PNC banks, which we also feel are minimally affected by what’s going on in Europe.

The world economy has suffered since 2010, when Europe’s problems surfaced. We project the Euro’s break-up as a good thing for world growth, once the shock wears off. Unemployment across much of Europe remains over 10%, with youth unemployment above 50%. In our view, one currency to deal with the problem is the wrong approach. Smaller countries rejecting the Euro will allow them to spend more on their people, thus increasing economic growth. This will help our investments in commodities and Latin America, as well. 

We continue to predict Latin America as a beneficiary of rising commodity prices, due to the end of the U.S. oil production bubble. Our first purchase was made this quarter in Latin America, and it’s possible we will buy more assets in the next. We find it interesting, so far this year, Latin American stocks are up 23% on average, while commodities are up 15%. (The S&P 500 is up 2%.) We think that trend will continue.

We did not add any new companies to your portfolio this quarter. We like what we own, and will continue holding them through the Brexit and Euro volatility.

We wanted to leave you with observations made during cocktail parties, social events, and casual meetings where investments were discussed. A common theme has been lumping all stocks into one pile, as though they are an asset class, like commodities. The assumption is all stocks are alike, and trade together. It’s further assumed, if negative on stocks, then go to one- hundred-percent cash, because no stock can withstand a market decline.

Except inside the S&P 500, numerous stocks do not correlate with the market. If the market goes up, some stocks have a better than seventy-percent chance of going down. And vice- versa. Prevailing wisdom aside, not all stocks are the same. Nor do they trade the same.

As an example, in our managed accounts, we now have over twenty-percent of your account in stocks that will more than likely rise, if the dollar declines. The direction of the dollar matters more than the Dow or the S&P increase. On down days in the overall stock market, it’s possible your account may be up, if the dollar is also down that day.

We are doing this, because we consider the dollar overvalued. Three years ago, your account was fully invested in stocks. Since then, as the S&P 500 rallied, we have gradually hedged your account by betting against our currency--which is somewhat a bet against the S&P 500. Today, the account is almost 100% invested in stocks, but the portfolio’s economic driver is the dollar going down. In other words, we are trying to protect your account from a decline in the S&P 500 and the dollar, without the unenviable decision to be 100% in or out of the market.

We wanted to let you know, your account will track less with the S&P 500, than it has in the past. This is by design. We would prefer to have bought bonds, were interest rates at normal levels, but bonds are in a bubble, and we don’t want to own them. Hence, we have invested more in stocks that rise when “stuff” does, and decline when it doesn’t. If the dollar rises, we think the stock market will do okay, but your account will probably under-perform the S&P 500. If the dollar declines, we think your account will more than likely out-perform it.

Feel free to call us, if you have any questions (417-882-5746). Sincerely,

Mark Brueggemann IAR       Kelly Smith IAR       Brandon Robinson IAR

Macro Investing

Trend Management, Inc. First Quarter Report 2016

If you like stock markets that are volatile and chaotic this quarter was for you. Our accounts on average finished the quarter in positive territory. We are sure when you looked at your account in February you were probably thinking that was not going to happen. It is surprising we finished up after the Dow Jones had its worst January in history. The markets aren’t out of the woods yet. There is a lot going on in the world we need to talk about, including a few thoughts on the election coming up. Don’t worry, we won’t pick a candidate. However, what’s going on in the political world is going to affect our investments.

The majority of this report will be about macro investing and the big themes we see changing. If you are not into macroeconomics skip to the last page. Before we get into world economics, we want to mention that we did not see anything noteworthy in what our companies reported this quarter. Earnings were about as expected. We will talk more about them next quarter. We would like to note that after they released earnings, both Royal Gold and American Public went up 50%. The reports weren’t that great, it was just that sentiment was too negative. It seems crazy to say they reported in line with estimates and their stocks went up 50% afterward but that’s how this business is sometimes.

You have probably heard this phrase from central bankers in the last 15 years, “You can never spot a financial bubble until it pops”. They said that about the .com market in 2000 and the subprime real estate crisis in 2008. We disagree with that statement. The exact timing of an end to a bubble is impossible to predict but that you are in one is not. We think we were in an oil production bubble and it has ended. This oil bubble was financed by cheap money in the USA that is now going away. The ending of that bubble will matter to the world. 

As you can see from the chart above, as the fed printed money to get the USA out of the Great Recession and one of the beneficiaries of that “free money” was the oil industry. Drilling for oil is not a great business. It needs lots of money to increase production which it usually doesn’t have access to. That all changed in 2011.

From 1986 until 2011 oil production in the US went from 9.6 million barrels produced per day to under 5 million barrels produced per day. From 2011 until the middle of 2015 oil production recouped all of that lost production. The increase in oil production on page 1 is not sustainable. The prevailing wisdom on why oil production has increased is new drilling techniques like fracking have made it easier to drill. That is part of the equation but not all of it. We would like to point out that fracking has been around for a while and started gaining in acceptance in 2005. From 2005 on these “new” drilling techniques didn’t move the U.S. oil production needle until 2011. Why?

A lot of the wells that are being “fracked” today are like cigar butts that are laying on the ground. There are one or two good puffs in them and then you throw them away. The marginal wells that were being fracked in this decade are like burning cigar butts. You get about 70% of your production in year one and then there are a few “puffs” left before you go to the next well. Because production declines so quickly in year two, these wells need cheap capital to succeed. When that capital showed up in 2010 the oil industry was off to the races and so was production.  

 

As you can see from the chart above, the availability of cheap capital in this sector is over. We think over the balance of the next few years’ oil production in the U.S. is going to decline back to the 6 million barrels a day level or lower. Even if the price of oil goes back to 100 dollars a barrel we don’t see credit coming back to fuel oil production like it did from 2010 to 2015. When a credit bubble bursts it is usually a decade before the participants who lent money to that sector tip toe back in. If there is a decline in U.S. oil production what should we do? The answer may surprise you.

Robert Triffin was a famous economist from the last century. He was famous for what was called Triffin’s dilemma which we will paraphrase; “That whatever country is the reserve currency, it must be willing to supply liquidity to the world when it needs it, even when that liquidity is to the detriment of the reserve currency”. The U.S. is the world’s reserve currency today. The dilemma begins when the reserve currency needs to choose between what’s right for the reserve currency’s domestic policy (the United States) and what’s right for the world’s economic good. Many times those goals diverge. Hence the dilemma of what should you do? Protect yourpeople or the worlds.

We bring this up because we have just lived Triffin’s dilemma the last few years though with a twist the markets haven’t figured out yet. There are two ways the United States can help the world get through Triffin’s dilemma of supplying liquidity. One is by printing money (liquidity) and the other is by running a trade deficit (demand). Printing money helps the stock markets of the world, running trade deficits helps the business of the world (to the detriment of U.S. business). When the U.S. federal reserve started printing money in 2008 it was one way to help the United States and the world’s financial assets. So far so good. The U.S. stock market rallied and world stock markets rallied. You can only print so much money to help the rich get richer in stocks and bonds before somebody has to buy a real asset. That is, we need more demand for actual orders of goods and services across the world. Higher stock and asset prices can only help demand “trickle” down for a while before it loses its effectiveness. Trade deficits supply demand to the world from the deficit country.

In the 2000’s the United States was a huge contributor to world DEMAND by running a massive trade deficit fueled by excess debt creation. Europe also ran a trade deficit along with China buying every commodity in sight. This was a perfect scenario for emerging market growth. Before 2008, the US was exporting over 450 billion dollars from oil alone to the rest of the world as part of its trade deficit. That money was consumed by the emerging markets which created growth for the world economy. As a frame of reference, the total GDP of Latin American countries was under four trillion dollars in 2008. Our oil deficit helped fuel the world’s economies tremendously. However, starting in 2012 our trade deficit in oil started to shrink. Because the world’s central banks were printing so much money (liquidity) nobody noticed. The decline in our oil deficit was caused by cheap money fueling oil production (higher oil production lowers our trade deficit). Last year the U.S. “only” sent out 100 billion dollars in “oil moneyto the rest of the world from its trade deficit. Most of that decline was because of increased US oil production and a reduction in the price of oil.

To make matters worse, Europe actually ran a trade surplus not because of increased exports but because Germany has imposed austerity measures on Southern Europe. Europe has squashed the demand of their citizens to consume. China has struggled because both the U.S. and Europe have pulled back. Even though China has a massive trade surplus with the U.S. which should benefit their people, China over the last decade has decided to impose austerity measures on their citizens by lowering their consumption as a percent of GDP from 50% to 35%. This level of consumer consumption as a percent of GDP is unheard of in a developed economy. So in Triffin’s dilemma, when the world needed more demand for goods, each of the major countries chose to protect their own financial system. Printing money which is being tried in earnest by the ECB and Japan to generate demand is not enough to fix this problem.

We think the decline in commodity prices worldwide was caused by the U.S. running a very narrow trade deficit (as a percent of our GDP) while Germany imposed austerity measures on the Euro zone. What we are predicting now is that the narrowing of our U.S. trade deficit is over. The oil bubble masked what is a deteriorating trade position in the U.S. When oil production declines in this country the U.S. will again start sending 100’s of billions of “oil dollars” out to help the rest of the world. They will welcome that money with open arms. When that occurs their economies will kick back in gear and they will consume all of that money versus what the U.S. would consume. They will even borrow more money to consume than the U.S. would because they have less debt to GDP than we do. The emerging markets we are looking at are all down over 50% from their highs 5 years ago. If our trade deficit widens, they will benefit and we should buy them. Why haven’t we? What are we waiting on?

For over 30 years now the guiding force in world economics is what is called the Washington Consensus. We will sum it up by saying the guiding principles of this consensus are free trade, free markets, less taxes and less regulation. The Washington Consensus is guided by the thought that markets know best which we tend to agree with. However, there is no acknowledgement that people/countries cheat or gamefree markets. Economics 101 doesn’t know how to handle cheating so they ignore it. Countries are more than happy to game the system for their own benefit (China, Germany and Japan). It appears to us that the Washington consensus is going to stop and be replaced by something else. Why do we feel that way?

Bernie and Donald are why. When the far left and the far right get together and agree on something you should pay attention. Both Bernie and Donald are running on a very anti-trade, anti-free market rhetoric. They are both advocating an end to trade agreements that are deemed unfair. Each might solve it in a different way but they are now changing the debate on what’s wrong with the Washington consensus. The supporters of these two candidates on this subject know something is wrong and they are willing to bet it has to do with trade and free markets. This political debate is brought up at a time when we are NOW predicting that the U.S. is going to start running huge trade deficits again as our oil production declines. The world needs those deficits; we might need the worlds money to fund those deficits but our politicians may stop it. Is that a bad thing? Sort of. 

 

 

As you can see from the US Trade Deficit with China chart there is something wrong in our trade with China. The trade deficit with China is at extreme levels. In the interest of brevity, we won’t look at Germany and Japan who have similar charts as the one above. The support for anti- party establishment candidates on both sides of the aisle are an indication the American people might think this is a problem as well. What will our leaders do about this?

We hear this phrase all of the time Trade wars caused the Great Depression”. We don’t agree with that statement. If that was the case, then why did the trade war of 1971 not end in a depression? The U.S. under Richard Nixon imposed a 10% tariff (and price controls) on all goods coming into the U.S. on August 15th of 1971. After that date manufacturing hours and inflation in the U.S. actually picked up. Bank loans accelerated as U.S. production of goods replaced imported goods. There was no depression.

What we think has caused the slowdown in worldwide growth, is a huge imbalance in trade of which the U.S. has been on the wrong side. The U.S. has over consumed but Germany, Japan and China have under consumed. In a perfect world where everyone plays by the rules, trade should balance evenly. We are for balanced trade, where money doesn’t pile up on one side of the Atlantic or Pacific Ocean to the detriment of the other side. If one country practices free trade and the others do not, you get the worldwide mess we are in now.

To make sure everything balances out, the currencies of the surplus countries should go up and THE CONSUMPTION of their citizens should go up. If the U.S. trade deficit widens too much, its currency should go down. This decline will decrease consumption and narrow the trade deficit. If China consumes too little, its currency will rise which will increase the consumption of its citizens. The Chinese government (and other surplus countries) should also encourage through public policy more spending on its citizens. That’s the way its suppose to work.

We are convinced that if the current system continues without intervention from our politicians, the U.S. will run larger trade deficits than it did in the last decade. Even if oil production stays flat from here which we don’t expect, the trade deficit is going to widen. Based on this view we intend to invest in emerging markets for the first time. We believe thatour current positions in Exxon, Royal Dutch, Nucor, IBM and Royal Gold are beneficiaries of a declining dollar. We don’t think that the anti-trade movement can change our trade agreements quickly. Theoretically it is the role of Congress to approve trade deals. That said, Richard Nixon quickly imposed trade tariffs in 1971, so it can happen. We don’t think a trade war will hurt Latin America compared to what it will do to those surplus countries we mentioned above.

We will summarize this report to make it easier for you to follow going forward.

  1. Oil production was in a bubble caused by cheap money. The oil bubble has ended.

  2. The oil boom temporarily caused the U.S. trade deficit to narrow which helped our currency go up but hurt world growth.

  3. The end of the oil boom will cause the U.S. trade deficit to widen and the dollar to decline.

  4. World growth will return as the U.S. “exports” more money to the world.

  5. Some form of protectionism is likely to occur led by the U.S.

  6. Inflation will return to the U.S. as the dollar declines.

  7. Wages in the U.S. will rise benefiting the middle class.

  8. Owning emerging markets who export commodities will be better than owning U.S. markets

  9. Central banks will be less important as fiscal policy and trade policies take over their role.

At some point this year we will be buying emerging markets. We will have a position of around 10% in this area.

As always feel free to call us with any questions you have on this report.

Sincerely,

Mark Brueggemann IAR             Kelly Smith IAR              Brandon Robinson IAR

Just as we thought!

Trend Management Inc. Year End Report for 2015

Our 2014 year-end letter mentioned concerns regarding 2015’s stock market performance. They were based on the unsustainable operating margins most companies were reporting. We predicted, should those margins decline, it would create a difficult headwind for stocks to deal with. To help protect against this uncertainty, in the first week of January, 2015, we raised cash in your accounts from zero to above 15%.

As of this writing, the S&P 500 is unchanged for the year. The Nasdaq is up, but the Dow Jones is down. Treasury bonds are down, junk bonds are down, and commodities are down. For the most part, it’s been tough to make money for investors. We’re squarely in that camp.

Our managed accounts will be down this year, for the first time in four years. Raising cash in January 2015 was to help cushion the blow of a down year, should it occur. We also wanted to have cash available to buy stocks or assets at cheaper prices. We bought stocks in August, and still have some cash left. We do not anticipate raising any more cash in the first quarter of 2016. We like what we own, and feel those stocks can handle what will probably be a rough first quarter or two. 

If a bubble exists, caused by too much money chasing too few goods, it’s in the junk bond market. The chart above shows the relationship between junk bond interest rates and the average stock. As illustrated, when junk bond rates go up, the average stock declines. In the short-term, we are not positive on junk bonds. Their rising interest rates indicate companies borrowing less money to invest in their businesses. The economy slows, and credit markets worry about a recession. Investors want higher yields on their money.

The current cycle is a little different than those we have studied in the past, because companies have borrowed increasing amounts of money to buy back their stocks, not to invest in their businesses. This has caused the leverage of companies to be too high, in our opinion. Borrowing to grow revenue is great. Borrowing to buy back stock, which doesn’t grow revenue, is a questionable practice. Some companies can do it. Others cannot.

In 2015, we tried hard to avoid investing in companies who would need financing in the next two years. If we are right, and there is more pain to come in the junk bond market, you don’t want to own stock in companies who will have to pay more to refinance their debts. If those companies issue stocks to get money, instead of issuing bonds, it will not be a good thing for their shareholders.

Companies who have borrowed money in the junk bond market at low rates for stock buy-backs probably won’t continue the practice in 2016. We think the game of supporting stock prices by borrowing money for buy-backs has run its course (for now). We don’t anticipate any of our holdings issuing stocks or junk bonds to finance their operations. The most likely scenario in 2016 is companies with good balance sheets will weather this storm fairly well. 

The pressure on the average stock is shown in the chart above. The Nasdaq 100 is dominated by companies with very little debt (Microsoft, Apple, Google). The Value Line composite is an equally weighted index of around 1700 stocks with less credit-worthy companies than the S&P 500 or the Nasdaq 100. The S&P 500 is a market capitalization-weighted index of five hundred stocks which, in general, have better financing than the Value Line. By the chart, companies who don’t need financing are doing well. Those who do are struggling. These parallels began to accelerate as junk bonds started doing poorly.

