1 SANDPOINTE

SandPointe Investment Perspective

Roger E. Brinner, PhD Chief Market Strategist and Co-founding Partner September 2014

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SandPointe Investment Perspective By Roger E. Brinner, Chief Market Strategist

The Fundamental Investment Strategy View from Our “One-Armed” Economist

President Harry Truman famously asked for a one-armed economist so that he could get an unequivocal, fact-driven assessment, rather than hearing “on the one hand…., but on the other hand…” In this, SandPointe’s first Investment Perspective, you’ll get this treatment.

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SandPointe Investment Perspective By Roger E. Brinner, Chief Market Strategist and Bryce Quillin, Chief Economist

• US equities will benefit from another year of profit growth and P-E ratio expansion - Real GDP growth in the US is shifting from 2% to 3+% real growth rates) unlike others who have prematurely predicted

acceleration, I have waited until the fiscal policy corrections were digested and wealth had been rebuilt to make this call - Confounding pundits who have repeatedly, mistakenly projected an imminent peak in profit margins for years (just

because the profit/GDP ratio was higher than “normal”), profits will rise more rapidly than GDP based on rising capacity utilization rates, price inflation still exceeding unit labor cost growth, and diminishing interest burdens

- Even if, as we believe, the competing 10-year Treasury yield is headed toward 3.5% or more within three years, this would still easily align with a trailing PE ratio of 23-plus versus 19 currently. 23.5, for example, implies an earnings yield (the inverse of the PE) of 4 ¼% that would still exceed T-bonds, and then the equity investor also gets earnings growth and the bond investor gets nada

- Another way of stating this is that the equity risk premium is still exceptionally, unjustifiably large and is taking its sweet time shrinking, even though the risk premia in bond markets are now at relatively low levels (e.g. the corporate Baa is 2.2% above the 10-yeaar Treasury versus 5.6% in 2008); Putin has scared the equity markets but they can rally strongly after his threats to Europe have been sized up and stabilized

• Long-term Treasuries are “dead men walking” for the next 3 years: everyone should know the real after-tax return will likely be negative yet such bonds still sit prominently in portfolios - A year from now, the 10-year Treasury yield will be near 3% versus less than 2 ½% today, producing a 1 ½% total return

with a capital loss of 1% offsetting the meagre coupon - Subtract 3% cost inflation and you’re underwater if you’re an endowment - Subtract 40% income taxes and 2% price inflation if you’re a consumer, so welcome to the investor scuba-diving team - Three years from now the federal funds rate will be at least 3% (2% inflation target plus 1-2% real return at cyclical peaks)

and I judge the 10-year Treasury will be closer to 4%, thus more capital losses to offset historically abysmal coupons - Why would a prudent investor accept such returns when the implied bond-equivalent long-term equity return is at least

11%: the 5 ¼% current earning yield (i.e. 19 PE) plus sustainable earnings growth of 6%?

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Equity Prices Respond to Four Fundamentals

Absolute and relative performance of US and global regional

equities

Earnings (Primarily Past 2 Years)

Competing Yield On “Risk-free” Sovereign Fixed Income

Perceived Risk/ Uncertainty of Earnings Due to Stage of

Business Cycle

Additional Risks Due to Abrupt Changes in Regulations or

Global Shocks

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Profit Growth, Plus a “Super-Rotation” from Risky Treasury Bonds to Equities, Continues to Bode Well for US Share Prices

-5

0

5

10

15

1981

1986

1991

1996

2001

2006

2011

2016

Bond Yield - Earning Yield

10-Year Treasury Yield

S&P 500 Earnings Yield (E/P Ratio)

History Forecast

INCREASING RISK AVERSION REVERSION

TOWARD NORMAL RISK AVERSION

SPREAD WITH NORMAL RISK AVERSION

April 2013 Forecast for S&P 500 price increase to Q2 2014:

+26.2% Actual gain:

+25.5%

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Central Banks Dominate Short-and Long-term Interest Rate Behavior, Responding to their Legislated Mandates to Control Inflation and Growth

Short-term interest rates

Job Growth

Core and Overall Inflation

Exchange Rate

“Quantitative Easing”

The Fed, the ECB, the Banks of England and Japan, and their Global Peers All React to National Conditions, with

identifiable national sensitivities and timing/patience

Additional Forces Critical to Sovereign Bond Yields

Government Deficits

Potential Election Impacts

Special Crisis Situations

Long-term treasury rates

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-6-4-202468

101214161820

-6-4-202468101214161820

1960

Q1

1962

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1964

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2016

Q1

2018

Q1

Fed. Funds Rate10-Year Treasury Note Yield

Policy Indicator: Job Growth+Inflation

The Economic Indicators Watched by The Fed Are Calling for Rate Increases and Bond Markets Began Responding Last Year

