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July 24_ 1996


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									                               Paladin Investment LLC
                                        I n ve s t m e n t Ad vi s o r
                                      1 3 2 1 5 SE 4 9 th St re e t
                                      B el le vue , W A 9 800 6

                                                                         Telephone: (425) 747-8301
PALADIN INVESTMENT LLC, IS A                                                     ________
                                                                         Facsimile : (425) 747-2978

                                 Inte rest Rates Continue Falling
                                         September 29, 2011
                                  Robert P Porter & Ronald Stein
The economy is clearly slowing down. Government statistics such as GDP and the
employment numbers have now begun to capture this slowdown. The stock and bond
markets have provided ample evidence for months. Retailers and technology companies
like Home Depot and Gateway Computer have warned that sales are slowing. Both
short-term and long-term interest rates have been falling significantly. The Fed has
acknowledged these facts by lowering the Federal Funds rate earlier this month.
The declines in the stockmarket (NASDAQ average down by 39% and the Dow down by
6%) were triggered by Fed rate increases over the last 18 months. The sharp run up in oil
prices has also contributed to the funk on Wall Street. Popular wisdom says that oil price
increases are inflationary; just the opposite may be true. Currently, most manufacturers
are unable to raise prices and the additional costs are coming out of profits. Rising oil
prices have been a tax on consumers who now have less money to spend on other things,
leading to a slowdown that has kept prices and profits in check.
The NASDAQ bubble has burst and most of these stocks will never return to their
previous high prices. Many non-technology stocks like the drugs, foods, and financials
are doing much better because their profits are more reliable. These companies have
substantial intrinsic value and their reasonable prices give investors considerable margin
of safety.
Our Monetary Model has gone from bearish to bullish during the last few weeks. This
model does not usually turn bullish before the Fed lowers rates, but the market has done
the Fed‟s job. Now Greenspan will have to catch up with the market. The model was
previously bullish from 1995 until last summer. The Dow Jones average tripled during
that period. Before that, the Fed eased money conditions in late 1990. From late 1990 to
early 1994, the Fed flooded the markets with money and the Dow Jones average
expanded by 63%. Once the Fed starts to lower rates, we can anticipate an extended
period of easy money that will be very positive for stock prices.
Stock Review

Interest Rate Sensitive Stocks
Interest rate sensitive stocks are the first to respond to rate changes due to market forces
and the Fed. Banks, brokerages, insurance companies, and homebuilders tend to do well
as rates drop. We own several of these stocks including Berkshire Hathaway, American
Express, Washington Mutual, New Plan Realty, and Clayton Homes. Of course a
company‟s fundamentals trump any market tendency. Banks with high loan losses may
not get much benefit during the early stage of the interest rate cycle. Strong banks that
are sensitive to the spread between short and long rates, like Washington Mutual, will get
quite a pop as rates drop. Inexplicably, companies like State Street exhibit interest rate
sensitivity even when their business is not sensitive to rates.
We have been buying interest rate sensitive stocks because they became inexpensive
when rates rose last year. The declines in many of these stocks were way overdone.
Now, like a compressed spring, many of these companies and their stocks are going to do

Economically Sensitive Stocks
Technology stocks are not helped by interest rate declines. Interest rates fall because the
economy weakens. Technology stocks are very sensitive to capital spending, which is
very sensitive to economic growth. Right now companies are rapidly reducing their
capital spending because the economy is slowing pretty quickly.
Tech stocks are the ultimate in strong economy stocks, which explains their runaway
performance last year when the economy exceeded its growth potential. Now, we are
getting the mirror image because the economy is slowing.
History teaches us that when overowned stocks like technology stocks hit a brick wall,
they do not recover quickly. We had a tremendous bull move in tech in 1982 – 1983.
When those stocks cratered, many of the favorites simply disappeared. Technology did
not recover for years afterward. Of course individual companies did well, but the vast
group of average tech companies did not recover quickly.
At the moment, we do not see much absolute value even though many stocks are down
50% to 90%. Cisco, Oracle, and others still sell at huge premiums to their historical
valuations as measured by a 10-year average of their P/E ratio. I predict that many of
these stocks will sell for P/E‟s at or below their historical range before this tech bear
market ends. Be patient, tech investing is a minefield right now.