The chart also conveys the difference between market capitalization-weighted and equally weighted indexes. With the equally weighted Value Line composite, the smallest stock’s movement, up or down, is as important as the largest stock’s up-or-down movement. Here’s how the S&P 500 and Nasdaq 100 differ: the movement of just one stock, Apple, (the largest in the index by market capitalization) will sometimes dwarf the movement of the bottom ten- or twenty-percent in that index. The fifty largest stocks in the S&P going up could mask downturns in the bottom 450. Indicative of this is the chart tracking the Value Line composite declining, while the S&P is down 1%. For the year, the average Value Line stock is down 11%, the S&P 500 is down 1%, and the Nasdaq 100 up 9.5%. 

We think it’s possible fewer stocks rising in the indexes may accelerate in the first part of 2016. If correct, we also expect this to reverse when junk bond rates begin to decline. If the Federal Reserve continues to raise interest rates and the rest of the world does not, it will make things worse for junk bonds. Our best guess is the first quarter will be tough as the market sorts out this stuff.

Now for a couple of notes on 2015’s worst and best performers. Stocks that did poorly were Berkshire Hathaway, (down 12%) Maxwell Technologies, (down 18.8%) American Public, (down 50%) and Royal Gold (down 42%). Our notable year-over-year winners were: Level3, (plus 10%) BGC Partners, (plus 12%, including dividend) and Microsoft (plus 20%). Overall, there were more losers than winners. Of the losers, we feel the only stock with the wind in its face is American Public. We think its earnings will continue to decline in 2016, but not nearly as much as the market predicts. American Public did buy back 2% of its stock last quarter, but didn’t borrow money to do it. We view it as a good use of its cash, because AP has no debt, and over $100 million in cash sitting on the balance sheet. We hope it buys back more stock.

For the fourth, consecutive year, Level3 has gone up and outperformed the market. We received a lot of calls in August asking why Level3 went from 57 to 41. Was it time to sell? We can honestly admit, we can’t peg any fundamental reason for the stock’s steep drop. During that period, no Level3 company news accounted for it. Or for the stock’s subsequent rally. Today it is 54. Such is life in the markets.

We’ll close with an update regarding commodities. To date, we have been wrong about their market direction. They declined in 2015, and reached very cheap levels. This hasn’t prevented them from going lower. It also has not deterred us from believing a major bottom in commodities is at hand. We do not know whether we will add to our commodity positions in 2016, but rest assured, we will at some point.

Please feel free to call us (417-882-5746) with any questions you might have. Sincerely,

Mark Brueggemann IAR        Kelly Smith IAR          Brandon Robinson IAR

The bottom of the World Wide Recession

Third Quarter Report 2015

This quarter the stock market suffered its first 10% correction since 2012. There were also new multi-year lows in commodities, emerging market currencies and junk bond prices. When you combine those four ingredients together it makes for a volatile market and we had that this quarter. We will outline our thoughts below for the market along with some comments on our individual stock holdings.

The markets are in flux because the world is fearful of another recession similar to what happened in 2008-9. To be more precise, the world is afraid that China’s economy is collapsing. China is the largest consumer of commodities in the world. The last twelve months decline in commodities is a sign to investors that the mess in China is real and not getting better anytime soon. The CRB index (a basket of 19 commodities) declined in 2008 from 470 to 203 before rallying to over 300 in 2011. The CRB index is now trading below those crash lows at 192.

This quarter we did buy a basket of commodities when the index was trading around 218. We are hoping we are near the low in commodity prices. The lowest the CRB has traded in the last ten years was on August 24th at 185. At that time oil was trading at $38 dollars a barrel (its $45 today). If we take out either of those lows this quarter it will be a sign to the deflationist camp that things are getting worse. Hence I would not expect stocks or anything else to be doing well at that time should commodities go below the August lows of 185. If we can hold those lows then I expect the stock market to be less volatile and trend upward. So in the short-term just watch commodities for a guide on what’s next in the stock market. For now, commodities are telling the stocks which way to go. For this quarter that was down.

If you are a consumer and don’t own stocks isn’t commodities going down a great deal? The answer is yes. The savings to fill up our car with gas at $1.95 makes us feel good. The same goes for natural gas at new lows which heats our homes. If you build a house and use copper or wood you would be excited to see these prices go down as well. However, if you are a producer of these goods and borrowed money to expand you facilities when prices were higher, you are not feeling as well. For now, Wall Street is focusing on the dark side of commodities going down. Companies produces this stuff and Wall Street has been actively selling them all.

At some point in this cycle the lower prices of commodities will cause the demand for products that are made with those commodities to go up. You and I will buy more of these products at a lower price causing demand to eventually go back up. Once that occurs WORLD WIDE, the bottom of this recession will be in.

We mention recession because we have said in previous letters that the world is in a recession. We still believe that the world is in one even if the U.S. is not right now. Europe, Latin America and Asia are just having a really bad time growing since the crash of 2009. We think the top of world growth was in August 2011. At that point Europe rolled over and we have not come back as a planet since.

This global recession has been ongoing for four years now but is finally getting acknowledged by the world community. As we stated in our last letter the effectiveness of printing money is diminishing in generating ECONOMIC growth but is still effective in pushing up stock prices. From a macro standpoint stocks will continue to be supported by the European and Japanese central banks printing over a trillion dollars this year. We think this money will help keep this bear market in the under 20% range (we were down around 14% at our worst in August).

However the money printing will not help those who don’t own stocks like it did early in the cycle. To do that, the world governments need to spend more money on some form of infrastructure. Whether it be bridges, bombs, schools or airports there is a lack of demand in the world that will need to be filled by fiscal spending. So far in the U.S. we have a potential deal of corporate tax cuts in exchange for Government spending on public works. We hope that goes through. It would be a bipartisan deal in a city not known for that lately. We shall see.

We believe this is the fourth market correction since 2009 where the market has gone down over 10%. They are all no fun and this one is no different. We think that once this one ends our stocks as a group will go to new highs. We will discuss some of our companies next and why we are positive on them. We won’t cover them all so feel free to call us on any not mentioned.

We wrote a lot about Maxwell in our last letter. This quarter they announced a restructuring of their business that lowers their breakeven costs dramatically. They also announced their first ultracap win in the United States with Cadillac. This is a very big win for them and one we hope is the start of more to come in

the auto sector. We think that the leadership at Maxwell is making the right decisions and the stock should respond to that. So far this quarter there have been four insider buys of the stock below 5 dollars. We view this positively.

Level3’s stock price had a really crummy quarter (down 19%). The market is fearful their enterprise business is slowing in the US. We don’t share that fear. We feel Level3 is in the perfect position to grow enterprise business for the next five years while AT+T and Verizon are distracted by pricing competition in cell phones. Level3’s largest shareholder also bought over 50 million dollars’ worth of stock this quarter. That shareholder has board seats that help give them insight into how the business is doing at Level3. We plan to hold this stock for another five years as they increase their enterprise market share in the US from the single digit levels to over 10%. We think they will be tough to stop from here on out. We expect Level3 to have free cash flow this year of 600 million plus and close to one billion next year.

Another poor performer this year has been Berkshire Hathaway. The stock has declined 14% this year from an all-time high of 150 to 129. Buffett has publicly stated he will buy his stock at 120% of book value and that target is 121.50. If the world’s greatest investor is willing to buy the stock if it goes down another 6% I am in no hurry to sell it to him at these prices. This quarter Berkshire also bought Precision Castparts for over 30 billion dollars in cash. This acquisition will be taking money that is earning virtually nothing in a money market and increasing that return (our estimate) to over 9%. This acquisition will insure higher earnings for Berkshire going forward.

Bgcp’s stock is also down this year by about 7%. This quarter they reported record earnings for q2. We consider the 56 cents a share dividend secure and likely to grown in the next 12 months. That dividend works out to a 6.5% yield with the stock trading at 8.5.

Apple’s stock was down 9% for the quarter. We view Apple as a cheap stock that is tarnished by the fear it’s the next Research In Motion Blackberry device. We don’t share that view because Blackberry’s didn’t have any apps written for its phones and the IPhone leads the world in that area. The apps make the phone hard to replace because they are written on the IOS operating system. We view IOS as the safest operating system in the world for phones and almost impossible

to replace. Apple has been a huge buyer of their stock and we continue to see that happening.