Bond Yield and Fed Funds Rate vs. Policy Indicator (Sum of Inflation and Employment Growth (1960-2018)

Extraordinarily Low Funds Rate 2009-2014

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The Fundamental Investment Strategy View from Our “One-Armed” Economists (continued)

• In dollar terms, commodities also shouldn’t offer any momentum plays to the investor • With the European Central Bank dropping euro interest rates as US rates rise, the dollar strengthens: it logically and

empirically gains about 8% for each additional point of the US-Euro bond spread • Restrictive Japanese fiscal policy and Chinese growth targets also require easy monetary policy • Other things equal, within 6-12 months, each percentage point rise in the dollar against a currency basket cuts dollar-

denominated commodity prices for industrial metals, farm products, chemicals, and energy by 7-9% • Gold and precious metals will be hard pressed to hold their value in a strong dollar, rising interest rate environment

• Looking beyond mid-2015, there are reasons for concern • Know these two facts of postwar economics: 1) the US has never had a recession that wasn’t preceded by significant Fed

tightening; and 2) the Fed has never raised the funds rate by 3% without causing a recession (classic declining real GDP recession or moderate “growth recession” with rising unemployment due to too-tepid GDP growth)

• The Fed has announced it will raise rates beginning next year and continue until normal rates are established • The normal peak would be 4 ½% in that the inflation is targeted at 2% and the average funds rate when unemployment is

under 6% (cyclical peak periods) is 2.6% above inflation; I expect a slightly lower 2018 peak in the 3 ½% to 4% range • As a result of this moderation, and the absence of a preceding overheated boom, I expect only a growth recession with

2% real GDP growth, slightly rising unemployment, and a brief profit retreat • In other words, 2016-2018 will be an extended balancing act by the Fed as it seeks to temper growth without reversing it;

the mid-1990s are the best example of a successful maneuver of this type by the Fed • Both equity and bond returns are likely to be low and volatile in this future stretch until the Fed’s degree of success is

learned

SandPointe Investment Perspective By Roger E. Brinner, Chief Market Strategist and Bryce Quillin, Chief Economist

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Global Economic Factors Drive All Commodity Prices, and Unique Supply Forces Impact Oil Prices in Particular

All Commodities: Farm, Metals,

Plastics, Energy, Chemicals

Oil Prices

Global Growth

General Inflation (GDP Deflator)

Dollar Exchange Rate

OPEC Oil Production

Non-OPEC Oil and Gas Production

Common Demand Forces Affecting All Commodity Prices

Additional Supply Forces Affecting Oil Prices

New Technology for Oil and Gas

The “noise” of severe weather, strikes, catastrophes, and other crises is dominated by these discrete fundamentals when the investor prudently

steps back from daily and weekly data

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Commodity Prices Have Cycled Massively, Consistent with Historical Patterns

• All commodities are driven by three shared fundamentals: − Exchange rate of dollar

vs. other currencies − Global economic activity − Trends in global GDP

price

− Note that in the graph, the simple sum of these 3 factors very closely matches the behavior of the average materials price index

− Our econometric model creates a weighted sum that matches even better

Source: Global Insight, BLS, IMF

0.50.60.70.80.91.01.11.21.31.41.51.61.71.81.92.02.12.22.32.42.5

1988

Q1

1989

Q1

1990

Q1

1991

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1992

Q1

1993

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2010

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2012

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2013

Q1

2014

Q1

2015

Q1

All

Pric

es R

elat

ive

to 1

990

Ave

rage

s In

dexe

d to

199

0=1

GDP Deflator

Exchange Rate

Average Materials (Farm, Metals, Chemicals) excluding Oil

Industrial Capacity Utilization

Simple Sum of 3 Factors

Drivers of Wholesale Materials Prices, 1988-2013

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Commodity Prices Move in Parallel, with the Exchange Rate Acting as a Dominant Common Force

Source: Global Insight, BLS, IMF

Historic U.S. Wholesale Prices of Key Crude Commodity Groups, 2001-2015

-30

-20

-10

0

10

20

30

40%

-90

-60

-30

0

30

60

90

120120%

2001

Q1

2002

Q1

2003

Q1

2004

Q1

2005

Q1

2006

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2007

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2008

Q1

2009

Q1

2010

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2011

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2012

Q1

2013

Q1

2014

Q1

2015

Q1

Infla

tion

vs. Y

ear A

go

Farm ProductsChemicals

Oil Prices (Right Scale)