Large Versus Small Cap Stocks
Quality large capitalization stocks are selling at an average P/E of over 30. Although
some are technology companies, most are not. Many of these large companies have had
steady earnings growth over many years, and are selling at two or more times their
average P/E ratios. General Electric is now selling at a P/E of about 40 compared to its
50-year average of 8 to 24. Of course GE is a different company today, but not too
different from what it was 5 years ago when it was selling at a P/E of 15. In contrast,
there are many quality small companies selling in the 8 to 15 P/E range at close to or

                                 P a l a di n I nve st m e n t L L C                          2
below their historic P/E ratios. In many cases their return on capital is comparable to
quality large companies. Typically their earnings are growing nicely, but tend to be
uneven because their businesses are not as diverse. The market is paying a large
premium for steady earnings with growth.
We had a comparable period in the early 1970s when we had the Nifty 50 stocks. These
were companies that were thought to be sound businesses whose reliable long-term
growth prospects justified almost any price as long as you owned them forever. Today‟s
large cap stocks are even more expensive. Some of those companies produced excellent
long-term results, but others like Xerox and Polaroid have been losers. All suffered
mightily in the 73-to-74 bear market.
Today‟s situation is not strictly comparable to the 70‟s because we do not have the high
levels of inflation and the serious oil shocks we had then. We do share the nifty- fifty
mindset for which the prices of many large cap growth stocks no longer accurately valued
their future prospects. Many of today‟s Nifty-50 have already fallen and many more are
ready for a fall as their profits are squeezed by high oil prices and a slowdown in the
economy. Quality small companies may also have a drop in profits, but their earnings are
lumpy anyway and their prices will tend to hold up pretty well.
Warren Buffet, referring to earnings quality, has said, “I‟ll take a lumpy 15% return over
a steady 12% return every time.” Sometimes the market pays too high a premium for
certainty and growth. This sure looks like one of those times.

Performance of the Super Model
It is really important to know that you are in a bull or bear market, and to act accordingly.
Marty Zweig1 of Wall Street Week fame developed two models (money and sentiment)
that attempt to provide the framework for bull and bear decisions. His principal findings
were that the stock market is a prisoner of the money and bond markets. Easy money
makes the world go around.
I (Porter) have continued Zweig‟s work without any attempt to track the vast number of
variables that Zweig followed. Life is too short for that. Instead I went after the big
picture. I have talked about these models before but now I want to show you just how
important a story they tell. First, I need to bore you with a brief description of the two
models and show you how I combine them into one big Super Model.
First, the Monetary Model is based on three interest rates - 3- month Treasury bill rates,
10-year Treasury notes, and 30-year Treasury bonds. Even if 30- year paper eventually
goes away, we will still be able to use the 10-year rates in this model. The markets
respond to changes in rates much more than the absolute level. Even if rates are low, the
stock market will have trouble if interest rates are increasing. I simply compare today‟s
rates to the average over the last year. I combine the rates of change to produce a number
that varies from 0 to 100. If the model is above 60, it is bullish; below 30, it is bearish.
Hey, it works! It is not rocket science but it gets the job done.

    M artin Zweig, “Winning on Wall Street”, Warner Bros, 1986. Zweig published a newsletter for 25 years that
    provided the data and original models that support this work. Unfortunately he quit publishing his newsletter about
    3 years ago.

                                             P a l a di n I nve st m e n t L L C                                          3
The second model is based on sentiment and psychology. We all realize that sentiment is
important, but in a perverse way. If too many investors are excited about the market,
they have probably committed their cash. Conversely, if they are in a funk, they have
probably sold stuff and have money parked. There are several ways to track this. I use
weekly data from Barron‟s telling what fraction of investment advisors are bullish, what
fraction of individual investors are bullish, and what futures traders are thinking. I
combine this with some basic technical junk like volume and price action. I realize that
normally this stuff is overrated so I don‟t count it very much. However, it is
unquestionably true that sentiment and the tape, as traders refer to the daily fluctuations,
occasionally reveal major changes in market direction.
A good rule of thumb is to weight the monetary information 4 times the sentiment
information. The Super Model, which combines the monetary and sentiment models, is
scored from 1 to 10 where 6 points are bullish and 3 are bearish. Again someone else
might choose slightly different values but it does not make much difference. The
Monetary Model contributes a maximum of 8 points; everything else contributes at most
2 points.
Now we can get to the truly useful stuff. I have extracted all the market turning points
over the last 35 years. Every time the Super Model increased to 6, I noted the date and
the market index. The next time the model fell to 3, noted that date and the market index
and recorded it in the below table. I used special indexes that count every stock equally.
Before 1995 I used an index tracked by Zweig; after that date I used the Value Line index
published daily. The actual index is not too crucial; it is important to weight all stocks
equally. The left side of the below table shows all the bullish signals; the right side
shows all bearish signals. Each line in the table, except the first and last, is a complete
market cycle. On 11/16/66 the model went bullish; the index stood at 109. It had been
bearish since the previous March as shown in the first row on the right side of the table.
From March 10 to November 16, the index fell 12.8% in 8 months. During the next 20.6
months, the market rose 43.1% until the next bear market began on July 26, 1968.
Now suppose we religiously followed these signals and had all our money in the market
during the 13 completed bull phases. We would have been invested for 250 months out of
a possible 420 months. Our portfolio would have gained over 3700% or about 19%
annually before dividends and interest earned on the cash while we were out of the
market. Sounds great. Everybody would like to do this!
However, suppose we had the bad luck to only be invested during the bear markets that
lasted for 172.4 months out of 420. We would have lost an astounding 81% of our
capital, or $81 out of every $100 invested. You would think we owned only dot coms!
Investors love to boast about their gains at cocktail parties, but these losses are far more
important. In order to recover from such a loss, you must quintuple your money just to
break even.
Buy and hold is the mantra of 90‟s investing. Take a look at how well buy and hold has
worked in a broad index like the Value Line. The total gain would have been 616% or
we would have made 6 times our original investment in 35 years. This is an annual return
of only 5.8% before any dividends, probably about 9% when dividends are included. It
gets worse if our money was in a broad mutual fund with 1% expenses; more than 10%

