“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

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

Shar

e of

Tot

al E

TF A

sset

s

S&P

500

Inde

x

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

4

Bear case: High valuations

5

0%

50%

100%

150%

200%

250%

$0

$5,000

$10,000

$15,000

$20,000

$25,000

1970q4 1980q4 1990q4 2000q4 2010q4

Wils

hire

500

0 / G

DP

Wils

hire

500

0, $

billi

ons

Wilshire 5000 Total Market Cap / GDP 1971-2017

Wilshire 5000 Wilshire 5000 / GDP

Tech bubble

Stimulus bubble

Credit bubble

Bear case: Extreme bullish sentiment

6

-50

-25

0

25

50

75

0

500

1000

1500

2000

2500

Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Dec-16

% B

ulls

- %

Bea

rs

S&P

500

Inde

x

Investors Intelligence: % Bulls - % Bears 2005-2017

% Bulls - % Bears S&P 500 Index

Bear case: Extreme leverage

7

-$300,000

-$200,000

-$100,000

$0

$100,000

$200,000

$300,000

0

400

800

1200

1600

2000

2400

Dec-89 Dec-93 Dec-97 Dec-01 Dec-05 Dec-09 Dec-13

Cus

tom

ers'

Acc

ount

s N

et C

ash,

$ M

illio

ns

S&P

500

Inde

x

NYSE Customer Accounts - Net Cash Balances 1990-2017

Net Cash Balances, $Mil S&P 500 Index

Bear case: Low cash levels

8

0.0%

4.0%

8.0%

12.0%

16.0%

20.0%

0

500

1000

1500

2000

2500

Dec-84 Dec-88 Dec-92 Dec-96 Dec-00 Dec-04 Dec-08 Dec-12 Dec-16

Equi

ty F

und

Cas

h

S&P

500

Inde

x

Equity Fund Cash Levels 1984-2017

S&P 500 Index Equity Fund Cash, %

Bear case: Low price of portfolio insurance

9

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

Impl

ied

Vola

tility

, %

S&P

500

Inde

x

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

10

11

Keys to economic prosperity 12

Economic freedom Respect for private

property Expanding division of

labor Delayed gratification

13

Print, print, print 14

Spend, spend, spend 15

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 out of it.” ~ Virgil Jordon, Business Week economist, 1932

16

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.”

17

Ben Bernanke November 8, 2002

Timothy Geithner January 27, 2010

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

18

-20%

-10%

0%

10%

20%

$0

$1,000

$2,000

$3,000

$4,000

1914 1918 1922 1926 1930 1934 1938

Annu

al M

oney

Sup

ply

Gro

wth

Hol

ding

s, $

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 19

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

20

21

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

22

Instant gratification Financial engineering – stock buybacks

23

-100%

0%

100%

200%

300%

400%

500%

600%

0

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

Stoc

k B

uyba

cks

/ Fre

e C

ash

Flow

Stoc

k Pr

ice

Quarter Ended

Aeropostale Annual Buybacks / Free Cash Flow

Stock Buybacks / Free Cash Flow Stock Price

Instant gratification Financial engineering – debt-fueled M&A

24

-$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

Cas

h +

Floa

t, $M

il

Stoc

k Pr

ice

Quarter Ended

Valeant Pharmaceuticals Net Cash + Float

Net Cash + Float, $Mil Stock Price

Instant gratification Financial engineering – debt-fueled M&A

25

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

Inte

rest

Exp

ense

R&

D E

xpen

se

Quarter Ended

Valeant Pharmaceuticals R&D Spending vs. Interest Expense

Interest Expense / Revenue R&D Expense / Revenue

Short selling landmines: Delayed gratifiers / disruptors

26

27

Short themes: Discretionary consumption + aggressive financing

28

Short themes: Auto finance

29

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

Fina

nce

Rat

e

Mot

or V

ehic

le L

oans

, $bi

l

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

30

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

31

-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

Con

sum

er P

rice

Inde

x, Y

oY

10-Y

ear G

erm

an Y

ield

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 of 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 on the 10-year is 25 or 30 basis points.”

32

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… 33

Mises anticipates Bank of Japan 34

0%

5%

10%

15%

20%

0

10,000

20,000

30,000

40,000

Dec-84 Dec-89 Dec-94 Dec-99 Dec-04 Dec-09 Dec-14

Dis

coun

t Rat

e

Nik

kei 2

25 In

dex

Bank of Japan Discount Rate vs. Nikkei 225 Index 1985-2014

Nikkei 225 Index BoJ Discount Rate, %

Mises anticipates Bernanke/Yellen Fed 35

0%

4%

8%

12%

16%

20%

0

500

1000

1500

2000

2500

Dec-92 Dec-96 Dec-00 Dec-04 Dec-08 Dec-12 Dec-16

Fed

Fund

s R

ate

S&P

500

Inde

x

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… 36

GRANT’S SPRING 2017 CONFERENCE – MARCH 15, 2017

Bearing Asset Management