2012 Year End Report
“The only thing we have to fear is fear itself.” We give a hearty tribute to FDR for that quote which I think sums up the year in review. We will also quote an old farmers saying which is “We killed the crop five times before we harvested it.” What both of those sayings have in common is that what we fear may not happen. In 2012, the financial end of the world was postponed yet again and it proved to be a good year for our clients. Since the crash of 2008 we have been fully invested which has not been an easy thing to do when the market along the way has dropped 21%, 17% and had numerous 10% corrections. Each time the market dropped it was quick, the news was horrible and the easiest thing to do would have been to go to cash and “wait for things to clear up.” As I write this letter on January 1st the fiscal cliff may have been temporarily solved but that settlement is only setting up the next big debacle which is the debt ceiling fight in March. The headline news is going to be cloudy for a while and clarity is not something we can expect out of our political leaders anytime soon. What do we think is coming next? I think you might be surprised by our answer.
For the last year we have been asked by clients and non-clients “What do you REALLY think is going to happen over the next few years when all of this deficit spending, money printing and fiscal irresponsibility finally hits the fan.” Usually the answer they want us to give them is the world is going to hell, there is no hope, buy gold and try and find a cave in the Ozarks as a backup living plan. Our sheepish answer has been along the lines of “If you put a gun to our head and told us to give you our best guess on what the stock markets response is to the above our answer would be that the stock market takes off and has a HUGE bull market.” At that point, the client laughs and generally says “You guys are always bullish because you don’t know anything else” and they change the subject. Honestly that’s generally what happens. We have been somewhat afraid to state what we think is the most likely outcome of what we think is next for fear of being laughed out of the room. Bearishness is cool and in vogue. Today, we are at the opposite side of the spectrum from 1999 where being bearish was stupid. Since the crash we have been optimistic and it probably does sound like a broken record. We have stayed bullish because the stock market has been the only asset class besides residential real estate that is historically cheap. We think all of that money printed by the Fed is going to find its way into those two asset classes come hell or high water. While we have been bullish we have tried to gauge what the public is doing to see when the party is getting to “hot” and it may have run its course for a while. In other words, when does the dumb money show up again and drive prices to unrealistic levels. One of the ways we answer that question besides using valuation levels is to judge sentiment of what individual investors are doing with their money. During the last four years the public has left the stock market in droves. They can’t sell enough stocks right now. In just the last 12 weeks the public pulled 50 billion out of stock mutual funds which is sort of a self-induced version of the “fiscal cliff.” To sum this paragraph up, the market has been cheap the last four years, the Fed is supplying liquidity and we have been willing to ride the roller coaster from 2008 on while we wait for the market to get fairly valued. It has not been a smooth ride but it has worked out for us.
What happens when the market is fairly valued? Then what? We have written in past letters that we would pull back on our stock allocation when we got to that level. We also said if our monetary work turned negative we would start selling whether we were at fair value or not. Today fair value in the market in our opinion is 1520 on the S+P 500 and we are at 1425 today. Two years from now when our system “gets rid” of the bad earnings of 2008 and 2009 fair value will be pushing 2000 on the S+P 500. For those of you doing the math in your head, yes, that is a gain of 40% from here. It could be a lot more than that but let’s just stop here and talk about why this might occur sooner rather than later. Why are we changing our stance on selling at fair value in 2013?
As we mentioned in the above paragraph, until this quarter we were targeting fair value as a place to sell some stocks. We also said if our monetary system went negative we would start the selling process earlier. Because the monetary system is very important, let’s talk about it. We developed this system after 2008 to give us a warning signal of impending doom and to forget owning stocks no matter how cheap they are. We didn’t have this system in 2008 and I wished we had. It cost all of us dearly for not having it. According to our back testing when the signal turns negative you generally have two years before the market tops out and heads south. The last sell signal was July of 2005 (S+P was at 1191) and you had until October of 2007 (S+P at 1541) to get out. The buy signal was October of 2008 and the market dropped 40% before it bottomed in March of 2009. As you can see the signal isn’t great on timing the S+P 500 on a short-term basis but it does tell you which way the wind is eventually going to blow. We bring this up because based on all of the money our Fed and other central banks are printing we won’t get a sell signal for at least a year on this system, maybe two. From there you still have another two years to edge your way out of the market. From a timing standpoint that could put us into 2016 or 2017 before we have the next MAJOR bear market. Before the Fed announced its latest money printing venture we were close to a sell signal that would start the clock ticking on reducing our holdings if we got to what we think is fair value; hence 2013 could have been a partial selling year. Now we don’t think we need to be in a hurry. This lack of a likely sell signal for years brings up a nasty discussion we have been having at work for a year now. What do you do with a market that is short-term over valued (this assumes we get over 1520 on the S+P next year) if the other assets you rotate into are even MORE over valued? If the market gaps up to 1550 (9% gain) in the first half of 2013 should we declare victory and punt? Why would you sell today if you think the S+P 500 will be worth 2000 in 3 years? Then again, did we not learn anything from 2008?