                                 P a l a di n I nve st m e n t L L C                           4
of all our gains would have been paid in expenses. Blind buy and hold is no path to
investment riches.
Super Model
Buy Signals               Buy to Sell No. of          Sell Signals             Sell to Buy No. of
Buy Date         VLE      % Change Months             Sell Date         VLE % Change Months
                                                        3/10/1966          125      -12.8%          8
   11/16/1966       109        43.1%     20.6            7/26/1968         156        1.3%        1.2
    8/30/1968       158         9.5%      4.1           12/31/1968         173      -45.7%      17.1
    5/29/1970        94        31.9%     13.8            7/16/1971         124      -12.1%        4.2
   11/19/1971       109        11.0%      7.3            6/26/1972         121      -37.2%      19.9
    2/14/1974        76         2.6%      1.4            3/29/1974          78      -33.3%        7.0
   10/25/1974        52        76.9%     31.6            5/31/1977          92       15.2%      35.7
     5/6/1980       106        20.8%      7.3           12/12/1980         128        5.5%        0.5
   12/26/1980       135         6.7%      6.5            7/10/1981         144      -11.8%        2.4
    9/21/1981       127        60.6%     25.3           10/21/1983         204       -4.4%      12.0
   10/15/1984       195        53.8%     28.9             3/1/1987         300       -1.7%      26.4
     5/1/1989       295       -18.6%     16.0            8/24/1990         240      -10.4%        2.1
   10/26/1990       215        86.5%     40.8             3/4/1994         401        5.7%      16.7
    7/19/1995     528.4        91.1%     46.5            5/14/1999        1010       10.4%      19.1
    12/8/2000    1115.3
                                        250.3                                                  172.4
Avg Length                   Buy         19.3 Hold                                 Sell         12.6
Gain                         3746.8%          616%                                  -81.4%
Annual Gain w/o Divs           19.1%           5.8%                                 -11.0%

With the Super Model we can avoid the truly staggering losses in big bear markets like
technology investors are experiencing. When the model turns bearish we should get
defensive. We can hold more cash, buy more conservative stocks, and take losses more
quickly. Such a strategy can increase our annual return to about 12% annually, when
dividends are included. Over 35 years our money would multiply by a factor of 50 or
$10,000 would become $500,000. We can make a lot more money if we stay in tune with
the market and avoid truly crushing bear markets. The Super Model is not a panacea but
it can help us appreciate the risk.

Using the Super Model Next Year
Here is where it gets really interesting. All around us there is doom and gloom. The
NASDAQ has fallen 50% from its peak last March. The S&P500 and the Dow are down
about 10%. But look at the Super Model; it turned bullish on December 8 because of the
drop in interest rates and increasing bearish sentiment. With minimal inflation and no
more irrational exuberance, the Fed can lower interest rates substantially. No doubt they
will because the economy and the market are pushing them there.
Contrary to the current wisdom and guru prognostication, this is the time to become more
aggressive. Financial stocks, quality small-cap stocks, food stocks, homebuilders, and
drug stocks should do very well in the early phase of this new cycle.

                                  P a l a di n I nve st m e n t L L C                            5
Growth Vs. Value 2
I am including Warren Buffett‟s delightful discussion on Aesop‟s classic advice “A bird
in the hand is worth two in the bush” which he applies to valuing a business. I hope you
enjoy it.

