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.


Mark Brueggemann IAR       Kelly Smith         IAR Brandon Robinson IAR


It is time to benefit

Year End Report 2013

Was it really just five years ago, when the market collapsed and took the whole world on a scary path toward another Depression? How can it be, the market went down 60% in 2008-2009, then reversed course, and in a five-year period, went up 175%? Did earnings really change that much? What causes this type of crazy behavior? What will our grandkids say about the mess we went through?

As always, we will try to give you the answers below.

Hindsight confirms buying or holding stocks at the end of 2008 was the single best thing you could have done to make money. We also know, it wasn’t easy to do. We went home after the flash- crash, (2010) and the European crisis, (2011) and wondered whether the financial world would ever return to normal. Many investors did sell out and missed the return to new highs in the S&P 500. Congratulations--you survived and recovered.

We think the fair value of the market today is 1650, based on the S&P’s earnings’ average over the past five years. As I write this report, the market is at 1825. For the first time since 2007, under our system, the market is actually overvalued by 10%. Stock prices have outpaced the growth of earnings, which won’t go on forever. We project, in a few years, when earnings rise and we’re rid of 2009’s bad earnings, a fair target for the S&P 500 is 2150. But how should we deal with this scenario where we are overvalued today, and undervalued three years out?

Veritably all the world’s central bankers are printing money to jump-start their economies. A money flood might be more accurate. The U.S. economy’s Gross Domestic Product (GDP) is around $16 trillion. With luck, our economy in 2013 will grow by 3%--inflation included. If the Federal Reserve wanted to increase our banks’ liquidity to help them deal with 3% growth in the GDP, the absolute maximum amount of money needed is $480 billion ($16 trillion of GDP x 3% growth).

In 2013, our Federal Reserve printed one trillion dollars--twice that amount. Where did that extra $520 billion go? A lot went into the stock market, which is a major reason your account performed so well. The Federal Reserve is creating a bubble in stocks by printing more money than the real economy requires. Because the excess finds its way into the stock market, we call it happy inflation, and why we predicted a big bull market for 2013.

Said another way, U.S. banks have $9 trillion in deposits and have lent $7 trillion, leaving $2 trillion to be accounted for. Until the world’s central bankers start to pull the excess from the system, the wind is at the stock market’s back. 

We do think a change is coming within the next eighteen months. When the global central banks print currency, it first goes into Treasuries, then high-quality corporates, followed by low quality corporates, stocks, then commodities. In our opinion, the next area for growth is commodities, and our asset favorites are gold and oil.

The last quarter of 2013, we bought Exxon, Royal Dutch, and Royal gold. Now starting 2014, we will sell some stocks in our taxable accounts and buy more Royal Gold. We waited until January to prevent creating a taxable transaction in those accounts by selling a stock two days before 2013 ended.

Besides the normal process of money flowing to commodities late in an economic cycle, two catalysts could speed up a bull market in oil and gold. One is the Middle-East. The other is Europe.

In respect to oil, we see a real problem with our country’s relationship with Saudi Arabia. For forty years, the quid-pro-quo arrangement has been the U.S. protecting Saudi Arabia militarily, and Saudi Arabia accepting our dollars in exchange for the oil it produces. In 2013, the U.S. reneged, when it didn’t protect Saudi interests in Iran and Syria.

It isn’t my job to determine what’s right for President Obama to do in the Middle-East. It is my job to interpret U.S. policy changes and capitalize on them. By walking away from Saudi Arabia, President Obama opened the window to something we may not like economically. We think there is a thirty-percent chance Saudi Arabia will start pricing its oil in currency other than U.S. dollars.

If that happens, the price of oil in the U.S. will increase. Our currency would decline, due to less demand for dollars to buy oil, and it would cause all commodities to go up. The CRB Index (a basket of commodities) was around 450 in 2008. It is now at 280. We think there is a good chance its correction is over, as well. Buying Exxon/Royal Dutch is a great way to protect your account.

Gold is a big asset beneficiary, if Saudi Arabia changes its oil pricing. Most of us remember how much gold values increased during the oil embargos in 1973 through 1981. What pushed us to buy gold this quarter was another event during the last week of December: The euro member-countries’ economic summit was a miserable failure.

The euro crisis has been on the back burner for two-and-a-half years. We think Euro Angst will return in 2014. For the euro to be a stable currency, Germany must share its money with the rest of the European Union. In return, the other euro countries must accept economic oversight, dictated basically by Germany. During those two-and-a-half years, we have heard the member-countries will comply. A week ago, they refused. 

We think this failure means money will leave the euro and head elsewhere. As a result, the European Central Bank (ECB) will have to print more. (At the end of this report, a chart shows the relationship between gold and the ECB balance sheet.) 

Some of the money will find its way to the U.S., and benefit our dollar (assuming Saudi Arabia doesn’t pull the plug). We think a good chunk will go into gold, which is why we bought Royal Gold the first week of 2014. Because Royal Gold is down 60% from its highs two years ago, it qualifies under our system. When a stock declines 60% and we buy it, we aren’t under any illusions it won’t go lower. We have followed this stock for nine months, and the mess in Euro Land initiated buying it this quarter. 

Our move into oil and gold stocks is what Wall Street quants (quantitative analysts) call non- correlated investing. In laymen’s terms, if you own a basket of stocks, like we do, and they decline, gold and oil stocks usually will go the opposite direction. Hence, they are non-correlated. 

Last quarter, 2013, Exxon was up 16%. Royal Gold was down 7%. The S&P 500 was up 10%. Royal Gold was doing its job--going the opposite way of the general market. Exxon was not. What probably didn’t hurt, and likely helped Exxon’s performance, was after we bought the stock, Warren Buffett bought a $4 billion position in it. 

For three years, gold and oil stocks have been poor performers, compared to the rest of the stocks in the S&P 500. We think that will change over the next eighteen months, and it’s better bet to own these stocks, than to have cash. In essence, we are starting to hedge your portfolio’s gains by not owning what traditionally goes up, when the S&P 500 goes up. 

We can anticipate your next question: Why not sell everything and go to cash? The answer is, we still believe the valuations of what we own are still good, while the overall market’s valuation is ahead of itself. As long as the world’s central bankers are flooding us with money, the value of stuff will do better than cash. We anticipate this trend continuing. Hence, we are buying more stocks that sell stuff

As is our tradition in these year-end reports, we’ll ignore what worked out in 2013, and focus on problems stocks. We owned three at the end of 2013’s first quarter. Now there is just one: Maxwell Technologies. This stock will be problematic throughout 2014, and here’s why: At the beginning of 2013, Maxwell caught some salesmen cheating on how they reported sales. The cheating caused Maxwell to restate its earnings. We felt comfortable this was a painful non-event, and it was. 

The bigger problem is China. Maxwell sells ultracaps (ultracapacitors) to improve the performance of electric cars, trains, busses, windmills--anything needing sudden jolts of electricity. In the last five years, average sales have gained around 25% per year. This is outstanding. A lot of that growth came from sales to Chinese bus manufacturers, (diesel and electric) who received a subsidy from the Chinese government to sell busses that reduce pollution.

The Chinese government has no exposure in ultracaps and wants into the business. It has made prior overtures to Maxwell for a joint venture, in terms reminiscent of a Mafia shakedown: Make an offer they can’t refuse. Except Maxwell has.

China pulled the subsidies Chinese diesel bus manufacturers received to use ultracaps. The government did not curtail the electric bus-makers’ subsidy. It all goes to Chinese-owned companies, who profit from battery or diesel sales, but not from the ultracap sales. China wants the technology Maxwell won’t give up. Government hardball is freezing out about 30% of Maxwell’s current sales.

We figured out this stalemate in quarter four, when Maxwell’s stock was around 7-1/2 bucks-- where it basically is trading now. We are assuming the bus subsidies’ issue will hang over this stock through 2014, until Maxwell’s sales increase in other areas and offset the loss of these orders.

Maxwell has signed a new contract with a Korean company to start the process, but it won’t happen quickly enough to help our earnings for the first part of 2014. At some point, we think China will give in, but not until the government is convinced it can’t inflict any more pain on Maxwell.

The enterprise value of Maxwell is only $200 million. If the stock stays down at these levels, we think there is a decent chance somebody will look past the China problems and offer a buy-out at prices higher than these. We have decided to sit through inevitable bad earnings coming in 2014, (in 2013, it had record earnings) and bet Maxwell is either bought out or grows its way out. Meanwhile, we will continue providing updates on Maxwell.

We view 2014 as a consolidation year for the stock market, as a whole. You can’t earn 30% per year, every year. (I wish you could, but you can’t.) We’re confident what we own is fairly valued, and will beat owning bonds or cash. As we explained earlier, if the market consolidates its gains, we think certain underperforming sectors, like commodities, will improve.

The Fed is now printing only $75 billion a month, rather than $85 billion a month. This is still a huge wind at our backs, and could cause our consolidation year prediction to be a mistake--to the upside. We continue looking for stocks we think will make 9% to 10% a year. These days, there are fewer stocks to choose from, but we are considering new ones popping up to buy next quarter.

As always, feel free to call us with any financial questions you have.


Mark Brueggemann IAR        Kelly Smith        IAR Brandon Robinson IAR

Government Quits its Job

Trend Management, Inc’s Third Quarter Report 2013


Our prediction from 2012’s year-end letter: “Thirteen years have passed without a party in our industry, and we think that will end now. What we boldly predict is a return to fun in the stock market, compared to the last five years, which have been hell. The Fed will engineer it, whether Congress and the president get their acts together or not. The fight today on the fiscal cliff is about 500 billion dollars; the Fed will print 1 trillion dollars, this year alone. Which is more powerful? We will not fight the Fed, but enjoy the ride.”

Fortunately, the stock market has gone up, as we predicted. Unfortunately, our political leaders have not gotten their acts together. As we type this letter, the government may shut down at midnight. We feel this is a poor way to run the people’s business and appears to be the norm, rather than the exception.

What does this mean for the stock market and the economy? In 1995, the government shut down operations on November 14th, lasting about a month. On the first day, the S&P 500 closed at 589.29. Two months later, the market was trading at 599.82, for a gain of almost 2%. The next year, it was at 735.88.

We tend to think the current, potential shutdown will play out about the same. But make no mistake, this is not good for the real economy. It wont help consumer confidence at all. That said, we think the Federal Reserve’s policies are more important to stocks right now, than is the debt debate. The only big winners we see in this mess are TV and radio talk-shows.

The public is taking notice; the stock market has been going up. We are aware of a change in behavior in investors’ attitudes about owning risk assets, like stocks. Money is trickling into stock mutual funds, while running for the exits from bond funds. This makes sense to us. Bonds are overvalued, and we have not been shy in telling investors about it. What is more difficult, is stocks are about 4% overvalued today, for the first time since 2007.

We use a five year look-back on earnings to determine fair value for the S&P 500. Right now, the number is in the mid-1600s on the S&P. As I type this, the market is at 1700. We are thrilled the market has recovered from the destruction of the 2008-2009 bear market. Yet it makes our jobto find value--harder.

Previous to this year, we joked about the day coming when you can no longer just throw a dart at the Wall Street Journals financial section and make money. We are now there. Prior to this year, investors were so depressed there were lots of companies to choose from, and we had trouble narrowing our buy list to twenty. Today we struggle to find twenty. The markets are no longer cheap, based on the prior five years’ earnings. Because we anticipate earnings, as a group, growing at 5% to 7% per year, you could say the S&P is about a year ahead of schedule.

Does fair value mean you sell out? We hear this comment all the time: “I don’t want to go through another 2008.” Neither do we. When your account declines in value, so does our pay. We are on the same page, here.

We have written in the past about how we deal with this, but for a brief recap: When the Federal Reserve starts to tighten credit, you usually have two years before the economy begins to slow down. In our view, this quarter’s tapering discussions in the press about slowing down the printing of money do not represent tightening. To us, tightening equates with less money in circulation than before, and that won’t happen for a while. If we thought the Fed was restricting credit, we would reduce the amount of stocks you own.

Our second fallback is the price of those stocks owned. We evaluate every stock to determine whether we should continue to own it, regardless of what the Fed is doing. If we don’t like the stock, we sell it. If it’s overvalued and its growth is slowing, we will reduce the size of the position or just sell it. Lose confidence in its management, and we get out.

A third fallback is bonds. If U.S. bonds or another country’s are a better investment than stocks, we will sell some of your stocks and invest in other asset classes. It is in this third area, where we have spent a lot of time of late.

If we don’t have a good idea for the money from selling an investment, we will put it in cash, until we find something we believe will do well. For the first time in six years, we actually have some cash in your account--a sign we are struggling to find new opportunities for investments. Your account may soon reflect this slightly different approach. If those investments are made, we will write about them in our next newsletter.

To sum this up, our process to avoid another 2008-2009 is a market call, based on what the Fed does, judging your individual stocks on their own merits, and comparing them with other asset classes. If you want more detail, feel free to call us and we will go over it.

A recent development involving banks and regulators isn’t receiving much press. For perspective, it rates mention, one agreed-upon cause of the housing bubble was the incentive politicians and regulators gave banks to make loans to home-buyers, whether those loans made sense or not. Banks then sold off sub-prime home loans, before borrowers defaulted and turned them toxic. But because everybody knew those loans were rotten, interest payments were broken up into tranches.

A tranche divides a mortgage payment into pieces and prioritizes each piece. For example, let’s assume a homeowner’s $100 mortgage payment has twenty tranches. The first tranche is $5, the second tranche gets the next $5, continuing on until the 20th tranche receives the last $5 of the $100 paid.

Then times get tough. The homeowner pays only $10 of the $100 mortgage amount. Tranches one and two will take their respective five bucks each. The remaining eighteen tranches receive zero. Hence, the market rated the first tranches as triple-A credits, and the rest in the Bs. Last decade, bank regulators said a AAA-rated investment required a very small amount of collateral to back up a loan, versus a lower-rated one.

Breaking up mortgage payments into tranches encouraged banks to write bad loans and sell them off as quickly as possible. Banks could sell AAA-rated loans quickly, because those loans required the banks to keep less collateral for them. As a result, banks levered-up their balance sheets. Hypothetically, before tranche-ing a loan, where a bank could hold a million dollars-worth of home loans, they could now collateralize five or ten times that amount. In our opinion, this was the major cause of the housing bubble.

In July 2013, the Federal Reserve issued new bank regulations, which said: (and we paraphrase) “Any bank loan to a corporation carved up into payments (tranches) will only need 20% collateral to back it up, versus a normal corporate loan.” 

This ruling immediately had us thinking, Here we go, again. A restart of subprime loans, except for corporate bank loans this time, not real estate.

The Fed’s motivation is to grow the economy by encouraging bank lending to corporations. It may succeed, but we feel it may also encourage companies to borrow money and buy out each other.