To try and answer those question we asked ourselves is their another period like today where the economy is pretty good and the fed just throws gas on a fire to boost it some more. The answer is yes and that period was 1998 and 1999. During that time period the economy was better than now but not great. There was a massive hedge fund called Long-Term capital which got into trouble. In 1998 the Fed started printing money to help out Wall Street who had lent money to this hedge fund (sound familiar). The S+P 500 was around a 1000 at the time. The economy didn’t need the money but the stock market took it and had one hell of a party with it. In the middle of 1999 the Fed started printing more money because of bank fears related to Y2K. I am sure you remember that people were pulling money out of their banks thinking that the world would end on January 1 of 2000 and the fed felt compelled to print lots of money to accommodate them. Again, the economy didn’t need the money so that excess money “went sloshing” into the stock market causing the craziest bull market I have ever seen. The market was ridiculously over valued compared to today’s prices but it didn’t matter. The party was on and it was fun while it lasted. After the turn of the century the Fed pulled the money out of the market (Y2K was a nonevent) and the crash of the NASDAQ began (please see our chart at the end of this letter for a visual look of how this played out). The high in the S+P 500 for that bull market was around 1550 and we are still below that level today. The high in the NASDAQ was over 5000 and we are only at 3000 today. Thirteen years have passed without a party in our industry and we think that’s going to end now. What we are “bolding” predicting is a return to fun in the stock market compared to the last 5 years which have been hell. The Fed is going to engineer it whether congress and the president get its act together or not. The fight today on the fiscal cliff is about 500 billion dollars, the FED IS GOING TO PRINT 1 TRILLION DOLLARS this year alone. Who is more powerful? We will not fight the fed but enjoy the ride.
In the 1998 to 2000 party the S+P went up 55% but the NASDAQ went from 1770 to 5130. That is almost a 200% increase in two years. As we mentioned above we can justify a 50% increase in the S+P 500 three years out to around 2000 and the market will not be overvalued like it was in 1999. We think the party will more likely be in the S+P 500 this time rather than in the NASDAQ. What we are trying to figure out now is which groups of stocks like the .coms and the techs of 2000 are going to have huge parabolic moves upward. Moves that will shock you because it shocked us back then. Maybe the gold bugs will be that beneficiary or it could be in USA industrials (our vote) but we think some groups are going to have a wild move up. For now we don’t have an answer to that question but we are working on it. We know we are REALLY PUTTING ourselves out there with this letter. We have thought about this subject for a year and this last Fed printing of money has forced us to go public and come out of the closet and confess we are VERY bullish. We are aware that most of you are probably either asleep at this point from reading this long letter or dialing our number (882-5746) to tell us we are village idiots. Just remember we are paid to invest your money based on what we think is going to happen and our pay is based on how accurate we are. In other words, we have a vested interest in being right. We do reserve the right to change our opinion but this is what we think is MOST likely to happen. Our fear of a war in the Middle East would slow this party down but not for long. So who would really benefit from this besides you and me?
Just about every pension plan whether it be state, local or private is having trouble making their payments to retired beneficiaries because they assumed they would make more off of their investments than they did. A huge bull market would make it easier for these entities to pay their retired union employees at the state and local level, it would also allow corporations to make less contributions to their defined benefit plans, thus freeing up money for business expansion or stock buybacks. Any gains from this bull market will also lower the state and federal budget deficits as you and I pay more in capital gains taxes. Bernanke wants the economy to pick up and a bull market in stocks appears to be another way to make this happen. Higher stock prices WILL solve some issues the government is dealing with and it’s our view they are going to make it happen or drown us in money trying. Now keep in mind the economy doesn’t have to grow like gang busters to give us a 1999 type bull market, just grow enough to give us positive earning and the rest will take care of itself. As a famous investor once said “If you put 20 teenagers in a room with a keg a beer something is going to happen”. Bernanke has supplied the beer and now we wait and see what happens.
Here are the returns on most of our individual investments this year. First off the good guys, Berkshire Hathaway up 17%, Wal-Mart up 17%, Wells Fargo up 27%, Rentrak up 36%, USG up 176%, Cintas up 19%, Lincoln Electric up 25%, Nucor up 13%, Direct TV up 7% and Level3 up 36%. And now for the loser’s, Maxwell Technologies down 49%, Corning down 1%, BGC Partners down 32%, TBT Proshares down 12% and American Public down 17%. We will ignore the winners and focus on the losers of this group. We like each of these investments and have no desire to sell. We have been buying more for accounts where we can accept for TBT. Our investment in TBT is a play on higher interest rates. We are trying to get a better handle on when the Fed will let long-term interest rates go back up so we have not been averaging that position down at this time. The problem with Maxwell is they sell a product that goes into cars that are sold in Europe and busses in China. 2012 was a rotten year to be doing that and they paid the price. We don’t see those problems continuing. If they do we would not be surprised if somebody buys these guys out in a takeover. American Public is our cheapest stock when we compare it to its growth rate. We view it favorably even though the industry they are in, for profit education is viewed like the plague on Wall Street. Corning is viewed unfavorably due to concerns about a glut of glass for big screen TV’s. Corning has a new product called Gorilla Glass that we think will make this less of an issue. The biggest surprise for us this year was how poorly BGC partners did. We got paid around 60 cents in dividends but the stock went down $1.70. That’s not a good trade off. BGC has electronic exchanges that make money when investors trade bonds, derivatives, foreign exchange and stocks. Their largest money maker is U.S. Government bond trading and foreign exchange trading. When the Fed announced operation twist where they locked in long-term rates and limited their volatility it really hurt BGC. We missed that dynamic and we are sorry about that. At some point the government will allow the bond markets to trade without government manipulation and it will be a bonanza for these guys. If and when the government tries to sell those bonds the fed has been buying, it will be a huge money maker for BGC. They are going to pay 48 cents a year in dividends, which with the stock at 3.40 a share makes it worth our while to wait this out.
In closing, 2012 was a good year and we thank you for your continued support. As you can tell from reading this letter we anticipate a few more years like this one in the near future. We know this letter is way more bullish than what you were anticipating. Predicting a market like 1998-1999 is way off the main stream of what Wall Street thinks, but it is what we think is most likely to happen. Let’s hope we are right.
Enclosed is a copy of our privacy statement for your information. Sincerely
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR