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Quarterly WebinarAugust 2017

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Two-part overview this quarter:

• First, the economy, inflation, bonds and energy• Second, the stock market: Wise Men vs. Wise Guys

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Section I: How's the economy looking?

• The good news: not on the cusp of recession• The bad news: losing momentum

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Last quarter we saw the Citi Economic Surprise Index was plunging

• And it got worse… but is now perking up a bit

• Tough to keep these way up or way down; Europe is the opposite status• Certainly very hard to allege US economy is strong, however

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These snap shots of the economy also don't look great

• Last quarter we noted restaurant sales considered a leading consumer indication

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Retail obviously struggling mightily

• Amazon gets the blame but could it be more than that?• Maybe the rising cost of healthcare is the real problem• The average family of 4 pays $26K in healthcare costs

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And it's not just healthcare…

• Rents are a huge problem• As in MEAN vs. MEDIAN household income• Clearly, this is one mean situation for consumers

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Perhaps that's why the savings rate is down to 3.8% from 6.3% in 2015

• If savings rates stayed constant, real consumption would be around 1%• Even so, real personal consumption is only growing at 2.4% now vs. 3.7% two years ago• With banks tightening credit

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This squeeze on the consumer is showing up in big ticket items

• Q2 Building permits –13% • Q2 Housing starts –22% • Q2 New home sales –12% • Then there’s auto…

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Running on empty?

• Ergo, Big Ticket/Big Trouble• Shouldn’t be a surprise; big ticket items

typically struggle late in an expansion • Like the flashing crosswalk signal

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And the ECRI's leading indicators (called the last 3 recessions but whiffed in 2011)…

• …not leading in the right direction• However, definitely better than in 2015

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Besides, the Fed isn’t worried

• Oops, maybe that’s not too reassuring!

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A few quick random economic observations

• 1.4% of 2% GDP growth this cycle has been due to falling unemployment – that’s done• Small businesses are the main driver of job creation – start-ups now at slowest rate ever• And mind the yield curve! It’s flattening but not in the danger zone – so far• Moreover, what about this trend?

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On the positive side, Jeff Gundlach sees no recession in the next 6 months…

• But this caught our eye

• We’ve never seen this before… so it’s grain-of-salt time • Yet, it’s allegedly had a 70-year accuracy record• Bottom line on the economy: still on high-alert for a recession but don’t think the odds favor one…

yet

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Inflation: still MIA

• A non-event and it’s become even more “non”

• Unit labor costs down or flat for 3 of the last 4 quarters• PPI report on August 10th had “a stunning array of price declines”

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Inflation: still MIA (continued)

• “It’s hard to find good explanations for the low-inflation era being experienced by the US.” – Jim Bullard, St. Louis Fed Governor

• Food for thought: what happens to inflation during the next recession/bear market?• Hint: it starts with a “de”

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Bonds

• Treasury yields in a tight range of 2.2% to 2.6%; toward low end now• Once again defying consensus which saw 3%+ • Start of QT (Quantitative Tightening; opposed to QE) should be T-bond supportive

• Bonds never rallied during QEs, stocks did• When the Fed stopped, T-note yields fell 83 bps on average

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Bonds (continued)

• Our far bigger fear is credit spreads

• There is also a strong tendency for spreads to rise sharply as Fed hiking cycle progresses • Best places to be in these phases: cash, treasuries, and very high grade corporate bonds

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Energy

• As we’ve seen, there’s been another sharp correction for MLPs

• It’s not just them…

• Energy market cap % of S&P now lower than in 2015!

• And most active managers are underweight the sector

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Are fundamentals really that bad?

• Actually, global oil inventories are falling

• And they’re falling at a time when they normally rise

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There's a 15 million barrel divergence – positively – from seasonal average!

• Key fact: big shift underway to capital discipline from reserve growth at any cost• Big Oil has been doing this for years, now aggressive frackers (PXD, APA, et al) getting religion

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Section II: Wise Guys vs. Wise Men

• Let’s start with the (bull) case for the Wise Guys…• …like CNBC talking heads and almost every Wall Street strategist who have never seen a bear

market coming• First, there’s been a shocking defection from the Wise Men camp lately

• GMO’s co-founder and public face says we’re in an anti-bubble!• And doesn’t see euphoria and/or speculative excesses (more on this when we get to Wise Men)• Jeremy Grantham: "This time is very, very different"

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This is a shocker for sure

• S&P has been able to sell at 65% to 70% above 1935 – 1995 averages for 20 years!• The average P/E from 1997 to 2017 was higher than 1929• Ergo, proof positive of how different things are• But asset prices are rising in a boring way• And profit margins may no longer be “mean reverting”

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Thus far, anyways, he's got a point

• At least for large- and mid-cap companies• Small-cap seems to be reverting • (Side note: notice how small-cap margins are always ½ of large-cap; yet, they trade at 36 times

earnings – or more!)

