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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: Fans of macroeconomics will enjoy this essay.


Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR