Trapeze Asset Management letter for the fourth quarter ended December 31, 2016.

2016 Hedge Fund Letters

Remember when trends were all about tie widths and skirt lengths. Now the zigging and zagging of just about everything is tracked. Though, trend-following dates back to the dawn of time—even during biblical times—recall the 7 fat years followed by the 7 lean years.

A trend is a tendency for general movement in one direction. Sometimes, as the saying goes, “The trend is your friend.” This is the order of the day for the stock market. With the U.S. bull market now in its 96th month without a correction exceeding 20%, it’s the second longest bull market in history. Though, Mark Dodson, of Hays Advisory, recently commented that, currently, the trend is your friend but your only friend. That’s because undervaluation, monetary stimulus and negative market psychology are all lacking. These essential elements normally combine to sustain a bull market.

Trapeze Asset Management

Trapeze Asset Management – Trendless

That said, markets can maintain an upward bias for some time, especially if interest rates are low (i.e., opportunity costs of investing elsewhere are low). And, with the continued backdrop of anemic global economic growth (still at a lower pace of real GDP growth than most periods), there continues to be no evidence of a near-term global recession, anathema for stock markets.

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. Though U.S. equities have lifted to all-time highs, and are trading just above fair value in our work, bear markets rarely occur without a recession. And, typically, a market peak is accompanied by euphoric sentiment which still isn’t apparent. Contrary to conventional wisdom, markets don’t die of old age but from full or overvaluation as a result of over-exuberance at a time when the economic growth is about to be choked off.

Our TRIM™ stock market indicators, which warned in early ’16 (we didn’t weight it too heavily in the absence of the typical overlapping TEC™ alerts), are back on buy in most regions. But, after the recent market run-up, and since the market is currently substantially overbought, we wouldn’t be surprised to see a market correction—averaging about 6% in a bull market.

Meanwhile, we continue to scour for bargains, though our own research, where our search for stocks trading for 85 cents-on-the-dollar or less, is providing the least number of potential investment opportunities in some time. Another reason a correction could be close is that stocks tend to inflect down from TRAC™ ceilings/FMVs (fair market values) once achieved, when they run out of short-term potential, as they appear to have now.

While a stock market correction could occur at any time, we still believe any decline in the near term will likely be modest and that growth and equity prices should continue higher, although likely at a below-average pace.

Trend Reversal

After years of low and falling interest rates, rates in most jurisdictions have been moving higher. U.S. 10-year Treasuries, after bottoming at 1.3% last July, now yield 2.4%. Foreigners, specifically China and Japan, have been net sellers of U.S. bonds in the last several months after years of buying. The recent bearish extreme in the bond market—because rates may have moved too far too fast and too many are betting on higher rates—might mean that rates could fall back somewhat again but if so, it would likely only be temporary. Foreign selling, Fed selling (and lack of ongoing buying as QE has wound down), higher inflation and accelerating economic growth should all conspire to lift interest rates.

Interest rate levels around the world still remain lower than in the U.S. 10-year rates in the U.K., Germany and Japan are 1.2%, 0.3% and 0.1% respectively, so rates in the U.S. shouldn’t skyrocket, especially since the U.S. dollar continues to somewhat defy gravity. It’s higher than its purchasing power parity (its FMV) and is putting pressure on corporate earnings and overall competitiveness. But, because rates are so relatively high in the U.S., that should offer continued support for the high U.S. dollar.

As long as rates don’t move too high, it should not affect the stock market. In fact, a slow, steady increase in rates may continue to benefit stocks as a migration away from bonds and toward stocks continues. Not to mention, most of the factors conspiring to lift rates also favour boosting stock prices. The latest data points showed an advance in global industrial production, along with a pickup in global trade, both recovering to a 2.7% pace, an acceleration in economic growth. For now, data like this should extend the bull market since it bolsters corporate earnings. Only when growth is too fast and inflation too high will the central bankers act to quell growth. Inflation has been muted but the latest release did show U.S. inflation at a 2.4% rate (the highest in 5 years), and the Global Inflation Surprise Index has surged in recent months. While moderate rising inflation is harmful for bond investors it’s a boon for stocks. With an earnings yield of 6%, even with 10-year Treasuries up to 2.4%, stocks are relatively more attractive than bonds, but if rates rise well above 3%, without a meaningful boost in corporate earnings, the relative attractiveness of stocks would dissipate.

Uptrends and Downtrends

In the U.S., leading indicators still show good growth ahead and unemployment continues to decline, now at 4.6%, and wages have been stable. This, and with promises of stimulus from large tax cuts and infrastructure spending, should maintain the U.S. growth outlook. Corporate income tax rates for Germany, Japan, the U.K. and Canada averaged 36% 10 years ago and now sit at 27% (Canada matches the average). U.S. corporate taxes have remained at 39% throughout. A Trump-levied lower rate should assist the competitiveness of U.S. corporations while boosting profits. Though, longer term, as the stimulus bolsters growth, it will likely raise inflation and contribute to rising deficits.

Negatively, debt levels, at all branches of governments, in most jurisdictions are at levels of serious concern, and now for corporations and consumers too (auto loan delinquencies at the highest levels since ’09). While the high debt levels themselves won’t necessarily tip the economy over, they can heavily impact the severity of the next recession. And, rising interest rates will increase debt burdens adding fuel to the potential fire.

Geopolitical issues may also be cause for concern. Whether it’s Russia asserting its power while it appears to have a friendly U.S. head of state; South China Sea tensions as the U.S. takes a hard line against a determined China; or Euro pressures from Brexit, or an outright Euro breakdown if we have Frexit too with Marine le Pen and her National Front Party leading in the polls for the April 23 election.

As money mangers we are constantly evaluating issues that might negatively impact our current or prospective holdings. Competitive threats, changing demographics, cost pressures or excessive leverage among other issues all need to be analyzed. And, as long/short managers (where authorized to include short sales from time to time), we need to look at the same issues to ferret out companies which are vulnerable to these issues. Whereas in the dot-com bubble shorting stocks felt easy, especially in retrospect as plenty of stocks were way overvalued, shorting, normally, is much more difficult. Especially since a rising tide tends to lift all boats. Because of this, our strategy has been to avoid most single name shorts for the last couple of years. But if we can find businesses that are susceptible to negative trends—think newspapers or shopping malls—or that are fads, and where the business is overleveraged and overvalued, we could hedge our portfolios with shorts. We are always on the lookout for these types of opportunities.

Trendy

What’s trendy today? Apps, Internet of Things, Big Data, 3D printing, FinTech, Sensors, Right wing policies (or perhaps just the politicians—the scariest trend over the last few years has been toward government leaders who resemble fictional villains—think the Riddler or the Joker—look no further than Russia, Iraq, North Korea, and, unfortunately, now the U.S. too, hopefully to a much lesser degree). Things that are currently in vogue tend not to endure. That’s why we gravitate to unpopular stocks, especially those that are ignored or misunderstood and therefore mispriced.

As value investors we are constantly looking for investment opportunities in undervalued companies but we also seek those whose share price may have positive momentum—an uptrend. The best time to buy occurs when the momentum is about to turn back up or accelerate ahead. We apply common sense and TRACTM in an attempt to optimize the timing of our purchases. And while it’s harder than most times now to find stocks to purchase that meet our criteria, that’s our raison d’être, and we’ll continue to work hard, turning over rocks and completing fundamental analysis in pursuing those opportunities.

Today, trends seem to come and go in a flash. Isn’t “fake news” so last month? The stock market, on the other hand, has exhibited less volatility with the volatility index at the lowest level in years. The overall market isn’t ebbing and flowing like it does normally. The S&P 500 has now gone over 90 trading days without a 1% decline and 50 days without a 1% move in either direction. While this lack of movement in and of itself doesn’t necessarily portend a market correction, we shouldn’t be lulled into complacency either. Times ahead will likely be much more volatile. And strangely, while volatility has been low, uncertainty, likely created by weak growth and Trump’s policies, is at a major high. Something to watch.

Secular Trends

The biggest investing trend today is the acceleration toward passive (index) investing. We continue to believe this should be a boon to us stock pickers. It certainly doesn’t make sense that this trend is hastening at a time when the markets are fully valued, offering the lowest prospect of long-term returns in years—the Value Line appreciation potential index, which has been remarkably accurate over the years, forecasting a 5-year return of about 5% per year. Clearly there’s a powerful force that guides trend following. Whether it’s with skinny jeans, narrow lapels or index investing. We stock pickers appear to be headed for the endangered species list. But, in the years ahead, when we expect slim long-term equity index results, it wouldn’t surprise us to see stock picking become trendy again.

Our Strategy

As value investors we look for bargains, and in the large cap arena they have become scarcer.

We still favour some unpopular sectors—precious metals and oil & gas—where our outlook for the overall industry is positive. Otherwise, we have been selecting investments from various industries, in various jurisdictions, which should provide us with the benefits of diversification. Some of our latest purchases even benefiting from recent consumer trends, such as skinny jeans—American Eagle, or mobile ads—Facebook (Instagram).

In Canada, now that energy prices and commodities in general are rising, we should see further economic improvement. However, with Canada’s total government debt high and the 2-year interest rate differential still heavily favouring U.S. bonds over Canadian, this could continue to weigh on the CAD exchange rate—another reason we have been increasing our holdings in stocks from outside of Canada.

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 FMV and assuming our earnings outlooks are favourable. Our objective is to continue to add more large cap positions to our All Cap portfolios as we find compelling ideas and as our current smaller cap positions are sold when they rise close to our FMVs.

After falling back to a floor in our TRACTM work, the price of gold has inflected back up and has given us a buy signal, the first since preceding its run up early last year. And with inflationary expectations escalating and a poor supply outlook, we remain bullish on gold. The supply/demand fundamentals for oil are also supportive of higher prices and the U.S. inventory overhang is now finally being worked through. Both gold and oil are still below their normal premium over the cost of industry production. Normally, these commodities trade at roughly 30-40% premiums to the industries’ average all-in costs. We expect this typical premium to return soon. Real rates are negative again in the U.S. as inflation has lifted more than interest rates which bodes well for gold and commodities in general.

Our All Cap portfolios continue to hold resource companies that are substantially below our FMVs and the further recovery that we anticipate in these commodity prices 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 currently hold a meaningful position in small caps.

Most of our small cap company holdings 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 accounts, has been preparing to liquidate its assets through a wind-down. In the next month or so, the company is expected to distribute $55 million (of its more than $60 million) of cash. The wind-down plan, including the distribution of cash and the sale of the remaining business and distribution of its proceeds, has finally been approved allowing the complicated corporate organization structure to be unwound. Its remaining business line, which is at near record year profitability, will be put up for sale shortly. Another return of capital should occur once the remaining assets are sold, though the timing and amounts of these payouts still remain uncertain. Our carrying value lifted about 4% at year end and has further potential upside, mostly dependent on the sale value of the remaining business.

Orca Exploration is improving but its share price is still in a holding pattern. While Tanzania’s outlook has improved, and the company is positioned to resume growing, we continue to wait for new contract signings and production to lift. Orca’s production capabilities now exceed 185 mmcf/d. The country’s demand for natural gas remains extremely high and Orca continues to provide nearly all of the natural gas to the country. New power plants are expected to come online, powered by natural gas, which will require long-term contracts with Orca.

Orca still trades in line with its net cash and receivables; therefore, we see little downside. We expect the company to receive a good deal of its receivables from TANESCO, the national power utility and Orca’s primary customer, this year. The World Bank is working with the country to help ensure payments are made. The company is displeased with the disconnect between its share price and the underlying value. We believe they may take steps to narrow the gap. Orca’s estimated reserves are valued at over $11 per share, and the combined value of its receivables and cash balances, net of payables and debt, is about 4 times the share price.

ProShares Short S&P 500 is about a 6% weighting in most 100% Growth mandate accounts. This is a long position in an ETF which mirrors the inverse performance of the S&P 500 (i.e., if the market declines the value of this position increases) on a daily basis. With the market at record highs, in line with its FMV and at a ceiling in our TRAC™ work, it remains a simple way of hedging a correction in the U.S. market. Though, in our view, we remain in a bull market; therefore, we would look to eliminate this position in the next correction (we did tax-loss sell the position for a number of accounts in December). We prefer to only short when our macro tools suggest overall market risks are elevated.

Kirkland Lake Gold has once again become one of our largest holdings. After reducing the position when it ran up close to our FMV estimate, we reestablished a position through Newmarket Gold, the company Kirkland recently merged with. Because market participants were confused about the deal and, at points, thought that the merger might not proceed, we were able to acquire shares in Newmarket (which we were prepared to own as a stand-alone company), which allowed us to ultimately receive Kirkland shares more cheaply, rather than by buying Kirkland directly. The company is now a 500,000 ounce producer and stands out relative to its peers because it operates in excellent jurisdictions (Canada and Australia), has a balance sheet with over $200 million net cash, enormous land packages, high grades and still has a below peer-group valuation.

We expect Kirkland to deliver free cash flow of over $130 million this year. The share price has recovered nicely, though, a higher gold price, which we expect, along with a potential for an improvement in grades and exploration success, should continue to elevate the share price. Our estimate of FMV, at today’s CAD gold price, is more than 20% higher than the share price.

Manitok remains a standout relative to its undervaluation versus our estimated FMV. With oil prices having moved up significantly over the last year and the fact that the company’s last production report was at record levels, above 7,000 boepd, we are surprised that the share price hasn’t risen higher. We believe the share price has been held back by lack of news and analyst coverage. As well results come in and the IRRs on these wells show the outstanding economics, it should be market moving. And, the former taint of high debt levels has been removed as Manitok’s leverage is now much more manageable. Drilling results have been much higher than the type curve and now that the company is drilling monobore wells, costs have been lowered substantially too.

Manitok has high quality assets trading at an unusually low valuation. The company has an attractive reserve life of 13 years and over 300 drilling locations. Its proved reserve value is $110 million (net of all debt) or $0.42 per fully diluted share, over 2.5x the share price. The proved and probable reserves are estimated at over $200 million or $0.75 per share, nearly 5x the share price. The company should at least be trading for its proved producing value of over $0.30 per share. As time passes, the concerns regarding the company’s balance sheet (and formerly unsupportive banking relationship), impact from dilution, and production glitches should dissipate.

American Eagle Outfitters has been impacted by weak apparel selling prices from suffering competitors. As this pressure abates, the company’s results should shine through. Jay Schottenstein, who was responsible for years of the company’s growth, has returned as CEO. The Aerie chain continues to grow its same-store-sales smartly, and with stores in only 13 states, it should have a long runway ahead. The company has over $2 per share of net cash, sells basics including denim and sells at a low multiple of free cash flow. Our FMV estimate is $23.

Our top holdings in our All Cap portfolios also include large caps Hanesbrands, Goldcorp, 21st Century Fox, Eastman Chemical and Berkshire Hathaway, which are discussed below in our Global Insight portfolio review.

Our All Cap Portfolios – Portfolio Changes

In the last few months, we bought several new large cap positions including Goldcorp, Facebook, American Eagle Outfitters and Dollar Tree, and we sold, then bought back, Hanesbrands after it fell through a TRACTM floor to its next floor—all summarized in our Global Insight portfolio review below. We sold Viacom and General Motors as both triggered sell signals falling below their respective TRAC™ floors and sold Fiat Chrysler Automobiles as it ran up considerably to a TRAC™ ceiling, close to our FMV estimate.

Global Insight (Large Cap) Portfolios – Key Holdings

Global Insight represents our large cap (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) model where portfolios are managed Long/Short or Long only. A complete description of the Global Insight Model is available on our website. Our target for our large cap positions is more than a 20% return per year over a 2-year period, though many may rise toward our FMV estimates sooner should the market react to more quickly narrow their undervaluations. Or some may be eliminated if they decline and breach TRAC™ floors.

At about 84 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear to be cheaper, in aggregate, than the overall market. Because of the run-up in stocks, and the fact the overall markets are fairly valued, we are finding fewer investment opportunities and therefore are holding much more cash than usual. ProShares Short S&P 500, given our negative near-term outlook, is about a 7% weighting in most 100% Global Insight accounts. This is a long position in an ETF which mirrors the inverse performance of the S&P 500 (i.e., if the market declines the value of this position increases) on a daily basis. With the market at record highs, in line with its FMV and at a ceiling in our TRAC™ work, it remains a simple way of hedging a correction in the U.S. market. Though, in our view, we remain in a bull market; therefore, we would look to eliminate this position in the next correction. We prefer to only short when our macro tools suggest overall market risks are elevated.

Shortly after selling Hanesbrands we repurchased it. Hanesbrands, an apparel manufacturer and marketer, has a portfolio which includes, among others, Hanes, Champion, DIM, Maidenform, and Playtex. The company’s globally owned supply chain, strong brands and economies of scale form an impressive moat. The stock price fell after disappointing Q4 results due to weak store traffic and lower orders from a large customer that brought inventories down to record low levels. We expect earnings growth over the next few years from acquisitions, growth of its online business, and cost synergies. Citing the “dislocation” in the current stock price, management is poised to execute a significant share buyback. A Trump tax plan that could lower corporate tax rates but impose import tariffs would be a net negative for Hanesbrands. Our FMV estimate is $28.

Berkshire Hathaway, with the rally in financial shares, is closing in on its TRAC™ ceiling and our FMV estimate. The company continues to grow its value, with book value up over 8% in the most recent quarter. Meanwhile, Berkshire’s ever-increasing substantial cash hoard could fuel additional growth while providing downside protection. Berkshire could certainly be the beneficiary of any material market sell off which would provide the company with acquisition opportunities.

Goldcorp was purchased when gold sold off in late December. Since then, the price of gold has rebounded by 10% lifting most gold shares. Goldcorp still trades at a 20% discount to our estimate of its FMV. While the company’s production has declined in the recent past, we expect reasonable production growth in the next few years. Meanwhile the company has been lowering its all-in sustaining costs—still likely the lowest of all of the major producers at $747 per ounce last quarter. And the company has a renewed focus on growing its NAV per share from mine site and corporate efficiencies along with reserve additions.

When we bought Apple a few months ago we noted that at 12x forward earnings investors were not paying the respect it deserved given the company’s continued dominance of high-end smart phones, envious margins and an iPhone 8 super cycle ahead. Just a few months later—despite no developments other than an in-line quarter—Apple has risen very close to our FMV estimate. The market’s sudden enthusiasm for Apple is a good reminder of how expectations can change so quickly—even for the largest company in the world. As value investors, we seek to exploit such mispricing and volatility. We are likely to part with our Apple shares in the near future and deploy proceeds into another company where the risk/reward is more favourable.

Eastman Chemical has ascended to a TRAC™ ceiling. We have grown more constructive on the business as it appears the strong performance of its Advanced Materials division will likely continue throughout ’17. On the flip side, Eastman’s Fibers business is facing challenges relating to Chinese destocking. Earnings for this year should hit $7.30, an 8% increase over last year. Our FMV estimate is now $90, still a bit higher than the current share price.

acebook, the social media giant, is a newly added position. With a price-to-earnings ratio of 24x forward estimated earnings, Facebook may not fit the typical value stock profile. However, when Facebook fell below $120, the growth expectations in the stock were far below what we believe the company will likely achieve over the next few years. Q4 revenue grew 51% over last year. Facebook monthly active users (MAU) hit 1.86 billion, up 17%. Facebook’s Instagram and WhatsApp have 600 million and 1.2 billion MAUs, respectively. Average revenue per user in Q4 was $4.73 and we see numerous levers to raise this going forward. The stock has been strong, rising to an all-time high recently, but still trades at a discount to our FMV estimate of $160.

Liberty Media (Sirius XM) is a tracking stock (LSXMK) for Sirius XM. Sirius shares have lifted to trade in line with our estimate of its FMV. While LSXMK has risen too, it still trades at a 15% discount to its holdings of Sirius, implying an estimated FMV of about $45 per LSXMK share. While the discount has narrowed, it’s still too large and remains a source of aggravation for Liberty management. We continue to believe the disconnect in price will narrow further. Sirius’ growth continues having recently reported a 3% rise in average price per unit, a 24% lift in annual EBTIDA, and guiding to over 10% EBITDA growth and $1.5 billion of free cash flow. Liberty’s only asset is its ownership of about two-thirds of Sirius, and Liberty’s position keeps rising with Sirius buying back its own shares fueled by ongoing free cash flow.

ohannesburg listed Naspers is the largest company in Africa. Its value is primarily derived from its holdings in Tencent—one of China’s leading internet companies. Tencent is a broadly based social networking platform with over 800 million users. Tencent has a 50% market share in China’s online games market and its primary brand, WeChat, has been growing dramatically. Tencent grew its revenue by over 50% in its latest quarter. While Tencent itself trades at a discount to our FMV estimate, Naspers, which owns just over one-third of Tencent, trades at a more substantial 30% discount to our Naspers’ FMV estimate when we include its cable and internet based investments and account for full capital gains taxes on its Tencent holdings. If Tencent were to rise by 25%, to our projected FMV looking out 12 months, Naspers could rise much more assuming it reaches its FMV.

21st Century Fox continues to grow nicely, despite concerns regarding cord cutting and its more volatile filmed entertainment segment. The company has a good combination of original programming (e.g., Modern Family, Homeland and various film titles) and exclusive rights (e.g., NFL, College Football, MLB). Fox News remains the number one news channel and Trump should continue to have a positive impact on viewership (it’s hard to look away). Closing the Sky acquisition and new programming should also add to underlying value. Our sum-of-the-parts valuation provides us with an estimated FMV of $36.

Global Insight (Large Cap) Portfolios – Portfolio Changes

n the last few months, we bought several new positions (most noted above in our top ten holdings) including Goldcorp, Facebook, Dollar Tree and Hanesbrands which we sold, then bought back, after it fell through a TRACTM floor to its next floor. We sold Viacom and General Motors as both triggered sell signals falling below their respective TRAC™ floors and sold Fiat Chrysler Automobiles as it ran up considerably to a TRAC™ ceiling, close to our FMV estimate.

Dollar Tree is North America’s largest single-price-point retailer, operating under the Dollar Tree and Family Dollar banners. We have long admired Dollar Tree’s business and impressive operating metrics. When its shares declined below $80 we saw an opportunity to purchase it at more than a 20% discount to our FMV estimate. Third-quarter results marked the 35th consecutive quarter of positive same-store sales. As a predominantly U.S.-focused business with a tax rate close to 37%, Dollar Tree stands to benefit from a reduction in the Federal tax rate, though changes to interest rate deductibility and import tariffs could offset tax savings. The company could still incur undue costs associated with the integration of Family Dollar stores though they appear confident in achieving significant synergies.

Income Holdings

The 10-year U.S. government bond yield is 2.4%. The Canadian equivalent is 1.7%. While still likely to rise from relatively low levels, the recent rise may have come too far too quickly. After rising to about a 10% yield early last year, high-yield corporate bond yields have now fallen all the way back to 5.8%. Because we believe rates are likely to rise over time, and yields in general are low, we have been finding fewer attractive opportunities than usual for our income accounts.

