Trapeze Asset Management letter for the second quarter ended September 30, 2016; titled, “Wall Of Worry.”

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There are a lot of economic negatives to worry about these days. Slow growth, annual GDP rising at only 2.1% on average since the ’08 recession. Stagnation. Low inflation. Burgeoning government debt relative to GDP. One third of global government bonds at negative yields (and a few corporate bonds now too). Corporate earnings per share declining for 6 consecutive quarters, even after historically high share buybacks. High share prices from relatively high earnings multiples—the S&P 500 at 17x forward earnings. Falling worker productivity for the third consecutive quarter. Flat retail sales, likely as a result of an over indebted consumer. High inventories relative to sales. The U.S. government putting the kibosh on several potential deals. Corporate insider buying at only one third of their selling—a poor ratio. General uncertainty, much stemming from an election year with two controversial candidates espousing controversial policies.

Trapeze Asset Management

Trapeze Asset Management

Though the anticipated dire consequences of Brexit may not materialize when implemented, other issues, including a potential bailout of Deutsche Bank, whose shares just fell to a record low, have negative implications for Germany and the Eurozone. China, the world’s second largest economy, continues to grow, albeit at a slower pace. And growth worldwide is sluggish with growth for 2016 expected to be 2.9%, the slowest since ’09.

Trapeze Asset Management – Stocks the Lesser Worry

[drizzle]Stocks may be the only game in town. Well, certainly the best game. The yield of 1.7% on U.S. 10-year treasuries is less attractive than the 2.1% dividend on the S&P 500 and an earnings yield of 6%, making stocks preferable, especially for taxable accounts which can enjoy a lower capital gains tax rate on equity sales compared to the tax on bond income. Moreover, the risk of bond yields rising and creating short-term losses on fixed income securities is likely greater than the potential loss on equities in the near term, even if a rate-hike driven correction were to hit the stock market.

Household net worth has improved almost 30% since the ’08 recession, and, in the current low rate environment consumers are taking advantage of their spending power in the housing sector. U.S. new home sales were up 12.4% in July, the highest since October ’07. Sales of previously owned homes were down 3.2% in July after 4 months of gains, with supply falling and prices higher. Foreclosures were at an all-time low. With the current low interest rates, household debt payments as a percentage of disposable income are at a 35-year low. U.S. auto sales should also continue to rise over the next year.

U.S. consumer confidence in September was at its highest level in 9 years so spending should pick up. Central banks want inflation, which should boost prices of goods in general. Look for energy and materials earnings to improve from rising commodity prices. Although energy earnings declined 25%, about 70% of U.S. companies beat earnings expectations last quarter.

U.S. Q2 GDP rose 1.4%. New orders for durable goods rebounded in July but were little changed in August. The unemployment rate is a low 4.8% with rising average hourly earnings of 0.3% in July.

Avoiding the stock market during a recession is typically a good idea. We still aren’t seeing the normal signs of a pending recession—oil prices are clearly not spiking, unemployment isn’t rising, bank losses are contained, and most importantly, the yield curve is not only not inverted, it’s actually steepening. Our own Economic Composite (TEC™), designed to alert us to recessions in various regions around the world, is not forecasting a peak in the business cycle. Even though equities are trading at fair value in our work, bear markets rarely occur without a recession. Our TRIM™ stock market indicators, which warned earlier in the year, are back on buy in most regions. So, while the stock market can suffer a correction at any time, we believe a decline in the near term will likely be modest and that growth and equity prices should continue higher, although perhaps at a tepid pace. Meanwhile, this doesn’t feel like a market top—where typically everyone’s optimistic, fully invested and buzzing about stocks.

The Fed says it is getting close to raising rates, likely in December, as the economy is reaching its growth and inflation goals. Better news for stocks than for bonds. Though rates are not likely to rise dramatically as further economic stimulus is still required. Look for continued monetary easing. The market is generally at all-time highs, clearly climbing a “wall of worry.” If not the only, then the best, game in town.

Our Strategy

We continue to buy shares that pass our due diligence process when we can find them at a wide enough discount from our estimate of their fair market value (FMV), and assuming our earnings outlooks are favourable. Our objective to add more large cap positions to our All Cap portfolios continues, as we find compelling ideas and as our smaller cap positions rise toward our FMVs and are eliminated.

While the prices of gold and oil have somewhat plateaued over the last few months, we believe that the supply/demand fundamentals remain in place to bring higher commodity prices over the next year or more. Furthermore, both are still below their normal premium over the cost of industry production. Normally, these commodities trade at 30-40% premiums to the industries’ average all-in costs. Typically prices below industry costs in the past have only been seen during periods of great economic dislocation. This period has been unusual.

While we have reduced exposure here, as some of our holdings rose close to our FMV estimates, our All Cap portfolios continue to hold resource companies that are substantially below our FMVs and we still anticipate further recovery in these commodity prices in the months ahead which should also help grow the companies’ valuations.

Our Portfolios

The following descriptions of the significant holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described.

Our All Cap Portfolios – Key Holdings

Our All Cap portfolios combine selections from our large cap strategy (Global Insight) with our best small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. Importantly, they tend to recover back to their fair values much faster than smaller stocks, so they can be traded more frequently for enhanced returns. However, our small cap positions are cheaper, trading far below our fair value estimates; therefore, our All Cap portfolios still hold a position in small caps.

Most of our small cap company holdings still trade well below our estimate of their respective FMVs. Although these smaller, less liquid holdings are potentially more volatile, the risk of permanent impairment appears minimal while upside potential remains high. We elaborate on these key holdings below.

Specialty Foods Group, a shareholding in a private company held in our taxable

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