I want to finish up this short-review of our stocks by talking about Exxon. We have owned this stock and it’s been a poor performer this year. The decline in oil has really hurt their earnings which we didn’t see coming. We bought the stock because it was very cheap, the dividend was good and we thought it could whether the decline in commodities better than most. So far that thesis has been wrong. We feel like we missed some signs that should have kept us out of buying the stock when we did. We are ok holding it at these levels but we feel like we could have done a better job on the purchase of this stock. Hindsight is 100%. We feel we could have done a better job here and hope to learn from it.

As we write this letter the market is trying to go to new lows for the year. We feel the fourth quarter is going to be a volatile one similar to the third quarter. Be prepared for some crazy swings in your account this quarter. As we said above, if the commodity markets stabilize we think the markets will too. If they don’t, then the world will be fearing a repeat of 2008 and it will get real messy. We like what we own and are willing to sit through what happens next. We have cash left over from what we sold at the beginning of the year and will look to put it to work on market breaks. We will paraphrase Warren Buffett here because we think he says it best about markets, “In the short-term the market is a popularity contest, in the long-term it is a weighing contest based on how much money your company earns”. Right now stocks are not very popular. In the long-term we think they will produce record earnings. The earnings are what matter.

The Christmas party this year is December the 17th at Highland Springs. Put that date on your calendar and we hope you can make it. We will send out a formal invitation after Thanksgiving to remind you.

Sincerely

Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR

Stay Calm

 

Trend Management Inc. Second Quarter Report 2015

For the first time in four years, our managed accounts are under-performing the S&P 500 at 2015’s halfway point. Several previous expectations of a tough market were met.

2014’s year-end report mentioned the distinct possibility the S&P 500’s operating margins might have peaked. So far this year, they have declined over 10%. This usually decreases earnings for stocks, too. And has, by over 5%. Because cash- on-hand makes sense in a market with declining earnings, we raised cash in January in anticipation of a messy 2015.

With two exceptions, the operations of our companies have been good this year. Our valuation assessment of Level 3 continues to rise more than its stock does, (up 6%). This stock is a big position for our clients. If we’re right about its business model’s momentum, Level 3 is poised to get bigger, and carry our accounts upward for the next few years.

One bad apple in our account is Maxwell Technologies. A sure-fire sign a stock isn’t doing well is Mark boarding an airplane and flying out to meet with its corporate executives. In Trend Management’s twenty-three-year history, Mark has visited Rentrak, Level 3, and now, Maxwell Technologies.

We doubled our money in Rentrak, and sold it. We are now profitable in Level 3, and the future is bright. We have lost over a quarter of our investment in Maxwell Technologies, and are frustrated its inability to predict its sales cycle. On top of that, this quarter, Maxwell sold stock to improve its balance sheet. This was not something that thrilled us.

Maxwell Technologies produces ultracaps with the ability to rapidly store and transmit power. Maxwell’s primary revenue source is the Chinese electric bus market. Applying the brakes on one of these busses generates electricity captured by the ultracap, then transmitted to help power the bus, saving wear- and-tear on its batteries.

In 2014, Maxwell’s then-CEO and CFO boldly claimed the Chinese bus business would ramp up. We believed them. They were wrong, and are no longer with the company. Mark met with Maxwell’s new CEO and CFO in San Diego, in June. (We have summarized their discussion below, but if you’d like more details, please give Mark a call.) During his visit, it was apparent that ultracap sales in this area can’t be predicted, and why.

The difficulty centers on no one knowing what subsidies the Chinese government will allot to these types of busses. The larger the subsidy, the more ultracaps Maxwell will sell; the lower the subsidy, the lower Maxwell’s sales will be. We don’t like this guessing game, but prefer it over telling you prospects are great, when in the short-term, this uncertainty must be viewed as a negative.

In the third-quarter 2014 report, we wrote: “We continue to think Maxwell’s growth prospects are real and exciting. The company will get it right operationally and grow, or it won’t. If it’s the latter, we predict Maxwell will be bought out by private equity at a much higher price.’’

What we said then, remains true today. Because Maxwell has not performed well operationally, an event we predicted last October occurred in June, after Mark’s visit with management.

A corporate activist has filed with the government, declaring his purchase of over 6% of Maxwell’s stock. The filing conveyed displeasure with the company, and the direction it was taking. This is the first indication private equity may decide to buy out Maxwell, or to force its sale. (Our candidate for the likeliest buyer is Corning, who did a joint venture with Maxwell last year. )

The clock is ticking. The fight will start with the activist trying to get seats on the board for voting purposes. Two investors own 23% of the company, and we’re sure their phones have been ringing. Next, Maxwell will restructure, or sell out. If Maxwell’s stock rises, the activist may take his profit and disappear. If the stock doesn’t go up, and Maxwell doesn’t restructure, the activist will agitate for a sale of the company.

We think the future of ultracaps is good. However, if this activist wins other shareholders’ support, Maxwell may not last as a public company and benefit from that future. If it is bought out, the upside is quite high. We will stay with our position, based on our hope and belief Maxwell’s operational performance will improve. 

The other poor performer’s name is familiar: American Public, an online university. Mark hasn’t purchased an airplane ticket, because we think we understand the issues it faces. 

American Public’s educational niche, comprising about fifty-percent of its sales, is active and retired military personnel. Five years ago, they represented 66% of AP’s sales. Now it’s about 36%. 

Our government continues to make it difficult for active (not retired) military personnel to receive their promised, college benefits. While American Public is struggling to project sales to its primary consumer group, most U.S. colleges are experiencing declining enrollments. 

One factor is the cost to earn a degree is high, compared to the post-graduation salary necessary to pay off student loans. We think American Public is less affected by this, compared to its competitors. Its degree specialties, law enforcement and the military, have stable to rising starting pay-scales. 

American Public’s cost per course-credit is 15% to 20% below the national average. Being one of the low-cost providers for online education should help it compete effectively in the market. AP’s move toward diversifying beyond the military has also met with some success. 

We bought American Public stock because it’s very cheap, and AP has a good business model. The company has no debt, and $112 million in cash is sitting on its balance sheetequal to over $6 per share. For this stock to be considered of the same value as a normal stock in the S&P 500, its earnings would need to shrink by 70%. We don’t anticipate that happening, but the market doesn’t agree. 

AP stock is currently trading at $26. If its earnings stabilized at 2014 levels, a fair buy-price for its stock would be almost $50. Last quarter, AP bought back over 1% of the company. We hope it’s even more aggressive at buying back stock at the market’s pessimistic price. In fact, if we were in charge, we’d initiate a Dutch tender offer (similar to an auction) for another 10% of AP’s stock. It would only cost AP $50 million, leaving $62 million still on its balance sheet. 

Unlike Maxwell Technologies, poor management is not among American Public’s problems. We don’t envision it as a take-over candidate, either. The stock is certainly cheap enough, but we can’t pinpoint who the natural buyer(s) might be. Despite an expected decline in earnings for the next twelve months, we will continue to hold AP stock and wait for enrollments to stabilize.

Our macroeconomic monitoring continues to indicate a global, economic recession. It’s improving, but by historic comparison, remains very poor. As a result, commodities lag, as well. (Because we’re contrarian investors, our interest in commodities continues to grow.)

Aside from the U.S., central banks continue to flood their respective economies with money. Stocks and bonds worldwide have benefited, but not the Joe Six- packs in the U.S., Mexico, Brazil, or Europe. At some point, we believe the monetary flow will find its way into the real economy.

A data point revealing subpar economic growth is bank loans in Europe contracting at over 1% a year. Typically they grow over 5% a year, but the demand for money just isn’t there yet, or in Asia, and Latin America.

The world has experienced bouts of fiscal austerity, despite recession, which is historically unusual. The traditional remedy was to print money and initiate government spending. Instead, today’s conventional wisdom theorized central banks could print money, and as a result, economies would grow. That approach ceased to work, circa 2012.

Europe, not the U.S., was ground-zero for that trend, but we think it will begin to reverse (this quarter?). Money printing will slow, with fiscal stimulus taking over to circulate those funds. World economies need more demand for products from somewhere. The public isn’t generating it, so governments must. What they will spend it on, we’re not sure. Possibilities include their militaries, infrastructure, airports, schools, and/or entitlement transfers.

