BCN Advantage – 2024 Annual Report

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For 2024, the S&P 500 rose +23.3% to 5,882, the Nasdaq +28.6% to 19,311, and the Dow +12.9% to 42,544. The IBD Mutual Fund Index gained +8.78%. 2024 marked the second consecutive year the S&P 500 rose more than +20%, a feat not seen since 1997-1998. In September, the Fed slashed rates by a half percentage point, followed by additional quarter-point cuts in November and December. The action marked the Fed’s first easing since 2020 and the termination of its most aggressive inflation-fighting campaign since the 1980s. Enthusiasm over Gen AI caught fire. For the second year in a row, the “Magnificent Seven” drove the lion’s share of gains. Apart from these 7 companies, the rest of the S&P 500 gained a mere 6.3% in 2024, and only 4.1% in 2023. DeepSeek triggered a sharp selloff. Nvidia was especially hard hit, suffering a near $600 billion loss of market cap in one day. DeepSeek claims its breakthrough model was developed using inferior Nvidia chips and cost less than $6 million. That’s staggeringly low, given OpenAI’s ChatGPT cost more than $100 million to train. Two years into the Gen AI phenomenon, just 11% of companies are in large scale production with AI initiatives. DeepSeek could be good news if the reduction in Gen AI costs enables wider adoption. Accelerated innovation could lead to the development of more advanced models, better algorithms, and new use cases for AI across industries. The top 7 companies in the S&P 500 are all Gen AI related and comprise over 33% of the index. Gen AI capex is slated to reach $425 billion in 2025. A foreign competitor offering a rival product at a fraction of the cost throws into question the exorbitant spending of American tech giants. Trump announced his plan for reciprocal tariffs – global tariffs customized on a country-specific basis and expected to go into effect by early April. The immediate consequence is higher consumer prices. The stock market is likely to react negatively, particularly in sectors heavily reliant on international trade. Currently, 41% of corporate revenue is derived from exporting goods and services. Over the longer term, these headwinds may largely be offset by tax cuts, deregulation, and reduced energy prices, which should cut production costs. Since bottoming in June, inflation has accelerated. January core prices rose 3.3% for the year, and 0.4% over the prior month, the largest monthly increase since April 2023. Inflation expectations rose to 4.3%, the biggest jump in over a decade. In hindsight, the Fed’s rate-cutting campaign looks too aggressive. Traders expect one cut for all of 2025 – and not until July, at the earliest. Ten-year rates have jumped sharply, from about 3.6% in September (the initial rate cut) to 4.5% today. Historically, ten-year rates should reach the 5.5% range and potentially 6% or higher. The negative impact is evident in an economy supported by rising debt levels. Average borrowing costs on our $36T national debt have increased from 1.5% to 3.5%, adding more than $700 billion per year to debt service. US corporate bankruptcies hit a 14-year high in 2024. Same for credit card delinquencies. Over the past two years, ongoing fiscal stimulus from the Inflation Reduction Act ($891B) and Secure 2.0 Act ($1.7T) have supported economic growth. At the same time, the Fed has quietly reduced its balance sheet by nearly $2 trillion – a pace of more than $75 billion per month. These are the most dangerous headwinds facing the markets (because their combination is the least expected): (1) continued quantitative tightening, draining liquidity, (2) elevated inflation, forcing borrowing rates to remain high, (3) reduced fiscal stimulus as previous spending bills are exhausted without new ones to take their place. A generation of investors has been conditioned to “buy any and all dips.” Given an S&P 500 that has skyrocketed from 667 in early 2009 to over 6100 today, it’s easy to understand why. Investor confidence for the next 12 months is near the highest levels on record. A recent AAII survey of retail investors shows an average 70% allocation to stocks, levels seen at previous market peaks and only slightly lower than the peak during the Dot.com mania. While not predictive of a near-term market correction, the survey does suggest much of the anticipated market gains are already priced in. Wall Street’s median estimate is for the S&P 500 to rise to 6600 this year, which would be a ‘disappointing’ return of just 12% after two years of 20%+ gains. As usual, no major analyst projected a negative return. Experienced investors understand the danger of late-stage bull markets. One example: Warren Buffett, currently sitting on a record $325 billion cash pile. When Trump entered his first term, the S&P 500 stood at 18x forward earnings. Today, the index P/E is 23x, well above the five-year average of 19.7 and 10-year average of 18.2. It’s only been higher during the 2021 post-pandemic boom and the 2000 Dot.com bubble. This leaves little room for error. Investors are betting on flawless results in a year when macroeconomic uncertainties loom large.

