MR. MARKET FLUNKS THE MARSHMALLOW TEST GRANTS SPRING 2017 - - PowerPoint PPT Presentation

“MR. MARKET FLUNKS THE MARSHMALLOW TEST” GRANT’S SPRING 2017 CONFERENCE – MARCH 15, 2017

Bearing Asset Management

Dante’s circles of hell, circa 2017…

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 Limbo  Lust  Gluttony  Greed  Anger  Heresy  Violence  Fraud  Treachery

Short selling

Bear case: Near extinction of bear funds

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0.00% 1.00% 2.00% 3.00% 4.00% 500 1000 1500 2000 2500 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Dec-16

Share of Total ETF Assets S&P 500 Index

Inverse ETFs

2005-2017

Inverse ETF Assets / Total S&P 500

Three bubbles in 20 years Magnitude and duration

Start Date Top Date Description S&P 500 Gain Duration 12/8/94 9/1/00 Technology bubble +241% 5.74 years 3/11/03 10/9/07 Housing & credit bubble +95% 4.61 years 3/9/09 3/1/17? Stimulus & sovereign debt bubble +255% 7.98 years Average of 11 bull markets since WWII +145% 4.70 years

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Bear case: High valuations

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0% 50% 100% 150% 200% 250% $0 $5,000 $10,000 $15,000 $20,000 $25,000 1970q4 1980q4 1990q4 2000q4 2010q4

Wilshire 5000 / GDP Wilshire 5000, $billions

Wilshire 5000 Total Market Cap / GDP

1971-2017

Wilshire 5000 Wilshire 5000 / GDP Tech bubble Stimulus bubble Credit bubble

Bear case: Extreme bullish sentiment

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• 50
• 25

25 50 75 500 1000 1500 2000 2500 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Dec-16

% Bulls - % Bears S&P 500 Index

Investors Intelligence: % Bulls - % Bears

2005-2017

% Bulls - % Bears S&P 500 Index

Bear case: Extreme leverage

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• $300,000
• $200,000
• $100,000

$0 $100,000 $200,000 $300,000 400 800 1200 1600 2000 2400 Dec-89 Dec-93 Dec-97 Dec-01 Dec-05 Dec-09 Dec-13

Customers' Accounts Net Cash, $ Millions S&P 500 Index

NYSE Customer Accounts - Net Cash Balances

1990-2017

Net Cash Balances, $Mil S&P 500 Index

Bear case: Low cash levels

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0.0% 4.0% 8.0% 12.0% 16.0% 20.0% 500 1000 1500 2000 2500 Dec-84 Dec-88 Dec-92 Dec-96 Dec-00 Dec-04 Dec-08 Dec-12 Dec-16

Equity Fund Cash S&P 500 Index

Equity Fund Cash Levels

1984-2017

S&P 500 Index Equity Fund Cash, %

Bear case: Low price of portfolio insurance

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10 20 30 40 50 60 400 800 1200 1600 2000 2400 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Dec-16

Implied Volatility, % S&P 500 Index

3-Month VIX Futures

2005-2017

S&P 500 Index 3-Month VIX Futures, %

“We are not in bubble territory or anything of that sort… Measured against interest rates, stocks actually are on the cheap side compared with historic valuations. But the risk always is interest rates go up, and that brings stocks down.” ~ Warren Buffett, CNBC interview, February 27, 2017

Bull case: Low interest rates cure all

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Keys to economic prosperity

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 Economic freedom  Respect for private

property

 Expanding division of

labor

 Delayed gratification

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Print, print, print

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Spend, spend, spend

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Print and spend…

“It may be well again to stress the all- important point that the Federal Reserve has it in its power to change interest rates downward any time it sees fit to do so and thus to stimulate business.” ~ Financial World, April 10, 1929 “Just as we saved our way into depression, we must squander our way

• ut of it.”

~ Virgil Jordon, Business Week economist, 1932

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Monetary stabilizers fail to learn from history

“I would like to say to Milton [Friedman] and Anna [Schwartz]: Regarding the Great Depression. You're right, we did it. We're very

• sorry. But thanks to you, we won't do

it again.”

“To stand back and let it burn is irresponsible. It's what happened in the Great Depression.”

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Ben Bernanke November 8, 2002 Timothy Geithner January 27, 2010

Did the early 1930s Fed really fiddle while Rome burned?

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• 20%
• 10%

0% 10% 20% $0 $1,000 $2,000 $3,000 $4,000 1914 1918 1922 1926 1930 1934 1938

Annual Money Supply Growth Holdings, $Mil

Fed Holdings of Securities vs. Money Supply Growth

1914-1939

M2 Money Supply Growth, Y-o-Y Fed Holdings of Securities, $Mil

“We must not forget that, for the last six or eight years monetary policy all over the world has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown.” ~ Friedrich Hayek, 1932

The trouble with monetary stimulus

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Professor Bernanke of Princeton was a leading scholar of the Great

• Depression. He knew how the passive Fed of the 1930s helped

create the calamity — through its stubborn refusal to expand the money supply and its tragic lack of imagination and

• experimentation. Chairman Bernanke of Washington was

determined not to be the Fed chairman who presided over Depression 2.0. So when turbulence in U.S. housing markets metastasized into the worst global financial crisis in more than 75 years, he conjured up trillions of new dollars and blasted them into the economy… He didn't just reshape U.S. monetary policy; he led an effort to save the world economy. ~ Time, December 29, 2009

Influence of Milton Friedman comes full circle

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Dichotomy in time preferences: 2005-2007 credit bubble

A long-time friend… points out a distinction in the behavior of the debtor

• class. Some have clearly acted

responsibly: they consolidated their debts into tax deductible mortgages, locked in the lowest long-term rates in 40 years, and tossed the interest savings into their rainy day and investment jars. From a consumption standpoint, little has changed except that these old-school borrowers pocketed a windfall compliments of their friendly neighborhood central banker. Others — to put it mildly — have gotten carried away. ~ Kevin Duffy “Are Mortgage Borrowers Rational?” June 24, 2006

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Instant gratification Financial engineering – stock buybacks

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• 100%

0% 100% 200% 300% 400% 500% 600% 5 10 15 20 25 30 35 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17

Stock Buybacks / Free Cash Flow Stock Price Quarter Ended

Aeropostale

Annual Buybacks / Free Cash Flow

Stock Buybacks / Free Cash Flow Stock Price

Instant gratification Financial engineering – debt-fueled M&A

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• $40,000
• $32,000
• $24,000
• $16,000
• $8,000

$0 $0.00 $50.00 $100.00 $150.00 $200.00 $250.00 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15

Net Cash + Float, $Mil Stock Price Quarter Ended

Valeant Pharmaceuticals

Net Cash + Float

Net Cash + Float, $Mil Stock Price

Instant gratification Financial engineering – debt-fueled M&A

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0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% Dec-08 Dec-10 Dec-12 Dec-14 Dec-16

Interest Expense R&D Expense Quarter Ended

Valeant Pharmaceuticals

R&D Spending vs. Interest Expense

Interest Expense / Revenue R&D Expense / Revenue

Short selling landmines: Delayed gratifiers / disruptors

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Short themes: Discretionary consumption + aggressive financing

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Short themes: Auto finance

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2.0% 4.0% 6.0% 8.0% 10.0% 12.0% $200 $400 $600 $800 $1,000 $1,200 Dec-93 Dec-96 Dec-99 Dec-02 Dec-05 Dec-08 Dec-11 Dec-14

Finance Rate Motor Vehicle Loans, $bil

U.S. Motor Vehicle Loans

1994-2016

Motor Vehicle Loans, $bil Finance Rate, 48-Month Loans

Short themes: Time preference dichotomy = opportunity for active investors

Company Symbol 3/3/17 Price Enterprise Value ($bil) Annual Revenue ($bil) 3/3/17 EV/ Revenue BlackRock BLK 390.17 $62.38 $11.16 5.59 SEI Investments SEIC 51.32 $7.47 $1.40 5.33 Affiliated Managers AMG 168.75 $11.13 $2.19 5.07

• T. Rowe Price

TROW 71.31 $16.08 $4.22 3.81 Invesco IVZ 32.33 $17.31 $4.73 3.65 GAMCO Investors GBL 29.54 $1.05 $0.35 2.98 Janus Capital JNS 12.33 $1.76 $1.01 1.74 Franklin Resources BEN 42.68 $15.19 $6.42 2.37 Legg Mason LM 37.06 $4.63 $2.78 1.66 Total excl. BLK: $74.62 $23.10 3.23

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Short themes: Government spending + reach-for-yield bubble

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• 1.0%

0.0% 1.0% 2.0% 3.0% 4.0% 5.0%

• 1.0%

0.0% 1.0% 2.0% 3.0% 4.0% 5.0% Dec-98 Dec-02 Dec-06 Dec-10 Dec-14

Consumer Price Index, YoY 10-Year German Yield

Germany 10-Year Notes

1994-2017

CPI, YoY Change 10-Year German Yield

Smart money recommends shorting German bunds at 2017 Barron’s Roundtable

“Some things should be avoided in a major way because they have risk without rewards. One

• f the greatest trades of the

year could be shorting German bunds.” “I would short 10-year Italian bonds and German bunds in the futures market… Inflation in Germany is at 1.7% and probably will top 2%. The yield

• n the 10-year is 25 or 30 basis

points.”

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Jeffrey Gundlach Felix Zulauf

“Credit expansion is the government’s foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everyone prosperous.” ~ Ludwig von Mises, Human Action (1949)

On interest rate suppression…

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Mises anticipates Bank of Japan

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0% 5% 10% 15% 20% 10,000 20,000 30,000 40,000 Dec-84 Dec-89 Dec-94 Dec-99 Dec-04 Dec-09 Dec-14

Discount Rate Nikkei 225 Index

Bank of Japan Discount Rate vs. Nikkei 225 Index

1985-2014

Nikkei 225 Index BoJ Discount Rate, %

Mises anticipates Bernanke/Yellen Fed

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0% 4% 8% 12% 16% 20% 500 1000 1500 2000 2500 Dec-92 Dec-96 Dec-00 Dec-04 Dec-08 Dec-12 Dec-16

Fed Funds Rate S&P 500 Index

Fed Funds Rate vs. S&P 500 Index

1993-2017

S&P 500 Index Fed Funds Rate

“The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment.” ~ Ludwig von Mises, Human Action (1949)

Epitaph for consumption-first policies…

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GRANT’S SPRING 2017 CONFERENCE – MARCH 15, 2017

Bearing Asset Management