In previous letters, we have mentioned Greece should leave the Euro. Many investors take the opposite view: Greece exiting the Euro would trigger a so- called Lehman moment, causing world stock markets to crash. We disagree. 

It’s true, Greece’s departure would make things bumpy for a while, but not like 2008. A Lehman moment would require all the world’s banks to own Greek debt, as they did Lehman’s debt and derivatives. Fortunately, that isn’t the case. We doubt whether any U.S. bank owns a single Greek bond. Most are held by European central banks and hedge funds.

As this letter is written, Greece has closed its banks and instituted capital controlsfirst steps to leaving the Euro. A nationwide referendum is scheduled during our 4th of July weekend. The country’s unemployment rate is 25%, with youth unemployment reaching 50%. (As a frame of reference, in 2009, U.S. unemployment never topped 10%.) How much more austerity is needed?

In any event, the markets will be more volatile this year, as this Greek tragedy’s final act plays out. Crazy swings in Chinese stocks this month (down 20% in June) are not helping. However, we raised enough cash in January to take advantage of what we’d predicted would be a difficult year in the market. The odds favoring more volatility means better chances for us to find things to buy.

Meanwhile, we will stay with what we own through this correction, and look to be profitable in the next six months. It’s unfortunate the first half of 2015 was a down one for us, but we like what we own, regardless of whether the market does.

Feel free to call us with any questions about your investments. Sincerely,

Mark Brueggemann IAR    Kelly Smith    IAR Brandon Robinson IAR

Raisin' Cash

Trend Management, Inc. 2015 First Quarter Report

In the first quarter, the stock market traded with more volatility than we are used to seeing. It finished slightly up, which sounds boring, but it wasn’t. We find it interesting the market went nowhere--in a hurry.

The average, intra-day change in stock prices was 1.1%. A definition of churning would be sixty- one days of the market rising or falling 1.1%, with no meaningful change in the price of the index. The stock market is rushing to go somewhere, but it can’t figure out where.

As you know, in the first quarter, we raised some cash for the first time since the crash. Reasons were outlined in the last quarter’s report, and we’ll elaborate more now. 

The chart illustrates a broad basket of commodities and the S&P 500. From late 2008, until the first quarter of 2013, stocks and commodities operated in tandem. This is fairly normal and makes sense, when you think about it. If business is good, stocks will rise, as will the demand for commodities.

From time to time, the balance goes out of whack. Cases in point: the economy entered a recession in late 2007, but commodities rose for a year, before entering a bear market. In contrast, stocks today are at record highs, yet commodity prices have collapsed. Something is wrong with this scenario. The price of commodities should indicate business is bad, but stocks are saying the opposite. Which is correct?

We think the commodities’ market is right about the state of business worldwide. In our opinion, the U.S. is the exception to a global recession, and commodities have declined as a result. GDP growth in this country is sub-par, versus history, but China, Latin America, Russia, India, and Europe experiencing recession leaves the U.S. to carry the ball. Because this economic imbalance can’t work forever, how should we play this?

At the bottom of the 2008 crash in stocks, the S&P was trading at 666. At the same time, the CRB index (the basket of commodities) traded at 203. Fast-forward to today: the S&P is at 2070, for a gain of 210%. The CRB index is at 217, for a gain of 7%. However, before the crash occurred, the CRB index was at 470. From its high, it remains down over 50%, while the S&P 500 is up over 35% from its 2007 highs.

As we have previously stated, when our Federal Reserve and world banks decide to print money, the bond and stock markets are helped first. We think money-printing has distorted the relationship between commodities and stocks. We have benefited by being invested in stocks, and very thankful for it. However, the system can’t detach forever. Either stocks will decline, or commodities will rise. Because the world’s central banks continue to print money, we think it makes more sense to invest in commodities, which are within 7% of their crash lows.

After our last report, we were asked if we thought stocks were way over-valued. Our answer then, and now, is no. Stocks are a little over-valued, but commodities are way under-valued. Our current best- guess at what will occur next is a reversion to the mean. Commodities will rise to a more normal level, and for a while, stocks will trade in a range. We think the margin of safety is to own stuff, versus paper, with the cash we have on hand. Sometime this quarter, you will probably receive confirmation by mail (or email) that we have bought a commodity-related Exchange Traded Fund (EFT). We have studied these funds for almost a year. The initial investment made will be in the actual commodities, using the ETF as the vehicle. We want to first own the commodities, rather than stocks in companies producing those commodities. (Time may reverse that thinking, but not this year.)

The next step is to invest in some combination of currencies and bonds denominated in foreign currencies. Finally, we may actually own the stocks of companies not headquartered in the USA.

If you’re keeping score, this equals four investment strategies based on one simple idea: commodities are too cheap. Historical relationships between commodities and currencies also tell us to own the commodities first. To date, we have dedicated over a thousand hours to this plan of action. Timing the exact bottom is impossible, but commodities are very close to their crash lows.

We don’t anticipate your portfolio owning more than 5% in actual commodities. We are saving our cash to next own the currencies and bonds. The hope is the dollar continues at record highs, while everyone else’s currency tanks. (So far this year, that’s been happening.) A sudden, higher move in the dollar this quarter may speed up our foreign-based investment strategy.

By now, I’m sure you’re thinking, “What about the stocks we have now? What will we do with them?” The answer is very little. We like what we own. We think they are fairly priced, and most importantly, think their earnings will grow. Get a stock-story right, where the earnings grow, and the market is less and less a factor in how the stock-price does over time. Get it wrong on earnings, and the market is a bigger influence on how much money you make than we like. For now, we think the companies we own will earn enough over time to compensate for a potentially sloppy market in the near future.

Below are a couple of charts we find interesting, that affect your investments. The first reflects the amount of debt owed on residential housing. We watch this as an indicator of confidence returning to Main Street, America: 

The public is not levering up and buying homes like it did before 2008. Seven years post-crash, the public’s residential debt is one-trillion less than before the crash. This lack of borrowing reflects too- zealous bank regulators, and a skittish public. So far, the latter’s reluctance to take on more debt means the economy is not yet running at full-throttle. 

Emerging market currencies are near their crash lows. The chart illustrates the carnage occurring in the world’s financial system. (For really bad currencies, check out Latin America. It’s not pretty.) To us, this indicates six billion people who own those currencies are experiencing decreases in their purchasing power. At some point this will end, but it hasn’t yet.

Financial history buffs should study 1937-38. The Great Depression started in 1929, and by 1937, the Federal Reserve was worried about inflation. The stock markets didn’t handle the fear of a Fed tightening very well, and declined. (Today, many financial gurus say today’s market reminds them of that period. We hope not.) What ultimately fixed world economies in 1938, was a massive World War. The fiscal spending wars demand put people back to work, but at an awful cost. Perhaps we can avoid that fate, this time.

We also want to point out, the decline in Asia in 1997-1998, affected commodities in a way comparable to today. We view the disaster in Europe starting in 2012 as similar to the 1997 Asian crisis. The dollar went up, like today. The U.S. stock market was strong, like today. And commodities tanked, (like today) because Asia was in a horrible recession, while the U.S. was not (like today).

We think this period is the best blueprint for current indicators. If that’s the case, commodities will bottom soon, the stock market will become very selective in what it buys, and highly leveraged investments should be avoided.

On a very happy note, Kelly is expecting child number two any day now. She will be out of the office for most of this quarter, which means you have to rely on Brandon and Mark for paperwork and operations. These aren’t their strong suits, so please have patience with them.

We look forward to reporting to you in the future on your investments. Thank you for your continued support.

Sincerely,

Mark Brueggemann IAR       Kelly Smith IAR       Brandon Robinson IAR

S & P has bottomed

Year End Report 2014

This year has been another good one for your account. 100% investment in stocks was a very profitable strategy since the crash, and we have profited from it. 

The S&P 500 will be up around 12% this year, but small stocks will rise much less. The return on our managed accounts will far exceed the market averages. The market is becoming very narrow in what it wants to own, and it concerns us. What we plan to do next is outlined below.

S&P 500 bottomed at 666 in March 2009. For those with a spiritual focus, that number resonates. It sure felt like a market from hell. Since then, the market has rallied to new highs this year, at around 2100.

What was once a ridiculously cheap market is now slightly overvalued. If you compare stocks to bonds, we still feel stocks are the better buy. Compare stocks to commodities and things become more complicated.