Exchange RateMetals

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Looking Beyond Mid-2015, There Are Reasons For Investor Concern Because The Economy Responds Predictably, Logically Strongly To Policy Shifts

National Output, Employment,

Interest Rates, Exchange Rates

and

Differentials versus Other

Nations/Regions

“Business Cycles” with predictable

sequences of strength and

weakness for each asset class

Monetary Policy

Fiscal Policy

Trade and Capital Policy

Regulatory Policy

If the wise investor looks beyond the noise of weekly data releases, trustworthy signals --patterns based on good logic and theory-- are apparent and thoroughly investable

Technology and Entrepreneurial Zeal

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Monetary Policy is Particularly Important: In the Postwar Era, Recessions Are Nearly Perfectly Paired with Preceding Federal Funds Rate Increases

Source: Global Insight, BLS, IMF

Federal Reserve Rate Increases Always Precede Every Recession

0

5

10

15

20

0

5

10

15

20

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2013

Q1

2016

Q1

Unemployment RateFederal Funds Rate

The only rate increase not followed by a classic recession occurred in the mid-1990s

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The Case for the Long-Awaited Acceleration of US Growth Improvement From 2013 to 2014 -2015 Reflects Clear Major Forces

The range of bad events has been greatly reduced, encouraging employment, consumer spending and investment

Global growth struggled in 2013 o The Euro-zone was in recession due to ultraconservative and late policy changes o The emerging nations felt the burden of higher bond rates and slow G-7 Growth

Fiscal policy was very restrictive in 2013, an adverse force equal to 2% of US GDP then but greatly moderated to only 0.5% now

2014 and beyond will see far higher growth o The extremely harsh winter grossly distorted Q1 in the US, but the loss is temporary, and

the official Q1 data probably overstated the weakness o Rising asset and property values leading to substantially improved consumer spending and

business investment & acquisitions o US housing legitimately, sustainably rising 10%+ per year o Europe is on the mend: positive growth soon to be aided by monetary policy stimulus o Asian growth will be fuelled by consumers as well as exports

15 SANDPOINTE

Fear/Uncertainty Greatly Reduced, First In North America And Then In Europe

Euro Will

Collapse US

Fiscal Cliff

War with Iran

2nd Great Depression

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2013

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2014

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2015

Q1

2016

Q1

Euro Periphery (PIIGS) Bond minus German Bond

Corp. BAA Bond minus 10-Year Treasury

Sum of Key SpreadsHistory Forecast

Bond Spreads, Reflecting Fears of Truly Bad Events, Now Markedly Lower

Stronger Hiring, Consumer & Capital Spending

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US Growth Strengthens as Fiscal Restraint Is Diminished and the Harsh Winter Effect Lapses

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-2

0

2

4%

-4

-2

0

2

4%

2007

1.8

2008

-0.3

2009

-2.8

2010

2.5

2011

1.6

2012

2.2

2013

2.2

2014

2.2

2015

2.9

2016

2.3

Perc

enta

ge P

oint

Con

trib

utio

n to

Rea

l GD

P G

row

th

Real GDP

Total Fiscal Stimulus or Restraint

Changes in Real GDP and Fiscal Changes as % of Prior Year Real GDP

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0

100

200

2014 Winter

1989

1994

1999

2004

2009

2014

This Was The Coldest Winter In 25 Years, And Cut The Q1 Real GDP Growth Rate By ~1.5%

1st Quarter Deviation From 1985-2013 Average Temperature (“ Heating Degree Days” with Reverse Sign)

Unusually Mild Winter

Unusually Cold Winter

18 SANDPOINTE

The Q1 GDP Figures Show Huge Drags on Final Demand from the Harsh Winter, Plus Strangely Weak Initial Estimates of Inventory Accumulation and Net Exports

Contributions to GDP growth, percentage point annualized rates

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0

2

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6

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-2

0

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6

12Q

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3

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4

15Q

1

15Q

2

15Q

3

15Q

4

Real GDPInventoriesNet Exports

Final sales to domestic purchasers

Discretionary Consumer Spending

Source: Commerce Department

history forecast

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70

75

80

85

90

95

100

105

110

115

120%

Jan-

13

Feb-

13

Mar

-13

Apr-1

3

May

-13

Jun-

13

Jul-1

3

Aug-

13

Sep-

13

Oct

-13

Nov

-13

Dec

-13

Jan-

14

Feb-

14

Mar

-14

14-A

pr

14-M

ay

Cons

umer

Spen

ding

,Inf

latio

n-A

djus

ted

(Per

cent

of20

12Av

erag

eM

onth

)

Bicycles

Garments

Health Care

Furniture/furnishings

All Durable Goods

Restaurants

Major householdappliances

New Autos

New Light Trucks

Almost All Discretionary Markets Were Hurt By The Cold Weather Last Winter, But Rebounded To Recovery Trend In March

20 SANDPOINTE

-30

-20

-10

0

10

20

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Industrial production,manufacturing

Real GDP, Goods Sector

The Officially Estimated Q1 GDP Drop Is Likely Exaggerated The Commerce Department’s Estimate Of Goods GDP Plunged In Q1, But The Federal Reserve’s Estimate Of Manufacturing Production Did Not

Real GDP in the goods sector and industrial production in manufacturing, annualized real rate of growth, Q/Q, percent

Source: Commerce Department, Federal Reserve

21 SANDPOINTE

-6-5-4-3-2-10123456

7%

-30-25-20-15-10-505101520253035%

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Real Consumer Spending

Consumer Sentiment (right scale: 5x)Household Net Worth (right scale: 5x)Disposable Income

Income, Consumer Finances, and Psychology Drive Spending in Systematic Patterns That Held True to Form Even Through the Great Recession

Source: Parthenon analysis; Bureau of Economic Analysis

Growth in Real Consumer Spending and Key Drivers, 2002-2016

Consumer Spending

Income Net Worth Psychology

Improving Wealth and Sentiment Offset the 2013 Tax Burden on Consumers, Setting the Stage for Strong Growth in Coming Years

Note that consumer spending growth is quite different from

income growth when wealth is moving in the opposite direction

22 SANDPOINTE

0

50

100

150

200

250

300

350

$400K

1965

Q1

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1969

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1991

Q1

1993

Q1

1995

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2005

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2009

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2011

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2013

Q1

2015

Q1

2017

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2019

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Infla

tion-

Adju

sted

Net

Wor

thpe

rAdu

lt(T

hous

ands

of$U

S)

Real Net Worth per Adult (2012 prices)2.2% Real Growth Trend from '72-'00 Peaks2.0% Real Growth Trend from '74-'91 Troughs

99% Of The Maximum 2007-2009 Real Wealth Destruction Has Already Been Reversed with More Growth to Come

Source: Parthenon analysis; Federal Reserve

History Forecast

The Peak-to-Trough Loss Was an Exceptional 23% (’07Q1 to ’09Q1)

23 SANDPOINTE

0

5

10

15

20

25

30

35

40

45

50%

RecordLow Prices

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

Sha

reof

Typi

calH

ouse

hold

Inco

me

Existing Housing

New Housing

Strong Home Demand Will Help GDP Directly and by Bolstering Furniture, Appliance and Vehicle Sales Though Home Prices Are Rising, Housing Remains At Historically Attractive Levels Of Affordability

0

20

40

60

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120

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$260K

Q4

2005

Q4

2006

Q4

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Q4

2008

Q4

2009

Q4

2010

Q4

2011

Q4

2012

Q4

2013

Median New Home Sale Price

Median Existing Home Sale Price

Source: U.S. Census Bureau; National Association of Realtors; BEA; Federal Reserve; Parthenon Analysis

New Home and Existing Home Sale Prices ($K), 2005–2013

New and Existing Home Prices as Share of Typical Household Income, 1996-2013

Carrying cost assumes 80% loan-to-value mortgage, at

prevailing income levels and mortgage rates

24 SANDPOINTE

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020

Ann

ualC

hang

e(M

illio

ns)

Net New DwellingsAdded

Housing Starts+Manuf. HomesAdult Population Growth/1.8Household Growth

U.S. Housing Remains Weak, But Demographic Demand Necessitates A Long, Major Recovery

• Almost 300,000 units are demolished per year (0.3%) and our household growth is 1.3 million, implying annual long-term demand for 1.6 million new units constructed

Source: Parthenon Analysis; Global Insight

Excess construction versus household

formation Inadequate

construction versus household formation

History Forecast

25 SANDPOINTE

Monetary Policy is Particularly Important: In the Postwar Era, Recessions Are Nearly Perfectly Paired with Preceding Federal Funds Rate Increases

Source: Global Insight, BLS, IMF

Federal Reserve Rate Increases Always Precede Every Recession

-5

0

5

10

15

20

-5

0

5

10

15

20

1959

Q1

1962

Q1

1965

Q1

1968

Q1

1971

Q1

1974

Q1

1977

Q1

1980

Q1

1983

Q1

1986

Q1

1989

Q1

1992

Q1

1995

Q1

1998

Q1

2001

Q1

2004

Q1

2007

Q1

2010

Q1

2013

Q1

2016

Q1

Unemployment RateFederal Funds Rate

The only rate increase not followed by a classic recession occurred in the mid-1990s