    Outstanding Investor Digest, Vol X V, December 18, 2000, p. 34. This article is a record of Warren Buffet‟s and
     Charlie M unger‟s comments from the 2000 Berkshire Hathaway annual meeting.

                                             P a l a di n I nve st m e n t L L C                                      6
…..growth stock or a value stock. Could you please give us a definition of these terms.

Warren Buffett
We‟ve addressed the question about growth and value in past annual reports. They aren‟t
two distinct categories of business. Every business is worth the present value of its future
cash flows. So if you knew what the company was going to disgorge in cash between
now and judgment day, you could come to a precise figure as to what it‟s worth today.
Now, elements of that can include the ability to use additional capital at good rates. Most
companies that are characterized as growth companies have that characteristic. However,
there is no distinction in our minds between growth and value.
We look at every business as a value proposition. The potential for growth and the
likelihood of good economics being attached to that growth are part of the equation in a
valuation – but they‟re all value decisions. A company that pays no dividends, growing
100% a year, but losing money – well, that‟s a value decision, too. You‟ve got to decide
how much value you‟re going to get.
Actually, it‟s very simple. When would you guess the first investment primer was
written? The first one I know of (and it was pretty good advice) was delivered in about
600 BC by Aesop. Aesop, you‟ll remember, said, “A bird in the hand is worth two in the
bush”. Incidentally, Aesop did not know that it was 600 BC. He was smart, but not that
So Aesop was onto something. But he didn‟t finish it – because a couple of other
questions go along with that. However, that is an investment equation: a bird in the hand
is worth two in the bush. But he forgot to say exactly when you were going to get the two
in the bush. And he forgot to say what interest rate you had to measure your birds against.
But if he‟d included those two factors, he would have defined investment for the next
2,600 years.
You will trade a bird in the hand, which is investing – you will lay out cash today. And
then the question – your investment decision – is that you have to evaluate how many
birds there are in the bush. You may think there are two birds in the bush or three, etc.
And you have to decide when they‟re going to come out and when you‟re going to
acquire them.
If interest rates are 5% and you‟re going to get two birds from the bush in five years, let‟s
say, versus one now, then two birds in the bush are much better than a bird in the hand
now. So you want to trade the bird in the hand and take the two in the bush – because if
you‟re going to get „em in five years, that‟s roughly 14% compounded annually and
interest rates are only 5%.
But if interest rates are 20%, you would decline to take two birds in the bush five years
from now. You would say that‟s not good enough – because at 20%, if I just keep this
bird in my hand and compound it, I‟ll have more than two birds in the bush in five years.
What‟s all that got to do with growth? Well, usually growth is associated with a lot more
birds in the bush. But you still have to decide when you‟re going to get „em and measure
that against interest rates and other bushes with other equations. That‟s all investing is.

                                 P a l a di n I nve st m e n t L L C                        7
It‟s a value decision based on what something is worth – how many birds are in that
particular bush, when you‟re going to get‟em and what interest rates are.
When we buy a stock, we always think in terms of buying the whole enterprise because it
enables us to think as businessmen rather than stock speculators. So let‟s just take a
company that has marvelous prospects, that‟s paying you nothing now where you buy it
at a valuation of $500 billion. If you feel that 10% is the appropriate rate of return (and
you can pick your figure), and it pays you nothing this year, but starts to pay you next
year, it has to be able to pay you $55 billion each year - in perpetuity. But if it‟s not
going to pay you anything until the third year, then it has to pay you $60.5 billion per
year – again in perpetuity – to justify the present price.
Every year you wait to take a bird out of the bush, you have to take out more birds. It‟s
that simple.
I question sometimes whether people who pay $500 billion implicitly for a business by
paying some price for 100 shares of stock are really thinking of the mathematics that are
implicit in what they‟re doing.
For example, let‟s assume that there‟s only going to be a one- year delay before the
business starts paying out to you and you want to get a 10% return. If you paid $500
billion, then $55billion in cash is the amount that it‟s going to have to be able to disgorge
to you year after year after year. To do that, it has to make perhaps $80 billion, or close
to it, pretax.
Look around at the universe of businesses in this world and see how many are earning
$80 billion pretax – or $70 billion or $60 or $50 or $40 or even $30 billion. You won‟t
find any. So it requires a rather extraordinary change in profitability to give you enough
birds out of that particular bush to make it worthwhile to give up the one that you have in
your hand.

                                 P a l a di n I nve st m e n t L L C                        8

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