For the last few years, CNBC has said the stock market is overvalued and in a bubble. When we hear something like this, it’s our job to try to logically prove it or disprove it. We compared stock prices to other asset classes like bonds, oil, gold, and commodities in general. Doing the math at the beginning of 2013, we ranked bonds as the most overvalued asset. Oil was a close second. The cheapest asset class was commodities in general.

During this time, we owned two oil stocks: Exxon and Royal Dutch. We were willing to own them, though our view on oil was negative. Those stocks were cheap, and if oil prices declined, we thought their refinery divisions would protect their earnings better than a pure oil exploration company.

As we write this, ranking asset classes has changed dramatically. Oil has plummeted more than we anticipated: from $108 to $49 in six months. It is now tied with commodities in general for the cheapest asset class out there. The huge drop shocked us, even though we thought oil was overvalued.

In our previous letter, we planned to own more commodity-related investments. Our prior projection is accelerating.

There are myriad ways to play the decline in oil, and how cheap commodities are in general. An obvious strategy is buying the stock or bonds of anybody who produces commodities or involved in drilling for them. Another option is investing in foreign currencies affected by the decline in hard assets, or by owning foreign stocks, as well. Or just buy an exchange traded fund that owns oil or commodities. 

We have debated this subject for a while. (When trades come through your account this year, you can see how it plays out.) We view this as a two-step process. First, selling some stocks you currently own to raise cash. Step two is investing the money in commodity-related stuff.

We are monitoring certain economic metrics to help us time buying those commodity-related assets. There will be a waiting period where some cash will sit in your account, earning virtually nothing. The reason? Because what we want to buy is still going down in value, and we are waiting for them to bottom out.

As we type this, the S&P 500 is slightly overvalued. We use S&P earnings divided by the S&P price (this is called the earnings yield) to ascertain the index’s value. We then compare the earnings yield to past history to deduce a fair value for where the market should reasonably trade.

A market valuing system Warren Buffett has used in the past identifies value in the market as it compares to our economy. Buffett divides the entire U.S. stock market capitalization by the U.S. Gross Domestic Product. 

As you can see from this chart, the market reflects historically high ground. The problem with Buffett’s system is it doesn’t take into account the companies’ earnings, (see above) or from where those earnings derive. We think it’s a mistake to compare the market cap of companies who do business overseas exclusively to the U.S. GDP. More and more American companies’ earnings are coming from overseas, but aren’t reflected on this system.

Buffett’s calculations also assume U.S. companies’ operating margins will not change much over time. We like his thinking, but it does have flaws.

All systems have problems, and ours is no different. By our method, the earnings yield used to value the market are achieved with the highest S&P operating margins in the last fifteen years. 

 

The average operating margin is usually 7.90%, with the median at 8.53%. Today’s number is 10.17%. This means every dollar of sales is being valued at 19.22% more than the median, and 28.73% more than the average.

Said another way, if a company’s sales stay the same and operating margins go down to the historical average, earnings for all the S&P will drop by over 20%. This potential problem has bothered us for a while now. What could cause those margins to reflect their historical norm?

A partial list would include U.S. wages rising as the economy reaches full employment. Although there is slack in employment statistics because many people have given up looking for work, two-hundred-thousand people per month are being hired. At some point, reducing unemployment will affect wages.

California dock workers’ labor issues are influencing how fast overseas goods are shipped to the U.S. Organized labor continuing its work slowdown increases the cost of goods sold to business. The dollar’s rise will make U.S. goods less competitive against foreign manufacturers, hence business might cut gross margins.

More employer-sponsored healthcare costs are being passed on to employees, who are struggling to pay them. This can’t go on forever. Workers can’t continue to absorb higher deductibles, if their wages don’t increase.

These reasons and others explain what we think could derail record margins, and why a little caution might be warranted.

Twenty years ago, the index was dominated by heavy industry. Today it is more service- and tech-related, which have higher margins. Rest assured, no matter what system is used, it won’t be perfect. Being generally correct is the best we can do on market valuation.

One last thing we want to discuss relates again to declining oil prices. Around 315-million people live in the United States. Of the 315-million, 141 million are employed. Of those 141-million workers, about one million are employed by the mining and drilling industries.

By comparison, when housing tanked in 2007, studies have shown the decline in construction directly and negatively affected 30% of the U.S. economy. Based on the stats above, the current decline in commodities, and by extension, the mining and drilling industries, should affect less than 1% of the total 141- million employed. For the other 99%, oil price declines should boost economic growth here and across the world--except for OPEC.

As you can tell from this letter, we think the markets are entering a transitional phase, where money will shift from one sector (non-asset related) to asset-related investments. We believe markets are opening a door for us to enter and profit from. 

Feel free to give us a call about this letter, and any changes to your financial affairs.

Sincerely
Trend Management

The Market is Sleepy!!

Third Quarter Report 2014

The stock market was due for a break, and we got one this quarter. The markets are in a nervous period, affecting some parts of the market more than others. Our thoughts are below.

Quantitative easing in the U.S. is ending. A lot of investors believe the only reason the stock market rose the past five years, is the U.S. Federal Reserve printed three trillion bucks (quantitative easing) and threw it at world problems. (We won’t argue much with that.) With our Fed reducing quantitative easing, many investors are now taking some profits.

The logic is understandable, but they may be missing something. It is a worldwide market. The Federal Reserve taking a break from printing money hasn’t stopped Japan, China, and the EU from announcing they’ll print over a trillion dollars more than our Federal Reserve, this year. The money will need to find a home, and we think it will place a floor under financial asset prices for a while longer.

When will the rise in financial assets end? Forget about unemployment stats, capacity utilization, trade deficits or balanced budgets. The simple answer is, as long as U.S. inflation is under 2.5%, the window is open to print money. World leaders want inflation, and we think 2.5% is their number. Until it’s met, they will keep printing money. We think it’s that simple.

Right now, inflation in the U.S. is at 1.4%, in Europe, .3%, and China’s inflation rate is 2%--all below 2.5%, and trending lower. We predict Central bankers won’t stop printing money, until prices--other than stocks--increase. If stocks rise, all the better. For now, party-on is the operative phrase.

We confess, we have been wrong in predicting when commodity inflation will return in the U.S. (Okay, we feel better for getting that out of the way.) We thought it would show up before now. If you trust the government’s stats, it hasn’t. There is inflation in stock and bond prices, but not in non-financial stuff the government uses to measure inflation.

We have made money on Royal Gold, Exxon, and Royal Dutch, since their initial purchase, yet our economic premise on why we bought them has been wrong. We like making money, but don’t like being wrong about why the money was made. Don’t misunderstand: buying cheap stocks is always a good idea. This has proven true with these three stocks. However, to get a huge move in a stock, we must also be correct about which way the industry’s fundamentals are trending. Based on what we wrote above, this bull market’s final act might be played when Central bankers succeed in driving up prices of non-financial stuff.

When we’re wrong about something, we try to figure out why. The chart below is an index we developed this quarter to help explain our previous miscues regarding inflation. 

 

 

One line illustrated here tracks the year-to-year U.S. inflation rate. The other, the Series 2 line, helps predict when inflation will worsen. There is no discernible turn in the Series 2 line predicting higher inflation. Both lines indicate no inflation fear in the market. 

This chart also shows when world economies are doing well, and when they aren’t. When business is good, the lines are near the top of the range. When bad, the lines dip to the bottom. With both indexes trading near their low ranges the past fifteen years, business is not optimal. Hence, the money printed by the bankers hasn’t yet circulated out into the real world and cause commodity inflation. It’s bottled up in stocks and bonds, from which we have profited.

When the money does begin circulating, the chart should reflect it, with the Series 2 line rising first. When this line goes up, inflation usually follows. At that time, we plan to own more stuff stocks than we do today, but for now, will hold our current positions.

Although we are happy our inflation stocks have risen, we aren’t kidding ourselves about getting this totally right. We haven’t, and we plan to continue to challenge our theory in this area. If you are an investor who has sold financial assets of late, it shows up markedly in the performance of small-cap stocks. The Russell 2000, a proxy we use to evaluate small-cap stocks, is down 9.2% from its highest point this year, and down 5.3% for the year. By comparison, the S&P 500 is down 2.3% from its highs, but is up over 6.5% for the year. This denotes an almost 12% difference this year between owning a big-cap stock and a small stock.