In a low interest-rate environment, banks look for yield and a AAA credit rating. They will achieve both with these loans. The ruling allows them to hold five times the corporate loans on their books, if they buy tranched loans. It tempts banks to write bad loans to bad companies, like they did before in real estate, causing a housing bubble. Our guess is, this time, it increases the odds of a stock market bubble. At the very least, companies may buy out competitors, because the financing will be there. This is a big nudge to corporate America to lever-up again.

Is it a coincidence, Verizon bought Vodaphone this quarter in the largest takeover in recent history? We don’t think so. Banks are getting the message and aggressively lending.

We continue to assess how new regulations, legislation, and politics may affect what we own. On the banking side, new lending rules are very positive for stocks. Also helping stocks is the Fed printing $85 billion per month. That money is inflating your Trend Management account, and we like that.

On the downside is Obamacare. No matter what political party you root for, the Affordable Care Act’s implementation will slow the economy. For now, we believe the positive flow of money into stocks will outweigh the ACA’s fiscal drag. As always, we reserve the right to change our minds, but that’s how we view it today.

If you’re financial situation has or is changing for employment reasons or any other factors, please let us know, so we can update our files.

The Christmas party is slated for December 19th at Highland Springs. A reminder will be mailed after Thanksgiving, but do mark the date on your calendar. We hope to see you there!


Mark Brueggemann IAR        Kelly Smith IAR       Brandon Robinson IAR

Hey Fed!! Why??

Second Quarter Report 2013 So far so good. It has been a good year for your account, but there are reasons for caution

this quarter.

For the first time this year, the stock market is now in a correction. As of this writing, we are in the midst of a 7.5% decline in the S&P 500. We expect a messy quarter, until credit markets calm down. We don’t feel this correction will be the start of “the big one,” like it was in 2008. We think the correction will resemble numerous declines suffered since 2009, in the 10- to 20% range. Here is our opinion of what we see occurring in the market now, and explanations regarding changes we have made in your account.

The stock market topped out in the second week of May, and since then, has been in correction mode. At that time, we noticed storm clouds forming, when the credit markets began behaving badly. Whether it was a U.S. treasury bond, a junk bond, foreign bond, or AAA-rated corporate bond, all went down, and went down big. When this happens, it isn’t a good environment for stocks, which again proved to be true.

Why is this happening? Why the sudden back-up in interest rates worldwide since May? The official response on CNBC and in The Wall Street Journal is the markets are worried about the Federal Reserve tightening credit. We suppose when you go from printing $85 billion a month to less than $85 billion, it does slow down credit creation, but it’s hardly a cause for concern.

We think it’s a real stretch to accuse Ben Bernanke of being the second coming of Paul Volker. By the end of this year, the Fed’s balance sheet will have grown by at least 20%, year over year. Humongous from a historical perspective. But if the Fed isn’t causing the problem, then what is? Inflation? Nope. Investor panic? Yes, a little. Bank regulators and Dodd-Frank? Yes and yes.

The markets are trading as though a giant margin call is out there, where investors who borrowed money are forced to sell--whether they want to, or not. Our first candidates for blame are Chinese bank regulators who instituted tough policies this quarter to halt Chinese banks lending to real estate and bond investors in China.

This is a very messy subject, but here is the abridged version. In China, a bank can take $100,000 in warehoused copper/gold, and lend it to twenty or thirty different people. Suddenly, $100,000 dollars in physical assets is used as collateral for two- or three- million dollars in loans. Each entity thinks it owns the title to that gold or copper. In reality, it doesn’t.

The Chinese government rightly decided to end this practice in April. By June, a full- fledged panic overtook the banks in China. Chinese investors aren’t sure who owns what.

To monitor this situation, we created a Chinese bank index of the largest bank stocks in China. As of now, they are setting new lows for the year. There is genuine fear about how these banks will rectify this mess. Until last week, the Chinese government was not providing liquidity to these banks. In the last week of June, the Chinese Fed caved, began buying stock in their banks, and giving them money.

Long-time clients know we are bearish on China, and this mess won’t be cleaned up overnight. We think the margin call created by the new banking regulations caused problems worldwide. It is finally being dealt with, but it will take time to run its course.

The second candidate for forced selling is a new provision regulating swaps in the Dodd- Frank legislation our politicians voted for in 2010. A rule within the bill mandates all swaps (we wont explain swaps; just trust us on this) and derivative counter-parties must put up collateral for trades. In theory, this seems like a great idea. Trade with somebody else, and you ought to provide good faith collateral, in the event you were wrong and must pay off. We tend to agree, but like all good ideas, problems arise.

At least $50 trillion in swaps and derivatives are out there, where no collateral was put down when the bets were placed. When people go to roll these over, or establish new positions, they now must put up money to do it. We have seen estimates where the necessary collateral ranges between one- and five-trillion dollars. That’s one heck of a lot of money to find under a couch cushion, even if you’re Goldman Sachs.

These rules are finally coming into play. You can either put up more money to support your position, or sell your position, (which is what we think they are doing now) or urge your local politician to ask the Commodity and Futures Trading Commission to intervene and abolish the regulation. Currently, the latter option is underway. The next “margin” call is in mid-July, if the CFTC does not act. We can’t predict which way this will go, but markets could stop in their tracks, until they either sell, or put up the cash, or the rule is bounced.

We don’t view it as a long-term problem, but it is a short-term one. We’re amazed nobody on CNBC is talking about it, nor is anyone writing about it. We think most selling will be in commodities and bonds, for the reasons outlined above. For the record, bonds and commodities had a horrible second quarter, so there is anecdotal evidence Dodd-Frank is causing a problem with those assets. We also think the stock market will overcome these issues by year’s-end.

There are changes to your account this quarter we need to explain. Because we don’t make a lot of changes in the stocks we own, this quarter was notable for turnover. In April, we sold Wal-Mart to buy Exxon. The primary reason is we view Exxon’s valuation to be twice as cheap as Wal-Marts valuation. We are also concerned Wal-Mart is slowing its international expansion, which affects its long-term earnings growth rate. We surmise Exxon is so cheap, because Wall Street anticipates a big drop in oil prices. We think fear is already priced into the stock value, and decided the switch made sense. We predict oil prices won’t increase by much this year, but it’s a good bet they’ll go higher in the future. 

We also bought Apple’s stock in your account, and cut back on Cintas and other holdings. Again, the primary reason for the switch is Apple is a very cheap stock, compared to what we sold. We give Apple a rating of 22, and rate Cintas at 7, (higher is better) so you can see there is quite a gap in valuation.

In our opinion, Apple is cheap, because competition in the handheld device business has caught up with Apple. There are concerns on Wall Street that Apple will be forced to reduce its phone’s pricing. We think it’s inevitable, but not the end of the world.

Apple charges AT&T $650 dollars per phone. A consumer pays $200 to AT&T for an iPhone. AT&T then charges a higher monthly fee, for a two-year period, to recoup the $450 AT&T paid to Apple. We think the iPhone’s price will fall, but the market has become too depressed about this company’s prospects.

The obvious winners in the cell-phone battles are Apple and Samsung. There is room for both to profit without blowing up each other’s business models. As cell-phone technology expands, the ability to earn additional fees through software sales will offset some pricing problems. We like Apple, and think it’s a good, long-term investment.

Our final transaction this quarter was selling half of your Rentrak position. To be honest, we’re just pissed off at this company right now. Our average cost in this stock is around $9, and we sold it for over $20. We have made money in this stock, but are having second thoughts about its new management team.

The more Rentrak grows revenue, the more its SG&A (Selling, General & Administrative Expense) increases. Rentrak is a software company, and as revenue grows, SG&A shouldn’t be going up like it is. We think it has a tremendous product. We know management wants to sell Rentrak in the next five years, at a higher stock price than it trades now. That said, we don’t intend to own a big position in a company that can’t, or won’t, control its costs.

In 2007, in Portland, I met with the company’s now-former management team. I met the new management in New York, in October. I just don’t have a good feel for these guys. I think they can ramp the business, but if the money doesn’t flow down to stockholders, we have made a mistake. We will continue to monitor these guys, and let you know how it goes.

A quick update on BGC partners: In April, it sold its electronic “on the run” Treasury bond business to Nasdaq. This business represents 7% of its revenue base. In return, it received $1.3 billion in cash and stock--equal to the total market value of BGC’s stock, on the day this was announced. BGC retained 93% of its revenue base, which is one heck of a deal, in our opinion. BGC now owns 10% of Nasdaq. This transaction in April is why the stock basically doubled last quarter. We continue to like this stock, and think its 8% dividend at these prices is secure. We think the stock should trade closer to seven bucks on this news (current price is $5.80). 

Our bad performers mentioned in our previous report, Level3, Maxwell, and American Public, were up 4%, 33% and 6%, respectively. Maxwell reported good interim results in April. We hope it completes its financial restatements by the end of July. At that point, we expect another move up in the stock. There is no news to report on Level3, or American Public, at this time.

Feel free to call us, if you have any questions about this report. We forecast the market going higher from here for the year, though in the short-term, it might get a little messy. Be prepared for some volatility, and have a good summer.


Mark Brueggemann IAR        Kelly Smith IAR       Brandon Robinson IAR

Lets Enjoy this Period!


First Quarter Report 2013

Our year-end letter to clients predicted the stock market would reach new highs, and this business might be fun again. This quarter, the Dow Jones did hit new highs, and the S+P 500 is very close to doing so. We sense investors starting to trust the market again, but it is a fragile relationship.

Most conversations with clients and non-clients begin with an individual saying, “When should an investor take profits?” Rarely (never?) do investors comment, “This is a great time to be in stocks and what are you buying?” But what we constantly hear is, “I don’t want to go through another 2008 again.”

I can assure you, we don’t either. We spend a lot of time trying to decide when the wind is no longer at our backs, but in our faces. With those comments in mind, this short review explains why we are still in the market and our forecasts for it.

So far this year, the Federal Reserve printed on average $2.83 billion a day, flowing out into the world seeking a home. On a smaller scale, the same can be said about Japan, Great Britain, Switzerland, and all of Latin America. The exception is the ECB, which is refraining from printing money at this time. Otherwise, global printing presses are wide open.

Last quarter, we predicted most of the new money would end up in the world's stock markets, which has been the case. We do not foresee anything on the horizon to alter our earlier opinion. Central banks flood the world with money to drive up asset prices and to counteract investors' fear of the unknown. The bond market is usually the first asset class to respond, which it did in 2008. The stock market is typically the next asset class to rally, and it is now up over a 100% from the March 2009 lows.

What has been difficult for us to time and predict are when this excess money will leave the financial markets, go into the real world, and trigger inflation. According to the government's CPI stats, it hasn’t happened yet. But when it does, currency printing will slow, if not end--one of our clues to reassess the financial markets.

The U.S. Federal Reserve has said a 6.5% unemployment rate would cause them to slow down the printing presses. We think the rate would be closer to 7%. The balancing act we are working with at Trend Management is which comes first: unemployment near 7%, or a market going to a short-term, overvalued position?

Right now, the market is at fair value, based on the last five years' earnings. In 2015, when we get rid of 2008's and 2009’s earnings, fair value would be 1700 to 1900. So should we sell at 1550 today on the S+P 500, while the Fed continues printing tons of money? Or hold out for a higher target? Until we detect signs of a change at the Fed, we're aiming for a higher target. But nothing in this paragraph should be cast in stone. We reserve the right to change our position but for now we are 100% long stocks.

On a happy note, this quarter, we had new highs in the following stocks we own: Wells Fargo, Berkshire Hathaway, WalMart, USG, Lincoln Electric, DirecTV, Nucor, Illinois Tool Works, Cintas, and Winnebago. Because we like to focus on which stocks are not working out, versus which are, this quarter our attention is on problematic stocks: Maxwell Technologies, Level 3, and American Public Education. 

Let’s talk about our badly performing stocks this quarter. The first is Maxwell Technologies (see chart A at the end of this report). By Maxwell's gross profits, operationally things are going pretty well. By its stock price, things are not.

In October 2012, Maxwell released a downbeat assessment of their guidance for the fourth quarter, due to uncertainty of how many UltraCapacitors it would sell to Chinese bus makers. Every 10 years China changes leadership. Maxwell didn't know how committed the new leadership was to fighting air pollution. It cautiously assessed future electronic bus sales, until the new leaders' priorities could be determined.

On December 18th, the Chinese leadership authorized the purchase of 5,000 electric busses--a huge order, and a good sign for Maxwell. The purchase was not announced on Maxwell's website and is not well-known by the Street. For those with knowledge of this order, the wind seemed to be at Maxwell's back. Entering into February, the stock rallied 50%.

Unfortunately, Maxwell's audit committee caught salesmen illegally booking 12 million-dollars’-worth in sales, (4% of annual sales) before Maxwell received the proceeds. Sales were booked at the end of the quarter to make quota, before ownership of the product changed hands. (This behavior goes back to 2011 and 2012.) When the audit committee identified the error, Maxwell's management decided to restate past earningsalways a disaster for the stock price. This time was no exception.

Maxwell has collected $8 million of the $12 million, and will recoup the balance by Q2, 2013. The company will not lose any money on the salesmen's misdeeds. It just recognized sales in an earlier quarter that should have been accounted in later quarters. (The sin it committed we know of.)

From an earnings perspective, this restatement is no big deal. From a psychological standpoint, it’s a giant mess. To add insult to injury, after we had bought some more stock, the accounting firm who audits Maxwell's books resigned the account, which subsequently hammered the stock, too. Maxwell will be sued by every Wall Street law firm to net easy paydays from the screw-up. We are guessing the settlement costs with trial lawyers will be between $5 and $7 million.

We had been buying the stock on the first news of the restatement, because we view what is going on in China more important than the “Twelve-million-dollar stuffing of the channel.” The accounting firm's resignation will put a hold to buying, until we have more clarity on this situation. Sometime in April, Maxwell will report. We expect the guidance to be better than investors think, due to the Chinese bus orders. Because China represents over 40% of Maxwell's sales, these orders are important.

To date, we have not played our hand well here, as we did not anticipate the accounting firm's resignation. We deserve some abuse for buying too soon. We don’t view this as a long-term impairment of the business, but just a complication that won’t clear up, until later in the year.

Maxwell has hurt our performance this quarter, but we expect it to add to our returns in the future, or we wouldn’t own it today. We will update you on this situation in our next report.

On to Level3 (see Chart B at the end of report). Just like Maxwell, the chart shows cash flow (EBITDA) is ramping, and the stock price isn’t. What happened to Level3 this quarter is familiar. It promised a 20- 25% cash flow gain for 2012, and came in at a gain of 18%. The market was not happy with that miss. (Cash flow growth at 18% is outstanding, unless you promised 20%.) Analysts decided to punt, and the stock sold off from $24 to $20.

Level3’s guidance for this year is cash flow growth in the low double-digits, which is very good, but the market understandably doesn’t believe anything these guys say, anymore. When you have a crisis of confidence in leadership, a change at the top is not unusual. This month, Level3 CEO James Crowe announced he is stepping down at year's-end.

We hope he leaves earlier. We have had enough of him. The question is, now what do we do? This year, Level3 will again have record cash flow, and we think eventually that matters to investors. Lately, cash flow and the stock price have not correlated, but over time they almost certainly will. With Crowe's departure, there may also be renewed interest in Level3. Three investors own over 50% of this company. If they conclude it is a lost cause, they will sell it. I doubt they will, but if they sell, they will accept the highest possible price, and we will benefit from the sale.

If I am wrong, and they are wrong on Level3's future, they have the ability to cash in and get us out at the best possible price. Again, I don’t think they will, but it is the benefit of having controlling shareholders who can make a change, if they choose. We will continue to hold this investment, as the cash flow ramps up.

American Public Education: (see chart C at the back). This investment makes me the angriest. American Public is an online education company, whose niche is the fields of military education and law enforcement. Its tuition rates are 20% lower than the average state school, and much cheaper than all for-profit education companies. What hurt American Public Education in Q1 was the sequester.

Our government recruits soldiers ensuring them $4500 per year in tuition assistance to go to school. The Department of Defense pays $250 a credit hour, which is the rate American Public charges its students. Two weeks ago, the military decided to suspend military tuition assistance, until the sequester debacle is resolved. Apparently, our government decided to renege on their word to our soldiers.

The total cost of military tuition assistance is $500 million a year. We give the Republic of Congo $1.5 billion a year in foreign aid, yet we can’t find $500 million to fund tuition for people willing to die for our country. Despicable. Just despicable.

We think it's a political ploy to draw attention to the sequester. It will blow over, but will last long enough to affect American Public's earnings the first half of 2013. Thirty-five percent of American Public's sales link to tuition assistance. Soldiers can use their VA benefits, the GI Bill and Title IV funds to fill the 35% hole, but it takes time. I anticipate earnings for Q2 and Q3 are anybody’s guess, until this problem does blow over. In the meantime, American Public announced it would buy back another $15 million in stock, while it’s down. The figure represents about 3% of the company's value. Over $100 million more in cash sits on the balance sheet with no debt, if it decides to buy more.

We didn’t expect the Department of Defense to do this to its soldiers, but I guess we need to be prepared for anything, anymore. Should the stock drop to the mid-twenties, we would consider buying more. If the Department of Defense changes its plans, the stock will rally quickly, because in normal times, fair value to us on this stock is above $50. This stock will be in a holding pattern, until we see what happens to the idiots running the Department of Defense. [Note: On Thursday, March 21, Congress voted to reinstate military education benefits. Although it is the right thing to do, American Public stock will still be affected in the next quarter.]

In closing, we'll share a few things we are thinking about. Obamacare kicks in January 1, 2014. How it will affect the economy is difficult to handicap. We have read and are observing companies are not hiring workers today to keep from paying the higher healthcare costs the ACA mandates. Labor- intensive businesses who pay low wages face a real dilemma. Should they raise prices on what they sell? If they can’t raise prices, should they cut their gross margins to compensate for the added health care costs, or just get out of the business?

I think one reason U.S. job growth has been poor the last few years is the total insecurity businesses have with this subject. It is possible corporations have already reduced head-counts as much as they can, and when 2014 hits, this will be a non-issue. We wanted you to know, we are thinking about the prospects, but haven't drawn firm conclusions, yet.

We also want to point out, we haven’t changed our stance on China. We remain very bearish on China’s economy, in general. A "60 Minutes" piece broadcast this quarter documented what we mentioned a year ago: China building cities with no one in them. China does this to generate GDP and jobs, but it destroys money and can’t continue. We think a lot of these cities' developers hide their bad debt in the government-owned banking system. High-ranking government officials own the major export and construction companies, and benefit from the money spent on “cities to nowhere.”

The Chinese people really don’t benefit from this, long term. What would help China's citizens most would be raising the currency's value. By doing so, food would be cheaper, and people would have more discretionary income to spend. The reason it hasn’t happened lately, is raising the currency would hurt export companies the Chinese leaders own. Currently, 83 billionaires occupy the Chinese version of the U.S. Congress. Do you think they got so rich from farming?

Inflation in China will also worsen, due to the amount of currency the U.S. continues to print. At some point, we expect a one-time change in the Chinese currency valuation, (10-to-20%) which poses serious ramifications for U.S. exporters and the U.S. economy. When it occurs, you want to be out of the bond market, because U.S. rates will take off to the upside, while declining in China. We can’t predict when this will happen, other than we think it will occur sooner, rather than later.

Thanks for your continued support and feel free to call us at 417-882-5746. Sincerely,

Mark Brueggemann IAR         Kelly Smith         IAR Brandon Robinson IAR

Fear!! Fear!! Fear!!

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 elseand 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

Bring in the Goods!!

Third Quarter Report 2012

The performance of our accounts was great in the first quarter of this year, terrible in the second quarter and pretty good this quarter. In total, it has been a good year so far and we are hoping there aren’t any European moments, wars or flash crashes left to ruin what has been a good year. We are going to spend a lot of time in this letter trying to simplify the fears about the world economy and how we think the U.S. Fed and the world monetary authorities are going to act.

I am reading my second book about Paul Volker, a past chairman of the U.S. Federal Reserve. The book is called Changing Fortunes and was written in 1991. In this book Paul Volker spends most of his time talking about how he and his Japanese counterpart worked to manipulate exchange rates to balance out trade deficits. In other words, if we had a trade deficit with Japan and the yen was trading at 250 to the dollar, they would try and raise the value of the yen to 200 yen to the dollar to see if our exports and imports with Japan would balance out. If they didn’t balance out, they would raise the exchange rate some more until we reached parity. After World War II the exchange rate was 360 yen to the dollar and today it is up almost 80% to 76 yen to the dollar. Today our exports and imports with Japan are basically in balance. The lead times to balance out trade deficits take a while but changing exchange rates will work over time.

Let us give you a real life example of how this would work in Greece IF THEY EVER left the Euro. Let’s say you own a manufacturing business in Greece and 40% of the cost of manufacturing your product is labor. As long as Greece is still in the Euro your only hope to lower costs to compete with Asian manufactures is to fire people or get them to take wage concessions. That is what they have been doing now for three years in Greece. Let’s say that you are able to get your workers to take a 25% cut in wages so that you are competitive with Asia. If we assume the price of your product doesn’t go down your labor costs are now only 30% (40%*.75=30%) of the cost of selling your product which is a total savings of 10%. Another way to lower the cost of your product if you weren’t in the Euro would be to have your currency go down by 10% which will give you the same result as if you cut the cost of your labor by 25%. Over the last 150 years most monetary authorities have chosen to drop the value of their currency to improve their business’s competiveness with foreign competition rather than cut the wages of their workers. This was talked about extensively in Volker’s book.

The problem a country has when they cut the wages of their workers by 25% is that other businesses that rely on selling to those consumers lose sales because their customers just took a 25% cut in pay and they don’t have money to buy their products. This starts a negative feedback loop of less consumption, fewer homes being built and debt reduction. If that is left unchecked the country goes into a depression like in 1929. Keep in mind that if a worker’s salary goes down by 25% his/her DEBT PAYMENTS DO NOT GO down by 25%. Lower wages help cause the system to implode, banks to go under and it’s a real mess.

Today, Greece is in a depression and they are trying to cut their wages to get out of it. In our opinion this won’t work. The only way out for them is to leave the Euro, depreciate their currency and print

money to give to their banks to cover the bad debts their citizens can’t pay right now. We have been predicting they would do this for a while and it hasn’t happened, so it’s obvious the Greek authorities would rather stay in the Euro and have 30% unemployment than have 10% unemployment and inflation. This will change at some point but so far Greece isn’t doing what we think would “solve” the problem.

We bring the Greek situation up because it matters to us even in this country when trying to predict what happens to our stock market and what we do with your investments. If our Fed had decided to not print money in 2008 and in essence asked our workers to lower their wages to be more competitive with China we would not own any stocks today. NONE. We would be in the same mess Greece is in now. Fortunately we are not. Because Ben Bernanke printed two trillion dollars and isn’t done yet, we think it is better to own assets (stocks are an asset) than to sell them like they are doing in Greece. It hasn’t always been pretty to be fully invested in this market the last three years, but we think we know what the Fed is trying to do and stocks are still a better bet than cash in the bank at zero. We want to give you some ideas of what we think the Fed is going to do next which is guiding our thinking on how we invest your money.

There is a school of thought in economic land that if consumers continue to borrow money the economy will continue to grow. The more people borrow, the more they spend and that usually means business is good. During recessions the RATE OF GROWTH of borrowing usually slows down which then slows down the economy. Most of the time, the Fed will raise interest rates to slow down the growth of debt. By making debt more expense to borrow consumers will slow down their borrowing which kills the economy and usually inflation as well. Once the consumer slows down their borrowing, the Fed then cuts interest rates to stimulate debt creation and the cycle starts again. The chart below demonstrates why we think the Fed is doing what they are doing. 

The chart shows the yearly rate of change of debt growth for the consumer sector going back to 1951. As you can see, the U.S. consumer has been confident enough since 1951 to increase the amount of debt he/she wants to “own” every year by 9% on average. Some years consumers borrow more than 9%, some years less but that’s the average and it never went below zero until 2009. Since 2009, consumers in our country have done something they have never done before since the Great Depression; they are getting liquid and paying down debt at a 1.66% clip. This hasn’t happened in the modern era since we have data. We think it’s a big reason the Fed is printing so much money. We aren’t trying to tell you it’s right or wrong, but we are just trying to figure out what they are doing and trade ahead of them to make money. We want to make money and if we think we know what the Fed is doing it certainly helps us make money for you. To stimulate consumer spending habits the Fed is buying up home loans (mortgage bonds) to lower the interest rate that you pay on your home loan, thus increasing the chances that you will take on more debt or spend that excess money on “stuff.If you have a $100,000 home loan at 6%, your interest payments are $6000 a year. Lower that rate to 3.5% and you free up $2,500 dollars of discretionary spending. The Fed will keep buying home loans until the consumer sector is confident enough to take on debt or the consumer FEARS INFLATION more than they do deflation. Once the U.S. consumer starts to take on more debt, we think that will be a sign the Fed will use to help it decide when it’s time to stop printing money. So far the consumer has not taken the bait and increased debt, hence quantitative easing 3 (QE 3) was announced in September.

Another macro criticism we hear a lot about is that our country’s debt to GDP ratio is at 100% and when that happened in Greece, Ireland or Spain they fell off a cliff and never came back. We are concerned about our country’s debt. It’s a mess our leaders should have fixed but didn’t. Our country’s debt is the issue our “trusted” political leaders will deal with when they get done lying to us during this election. What is different for us, though, compared to Europe’s indebted countries is that we can print money and have a singleness of purpose that they do not have. In Europe, the ECB (their Fed) has 17 countries they need to keep happy and those 17 countries couldn’t agree on what to do to help Greece, Spain or Ireland. That indecision (mostly Germany’s fault) has really kept them from recovering (see Greece example above). Those countries needed liquidity and debt relief and they didn’t get it. We can’t say that about our Fed which is flooding us with money and trying to lower the value of our dollar as well. What we think the Fed is going to do for the next 10 years or so is keep the interest rate on our debt below what the rate of growth in GDP is. If GDP with inflation grows at 5%, interest rates will be below that number to help increase our ability to pay our debts. If GDP is 2%, interest rates will be zero and if GDP goes to 10%, rates will be less than 10%. By doing this debt will shrink gradually to lower the debt to GDP ratio and we will get out of the debt trap we are in. When we predicted that interest rates would go up we blew that call. WE didn’t anticipate the Fed MANIPULATING interest rates to keep them under GDP. That’s our fault and we are confessing that sin now. It is our opinion that you can ignore 95% of what they say on CNBC as it pertains to interest rate and just focus on debt creation in the private sector and GDP. When debt goes up, GDP will too, and the Fed will keep interest rates below GDP. They will keep buying mortgages, printing money and doing what they have to gradually bring down the debt to GDP ratio.

I am sure by now you are thinking that the most important people in the world are the leaders of the large Central banks. Yes, they have been for the last 5 years. What would change that? Here are two problems we are wrestling with that are not easy for us to answer. We are worried about a war in the Middle East or in China. You might think that’s an ignorant worry. In the Middle East, it seems they have been at war for at least 1000 years. That might be true, but some wars cause more issues than others. At some point the world is either going to let a crazy guy in Iran have a nuke, or they won’t. Our guess is they won’t and that is our biggest unquantifiable worry. How does a war with Iran play out EVEN IF the U.S doesn’t send troops. Let’s go over some of our homework we have been doing on this subject.

In May of 1940 Germany started invading their neighbors and the stock market dropped 16.5% in three months. The markets stabilized for 15 months before Japan bombs Pearl Harbor and the markets drop another 19% before bottoming for good in April of 1942. The total drop in the market was around 36% and it happened in two waves. From April of 1942 on the market goes up and never looks back. If you held stocks through that period you would not have got back to break even until July of 1943 or around 38 months from when Germany started invading its neighbors. In June of 1950, the Korean War starts and the market dropped 12% in one month before bottoming out and going back up. There was no wait time to speak of in getting back to break even. The market never went lower after that drop. In August of 1990, Saddam invades Kuwait and the stock market dropped 16% in three months before bottoming out. The market then went up from there and was never lower than what it was in November of 1990. It took seven months for investors to get back to break even from when Saddam invaded Kuwait. We have not included the Vietnam War in this example because that’s a war that was gradual in nature and not a sudden event, so different from what we are anticipating. If you want to use the year troops were deployed in Vietnam as the starting point of that war then we would use 1965 when the S+P was at 84. When Saigon fell in 1975 the market was at 84. The stock market actually went up in 1965 after the US committed troops, but we just don’t feel like this war helps us with our decision making. If you add up the four events, minus Vietnam, above that were sudden in nature, you have an average decline of 16% from the time the war started (or was thought to be starting) until the market bottomed. The time it took for the market to drop 16% was 3 months. From there the market bottomed and was never lower except for Pearl Harbor in 1941. We are aware that the U.S. fought two wars this decade. If you want to include 9/11 into this equation, the market dropped from 1183 on the S+P to 965 for a drop of 18.4% in three weeks after the towers were bombed. If you include this event in your calculations the average market drop would be 16.5% and the time to get to the bottom was less than three months.

So, what do we do with this information? We have zero credibility in predicting wars, but we are worried about the possibility. Assuming the above history matters, if there is a war that breaks out the odds favor the market will decline around 17% and then bottom. From there the market will not go below that level in our lifetime based on war fears. Let’s assume we knew the day before that a war was going to break out with Iran. Should we sell all stocks in a taxable account to make what history says is a POTENTIAL 13% gain after tax? In each instance above (ex Pearl Harbor) the market never went lower than the initial decline of 16%. Would it be worth it to cash in and then TRY and catch the next bull market? What if the market only goes down 10% and then goes up? For now, it’s not worth trying to do this. In the Great Recession without the “benefit” of a war we have had declines of 20%, 17% and

10% over the last three years and our macro system during that time “told” us to sit through it. Should the market get over valued (above 1510 on the S+P 500 this year) then maybe it makes more sense. Should our monetary work go negative, we would sell some stocks war or no war. We are giving you this information and looking for your opinion. Let us know what you think.

The fiscal cliff is coming, the fiscal cliff is coming. The other fear we get is the fiscal cliff will cause us to go into a recession. We agree it’s not going to help the economy at all. In fact we just can’t believe our politicians have gotten us into this mess just to protect their jobs. It’s our fault we let them get away with it. We are currently running a budget deficit of around 8% of GDP, which is WAY above normal. Even in World War II we hardly did that so the government is currently in a very simulative mode to jump start the economy and get themselves reelected. To reduce the yearly budget deficit from 1.2 trillion to 500 billion (500 billion would be about 3.2% of GDP which is close to normal) the Government needs to raise taxes and cut spending by 700 billion. This is the fiscal cliff everyone is rightly worried about. We have a 700 billion dollar fiscal drag staring us in the face which probably won’t happen all at once. What should investors do? Remember that guy Ben Bernanke? What did he do this month? He just decided to lower the interest rate on every home mortgage by implementing QE 3. What does that mean? There are currently 9.6 trillion dollars of home loans in the United States. If you were to lower the interest rate on those loans by 1% (his goal?) you would free up consumer spending by about 100 billion dollars a year. So, the government potentially takes away 700 billion in fiscal stimulus in a worst case scenario and the Fed releases 100 billion back to the masses. After Bernanke announced QE3, he then went to talk to congress in a PRIVATE meeting and it’s amazing that there have been zero leaks about what he told our trusted leaders. He said something to them but it’s not public or being reported in the press. When congress has a private meeting with Ben and no reporter has what was said, we think it must have been important. Our guess is he told them it’s time to cut the deficit, we are making it easy for you to do it now, don’t do it all at once but start the process while I still have control of this mess. We think a fiscal deal will happen before July of next year. Our best guess is they will raise taxes on capital gains from 15% to 20%, lower corporate taxes, eliminate the mortgage interest deduction for home owners, and cut defense spending some more while going after Medicaid and Medicare. If the fiscal deficit goes from 1.2 trillion this year to 800 billion next year that is still a lot of stimulus for the economy (5% of GDP) compared to history. If capital gains taxes were to go up 8.6% to 23.6% from 15% (assuming your gain in your stock is 200%) you would need to see your stock go up by 7.1% to make up for the higher tax. So in other words if your stock was at $10 it would need to go to $10.71 to make up the difference. For now we can live with that. That doesn’t mean we like it, we just have to deal with it.

I am sure after reading this you are getting the impression that the most important person on the planet is Ben Bernanke, and in our opinion, for now that is right. Because we have political grid lock in the world, the monetary authorities have taken over the leadership roles of the economy and some would say the budget as well. Nature abhors a vacuum and Ben has filled the vacuum. If you like to read, here are some helpful articles on Bernanke and what he is trying to do:

Essays on the Great Depression/ Ben Bernanke Bens thoughts on Japan Ben’s 1999 helicopter speech

If you read the book and the two links above, you will get a glimpse of the playbook he is using. If you have any questions feel free to give us a call on this subject (882-5746). It’s not easy to hack through this and I feel your pain for having read this long letter. On a happier note, the Christmas party will be at Highland Springs again this year on December 20th from 6:00-8:00pm. Mark your calendars and let’s hope for a big rally in Q4 of this year.


Mark Brueggemann IAR,          Kelly Smith IAR,          Brandon Robinson IAR

Welcome to the Bull!!

Second Quarter Report 2012

Our managed accounts had a great first quarter followed by a crummy second quarter. Our returns for the year are positive but we took a pretty big hit this quarter which wasn’t a lot of fun to watch. With the exception of two stocks (American Public and Maxwell), the first quarter earnings reports from our companies were good. Later in this report we will show you some graphs of the stocks we own and the metrics we look at to tell us how those companies are doing. The problem we faced in the second quarter of 2012 is the same problem we faced in the second quarter of 2010 and 2011: which is the undue influence Europe is having on our markets. When I tell you we are suffering from Euro fatigue it’s an understatement. We are sick of this issue but it is the one we have to talk about again because it is the cause of the world’s problems at the moment.

Around 15 to 20 percent of the S+P 500’s earning come from Europe. Europe is an important part of the world’s financial system but they ARE NOT the main driver of the world’s economy, that honor would go to the U.S. and Asia. Europe is in a recession, the rest of the world is not at this time. Here are a few U.S. stats that we think matter quite a bit in judging the strength of our economy. Housing permits in the U.S. are up 30% year over year, car sales are up 20% year over year and bank loans are up 12% year over year. Now I will concede that the increases above are from a very low base but they are up strongly from last year and those are the best stats since the Great Recession started. As a frame of reference for those same economic numbers last year at this time housing permits were up 12%, car sales were flat versus the previous year and bank loans were up only 3%. Based on those numbers which we consider important, the economy is getting better in the USA and that momentum will continue. Europe is another story. If you look at just bank loans to individuals and corporations in Europe they are declining this year versus 2011. In 2011, European bank loans were up 3% versus 2010 so the economy in Europe is decelerating and heading the wrong way. When there is no increase in lending to consumers and businesses of Europe there is not going to be any growth in that region. We wrote six months ago that when the ECB printed a trillion dollars and loaned it to the banks of Europe at 1% it would solve this issue. We were right that it fixed the stock market going down, but we have been wrong on the economy of Europe getting better. When will this situation get better? Will it ever get better?

Our case studies for Europe and what they should do next are based on what happened to Latin America in 1982, Asia in 1997, Argentina in 2002 and Iceland in 2007. In the instances above each of those countries or regions defaulted on some of their debt, depreciated their currencies to gain a competitive export advantage, had their central bank print a lot of money to help their banks and instituted inflationary policies to paper away their debt obligations. Today those regions have a higher growth rate than Europe and the USA. In each instance above with the exception of Iceland, the U.S. stock market was higher three years later with an average gain of over 35%. Europe is in the process of doing all four of those remedies now. The United States was able to implement most of those four remedies by the middle of 2009. How can we tell when this European mess is over or at least have a decent guess it’s over? One of our favorite hedge fund managers is Ray Dalio who runs Bridgewater Associates, the largest hedge fund in the world. Ray has made a living trading macro events like what is happening in Europe and we have tried to read everything we can on him. He has said in the past there are three things you need to do to get out of a crisis: supply liquidity, change the accounting rules and provide a safety net to investors. We agree with that statement. Let’s use the USA crisis as an example of how those three steps played out in 2008-2009. Lehman Brothers goes bankrupt on 9/15/2008 with the S+P 500 trading at 1250. Immediately after the Lehman bankruptcy, the Fed started printing money and our Fed balance sheet doubled in TWO MONTHS. The Fed supplied liquidity immediately which fulfills step one of our three step process to get out of a crisis. Even with all of the money being printed fear and selling continue. The S+P 500 closes at 930 on 11/14/2008. In late September through November the Fed throws a safety net around U.S. bank deposits and money market accounts saying they are now guaranteed by the government and that no one will lose money in them. Even though Fannie Mae and Freddie Mac are in bankruptcy the federal government assures investor’s no one will lose money on their bonds. The safety net is employed and step two is fulfilled. The S+P 500 is unimpressed and closes December at 872 down 30% since Lehman went broke. In 2009, fear continues to run wild as the market is afraid of what happens when the banks mark their portfolios to market so, on the week of March 9th,2009 the U.S. Government postpones mark-to-market accounting. Accounting rules are changed because of the crisis. This was the last of the three steps to ending a crisis that needed to be completed. The market bottoms the week of the accounting change at 666 (down 46% since Lehman went under) and now is trading at 1314 four years later. Our financial leaders got the job done in less than six months using Dalio’s guideline as a road map. Four years later here is where Europe is today. The ECB is supplying plenty of money/liquidity to the system and it is our guess there is more coming so that step is completed. The next two steps have not been completed by Europe and that’s the problem we are dealing with today. Investors in European banks don’t have confidence whether their deposits are safe and so they are pulling their money out of the banks in southern Europe and sending it over here or to Switzerland or Germany. So this step has not been completed. There is also total confusion as to how the bonds of Greece or other European countries should be valued on a mark-to-market basis should one go into default. How should a bank value that bond particularly if the country gets out of the Euro and goes back to their original currency? Should you value the bonds at market value, hold to maturity value, mark to wish (my favorite) and what currency should you use to value it? These questions are still out there and unknown by us. As a history note, when all of Latin America went broke in 1982 our U.S. banks were TOLD to mark their loans at full value (even though they were in default and you couldn’t sell them at full value) until they could save up enough money to write them down. So we changed (lied) the accounting rules until we could deal with the issue in an honest manner. If we didn’t change the rules EVERY MAJOR MONEY CENTER bank would have been wiped out in 1982. Every one of them. Based on the above three step process for ending a crisis we are going to be dealing with Europe issues until they provide a safety net to depositors/investors and they learn how to lie on their accounting. I am confident they can learn how to lie because they are politicians but I am unsure when they throw the safety net out there to the depositors and investors. Until Germany agrees to a Euro wide bank FDIC deposit type system this is going to be a messy period for Europe. Money will continue to leave the weaker banks in the weaker countries until SOMEBODY says the ECB is standing behind these assets or those countries leave the Euro. The money that the ECB will print will slosh around the world and show up in U.S. Treasuries, stocks or German Bunds until confidence returns to European banks. This month the Europeans started giving money to their banks (Spain is getting 100 billion for their banks) which is a good start in restoring confidence but it’s not going to be enough. They must throw a safety net around these bank deposits so that money will come back into these banks and give investors incentive to LOCK in the higher rates these banks are offering. If there is no guarantee then rates will stay too high in the “bad” countries and too low in the “good” countries. The ECB has thrown two trillion dollars at this problem in the last three years with a trillion of that coming in the first quarter of this year. Most of that money has ended up in our stock market, U.S. treasuries or German bunds, but it has yet to help those countries who need it most. We hear a lot of investors say “Europe will be another Lehman moment and the world is unprepared for it”. I can assure you we worry about this a lot but investors are more prepared now than ever for a “Lehman” event. Before Lehman Brothers went bankrupt our banks held one billion dollars at the Fed as safe money for a rainy day. Today that number is 1.5 trillion dollars which is down from 1.7 trillion dollars early in the year. Keep in mind that the ENTIRE FED balance sheet before Lehman was “only” 850 billion dollars and now we have twice that sitting in their bank not counting any money that is floating around outside the bank. If that isn’t a sign that investors are rat holing money for an event I don’t know what else it could say. There is money sitting there waiting for a disaster and we may get it, but we are more prepared than ever to deal with it.

If you are still awake after reading about Europe we are going to visually show you what our companies have been doing the last five years. We have decided to show you a chart of a stock, and then show you a single metric we think matters to the performance of the stock. For the most part you will see the metric going up indicating the company is performing okay, and for the most part you will see the stock trading all over the place regardless of what the metric is doing. We thought this might be a better way to see how our companies are performing operationally and how the market for that stock doesn’t always go with the fundamentals.

We want to show you Maxwell Technologies first because it had a bad quarter and its stock price took a beating because of it. In the last four years the company has grown its quarterly sales from $17 million a quarter to $40 million a quarter. In this economy that’s pretty impressive. So why is the stock down so much this quarter? Maxwell needed to sell $30 million worth of stock to build a new facility in Arizona to accommodate their rapid growth. They had sold $10 million dollars of stock before they lowered 2012 guidance on their sales growth from 25% a year to 17% a year. That’s all it took to take this stock down from $18 to $6. Their reason for lowering guidance was that new car sales in Europe are down because of the recession and we can see that as being legit. When the market thinks you need to sell $20 million dollars of stock in a bad market they kill you and that’s what happened here. The company has little debt and $30 million sitting in the bank so this isn’t a bankruptcy issue but a funding issue because they need to expand. Since the stock has plummeted we have had ten insider purchases of the stock from $10 on down (the Ceo and the chairman of the board bought the most) which is a pretty positive sign. The last time we saw this much insider buying in a company was at Rentrak when the stock was in the $12 range (it’s now $19). We don’t think Maxwell will sell stock down here (that’s according to Maxwell management) to fund that last $20 million dollars but the market disagrees. We think they will do some sort of a bank financing or bond sale to get the last $20 million they need for the new plant. As long a they keep growing sales we think they will either be bought out or the stock will go back up to the $20 area. 

Speaking of Rentrak here is their stock price and the sales of their AMI division. The AMI division is the future of Rentrak and it is the service that now tracks all of Springfield Missouri’s television ratings by computer versus Nielsens journal entry business. Take note of how sales accelerated last quarter. The ramp is here for Rentrak

American Public group was the other stock to have a bad earnings report. To combat students who take out school loans just to get the money but don’t go to school, they instituted some tough anti fraud measures this quarter that hurt their sales. They changed the system and we are waiting to see how sales look. We had a large insider buy two weeks ago, so we hope he knows the results. Sales have been great here for the last four years and this is their second mishap that they have gone through in that time. The last one was temporary and we think this one will be too. This is probably our cheapest stock right now versus its historical growth rate. 

Level3. As you can see on this chart the integration mess up in 2008 killed their ebitda and stock price. The ebitda line turned up in 2010 and we are waiting for the stock to do the same. 

Berkshire Hathaway. Non insurance earnings year over year are at an all-time high. Buffetts stock buyback price is around $78 (the stock is $81). The stock is cheap. 

BGC Partners. We are getting paid around 10% to hold this stock. The stock price has followed its pretax earnings pretty well. They have had some slower earnings lately because of the mess in Europe. We view this as temporary. 

Corning. Earnings recovered in this stock but the market doesn’t believe they are sustainable. We disagree but for now the market is winning. 

The last two charts are Macro charts we use to predict when we are headed into a recession. When interest rates go above the return that business’s can earn on their money, the marginal borrower is squeezed out and we are in danger of going into a recession. Right now there is no risk of a recession according to this metric. 

The next chart is our fear index related to the credit market chart above. Currently, the crisis in Europe has not affected the flow of credit. The window is open to borrow money. As you can see in 2002 and 2008 that window was shut tight which helped cause the recession. Take note that this index was at higher rates nine months before Lehman went bust than we are now. The index is also at lower levels now than during the two previous European panics. 

Our last paragraph today is to say thank you for your business. We know this last 18 months with its up’s and downs have been pretty frustrating. Our target for this year is still 1500 (we are at 1314 now) on the S+P 500 and in three years over 1700. We have tried to lay out to you what we think is the most important data to look at and why we think the market is headed up. As always, feel free to call us if you have any questions. Kelly will be back to work July 5th and so will our newest 8 week old analyst Beckham Smith. We think he is a superstar in the making.


Mark Brueggemann IAR          Kelly Smith IAR         Brandon Robinson IAR

A Great Quarter... What a novel concept!!

[Trend Management, Inc.] [First Quarter 2012]

The stock market just had a great quarter and we participated fully in that move. It’s always better to “Get caught with your pants up” in a market rally than to “Get caught with your pants down” in a market decline. The biggest problem we have been facing perception wise in the last two years is the fear of a total collapse of the financial system similar to 2008. As we wrote in our year end 2011 letter we thought that fear was behind us and at least for one quarter that is true. We would encourage you to reread that letter if you have it or we can mail you another one to read because we haven’t seen anything new that has changed our view on what happens next. This quarters report will be a short one which is a rarity of late.

So far this quarter 90% of the calls we get from clients go something like this “The market is up, should we sell everything and wait for the market to go back down?”. If you look at the chart below you can see that the majority of investors feel the same way. Even after a 12% rise in the market this quarter investors have been pulling money out of stock mutual funds and putting it somewhere else. Even during IRA season when money normally flows into the stock market investors have been selling. There is an old Wall Street saying which says “A bull market climbs a wall of worry”. Based on the chart below we have a wall of worry out there somewhere that is causing investors to get out. Right now the public is still “out” of the market and licking their 2008 wounds. We don’t see anything in this indicator that causes us a problem yet. 

Why did the market go up 12% this quarter? Our best guess as to the reason why the market went up is the chart below. Just about every central bank in the world printed money this quarter. The world is being flooded with money and when that has happened in the past the value of everything usually goes up. Whether it be a soybean, unleaded regular gas, stocks, bonds or movie tickets the pressure is on the upside in our opinion and not the downside. There is usually a lag time of about a year from when the money is printed until you start seeing an upswing in the economy. If you use the crash of 2008 as an example the Fed started printing money in September of 2008, the stock market bottomed in March of 2009 and the economy started to rebound by July of that year. As you can see from the chart below the world’s Central Banks started printing money in July of 2011, the market bottomed in August of 2011 but really didn’t take off until December of 2011. We expect to see better world economic numbers by the end of 2012. 

Real interest rates are the difference from what you get paid in interest and what the inflation rate is. Today the real interest rate on a 10 year bond is minus 1% (you get paid 2% and inflation is 3%). The historical real interest rate is about 2.5%. The first chart below shows we are in unusual times right now. We have been horribly wrong on our call that interest rates will go up on long bonds but we will keep predicting that until history doesn’t matter anymore. If you haven’t done it already, lock in your home loan with a fixed rate. For reasons that are hard to explain, the next chart (bond fund flows) shows the public throwing money at bond market mutual funds even though bonds are historically a very bad bet. Sell stocks, buy bonds is the trend right now. As you know, we think that is a bad bet. 


This last paragraph is the best one of all. Somewhere between the time you get this letter and May 12th the first grandbaby for my family is going to show up. My daughter Kelly, who also is one of our trusted employees, is soon going to have the cutest baby ever. She will be off work for about two months after the baby is born and then come back on a part time basis in late July. She will return to full time status in late August. We are telling you this because she will be missed during this time frame and we want you to show patience with Brandon and I when you call in with an operational question that we are terrible at answering. I can assure you we will get you an answer to your question but it won’t be as fast as Kelly does it. We are thanking you for your patience ahead of time.


Mark Brueggemann IAR            Kelly Smith IAR           Brandon Robinson IAR

Are we seeing Consumer Confidence?


Trend Management, Inc. Year End Report 2011

Warren Buffett once said “If you stick around the markets long enough you will see some really strange things”. I think this year’s stock market trading will qualify as the strangest one I have seen in my 28 years of being in the business. As I type this letter the market for large cap stocks is going to finish the year about unchanged and the market for small cap stocks will be down five to seven percent for the year. During the year, the S+P 500 has fluctuated up and down on a closing price range of over 1250 points while finishing the year around 1250. To put that trading into perspective, the market basically had a trading range of 100% and yet it finished almost unchanged. How does that happen? We will talk about that below.

The economic statistics in the U.S. are getting better. A lot better. Consumer confidence had a record jump up in October, housing construction has gone positive for the first time in 5 years, automobile production is up for the year, the S+P 500 will have record earnings, GDP just made a new high, and bank lending is coming back in the U.S. Yet nobody cares. We can tell that nobody cares about the above good news in the economy because the public continues to pull money out of the stock market every single week (since 2008 they have pulled out over one half trillion dollars). With the public “fleeing” the market, that just leaves hedge funds and high frequency traders to determine which way the market will go on a short-term basis. A hedge funds opinion is only good until lunch time so they aren’t a group that sticks around for long. If there is a rumor about anything in Europe the market is good for a 2% move up or down based on that rumor. We have basically had 100% of those types of moves this year. With great certainty these funds have traded the market and yet don’t have anything to show for it (the average hedge fund lost money this year). Because so many investors lost money in 2008 almost everyone who trades and particularly those who trade on borrowed money (like hedge funds) have developed systems to try and protect themselves from another collapse like 2008. Most of those systems base their buy or sell decisions on the PRICE of the index they are trading. If the price goes up, they buy more; if it goes down they sell more. They want to trade with the “momentum” of the market while being in “synch” with the news. This type of trading was particularly true for the gold market in the second half of this year. When you don’t have the public in the market buying stocks or other assets on a long-term basis to help slow down these swings you get a crazy market like this one.

Huge frightening moves down followed by sharp rallies in the other direction with the end result being not much real change IN THE PRICE of what you own. It doesn’t make it easy to sleep when you have a market up or down 2% almost weekly. What does make us sleep well is that those same stocks the hedge funds are trading daily are actually real companies who as a group had a record year for profit. We hope these companies might buy back their own stock if they think it’s cheap, perhaps pay higher dividends to shareholders, or they may even buy other companies if it makes sense. Eventually those actions will bring the public back to this market because parking your money in cash at zero when inflation is at 3.5% doesn’t make much sense. We think next year the earnings for companies will matter more than the fears of what’s going on in Europe. Why do we feel that way?

When the stock market was screaming upwards in 1999 you could hardly find anybody who thought that the party was going to end. Oh you might have heard a little grumbling from somebody who sold stocks in 1995 thinking the market would correct and when it didn’t was mad because they missed out on all of the fun. Absent that guy, when the market peaked in March of 2000 at 1552, prevailing wisdom was that it was only going to be a temporary correction before the market took off again. With the market trading at 1250 eleven years later we now know that wasn’t the case. What happened? The answer is investors were paying too much for stocks back

then based on history. The average five year earnings for the S+P 500 in March of 2000 were $44.72. If you want to compare those earnings to say a U.S. 10 year treasury bond just take those S+P 500 earnings in 2000 of $44.72 and divide it by what you paid for those earnings of 1552 (the price of the S+P 500) and the yield to you is 2.9%. Ten year treasuries were yielding 6% at the time. So in March of 2000 you could take a sure 6% on treasuries or gamble that the earnings on the S+P 500 would grow rapidly (within 5 years) from $44.72 to at least $70 dollars to make up for the difference in yields. As we now know that bet didn’t pay off. Eleven years later we have the reverse situation. The average five year earnings on the S+P is $73.48 and you only have to pay 1250 to get that. If you take those earnings of $73.48 and divide it by 1250 you get an earnings yield of 5.88%. Today ten year treasuries are yielding 1.92%. We are in the EXACT OPPOSITE SITUATION as 1999. For anybody buying a treasury bond today to be right versus owning stocks the earnings on the S+P 500 would have to crater (down about 50%) and yet S+P earnings just set a record this year of around $97 dollars a share (remember the $73.48 we use is a five year trailing average). In 2000 investors were willing to bet on rapid growth in earnings and today they are betting on a rapid decline in earnings. We think a bet on a permanent decline in S+P earnings is a bad bet. It hasn’t happened since 1929 where earnings would have been this poor. When we do the math on what the market expects S+P’s earnings to be, we think the market is discounting a recession that is worse than the one in 2008-2009 period. We just don’t see that happening. A long-time client of ours who doesn’t buy green bananas anymore always asks us “Will he live long enough to see it?”. Though we aren’t good at predicting everyone’s life expectancies we think we can put a decent time frame on this for our green banana client.

For the S+P to be earning twice what the Treasury bond yield is occurs very rarely. In fact it has never happened in the last 35 years until the crash of 2008-2009 and this year. We are witnessing something very strange versus history. Usually stocks yield less than treasuries because stock earnings grow and treasury bonds interest payments don’t. In the last ten years S+P’s earnings are up 64% which is a little slower growth than historically normal but still decent. As a base history case the average earnings yield on the S+P 500 since 1990 is 4.89% and the average yield on the ten year treasury was 5.24%. When you see today’s huge gap between the ten year and the S+P earnings yield it means we have a confidence issue the market is dealing with. That issue is Europe and what happens to the Euro currency if it collapses. We are on record as saying that Greece should default and leave the Euro. We still feel that way. We don’t see a painless way out for them. Their best bet is to leave the Euro, devalue their currency and become a cheap tourist attraction to boost their economy. We thought this would happen in September but it did not. We still expect them to get kicked out or kick themselves out of the Euro. We think the world economy and the banks can handle their default. More than likely the stock market will sell off on this news but we think it will be temporary. When you have two years to prepare for an event it is not going to be a surprise. What has kept EVERYONE on edge is what happens if somebody like Italy or Spain defaults? That fear is THE FEAR the market is dealing with and up until the last two weeks of December we didn’t see an end to this issue. We now think we see the end of that fear for the next two years and we will explain it next.

If I loaned you money for three years at 1% and you could buy a three year government bond from the country you live in at 6% would you do it? For the vast majority of investors the answer is yes. This is what investors call a “carry” trade. You are going to make a 5% return on your money (I get 6% and I pay you 1% which means I make 5%) with no risk unless your government goes under. It’s free money. This trade is what the European Central Bank (ECB) just offered in December to all of their banks. You can borrow an UNLIMITED amount from the ECB at 1% for three years and do whatever you want with it. The ECB will also make this offer to you again in February if you want to do it again. Last week European banks borrowed almost 500 billion Euros to take advantage of this offer. Why does this solve the Euro crisis, in our opinion, for the next 3 years? Let’s use Italy as our test case example for this trade. If you are a bank in Italy you have to own Italian bonds to do business, because it’s what your clients own for the most part. In the U.S. our banks own our treasuries because it’s what their clients own and our government encourages them to do so. Italy has the fourth largest debt of all the world’s economies. That said, their budget deficit is only 25 billion a year which is very small compared to the U.S. budget deficit of over one trillion. The reason Italian bond yields have gone up to the 7% range is that they have to roll over 300 billion dollars worth of bonds in 2012, as well as borrow an additional 25 billion to fund their budget deficit. In this fear driven market investors are worrying that when those 300 billion in bonds mature the current owners WONT roll over their money into new Italian bonds, but will flee with that money and go somewhere else with it. If that was to occur then Italy is in trouble. That’s the fear we have been dealing with for two years now. With the ECB giving the banks of Italy UNLIMITED money for the next three years it won’t take the Italian banks long to figure out how to borrow at 1% and invest it at 7% in their own bond market. In essence the ECB is letting the banks fund their own government’s debt market while allowing the banks to make a boat load of money risk free on that 6% spread. By doing this the ECB is going to bail out both the banks (who need to raise capital) and their host countries for the next three years. So we can’t figure out how Italy can go broke when they have somebody willing to lend any amount of money they need to their banks at 1% to buy Italian debt. The only way this “system” would fail would be if the Italian banks say “No thanks” we don’t want this money or they borrow the money but don’t buy their own Italian debt. Because demand was so strong for this money (500 billion euros) we know the banks took the money. Now we have to wait and see if they can figure out how to make 6% with minimal credit risk. Based on this long winded paragraph we are betting the crisis is over for the next two years plus (except for Greece) and that the stock market will figure it out sometime in 2012. When it does, we expect to see a pretty strong bull market ensue in U.S. stocks. A fair target for the S+P 500 today is 1500 or 20% from here. A reasonable target three years from now would be over 1750 or 40% from here. Please remember we have been wrong before so don’t chisel that prediction in concrete. That said, it’s our job to tell you what we think is the most probable event based on what we know today and we think a 20% up move in stocks is the most logical outcome from the ECB solving this mess. Feel free to come by the office and we will show you more detail on how we got there.

Let’s talk about some of our stocks briefly. For the most part our stock selections did worse than the S+P this year. They had done better the previous two years but they definitely under performed this year. Why? The answer is we are invested for an economic recovery and the market doesn’t believe one is going to occur. Even though Berkshire, Johnson and Johnson, Corning, BGC Partners, Wal-Mart, Wells Fargo, American Public, Liberty Interactive, Cintas and Maxwell had good or record earnings their stock prices didn’t really do much. At some point the market will notice this as we mentioned above. We expect each of those companies to have better earnings next year. Though BGC partners had record earnings they are going to have a slow fourth quarter due to lower trading volumes caused by investors concerns of Europe and the bankruptcy of MF Global. We view this as a temporary problem and not a long-term issue. Right now BGC is paying over a 10% dividend yield to us so it’s ok to sit and wait on trading volume to come back. For the rest of this letter I would like to talk about a few stocks and our view on the economy in more detail.

Let’s start with our old favorite Level3. Level3 has finally fixed its past issues and will report record earnings next year (I am including the increased shares they issued to buy Global Crossing when I say this). Because of their merger with Global Crossing they now go to Asia and Latin America which are growing very rapidly. Level3’s reward for this merger was to see their borrowing costs DROP BY 4% this year while getting a credit upgrade by S+P. Yet the stock dropped from a midyear high of $40 to $17 at year end (It started the year at $14.50). It’s pretty rare when a company’s stock doesn’t go up a lot, when they are able to borrow at 4% less than they use to but that’s what happened this year. This would be analogous to your personal FICO score going from 600 to 800 and your creditors still view you as a bad credit risk. For the year Level3 will grow their revenue by 8% with earnings increasing at double that number. We think that revenue growth rate number is sustainable for many years to come. Level3 has over 6 billion dollars in net operating losses they can use to shield them from paying any taxes on earnings which are now coming soon. Those NOL’s amounts to around 9 dollars a share in tax free benefits. With the stock trading at 17 the market is basically saying the network that they spent over 100 dollars a share on is worth $8 or 8% of replacement value (17-9=8). We find this valuation nuts but it is what it is. If the NEW Level3 continues to grow revenue at 8% a year they will have yearly free cash flow of over $2.50 a share starting in late 2013. We hope they take that money and plow it back into the network where they say their payback on new money spent is around 18 months. In the enterprise market (large and small business) they have around a 3% market share while being the low cost provider for bandwidth. The opportunity they have here is huge. The wind is at their back, the balance sheet is fixed, they control their own destiny from here. Our timing on this stock has been horrible and we have confessed to that in the past. In 2007 Level3 was right where they are today and they messed up the integration of the networks they bought and it set us back 4 long years while they fixed it. We think this time they get it right and we don’t just make 15% on this stock from last year but a whole lot more.

What’s wrong with Berkshire? We get that question a lot. Why is a AAA rated company down 5% for the year when they are reporting record pretax earnings? When a company’s earnings go up and the stock goes down usually management tries to buy back its stock if they think it is cheap. For the first time EVER Buffett actually did buy back some stock in q3. We don’t know how much he bought back in q4 yet but we are guessing it’s over a half a billion dollars worth. He told investors he would buy back his stock at up to 10% over book value. We place that price target at $74 dollars a share and the stock is at $76 as I type this. What we find interesting is that the world’s greatest investor is telling you at what price he will buy back his own stock and yet the stock really hasn’t responded by going up much. More than once in the past I had wished that I knew what he was buying before everyone else was told through an SEC filing. Today we know that information and it doesn’t seem to matter? Why is that? Our best guess is that he is 81 and the market is worried about who takes over for him when he dies. Thirty years ago Berkshire was correctly viewed as a one man show but that is not the case today. Berkshire is now a collection of fantastic businesses that have over one billion dollars a month in free cash flow. That won’t stop when he dies. The market is saying he won’t be around to invest that cash at some point and I agree. He has hired two guys to help invest the money and their track records are good but I agree they won’t be as good as Buffett was. What the market is missing though is that if the stock stays here Buffett or the board of directors will just keep buying back Berkshires stock which will eventually drive up the stock price. 

When you have a billion dollars a month in free cash flow you need to invest and the market cap of your stock is 126 billion it would only take 10 years to BUY BACK all of Berkshire’s stock and take it private. Heck he could start paying dividends to shareholders if he wanted to and the yield would be around 10% at today’s stock price. If by chance the stock doesn’t go up in the next five years he could spend 60 billion buying back stock AND THEN pay a dividend to the shareholders who are left. That yield would be around 20% to the investor. This won’t happen but I hope you get the point. We view this stock as a very good buy right now.

Our last paragraphs are going to be about something we wrote about over a year ago. If you hate optimistic talk about America you can skip this. When we wrote about the rebirth of American manufacturing and how the U.S. economy is poised for some strong growth in the future the response we got wasn’t positive. Blah or “yeah right” would be a better description of what we heard. We can’t blame people for feeling that way after watching a 30 year decline in the middle class and manufacturing occur in this country. Trying to predict the end of a long-term trend like that is dangerous from a forecasting standpoint but we did it anyway. We want to revisit this idea but discuss it from a different angle. When we talked about the rebirth of manufacturing we focused mostly on how the Chinese currency would have to go up versus the dollar and how that would make our goods produced in the U.S. more competitive. Since we wrote that letter the Chinese Yuan has gone up about 8% which we think is good but we think that’s just the start. Its going higher whether they like it or not and every one percent increase in their currency improves our ability to compete with them. What we DIDN’T talk about last time is something that is just now being talked about which we think has HUGE ramifications for investors over the next 10 years. Energy costs. Somewhere around 2005 a technology called fracking became commercially feasible for drilling natural gas and oil. We can thank a former vice president who happened to be a past CEO of Halliburton for getting legislation passed to make this technology more available. Of course he did it to benefit his old company (what a shock) but it’s going to benefit the U.S. a lot more. What fracking has done is lower the cost of natural gas in this country to a price lower than anywhere else in the world except the Middle East. Oil is trading at $100 dollars a barrel worldwide but an equivalent barrel of oil priced in natural gas is trading at $16 a barrel in the United States. Oil is 6 times more expensive than natural gas at today’s prices and it has a smaller carbon footprint. There are environmental concerns about fracking that I won’t go into in this letter but we feel the fears are over blown based on what we have researched. Some groups hate anything that isn’t solar power and I think fracking is an easy target for those groups. It’s new, it’s from an oil company and that’s enough to not like it. So why does lower natural gas prices and west Texas crude oil prices matter to U.S. manufacturing?

Nucor is a steel company who has complained a lot about how the Chinese are unfair competitors. They complain about how the Chinese manipulate their currency and how they try and dump their EXCESS steel below cost into the United States. The have said the same thing about some steel companies in Brazil. About 9% of the cost of producing steel is the cost of natural gas. The price of natural gas in China is NOW about twice what it is here in the U.S. (In Europe it is higher than that) versus being equal five years ago. In other words, Nucor now has a 9% cost advantage in energy costs when it produces steel in the U.S. versus their Chinese competitors. The same thing goes for their Brazilian rivals. Nucor just built a plant in Louisiana to take advantage of this new edge. Not to be outdone a Brazilian company actually decided to build a steel mill in the U.S. rather than in Mexico this month. Why? They said the cost of energy in the U.S. is 30% lower than the cost of energy in Mexico. Even with lower Mexican wages it was cheaper to produce in the United States. We are seeing the same thing occur in the plastics industry where cheap natural gas is making it better to produce here than not. The U.S. is sitting on a huge amount of natural gas so we won’t be running out of natural gas anytime during my lifetime. In fact a strange thing is also happening on oil imports from the Middle East and OPEC. We use to import in to the U.S. 50% of our energy needs and now its 40%. There are now projections that we could be off of OPEC oil by the end of the decade if this production trend continues. What this means for America is huge. We are going to have a lower currency versus our main competitors (China, Korea and Japan) and now we have a cost advantage on the energy we use. Obviously this is good for our economy and the middle class that has been hollowed out over the last 30 years when we shipped our manufacturing jobs overseas. We are aware that the Chinese are working on fracking as well but we view them as being years behind us and not close to catching up. Korea, Europe and Japan don’t have any natural resources like we do to take advantage of this, so fracking is not going to help them. As the jobs come back to this country I look for inflation to come back as well but that’s down the road. Please keep in mind that if you want to ship something into the USA you can always tack on about 15% for the cost of freight which helps our cost advantage against imports as well. So to sum it up, we are bullish on the American economy going forward. It’s not a popular view on the TV talk shows but its how we see it. We have some investments based on this idea but we will have more over time.

We want to thank everyone for their support of Trend Management. As you can tell we are pretty optimistic about the next few years. The first quarter could have some S+P downgrades of Europe for investors to deal with but we think the table is set for a few good years in the market. Enclosed is a copy of your privacy statement. If you have had any changes in your financial situation, please get in touch with us so we can update your account.


Mark Brueggemann IAR           Kelly Smith         IAR Brandon Robinson IAR

Greece is Bankrupt

Third Quarter Report 2011

Greece is bankrupt, the U.S. government almost defaulted on its debt, commodity prices made a new high before they tanked, World stock markets collapse, European banks stocks drop 50%, Brazil starts a currency fight with China, U.S. consumer confidence drop as much as it did after 9-11 and the Chiefs and Rams are 0 and 6. As you can guess from the headlines it wasn’t a fun quarter. The stock market is at another cross road similar to last year at this time. We think the most logical resolution of this intersection is for the markets to go up like they did in 2010. This was not a good quarter for the PRICE of our investments but we don’t think now is a time to shy away from owning stocks. We will outline below why we feel this way.

I guess we are going to have a debacle a year now in the stock market and the third quarter of this year was similar to last year’s second quarter. The markets were a mess then and they are right now. We have included some charts in the back of this report to show you how ugly it got out there. As we have stated in previous letters we have worked on a macro system since 2008 to tell us when to lighten up on stocks and favor bonds or other asset classes. It’s a fairly complicated system but in its most basic sense it boils down to this, if there is credit available in the world for business the world economy and their stock markets will do ok and when there isn’t it won’t. Though the stock market decline has raised the cost of capital for some firms since July 15th there is still plenty of credit available in the world to fuel a stronger economy than most investors think is going to occur. Hence, we are long stocks and not bonds or other alternative investments. In back testing our system from 1970 to today there were three periods where our monetary system was this positive and the U.S. stock market tanked. Those three dates were the crash of 1987 (the market dropped 50% in 8 weeks), the flash crash of last year (we lost 17% in 4 weeks) and this year’s crash (we lost 20% in 6 weeks). In the first two examples the market actually finished up for the year whereas this year the markets are still down over 10% as I write this. We hate having bad quarters and this one stunk. You lose money (and so do we), we make less in management fees and generally the mood around the office is not good. We have tried to figure out a way to trade these swings where we “speed” up the turnover in your accounts to take advantage of these 15% moves. To date we don’t have anything we would like to show you though we continue to work on that idea. We feel it is better today financially to take a long-term view of “the economic cycle” which means less trading but more exposure to messes like what we have been through the last two years. We continue to think that the amount of money printed in the world will drive prices of ALL asset classes higher. Why didn’t it happen this quarter?

Europe is a mess and it’s become the world’s problem. Let me explain why the stock market is acting like it is based on Europe’s woes and the worlds experience in 2008. When Lehman Brothers collapsed in 2008 it started a bank run that was the worst thing I have ever seen. Investors always remember the last war they fought and when it became obvious in August (we wrote about it in June in our last letter) that Greece was going to default, maybe investors remembered what they should have done in 08 during the Lehman bankruptcy and started selling. They sold gold, oil, soybeans, emerging markets, pork bellies etc and bought the government debt of countries they view as safe. The preferred way to get safe was to buy U.S., German or Japanese bonds with yields of 2% or less. In our opinion this is crazy when you have U.S. inflation over 3% but it’s not crazy to investors who lost money in 2008. The obvious question that should be asked of us is “Why didn’t we sell if we predicted in June that Greece would go broke?”. The answer is we don’t think this move is going to be the start of another 2008 debacle where the market drops 60%. If we are wrong we will be guilty of predicting a flood and not building an ark which is not a good thing. That’s not something we think we are doing but let us elaborate on that next.

If the markets fear is that there is a run on collateral like 2008 then ground zero for collateral runs is the banks. If there is a panic it will be felt there the worst. So far this quarter all bank stocks have been hit hard and particularly European bank stocks. The question we ask ourselves daily is “Prove its different this time and that this European crisis won’t end up like another 2008”. 

The graph above is one of our bank warning signals that help us decide when the U.S. is having SEVERE bank funding problems. We developed this system after 2008 to help us judge how bad it is out there. When the bottom line spikes up there is a problem with banks in this country and more than likely there is a lot of fear in the stock market. As you can see from the chart most of the time nothing is happening and that is the case right now. There is no fear in our banking system compared to 2007 and 2008. It’s just not there. The stocks of the banks are tanking like its 2008 but the actual funding of U.S. banks is actually very, very, strong. I will give you a case in point; there was a Wall Street journal article about 6 weeks ago where a foreign investor wanted to put 500 million into one of our U.S. banks. The bank said we don’t want your money because we don’t have anywhere to lend it. The investor said I WILL PAY YOU 15 basis points (that’s just over one tenth of one percent in interest expense) to hold the money and the bank said OK. Now think about that for a minute, a foreign investor is willing to pay somebody to hold his money ($750,000 a year) in the U.S. rather than hold it in the country he is living in. He would rather PAY a U.S. bank to hold his money than receive interest in the country he lives in. This obviously shows this investor is very afraid of the banks in his country but he is not afraid of the banks in the United States. It is our guess it’s a European investor who doesn’t know what’s going to happen to Europe and the Euro so he is stashing his money in the U.S. until that situation gets cleared up. We have another banking fear index that tells us how scared they are in Europe. 


As you can see from the chart there is some fear creeping into their bank market but it’s not even close to what it was like in 2008. So to sum this up, we have the fear of 2008 but we don’t have the actual run on the U.S. Banks like we did back then. Europe is experiencing some issues that we are monitoring closely. WHEN Greece defaults we will see how the system handles it and decide if the system is going to roll over again or not. It is our guess that when Greece defaults the European monetary authorities will “TARP” their banks like the U.S. did and THIS STOCK market correction will end. By injecting capital into the banks you end the contagion fear and confidence will return to the system. Until they do that we will have a very nervous market that we are monitoring closely.

Did you know that the S+P 500 will report record earnings this year? If you didn’t know that don’t feel bad because nobody else talks about it either. Why talk about good news when you can focus on Greece. Here is a quick rundown on how some of our companies are doing. We have been saying for awhile that Berkshire Hathaway’s stock is ridiculously cheap. This week Warren agreed with us and decided to buy back his stock for the first time since the market low of 2000. Earnings on his non insurance business are up 10% year over year and I look for that number to accelerate. Bgcp’s earnings are up 34% year over year while paying a dividend over 8%. Level3’s earnings are up 12% year over year. Wal-Marts earnings are up 6% year over year. Wells Fargo’s earnings are up 30% year over year. Maxwell Technologies has a growth of 53% in earnings year over year. American Public’s earnings are up 28% from last year. Rentrak‘s earnings are up about 50%. Cintas’s earnings are up 12% and we do have one down report, Corning’s earnings were down 7% year over year. We have more stocks we could put in here but you get the point, earnings are good but the stock prices don’t reflect it. This type of thing only occurs when the public is bummed out and we have some data on that to show you. 

The chart above shows money going into and out of U.S. equity funds. As you can see from the chart above investors have surrendered and given up on stocks. In the last 4 years they have pulled out over half a trillion dollars from the stock market. You can hardly blame them with all of the volatility we have had to deal with lately. If I could find an 8% treasury bill right now I might give up too but I can’t find one I like. Yes, Brazil’s rates are above 10% but we don’t like what they are doing over there right now and rates in Australia and Canada aren’t high enough to entice us to go there. As you can tell from the chart the public was starting to stick their toe back in the water in 2010 until the flash crash sent them for the exits and they haven’t come back since (the stock inflows in January 2011 were Ira related). John Templeton use to say “If you have to wait in a long line to buy something you aren’t getting a bargain”. I can assure you there is no line to buy stocks right now which is why we continue to buy them. I am convinced when investors hate something we are near the lows. Can the market go lower? Sure. Will it stay there? We don’t think so. I have been telling Brandon and Kelly lately that someday this business will be fun again, Governments don’t always talk about defaults every day, U.S. politicians weren’t always this dumb(that might be a stretch), that earnings for companies really did matter and there really was something called inflation when I grew up. What will be the catalyst to change the mood investors are in? 

We think a resolution in Europe is the start. When Greece defaults the banks of Europe are going to need more capital. If the banks get “Tarp” money from their governments the markets will take this very positively. We also continue to feel that any unrest in China is a sign that they can’t keep manipulating their currency rate to help their exporters while not paying their workers enough to eat. It appears we are heading for a conflict there and we will take any problems in China as a sign that changes in their export policies will occur. There is also a currency manipulation bill in Congress that bears watching coming up in October. This bill is aimed directly at China. The raising of the Chinese currency will help our economy bring back jobs to the USA. We also feel that the elections will help the national mood. Without being too political right now everybody is depressed and at least after November of next year only half of the country will be depressed. We also think housing has bottomed which is still the most unpopular thought we have right now. If we are right, that will lower the unemployment lines and make GDP better.

We are going to have the Christmas party this year on December 15th at Highland Springs. The time is from 6 to 8. We will be sending you an invite after Thanksgiving but we wanted to give you a heads up of when it is.

Finally this paragraph is a sales pitch so you might want to skip it. We think the market is cheap and we are looking for more investors who might want to invest with us. I know it’s counter intuitive to ask for money and referrals after we just put in a crummy quarter for you but we think the values here are great and we are willing to bet accordingly. Thank you for your support.


Mark Brueggemann IAR           Kelly Smith IAR         Brandon Robinson IAR

P.S. Level3 is going to do a 15 for 1 reverse split on its stock October 19th. What this mean to you is that if you have 1500 shares priced at $1.40 which is worth $2100 dollars today you will now have 100 shares priced at $21 dollars for the same value of $2100. Level3 will also now be listed on the New York stock exchange. The company hopes these changes will improve the trading of their stock. Some institutions cannot own or buy a stock priced below $5 and now they will be able to buy Level3 if they so choose. We view this event as a mild positive. 

Has Housing Recovered?

Second Quarter Report 2011

Sell in May and go away! That phrase is an old Wall Street saying about the stock market and for this year it has been very accurate. The stock market was down for seven straight weeks before rallying the last week of June. Our accounts that we manage for you took a hit in June as well and we will go into detail about what we think we will be doing next. Our long-term view of the economy and the stock market hasn’t changed (we think it goes up), but after the market mess in June we need to elaborate a little about our market views.

So what has the world so scared these days? The answer would be Greece and we don’t mean the movie but the country. Greece has been in default on its public debt for about half of the last 150 years. The country has been a fiscal basket case for years and it continues to be that way today. Greece is bankrupt and there are no easy solutions to fixing this problem today. We have a view on how all of this is going to play out. We will use the last country to go through a mess like Greece is in today which is Argentina as our case study. We think the timeline for what happened in Argentina in 2001 will be fairly similar to what Greece is going to experience. To stop inflation in Argentina their government adopted a currency peg in 1991 that linked the value of their peso to the U.S. dollar. Each peso was worth a dollar and this peg kept their central bank from printing more pesos than they would have if they hadn’t linked it to the dollar. The problem with a system like this is that unless you link your fiscal policies and monetary policies to the country with which you peg your currency to, a peg system will not work. An everyday analogy of this mistake would be linking my bank account to Warren Buffett’s in how much money we can spend; there is a slight difference in what he can spend at Tiffany’s and what I can spend. The Greek country was admitted into the Euro without linking its fiscal or monetary policies in 2001. Each Greek Drachma was exchanged for a Euro at the time of the monetary union and the Greek drachma ceased to exist at that time. For about eight years each country enjoyed low inflation and low interest rates and life was good. To enjoy this new found prosperity the people of Greece and Argentina decided to borrow more money than they should have. The markets were willing to lend them the money based on the idea that each peso or drachma was worth a dollar or a Euro. Both countries’ piled on more debt than they could pay for and eventually the markets noticed. At this point the powers that be called in the IMF (International Monetary Fund) to try and fix this problem. The IMF decided it would lend more money to Argentina in 2000 IF THEY would adapt austerity measures (i.e. cut spending and raise taxes). The IMF showed up with the same plan in Greece in 2010. Both countries quickly passed austerity measures that were not popular with their voters but they did it to get new money from the IMF which would keep them from defaulting on their debts. The markets cheered and the crisis was declared over (except it wasn’t). Starting in 2001 the austerity measures that Argentina passed didn’t pan out and their economy continued to do very poorly. The same thing happened to Greece in 2010. Starting in late 2001 the Argentine people started pulling their money out of the banking system in Argentina and sending it overseas before the Government could stop them. Starting in December of 2001 the Argentine government froze the public’s bank accounts and said “You can’t send dollars out of here anymore to overseas accounts”. This act was the beginning of the end of the peso/dollar peg. The

public in Argentina which was already fed up with austerity measures to pay the foreign banks rioted on December 19th and 20th. The riots were so bad the president of the country resigned. On January 1st of 2002 the Argentine congress elected a new president. On January 6th the dollar peso peg was broken and the crisis ended three months later.

As I write this the Greek public has pulled between 8 to 20% of their money from the Greek banks depending on whose estimates you want to use. If the Greek monetary authorities do what the Argentines did we are going to see a freeze on bank withdrawals from Greece sometime this year. Once that is done the next step will be for the Greek government to convert those Euros to drachmas and pull out of the European Union. In Argentina each dollar in 2002 was converted to 1.40 pesos if you left the money in the bank. If you were smart enough to pull the money from the bank before they froze your account you could get 3 to 4 pesos per dollar in the black market. This conversion disparity is one of the main causes that sparked the riots in Argentina that toppled the Government. If you watch the evening news today you know they are already rioting in Greece but their banks have been kept afloat with loans from the European Central Bank which is a plus that the Greeks have that the Argentines did not. That said, the Germans and the French who control the European Central bank don’t want to give Greece anymore money and neither does the IMF. So as I write this, the world is waiting to see how it all plays out. Our best guess is that the Greek politicians will pass another austerity measure; the people will riot worse than they have ever done later in the year, the president will resign and Greece will leave the Euro which is what happened in Argentina. We don’t see any PAINLESS way out of this mess for Greece unless the other members of the Euro want to give Greece money for the next 50 years to help pay off their debts. I don’t see that money transfer happening for long but for now the market thinks it will happen. Under certain circumstances we will try and buy some stocks in Greece depending on how this divorce occurs. We will keep you abreast on what we do there if anything.

The reason the world stock markets have been going down since May is the fear that when Greece defaults on its debt we will have a run on the banks similar to what happened when Lehman brothers went under in 2008. We don’t think that is going to occur because the world monetary authorities are printing plenty of money to stop a run on the banks right now. As a quick reminder, virtually ALL of Latin America went bankrupt in 1982. The majority of our major U.S. banks were fully invested in those countries and yet the U.S. stock market was up 50% two years later. Our banks were bankrupted if they marked those loans to market in 1982 but the politicians/regulators just lied and said those loans were good until the banks could deal with them six years later. The same scenario happened during the Asian crisis in 1997 with our market going up 50% two years later and the regulators postponing the recognition of losses for years. Our guess is that when Greece acknowledges that they are broke the accounting authorities will still recognize the Greek debt at an artificially high value to keep the banks from having to write them down. We have case history on our side on how they will deal with this and I don’t think they will rewrite the playbook this time.

Let’s talk about our stocks for the first time in awhile and get off of world affairs for once (and the crowd cheers). In our year end letter we threatened Level3 with the following comment, “For the record we think they need to grow their CORE REVENUE by about 2% EACH quarter to make us happy”. In their first quarter which is their weakest quarter of the year they grew revenue by 1.3% which made us smile a little bit. What has cheered us up on this company is the merger they announced with Global Crossing in April. This deal is going to fix their balance sheet and finally put us on the road to some pretty big growth rates if they don’t screw it up. Level3 is going to have some money to spend to grow this company and there are a lot of companies who need bandwidth right now. We also think the merger allows them to consolidate the long-haul business in a way that gives them pricing power down the road when they negotiate their contracts with Google, Facebook and Netflix. We hate to say anything nice about Level3 since our angry statements were made when the stock was 98 cents and its now $2.29. They appear to respond to threats so we will shut up and report on them more after they report earnings in July.

We have been waiting five years to buy a housing related stock and we finally got the signal to buy one this quarter. Our first purchase was USG at around $14. They sell wallboard and housing related stuff for the construction business and their orders collapsed when housing collapsed in 2007. We are making a call that the housing market is bottoming out and we wanted to pick a company that is very sensitive to a turn in new construction. Forty percent of USG’s sales are to new homes and we think the bottom is in for how bad residential real estate can get. We have been working on the housing industry since 2007 to predict when the bottom might come and our indicators say it’s here. We don’t think that in this cycle we over built homes this time like we did in the cycles of 1973 and 1991. We actually think we built fewer homes nationwide in this cycle than we did in previous cycles which may surprise some of you. The BIG difference in this cycle is that Wall Street allowed you to over leverage your home to a ridiculous degree which we didn’t or weren’t able to do in 1973 or 1991. It is this over leveraging or extending of credit using your home as collateral which has caused home prices to plummet more in this cycle compared to the others. We have been at 60 year lows in housing construction now for about two years so the supply of new homes has dried up dramatically. As the U.S. dollar declines in value we are also seeing foreign buyers come in and buy houses for cash which is helping to soak up excess homes in California, Arizona and Florida. We have mentioned our new found bullishness on housing to a few clients and friends and so far everybody thinks we are nuts. Nobody likes this idea right now. This is usually a good sign that we are not over paying for these companies because nobody else wants to buy these stocks. Our timing might be early but we like our odds of being right here long-term. We plan to increase our exposure in this area over the next year by selling some of our current holding to buy into this area. Two of our poorer performers this quarter were Berkshire Hathaway and Corning. Berkshire is a very large position of ours and we don’t like it when it goes down but we are not concerned with them. We think the decline in the stock is linked to how many catastrophic disasters there have been this quarter that will hurt them on the insurance side of their business. From time to time this happens and it’s just the risk you have in running an insurance company when a 9-11, Katrina or Tsunami occurs. In the past when these disasters hit the insurance industry raises prices to recoup their losses and Berkshire ends up making more money than ever. If you want proof of this type of behavior wait until you get your renewal rate in Missouri for your home and car insurance after what happened in Joplin. I doubt your rates go lower. Berkshire also has a lot of housing related investments that have been doing poorly

lately but as you now know we think that is turning around. As for Corning the market is worried about saturation in big screen TV’s in the U.S. I think there is some truth in that but I think the stock price adequately reflects that risk. One of our fine employees just bought a 70 inch big screen TV so in the U.S. we may not be buying as many TV’s as we use too but we sure are buying bigger ones that use Corning’s glass. Corning also has a new product coming out for big screen TV’s called gorilla glass that we think will help their sales as well. So for now we continue to buy more Corning while betting on moderate growth in big screen TV’s in the US and Asia.

Two other stocks that I want to mention that have been struggling lately have been Wells Fargo and Wal-Mart. Wells Fargo is also a company that will benefit from a return to residential construction. The company has done ok on the earnings front since the crash without any help from the real estate market but investors don’t seem to care right now about that. Wells Fargo has no Greek bonds or assets but in Wall Street’s eyes if Greece fails so will a lot of U.S. banks and Wells is a bank. As you know from our writing above we disagree with that logic but right now the market doesn’t care what we think. We think Wells is a great bank and will do better and better as the economy turns around and Greece gets fixed. Because Wells Fargo is also the largest originator of home loans in this country it’s also a sneaky way to bet on housing. Another negative factor this quarter for the large banks has been fear of what the new regulatory capital requirements will be for large (too big to fail) banks. The largest banks in the world may be FORCED to raise more capital in the next five years to back up their loans. This never ending regulatory assault on banks has slowed down the world economy because the banks have slowed down their lending of money until they know how much money they need to hold on their balance sheet to back up each loan. If banks don’t lend, the economy doesn’t grow. For better or worse we should know in Q3 of this year what the new capital levels are which should increase bank lending once they know what the new rules are. Wal-Mart has been frustrating for us lately. Every once in awhile big company’s do dumb things and Wal-Mart is in one of those spells right now. About three years ago they decided to limit the amount of inventory they carry to increase their inventory turns and speed up their cash conversion cycle. To help tick off their clients even more they also decided to raise prices on their non sale items. The problem with limiting your inventory is that as Wal-Mart limited the selection that their customers had, their customers started shopping at other stores to get those items and their store foot traffic declined. The limiting of inventory in their stores was a dumb idea by upper management (Why build big stores and then not fill them?) and they realized it this year and made changes to bring the extra selection back to their customers which will take time to implement. It also takes time to get those customers to come back and look for those items you discontinued. The other mistake they made of raising gross margins to make more money is also coming back to bite them. By raising prices they have allowed Dollar Tree, Dollar General, Aldi’s and a host of other “dollar like” companies to come in at the low end of the market and attack them. They swear they are going to stop this by lowering gross margins to fight their new found competitors. As we see it, this is going to take about a year to show up in their U.S. returns because of how big Wal-Mart is. When you are as big as Wal-Mart your sales growth will be in line with what the unit growth of GDP is in this country, which is around 2% right now. If you cut prices by 3% and your unit growth in the U.S. is only 2% you are going to have a negative sales comparison until the year is over. This is what we think is happening to Wal-Mart in the U.S. and in about 12 months we should be passed this. Fortunately Wal-Mart is doing well internationally which is around 30% of their sales and that should carry us until we get passed this period. The stock is cheap and we will continue to hold it until they get passed this self induced mistake. Wal-Mart currently pays a dividend equal to the ten year Treasury note which does help us while we sit and wait.

In closing it has been a messy second quarter very similar to what we went through last year with Greece and the Flash Crash. We will sit through this period owning stocks like we didn’t last year because our macro system is still very positive and our valuation system for common stocks is still cheap based on the last 20 years of history. We think the stock market this year, like last year, is a better place to be than bonds, cash or commodities. If you have any question on any of this please give us a call (417- 882-5746).

One house keeping note, Mark is going on his first two week vacation of his life in August to celebrate his 30th wedding anniversary. He will be in Europe the second and third weeks of August. Though he will have internet access somewhere in Europe he probably won’t use it much or there won’t be a 31st wedding anniversary. Kelly will be gone the first week of August and we are waiting to hear what Brandon is going to do. We don’t anticipate any macro changes that will need to be made during this time frame but we wanted to let you know when our vacation time is if you want to get a hold of us ahead of time.


Mark Brueggemann IAR            Kelly Smith          IAR Brandon Robinson IAR

Tsunami's, War, and a 5% market increase!!

First Quarter Report 2011

In this quarter we had the beginning of a war in Libya, the ouster of two long time dictators in Egypt and Tunisia, a 7% stock market correction, public uprisings in Bahrain and Wisconsin while Japan the third largest economy in the world suffered a horrific earthquake and tsunamis. When you add all of that up you would expect the stock market to be down a lot and yet it managed to finish up over 5% for the quarter. 

This letter is going to be a little different than our previous ones. We are going to talk about what we think we see coming next in the world economic system over the next ten years and why the problems of this quarter were forgotten for now but won’t be forever. This is a very long letter and we apologize for that. That said, when we are discussing something new that we are going to do with your money, you need to know about it.

You need to look at the last page of this report to see a chart that we think graphically shows THE PROBLEM we are faced with in the United States. That chart is a graph of the debt of our country divided by the income of our country and we define income as GDP (Gross Domestic Product). This chart is THE problem we are going to have to deal with as a country and as investors. As a country we have borrowed too much money in relation to what we earn and there is going to be a reversal of that trend over the next 20 years. We don’t think that the U.S. government’s debt is going to continue to grow as a percent of GDP anymore and that is going to cause problems for our country. This debt subject has been one we have been fighting about at Trend Management for the last 18 months, and after 25 books and numerous articles we have come to some conclusions that we feel comfortable enough to talk about how we might invest your money as this debt unraveling occurs.

As you can tell from the chart, in 1987 the total debt as a percent of our GDP got to levels last seen during the Great Depression and just kept going up from there. Investors have been talking about a U.S. debt debacle for 24 years now while comfortably predicting another depression was coming because of all of this debt. To sum up their thought process, the end of the U.S. as we know it was at hand in 1987, 1991, 2001 and there is no hope of avoiding it (even though we did for 25 years). We don’t share that dire view but we are aware of it.

During that period from 1987 until 2008 the U.S. survived and prospered which is the opposite of what occurred in the 30’s when this country last tried to deleverage. The aftermath of the 1929 deleveraging was a horrible depression. A natural question to ask is: “Why didn’t this large debt to GDP ratio in 1987 cause a depression like it did in the 30’s?”. The answer we think is that we had countries willing to invest their surplus money back in the U.S. to fund our government debt at the same time our Federal Reserve didn’t let the banks go under (like they did in the 30’s). If our banks had gone under like they did in the 30’s a rapid debt deleveraging would have caused another depression which we have been spared from for now. Those emerging market countries that had a trade surplus with us (mostly Asian countries) also helped continue our debt build-up by reinvesting their earnings (from selling to us manufactured goods) into our treasury bonds. Those emerging countries received a good interest rate on their money while trusting our Federal Reserve to protect the value of their investment (they trusted us to not depreciate our currency). One of the byproducts of the emerging countries buying our debt is that it helped “prop” up the value of the U.S. dollar which allowed our citizens and government to spend more money than we should have. The U.S. consumers purchasing power benefited from this higher dollar because it lowered the cost of goods he bought shipped in from mostly Asia. One of the consequences of this spending “orgy” enabled by our emerging market friends propping up our currency was that our manufacturing base and middle class was severely depleted by the off shoring of these jobs that used to be in the U.S. There has been lots of talk about how unfair this trend has been to the young and uneducated in this country (it was terrible), but the flip side of this argument that few people want to talk about is how the low inflation this out sourcing caused was a huge benefit to the elderly and those who had money over the last 30 years (it was fun to be retired). This disinflationary trend has been going on for 30 years which is what our next chart shows below. 



What the chart above shows is that from 1955-1980 you would have made more money investing in the stock market and “tangible stuff” than you would have if you lent your money to someone who bought something tangible with their money. From 1980 present you would have been better off to have lent people money and collected interest rather than own something. What we think is the next consequence of our debt deleveraging is that you will want to own stuff and stocks again and not be a lender or bond holder at these rates or higher rates for awhile in the U.S. The 30 year trend in lending money over owning things in the U.S. is over for awhile. Why we feel that way is next. 

The solution: 


federal government is going to change the rules. It won’t be a default like the Governor did, it will be a

papering over of our obligations which is called inflation. We have politicians that won’t raise taxes, we have politicians that won’t lower spending so to fix this stalemate the FED will solve this problem by

The above chart is a long-term picture of the U.S. dollar versus the currencies of emerging market countries that we are running big trade deficits with. The solution to our problems of high unemployment, high debt, and low GDP growth is to take the value of our dollar to new lows versus these currencies which will make it easier for our U.S. based manufacturers to compete with these emerging countries (most of these countries are in Asia). Our currency will go down until we have a
TRADE SURPLUS with these countries
again. We don’t see ANYWAY our currency doesn’t go down versus those currencies over the next 10 years. It’s inevitable in our view. When your currency goes down your ability to buy things with money IN TODAY’S PURCHASING power goes down with it which is what we have to protect you from. Another way to say that is if your currency goes down you will have inflation eventually. A hamburger that used to cost you a dollar in 2008 might cost you 3 dollars in 2018
which means you are going to buy less of them unless your purchasing power goes up. If you are an Asian creditor and you see your largest client printing over 200% more dollars in a two year time frame to pay its debts (which has historically
ruined the printing country’s currency) you have to think twice about continuing to LEND that country ANY money. The happy side of this equation is that as our currency goes down that poor uneducated person in the U.S. with no money actually gets a job instead
of living off of the system which gives him or her the ability to buy that $3 hamburger instead of having the government ration him/her a burger once a month. There is going to be a constant monetary battle in this country where increasing GDP by printing money will outweigh the effects of higher inflation. There will be more jobs and GDP to help us deal with the debt but the loser will be anybody who LENDS
MONEY to the government or states to do this (see chart 2 above). Our government has initiated policies that will attack the lenders of money who did so well over the last 30 years. 

What happens when you don’t grow GDP but your debts keep growing? If you want to view this battle in real time look at Wisconsin. Whats that fight all about? In its most basic sense Wisconsin can’t pay their state workers the money that they were promised 20 years ago by their politicians. The citizens of Wisconsin didn’t earn enough GDP to support the state workers that are still working and, more accurately, the retired workers and their benefits. Most of Wisconsin’s problems are based on the health care and retirement costs of their elderly state workers. The more their older workers get paid the less young workers the state can hire UNLESS YOU GROW Wisconsin’s revenue in relation to its debt. We went through this same problem with GM and Chrysler in 2008 when they had $100 billion of pension and health care liabilities for older workers and the market capitalization of those two companies was valued at only $5 billion dollars. The car companies solved that problem by filing for bankruptcy and giving part of the ownership of the company to the union to satisfy those claims. The states can’t do that (can Wisconsin give their state workers the Packers?). A state cant file bankruptcy and more importantly they can’t print “Wisconsin bucks” to paper over these past promises their politicians made so they are going to default (just like GM and Chrysler did) on their obligations to their workers. For better or worse the Governors of a lot of states are going to have to say no, we can’t pay that bill anymore which then starts the battle you just watched in Wisconsin. The Governor of Wisconsin defaulted on the obligations that other politicians had made to the workers because he didn’t have the money to pay those obligations. Look for this type of fight to continue in other states. 

Our current Federal Reserve chairman is an expert on debt deflations and the problems that come with that. He wrote about the debt deflation of the 30’s in a book called “Essays of the Great Depression” by Ben Bernanke. I think you should read it. When a FEDERAL government comes up against a problem where they are either going to default on their obligations or print money to solve it the solution is almost always to print money and deal with the inflation later. Initially the printing of the money causes EVERYTHING to go up in price, which is what we talked about in 2009 and was one of the main reasons we were so confident in owning stocks in 2009 and 2010. The Government is printing money and you are benefiting from it right now with your account going back up. The first signs of inflation from the Fed printing money are called profits in your stock portfolio. We welcome that inflation. At some point in a typical cycle REAL COMMODITY inflation comes back and your currency starts to go down more than the government is comfortable with. When that event occurs the Federal Reserve will try and tighten monetary policy and slow inflation down which will also drive the value of your currency back up. The problem the Fed is going to run into this time is that with all of the debt we have outstanding, they can’t tighten credit too much to slow down the economy or we won’t earn enough GDP to pay our HUGE debts to our foreign creditors. This problem means our currency has to go down more than the Fed would like in order to give our exporters a chance to compete with Asia and earn a trade surplus. It will also make it easier for our currency to go down when those same Asian countries who were big buyers of our bonds for 30 years decide to do something else with their money. China is a rich country but its people are poor (their GDP per person is one tenth of ours and yet they have 2.85 trillion dollars in foreign reserves.). If they don’t increase the amount of money their citizens get (especially with food costs going up) China may soon learn what the presidents of Egypt and Tunisia did, RUN. China is battling massive inflation in their country today and they don’t like the social unrest this is causing. Every dollar that China invests in the United States is one less dollar their citizens have for food, healthcare, and improving their living standards. Don’t you think the citizens of China would benefit MORE from that 2.8 trillion in foreign reserves THEIR LEADERS have invested outside their country if those leaders spent that money on THEM rather than subsidize our U.S. healthcare needs? Of course they would. However, China has up until now been more willing to invest that money in U.S. treasury bonds which has helped HOLD UP the U.S. dollar while benefiting their export company leaders rather than the average Chinese person. A good question to ask is, “Who OWNS these privileged exporters?” I will give you a hint, it’s not the poor people of China. We feel the “stiffing” of the average Chinese person is over and it has ramifications for what’s next in our country. As our Fed prints all of this money it is causing a large rise in food prices worldwide. The average U.S. consumer pays around 15% of his or hers income to eat. In the Middle East and Asia that number is over 60%. Is it any wonder there are riots across the world right now as food prices double from a year ago? What good is it to have a manufacturing job in China if you can’t afford to eat? It is NOW in the best interest of politicians AROUND THE WORLD to try and slow down food inflation before their people riot and throw them out. One way to do that is raise the value of your currency which makes food cheaper for your people to eat. The easiest way to raise your currency is stop buying any U.S. bonds and let the U.S have some of your inflation. 

As you can tell from this letter so far the stars are aligned for everybody to do the opposite of what they have done for the last 30 years and that the chart borrower vs saver is going to reverse to the upside again. Everybody’s self-interest is aligned in reversing that chart. The emerging market countries will want their currencies to go up to feed their people which means they won’t want to buy a lot of our debt which will remove one LARGE buyer of our currency. The U.S. will want it’s currency to go down to
service its debt (remember we borrowed in dollars and we can print a lot of them) and help paper over the promises they have made to their citizens over the last 30 years that they
can’t keep. This won’t be the end of the world for the U.S. or the emerging countries that have been supporting us, just a change in modus operandi. We are going back to a 20 year run where it is better to be a borrower rather than a lender in this country and we think the middle class and poor might actually like this NEW/OLD world when they see jobs show up again. The group who won’t like this are the elderly (that’s me) and anyone who has money invested in something that isn’t tangible. Those two groups are the target because they have benefited more than the poor and the young during the last 30 years (see borrower vs lender chart above) and the cycle is going to reverse. Please keep in mind that being old and rich wasn’t such a bad thing from 1955 to 1980, it was just better to be that way from 1980 on. The obligations that our politicians promised us can’t be paid with “stable dollars” so just like the Governor of Wisconsin did, our federal government is going to change the rules. It won’t be a default like the Governor did, it will be a papering over of our obligations which is called inflation. We have politicians that won’t raise taxes, we have politicians that won’t lower spending so to fix this stalemate the FED will solve this problem by printing more money which we think will bring inflation back. The politicians who won’t raise taxes will not index the tax tables for inflation so as our income goes up from inflation so will our taxes (and the no taxers will claim ignorance on this subject) and the politicians who won’t cut spending will stand by while your money is papered over and some rationing occurs of their favorite projects (they will also claim ignorance on this). If you are old enough to remember the Vietnam War one of our presidents had to decide between choosing guns or butter, he chose both. By not making a choice he actually made a choice to let the Fed fix this problem by printing money to satisfy everyone. The Fed allowed us for awhile to have both guns and butter which caused the inflation problems of the 60’s and 70’s. Today we are faced with a similar dilemma, cut taxes or cut spending, and our elected leaders will do neither (don’t you know the Governor of Wisconsin wishes he could do nothing?), which means here comes the inflation. So, how does Trend Management plan to deal with this?

If you haven’t fallen asleep after reading the last five pages we will give you a simple answer to what we plan to do next. In general we are going to be an owner of stuff in the U.S. and a lender of money outside of the U.S. That pretty well sums it up. A country that has a depreciating currency isn’t a horrible thing if you own something besides the actual currency. One of the biggest daily percentage up moves in the Dow Jones Industrial average was the day Richard Nixon and Paul Volker devalued the dollar in August of 1971. The Dow was at 856 and it closed at 889 the next day. Fifteen months later the Dow was at 1020 for a total gain of 19%. During that same time frame ten year government bond rates actually went down from 6.58% to 6.37%. It wasn’t until the late 70’s before the bond buyers figured out what was going on and demanded much higher interest rates on their money. We think something similar to that is going to occur. Until the stock market gets over valued from all of this money the Fed is printing we feel comfortable owning stocks that we think we can understand that are priced fairly. At
some point the U.S. dollar is going to drop and that will push the stock market up for awhile without causing any inflation in the governments CPI index. Everyone will be happy for awhile until inflation comes roaring back. Because this last crash was so traumatic investors will wrongly ignore the rising inflation and
cling to their bond portfolio’s way to long (just like the generals we are always fighting the last war instead of the current one). At some point the Fed will tighten and we will sell stocks in the U.S. and invest the money in an emerging economy that has higher interest rates than the U.S. does. We hope to make money from the interest on that debt PLUS get an appreciation in the currency of the country we own versus the U.S. dollar. If we can’t find emerging market debt we like we will invest our
money in short-term treasury debt until we are sure that the Fed tightening is over and the debt deflation is under control.
We don’t think we will sell 100% of your stock holdings but we are guessing it might become a 50/50 type of account (versus 100% stock today) split between stocks and bonds. We are telling you this ahead of time to give you some time to think this over. Our best guess is we don’t do any of these types of macro moves this year. More than likely this is a 2012 or 2013 event but we are preparing for it now. Before we do this we will announce it in our letters and we will set up a meeting with everyone to discuss what you want us to do. We want to see you in our office and go over this when we start to make these changes. It’s important, it matters and we need to see you when it happens. 


We promise you our next letter will go back to talking about how our stocks are doing and it won’t be this long. We wanted to get this letter in your hands to give you time to think about what we think is coming next. It is easy to talk about this stuff but it’s harder in real life to do it and we have a plan on how we will do it but our timing won’t be perfect. We are pretty sure we will sell stocks too soon and buy bonds too soon and everyone will want to shoot us. After what we all experienced in 2008 that’s a risk we are willing to take.


Mark Brueggemann IAR         Kelly Smith IAR           Brandon Robinson IAR