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… 2  Limbo  Lust  Gluttony  Greed  Anger  Heresy  Violence  Fraud  Treachery  Short selling

Bear case: Near extinction of bear funds 3 Inverse ETFs 2005-2017 2500 4.00% 2000 3.00% Share of Total ETF Assets S&P 500 Index 1500 2.00% 1000 1.00% 500 0.00% Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Dec-16 Inverse ETF Assets / Total S&P 500

Three bubbles in 20 years Magnitude and duration 4 Start Top S&P 500 Date Date Description 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 +255% 7.98 years bubble Average of 11 bull markets +145% 4.70 years since WWII

Bear case: High valuations 5 Wilshire 5000 Total Market Cap / GDP 1971-2017 $25,000 250% Stimulus bubble $20,000 200% Credit bubble Wilshire 5000, $billions Wilshire 5000 / GDP Tech bubble $15,000 150% $10,000 100% $5,000 50% $0 0% 1970q4 1980q4 1990q4 2000q4 2010q4 Wilshire 5000 Wilshire 5000 / GDP

Bear case: Extreme bullish sentiment 6 Investors Intelligence: % Bulls - % Bears 2005-2017 2500 75 50 2000 % Bulls - % Bears S&P 500 Index 1500 25 1000 0 500 -25 0 -50 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Dec-16 % Bulls - % Bears S&P 500 Index

Bear case: Extreme leverage 7 NYSE Customer Accounts - Net Cash Balances 1990-2017 2400 $300,000 Customers' Accounts Net Cash, $ Millions 2000 $200,000 1600 $100,000 S&P 500 Index 1200 $0 800 -$100,000 400 -$200,000 0 -$300,000 Dec-89 Dec-93 Dec-97 Dec-01 Dec-05 Dec-09 Dec-13 Net Cash Balances, $Mil S&P 500 Index

Bear case: Low cash levels 8 Equity Fund Cash Levels 1984-2017 2500 20.0% 2000 16.0% Equity Fund Cash S&P 500 Index 1500 12.0% 1000 8.0% 500 4.0% 0 0.0% Dec-84 Dec-88 Dec-92 Dec-96 Dec-00 Dec-04 Dec-08 Dec-12 Dec-16 S&P 500 Index Equity Fund Cash, %

Bear case: Low price of portfolio insurance 9 3-Month VIX Futures 2005-2017 2400 60 2000 50 Implied Volatility, % 1600 40 S&P 500 Index 1200 30 800 20 400 10 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Dec-16 S&P 500 Index 3-Month VIX Futures, %

Bull case: 10 Low interest rates cure all “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

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Keys to economic prosperity 12  Economic freedom  Respect for private property  Expanding division of labor  Delayed gratification

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Print, print, print 14

Spend, spend, spend 15

Print and spend… 16 “It may be well again to stress the all- important point that the Federal Reserve “Just as we saved our way into has it in its power to change interest depression, we must squander our way rates downward any time it sees fit to out of it.” do so and thus to stimulate business.” ~ Virgil Jordon, Business ~ Financial World , April 10, 1929 Week economist, 1932

Monetary stabilizers fail to learn from history 17 Ben Bernanke Timothy Geithner November 8, 2002 January 27, 2010 “I would like to say to Milton “To stand back and let it burn [Friedman] and Anna [Schwartz]: is irresponsible. It's what Regarding the Great Depression. happened in the Great You're right, we did it. We're very sorry. But thanks to you, we won't do Depression.” it again.”

Did the early 1930s Fed really fiddle while Rome burned? 18 Fed Holdings of Securities vs. Money Supply Growth 1914-1939 $4,000 20% Annual Money Supply Growth $3,000 10% Holdings, $Mil $2,000 0% $1,000 -10% $0 -20% 1914 1918 1922 1926 1930 1934 1938 M2 Money Supply Growth, Y-o-Y Fed Holdings of Securities, $Mil

The trouble with monetary stimulus 19 “ 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

Influence of Milton Friedman 20 comes full circle 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

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Dichotomy in time preferences: 2005-2007 credit bubble 22 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

Instant gratification Financial engineering – stock buybacks 23 Aeropostale Annual Buybacks / Free Cash Flow 35 600% 30 500% Stock Buybacks / Free Cash Flow 25 400% Stock Price 20 300% 15 200% 10 100% 5 0% 0 -100% Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 Quarter Ended Stock Buybacks / Free Cash Flow Stock Price

Instant gratification Financial engineering – debt-fueled M&A 24 Valeant Pharmaceuticals Net Cash + Float $250.00 -$40,000 $200.00 -$32,000 Net Cash + Float, $Mil $150.00 -$24,000 Stock Price $100.00 -$16,000 $50.00 -$8,000 $0.00 $0 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 Quarter Ended Net Cash + Float, $Mil Stock Price

Instant gratification Financial engineering – debt-fueled M&A 25 Valeant Pharmaceuticals R&D Spending vs. Interest Expense 10.0% 25.0% 8.0% 20.0% Interest Expense 6.0% 15.0% R&D Expense 4.0% 10.0% 2.0% 5.0% 0.0% 0.0% Dec-08 Dec-10 Dec-12 Dec-14 Dec-16 Quarter Ended Interest Expense / Revenue R&D Expense / Revenue

Short selling landmines: Delayed gratifiers / disruptors 26

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Short themes: Discretionary consumption + aggressive financing 28

Short themes: Auto finance 29 U.S. Motor Vehicle Loans 1994-2016 $1,200 12.0% $1,000 10.0% Motor Vehicle Loans, $bil $800 8.0% Finance Rate $600 6.0% $400 4.0% $200 2.0% Dec-93 Dec-96 Dec-99 Dec-02 Dec-05 Dec-08 Dec-11 Dec-14 Motor Vehicle Loans, $bil Finance Rate, 48-Month Loans

Short themes: Time preference dichotomy = opportunity for active investors 30 Enterprise Annual 3/3/17 3/3/17 Value Revenue EV/ Company Symbol Price ($bil) ($bil) 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

Short themes: Government spending + reach-for-yield bubble 31 Germany 10-Year Notes 1994-2017 5.0% 5.0% 4.0% 4.0% Consumer Price Index, YoY 10-Year German Yield 3.0% 3.0% 2.0% 2.0% 1.0% 1.0% 0.0% 0.0% -1.0% -1.0% Dec-98 Dec-02 Dec-06 Dec-10 Dec-14 CPI, YoY Change 10-Year German Yield

Smart money recommends shorting German bunds at 2017 Barron’s Roundtable 32 Jeffrey Gundlach Felix Zulauf “Some things should be avoided “I would short 10-year Italian in a major way because they bonds and German bunds in the have risk without rewards. One futures market… Inflation in of the greatest trades of the Germany is at 1.7% and year could be shorting German probably will top 2%. The yield bunds.” on the 10-year is 25 or 30 basis points.”

On interest rate suppression… 33 “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)