As we mentioned in last quarter’s report, we think a shift is occurring, where portfolio managers are selling hedge funds and alternative asset funds. The proceeds are being allocated back into large cap stocks, as indicated by the stats above. For a market technician who studies technical data, like advance/decline lines, new highs and new lows, margin debt, sentiment, etc., the underperformance of small-caps is a negative.

We believe it signifies a tired market in need of a break. It isn’t the end of the world--just a necessary pause that happens in every bull market. The last 5%-plus correction was in February 2014. We anticipate another 5% to 7% correction period, now. It continues to make sense to bet on further upside, after this period is over.

A quick update on a few of our stocks. Level3 is merging with TW Telecom. Level3 has abundant long-haul and metro fiber assets. TW Telecom has over twenty-thousand buildings hooked up with its own fiber, enabled by other people’s long-haul and metro fiber assets. These two companies combined will improve both networks, lower costs, and improve customer service. Their respective networks’ overlap is less than ten-percent, so the merger increases the ability to reach new clients and better control sales.

October 5th marked the end of the poison pill preventing large shareholders from buying Level3 stock. For the first time in three years, anyone who owns more than five-percent of the company can buy as much stock as desired. In the short-term, we think this is more significant than the merger itself, and expect a steady buying pressure to the upside. In the past seven days, four brokerage firms have upgraded the stock. We are shocked Wall Street would try to buy stock ahead of its customers. Shocked, we tell you.

American Public stock continues to struggle. Nothing new to add here, but we like this company and the business. Someday, we will like its stock price, again. Maxwell Technologies continues to be a wild, roller-coaster stock. The interim CEO who talked about Maxwell’s huge growth opportunities wasn’t named its CEO, and left the company. The new CEO won’t comment on new growth opportunities discussed by the interim CEO, until the contract is signed. The market hated the new CEO’s stalemate, and the stock tanked.

We continue to think Maxwell’s growth prospects are real and exciting. The company will get it right operationally and grow, or it won’t. If it’s the latter, we predict Maxwell will be bought out by private equity at a much higher price. Why? Its stock is valued at $250 million, and we believe the patents Maxwell holds are worth more than that. Throw in the design wins in the auto industry, (announced and rumored by the since-departed, interim CEO) and it’s worth taking a chance.

If Maxwell fails operationally and is forced to sell, at a minimum, it could get an offer at $20 a share. If its problems find solutions, with all the opportunities ahead of it, Maxwell stock should rise. In our opinion, at these prices, it is a low-risk trade.

This year’s holiday party is Thursday, December 18th, from 6 p.m. to 8 p.m. at Highland Springs. Carol Reinert and her band will be back again, and we’re looking forward to a great time, as always. Formal invitations will be mailed after Thanksgiving, but go ahead and mark your calendars. We hope to see everyone there, and break last year’s attendance record. When you are at the party we will introduce you to Randall Herion, he is Trend Management’s fourth employee. We are excited he is joining our firm and I am sure you will enjoy meeting him.

Sincerely

Mark Brueggemann IAR        Kelly Smith IAR       Brandon Robinson IAR

Trading for Dummies!

 

Trend Management’s Second Quarter Report 2014

As we’re writing this letter in the last week of June, the market is at an all-time high. A friend in the brokerage industry told us, this is the most hated rally in history. Why did he say that? We think it’s because so many people are sitting on too much cash or alternative assets.

Since December 31st, 2012, the market has taken off with only one, seven-percent correction to allow an investor to buy the dip. This is unusual, and won’t last forever. Since the beginning of this bull market, we have been fully invested in stocks, until very recently. What we are thinking about in the investing world is discussed below.

In the past year, we added Exxon Mobile and Royal Gold to all our portfolios. In some accounts, we also added Royal Dutch Petroleum. The theme here is, these companies would benefit from inflation coming back. We think there is an inflation scare coming for our leaders to deal with. We don’t think it will be like the Second Coming of 1980, but will be enough to shake the Federal Reserve’s complacency about printing money. We have stated before, the Fed and politicians in developed countries worldwide want some inflation to help grow their economies. We think they might get it in the next twelve months.

What might cause this? Currently there are so many conflicts in the Middle-East, we have trouble keeping track of them. We think one of them might affect the world’s flow of oil, or the flow of trade. Those are two different subjects to elaborate on.

Everybody knows, a disruption in oil production increases its price. Fear of a potential supply disruption in Russia, Ukraine, Iraq, Iran, Egypt, Saudi Arabia, and Venezuela is rising. The good news is, the U.S. continues to ramp up its oil production. This will put us in a better position than the rest of the world, should the oil supply decrease.

As we have stated in previous letters, the Fed printing money has trumped our concerns about wars and the Middle-East, but it can’t go on forever. At some point, the Fed will pull back the reins on quantitative easing, and it will affect the markets more than we want. We plan to profit from the rally in oil with the stocks listed above. We hope to add more inflation hedges, if we can get them at the right price.

A fear we have, but investors don’t worry enough about right now, is the disruption of trade and the flow of money. The last thirty years have been an unusual period in history, where businesses have been relatively free to build factories in any country they choose. Those companies are also counting on large sales outside the U.S. Money worldwide has been able to flow fairly easily from country to country. 

What if those change? What happens? Consider two countries who decided free trade and the flow of money weren’t good ideas: Venezuela and Argentina. Both decided foreign business ownership within their countries was bad for their citizens. They took the assets of some foreign companies and claimed them as their own, without due process. In the Ozarks, we call it stealing. They call it wealth redistribution for the poor. Of course, that isn’t why it was done, but who can argue with helping the poor?

Once some assets are nationalized, other investors ship out their money and capital from those countries, before their governments can seize them. This causes shortages of food, products, and money. Those actions contributed to massive inflation in both countries--now over thirty- percent per year. Venezuelan and Argentine politicians blame the evil corporations for this inflation. They then feel empowered to take more corporate assets to help the poor deal with the high inflation. This cycle continues until the country runs out of foreign exchange, and the economy collapses. At that point, a change in leadership occurs.

We bring this up, not because we anticipate it happening elsewhere in the world to the degree it has in Venezuela and Argentina. It’s to illustrate a gradual shift in the flow of funds can cause an acceleration in inflation, that won’t be predicted by standard economic analysis.

For example, if Asian countries decided to hinder the free flow of capital, it will affect us, because a lot of the goods we consume are manufactured there. We know from the South American countries’ experience, any change in the free flow of capital will raise the cost of products manufactured worldwide, and initiate a pause to quantitative easing. In turn, the end of quantitative easing will slow down the profits we are making in the stock market.

They are related. We bring this up to assure you, we are monitoring this potential development. There won’t be a single, Aha event making this visible to the world. At first, it will be gradual and we hope to catch it. If it occurs, it will initially involve companies who outsource their manufacturing to Asia. As their costs increase, so will ours in the U.S., which is inflationary.

Our final comment pertains to something we’ve observed for a while at Trend. Those who follow Wall Street asset allocators will find it interesting. Ten years ago, pension consultants and asset allocators recommended owning a lot of stocks. In 2003, corporate pension plans had 61% of their money in stocks. Today, it’s 43%. Public pension funds in 2003 had 61% of their money in stocks. Now, it’s 52%. The real shocker is endowment funds: 50% of their money was in stocks a decade ago, decreased to 34%.

Where did the money go? Into alternative assets like hedge funds, tree farms, long-short funds, private equity and other investments, besides plain, old stocks. Since the crash, returns have been poor on those alternative classes, with the exception of private equity. We mention this, because it explains something we have seen in the markets when we allocate your money. Large cap stocks are still fairly valued, but small cap stocks are overvalued. It’s really strange, but we can explain why.

Pension plans own large cap stocks, and as they’re sold to reallocate the money into alternative assets, it has depressed the price of large cap stocks. This trend has occurred due to group- think among public pools of money, advised by consultants. Alternative assets are sexy, unknown to most, and it makes for a great sale. The herd-like selling of large cap stocks created an opportunity for us, and we took it. Hence, your portfolio owns more large cap stocks than usual, because it’s where the most value is.

In time, the flow of funds will return to large cap stocks. An interesting test-case to watch is what Harvard does next. In 2008, it was a leader in using alternative assets and received universal praise for it. Today, Harvard is among the worst-performing endowments out there. If it throws in the towel and goes back to stocks, it will change the way people view this asset class.

