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.


Mark Brueggemann IAR        Kelly Smith IAR       Brandon Robinson IAR