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What has created this twenty year anomaly?

• First, a true economic boom (and market mania) in the second half of the 1990s• Then, a collapse in interest rates after the tech crash (Fed Bubble 2.0)• Since the financial crisis ended, powerful combo of rising earnings, central bank money creation,

and company buy backs (the latter two continued even as the first stopped) • Another anomaly: we’ve had the two worst post-WWII bear markets in this era

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So all of this….

• Weak $, narrowing credit spreads, etc. more than offset the Fed’s tightening

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And this….

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…has led to this

• We’ve seen this before but far stronger bull market than average since WWII…• …despite the weakest economic expansion

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And the Wise Guys think it will keep on going because…

• Global economy accelerating

• Plus strong S&P profits

• Earnings recession (mostly energy) over – party on!

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Now for the Wise Men

• Let’s start with today’s main bull story: profits• Consider these images and factoids

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Now for the Wise Men (continued)

• For overall US corporate sector, profits have gone ex-growth since 2012• Yet, the S&P is up 88% (total return) since then• GAAP earnings up a mere 9% over the last 5 years• Growing gap (pun intended) between GAAP and non-GAAP illustrates this• Much hyped Q2 earnings only +3.7% YOY, ex-energy

• Small-cap earnings basically flat vs peak 10+ years ago! (Even under Russell’s generous definition of profits)

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Speaking of peaks…

• Stocks not reacting well to good earnings

• …Maybe we’ve got a case of peak earnings on our hands

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Main factor for sustained high profit margins…

• …equally sustained low wages – until lately

• Meanwhile, returns on capital keep falling as cost of capital continues rising

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Rapid-fire chart and factoid review

• Starting with what I think has been the main cattle prod in this bull’s behind – central banks• The prod looks set to become much less prodding

• But, after a drop off in the spring, they slammed down the accelerator again

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And yet, some sub-surface erosion

• This happened before the big sell off in the summer of 2015

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Along the no bubble line, what about these charts?

• Schwab just reported a 44% spike in new accounts; the fastest pace since 2000 peak

• Fed minutes just said no evidence of stock investors using excess leverage• Yet, margin debt now rising at 20% annualized rate!

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Most hated bull market?

• Second longest up market since 1896• Maybe least trusted – and least justified – but not most hated

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What will kill this very old bull? Maybe this….

• Selling volatility has been incredibly profitable – and popular

• The inverse VIX (shorting volatility) was up 100% this year (until lately)• Now the world’s 34th most actively traded ETF• A huge accident waiting to happen…

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What about valuations? So egregious just one slide is necessary

• NYSE composite P/E at 26.5; only been this high before in recessions!

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Which is why Jeremy Grantham's firm, GMO, still has these return projections

• 97% historic accuracy rate – even in “very, very different” last 20 years• Our only quibble would be that we believe small caps will be worse • 80 P/E when including money losers (even “official” P/E of 26 is crazy)

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Howard Marks is another of the proven Wise Men; he's not wavering

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Unsurprisingly, we think Mr. Marks is on the mark

• We also disagreed with Jeremy Grantham on his peak oil/commodities (supply) call of a few years ago

• Besides all of the aforementioned risks, there’s also a pretty significant one lurking on the Korean peninsula

• Is that all priced in?• And whatever became of Trumphoria (i.e. “what happens if it morphs into Trumphobia”?)

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Let's do a quick sum-up

• Odds of a recession increasing again• Barring a market panic before then, Fed likely to raise several more times and shrink its balance

sheet• Key things to watch: credit spreads and the yield curve• For now, good-to-OK but trend is worsening• We are concerned about 2018 – possible recession and serious bear market • To us, super high margin debt, massive selling of volatility, combined with central bank

tightening/tapering seems like a deadly mix

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How to cope with these high-risk conditions:

• Big market falls tend to happen in the fall• Be prepared to move very quickly to buy stocks in sudden panic• It’s been a while since we had a “flash crash” – we’re due! • While that (or a “crashette”) is fairly likely it might be something more ominous

Thank you!- David Hay

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