In closing, we are aware of the pending merger of Level3 and Time-Warner/Telecom, announced in June. We are waiting for some legal documents to be filed before we comment on it. We will update you in October.

Meanwhile, we have written a long essay on how to improve the U.S. economic system. We decided to save some trees (it’s a long essay) and post it on our website: Trendmanagementinc.com. Fans of macroeconomics will enjoy this essay.

Sincerely,

Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR

To Buffett... Or Not to Buffett!!

 

First Quarter Report 2014

The markets were choppy this quarter. The S&P 500 was up, the Dow was down, bonds were up, commodities were up, and emerging market stocks were down. From the data, it’s pretty hard to come up with a theme. We expect more sloppy markets for a while, as the world tries to handicap what a Fed taper looks like. So far this year, it’s a stock-pickers’ market, and we have had some successes.

As is our tradition, let’s start by talking about what isn’t working: American Public. Try as it might, it just can’t seem to catch a break. American Public’s business is online education, and it thrives in military, security, terrorism, and law enforcement classes. However, government budget problems are causing military personnel real, short-term issues regarding whether they will get “free” money to go to school.

Thirty-four percent of American Public’s business is with active military personnel of the U.S. government. Sixteen-percent is retired military personnel, using veteran’s assistance benefits to pay for classes. Sales to active military soldiers were down nine-percent year over year, while sales to retired military personnel were up twenty-nine percent. Why the huge discrepancy between retired military enrollment versus active military? The answer is government funding.

The 2013 sequesters and budget fights hit the benefits active military personnel receive, but not the retired military benefits. Without boring you with too much detail, an active military soldier now does not know whether funding for his schooling is available on a predictable basis. A retired soldier does know. Hence, American Public’s sales are doing great in one sector, and not another.

We think a measure of predictability will return to the active soldier’s benefits, at some point. In what quarter it happens is anybody’s guess. If I were a soldier and I could receive $4000 per year free, (16 credit-hours a year at American Public) I would wait to enroll, until the uncertainty is pay out-of-pocket for tuition, when military benefits will pay for it, if you wait? In the meantime, we like the valuation of American Public stock and view it to be a very good value.

Speaking of value, have you followed Maxwell Technologies this quarter? In our last report, we cautioned you to be prepared for some poor earnings this year. Maxwell reported in February, and the earnings were as bad as predicted. It still hasn’t received the Chinese diesel bus order we wrote about last quarter, either. The news drove the stock lower in February. But all the bad news aside, the stock went up 75% this quarter to 14.

What happened? Operationally, not much this year, but quite a bit has on the news front. Maxwell is now designed into electric busses in China, which we didn’t know about last year. It is predicting multiple wins with tier-one auto companies in 2015, which we didn’t know about, either. Maxwell is also in discussions with Corning on some sort of joint venture in the solar industry. It is winning business in the U.S. diesel truck business, too.

All this was announced this quarter via its conference call or meetings with Wall Street. Start trying to guess how much this could move sales and it’s a very large number. L-a-r-g-e.

The bad news is, this revenue stream is six- to twelve-months away. Revenues will start out slowly, then grow rapidly. We think there is a chance the market may be a little too excited in the short- term, and not excited enough in the long-term. This is already a big position for us, so we can’t buy much more for clients without violating capital allocation rules on initial positions. That said, we don’t mind if Maxwell Technologies grows its way to an outsized position in your account. This could be a fun stock in the next eighteen months, if Maxwell is telling the truth (we think it is). Be prepared for some wild swings in the stock as the market sorts this out. 

The last happy stock we’ll talk about is Royal Gold. It rose right after we bought it, and hasn’t looked back. That’s the good news. The bad news? The reason we predicted it would go up hasn’t happened yet. Are we just lucky here? Or is our logic correct: the European Central Bank (ECB) will print money, causing gold to rise.

We think the odds the ECB will print money are better today, than three months ago. Three months ago, we didn’t know Russia would invade Crimea, and European leaders would be so shocked by it. Didn’t they learn anything when Russia invaded the Republic of Georgia years ago? Apparently not.

Europe must now spend more on defense, which is a plus for Europe’s jobless situation. The economic win-win for Europe in higher employment for defense, and its need to grow the economy, seems like a reason to accelerate money-printing by the ECB. And this will help gold.

We are long-term negative on the euro surviving in one piece. Right now, the market doesn’t share our view, which is why gold has performed so poorly, until this quarter. If Russia is allowed to annex Ukraine, and Europe doesn’t defend it, I expect a real rush for the exits from the euro. It just makes sense. Would you keep your savings in euros, when it could convert to Russian rubles next week? Me, neither. We still like gold here, and our best bet is to own the stock, Royal Gold.

The lack of response by the free world to issues in Crimea will embolden other countries to take a shot at land grabs, while the world’s police are asleep. China has pushed to take over more territory in Asia, as has Iran, in the Middle-East. This will make the markets more event-driven than I would like.

In our 3rd quarter 2012 Report, we reviewed what happens to the stock market during wars or regional conflicts. The average decline was 16.5%, and it took about three months for declines to play out. (These numbers included the Gulf wars, World War II, and the Vietnam War, to name a few.) The

fooler in this study was once the decline was over, the market went up and rarely looked back. The phrase “War is good for business” is awful, but based on our work, is factual.

We will continue monitoring what is sure to be more conflicts this year. For now, we think the printing of money worldwide is the most important determinant of what we should do next.

We did sell one long-term position this quarter: Cintas. We sold out, because Cintas was overpriced, based on our expectations for the company. We hope to find a new home for the cash, soon.

Our final thought for this letter is a comment on Warren Buffett’s announcement in his annual report this year. He stated, when he dies, he has instructed the executor of his estate to put 90% of his wife’s inheritance in an S&P 500 index fund. The rest will be placed in cash.

What I find interesting is the greatest asset allocator of our time believes this is the best way to care for his widow’s finances over the next ten or twenty years. Buffett made one decision for his executor. Buy stocks and hold them, is the message. The reason I bring this up is I doubt five-percent of the world’s financial people would recommend Buffett’s approach. The typical breakdown is 60% stocks and 40% bonds. Sometimes, a mix of 50% stocks, 30% bonds, and 20% alternative assets. In Buffett’s case, it’s almost all stock and some cash—with the 10% cash an interesting way to smooth out cash-flow needs (see below).

Most financial plans factor-in a 4% withdrawal of the account’s value per year for living expenses. If it’s assumed the S&P 500 pays 2% in dividends, it represents a cash-flow to the account of 1.8% (90% times 2%). If no money is withdrawn from the account, and stocks go nowhere, after Year One, the ratio is 11.8% in cash, and 88.2% in stocks. 

In our opinion, Mr. Buffett’s approach says you’re better off in the long term to ride out stock market ups-and-downs, and use the 10% cash as a buffer to avoid selling stocks during a period like 2008. Keep in mind, Mr. Buffett is very well aware of what a disaster 2008 was.

Let’s say, hypothetically, $100,000 was invested in October 2007, according to Buffett’s 90/10 system (the worst month to open a stock account seen in our lifetimes). Let’s say the S&P 500 was at 1550, which was then, a new high. We would invest $90,000 at 1550, for a total of 58 shares of the S&P

To fund the cash shortfalls in years 2012 and 2013, we would need to sell about two of the 58 total shares, which is calculated in the value of the stock portfolio in 2013. After six years, the account would basically be where it started, despite investing in the worst market in our history. 

The key to Buffett’s thinking in our opinion, is the cash cushion to prevent selling stocks during a really bad, economic time. Basically, you could wait five years before selling anything to fund retirement needs. Based on history, during those five years, the earnings of the S&P 500 will probably be at least 25% higher. Earnings gains will help support the account going forward. Starting in Year Six, to fund retirement needs, you will liquidate 2.2% of the portfolio per year, (some years more, some less) for the rest of your life. That key is, as always, don’t panic during the decline. If you do, you will have made a bad decision, leaving yourself in really bad shape.

We doubt many will emulate Mr. Buffett’s estate planning, but we wanted to pass it along, and let you think it over. Warren Buffett is a genius, and his publicly announced strategy relates to a real problem we all face.

As always, call us if you have any questions about your account.

Sincerely

Mark Brueggemann IAR       Kelly Smith         IAR Brandon Robinson IAR