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