Accordingly, we have been holding a larger than usual portion of the accounts in cash while we await more favourable investment opportunities.

We bought one new position recently—the Morguard North American Residential REIT. The REIT yields 4.4% but trades well below our estimate of its FMV. And, it has significant room to lift its dividend payout. It owns 46 multi-family apartment buildings in Canada and the U.S. where it collects steady income. The REIT is growth oriented with a focus on acquiring high-quality apartment properties. We were pleased to see other similar REITs acquired recently at prices which justify our estimated FMV.

Our IBI Group 7% Notes matured on December 31 and our Uniserve Notes were extended to March 31, 2017 and began paying interest again in January.

We continue to hold a number of undervalued income positions and collect outsized interest income on these positions due to the depressed prices. Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of over 8%.

Of note, regarding our top holdings in our income accounts: Specialty Foods, now an equity holding of a private company, is planning to return capital to us (see the reference under All Cap holdings above); Advantex Marketing debentures maturity was revised to March but it remains well secured by the company’s asset base; Manitok collateralized notes are well covered by its reserve base; JAKKS Pacific’s convertible bonds may benefit from the possibility of a buyout; Ruby Tuesday’s bonds are well covered by underlying real estate; Enerdynamic Hybrid Technologies’ interest payments remain in arrears but the asset value is above the outstanding secured debt; Morguard North American Residential REIT is a discount to its peers; Care Capital Properties REIT’s income stream is non-cyclical and growing; Northwest International Healthcare Properties REIT’s units and bonds are underpinned by a stable income stream; and, Calfrac bonds, where the recovery in oil price should bolster earnings.

When It Breaks

Economist Herb Stein quipped, “Trends that can’t continue, won’t.” So we watch for the inevitable end to the bull market—for the next recession, using our economic composite and for the market panic that normally follows, using our market momentum indicator. Meanwhile, both remain positive and appear far from alerting us to bear markets in most regions around the world. We also closely monitor our TRACTM signals for the overall markets, for a negative inflection from a ceiling and to embrace the trend in place. Currently, the U.S. market is at a ceiling and a bit overvalued, based on our TVMTM work.

Next month the S&P 500 will make history for the longest (from the ’09 low) bull market—without a correction in excess of 20%. However, this is nuanced because it fell 22% on an intra-day basis in a 6-month period ending in October ’11, but only 19% on a closing basis. And there was clearly a bear market in broader U.S. indexes. For example, the Russell 2000 fell 27%, in the decline which ended early last year and, while the S&P 500 fell 15%, the median stock fell 25%.

We have not been finding nearly the same number of investment opportunities as usual. While we prefer to be fully invested, perhaps the markets are indicating there may be a better opportunity ahead to become fully invested. Given the full valuations of the equity indexes and current overbought levels, we remain comfortable being underinvested in our growth accounts in equities. Believing, as we do, that we are in a prolonged economic cycle, we welcome any correction to provide us the investment opportunities to be more fully invested.

Meanwhile, if some of the recent positive trends reverse, and our tools alert us, we won’t be shy about attempting to diminish and, where we are authorized, hedge off risks.

The term “trend” now has a broader use. Trending is a term used in reference to the buildup of posts on social media. And we find ourselves in a day and age when the leader of the free world is posting using stream of consciousness—annoyingly against a department store that no longer supports his daughter’s line of clothing or worse, tweeting against judges who disagree with his policies. This is a trend we shouldn’t miss.

And there are plenty of past trends we don’t miss. Like mohawks, avocado green appliances or shag carpet. The complete saying we noted above is, “The trend is your friend until the end when it breaks.” We will miss the upward trending market once the current trend breaks so we’ll try our best to choose our friends carefully.

Herbert Abramson and

Randall Abramson

February 24, 2017