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BCN Advantage – 2023 Annual Report

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For 2023, the S&P 500 rose +24.2% to 4,770, the Nasdaq +43.4% to 15,011, and the Dow +13.7% to 37,690. The IBD Mutual Fund Index gained +18.21%. A strong year – but far less impressive once the 2022 decline is factored in: The S&P 500 began 2022 at 4,766 – leaving the key index effectively unchanged after 2 years. The Dow also remains flat while the Nasdaq is still negative. Even worse is the performance of the IBD Mutual Fund Index (which tracks bellwether growth funds). After 2 years, the index remains deeply negative following its -35% decline in 2022. How have BCN Advantage clients fared? On average over the same 2-year period they’ve easily outperformed the major indexes. Especially noteworthy: our clients have done so while maintaining an average cash (risk-free) allocation of 55%. Exceeding the S&P 500 while reducing risk has always been our long-term goal. For 2023, total federal debt increased by $1.70 trillion – and has now surpassed $34 trillion. By comparison, GDP increased $1.61 trillion to $27.36 trillion. Unemployment ended the year at 3.7%, with the labor force participation rate ticking up slightly to 62.5%, still below pre-pandemic levels. Since July, the Fed has left rates unchanged at 5.25% to 5.50%. They hiked in response to the post-pandemic inflationary shock, as PCE spiked from 1.75% in February 2021 to 5.6% by February 2022. The Fed signaled a “pivot” following their December meeting, when they projected 3 rate cuts in 2024 – with GDP growth slowing to 1.5% and unemployment rising slightly to 4.1% as core PCE falls to 2.4%. Core PCE (the Fed’s preferred inflation gauge) ended 2023 at 2.9%. The markets expect 6 cuts in 2024 – beginning in May – which assumes the Fed will ease much faster to prevent recession. Initial claims for unemployment are the key leading indicator. For now, initial claims are low, near the 200K level. If initial claims move sustainably above 250K, the probability of recession increases significantly. Though always widely anticipated, “soft landings” are historically elusive. It usually takes 24 months for higher interest rates to fully impact the economy. The initial rate hike was March 2022. History also shows that a recession usually occurs about 15 months from the time the yield curve inverts (with the lag varying from 10 to 24 months). The spread between the 10-year and 2-year went negative in July 2022 – the longest inversion since 1980. In the wake of their most aggressive rate hikes ever, the Fed’s own model shows a 70% probability of recession, the highest in 40 years. The ISM Manufacturing Sector has been in contraction for 14 consecutive months.  Since 1968, there have been two such periods: 2000-02 and 1981-83. The ISM Services Employment Index recently plummeted to levels not seen outside the pandemic, Great Recession and Tech Bubble. The index has never fallen this rapidly without an economic downturn. Are reliable indictors wrong this time? Or have lag effects simply taken longer to resolve – the result of massive fiscal stimulus and continued deficit spending post-COVID? The Fed projects GDP growth will slow to 1.5% in 2024 – despite their rate cuts. The Atlanta Fed’s Sticky Price CPI tracks goods and services (like housing and health care) that change in price less frequently. Sticky Price CPI currently sits at 4.6%, more than twice the desired target. A resurgence of inflation would delay rate cuts already priced in by the markets. Or worse, force the Fed to lower rates even though inflation remains stubbornly high – both to avoid recession and allow for manageable payments on our rapidly growing national debt. At current rates, borrowing costs on $34 trillion balloon to $1.7 trillion – expanding faster than annual GDP. It’s not clear who will be buying the projected $2 trillion in treasury debt needed to finance the 2024 deficit. Likely it won’t be the Fed, which has quietly trimmed $1.25 trillion from its balance sheet since April 2022 – “quantitative tightening” from an all-time high of $8.95 trillion in the aftermath of COVID. Many believe stocks will explode higher once the Fed begins lowering interest rates mid-year. But the markets are already priced for a perfect scenario: the S&P 500 is currently trading at 20.5x estimated 2024 earnings – right at its 5-year average. So, what happens during the second half of 2024? The rally in 2023 was primarily seen in 7 technology stocks: Apple, Amazon, Alphabet, Nvidia, Meta, Microsoft, Tesla. Investors are still chasing the A.I.-theme. Microsoft co-founder Bill Gates believes artificial intelligence models (like the one running ChatGPT) are the most important advancement in technology since the personal computer. Narrow markets are fine – until they aren’t. The unwinding of the 2000 Tech Bubble began with a Yahoo earnings miss. Similarly, an earnings miss for stocks like Nvidia could derail this market. Election years have seen few declines. Since the inception of the S&P 500 in 1927, there have been only 7 down years across 24 election cycles (29%) – including the Great Depression. And money market funds could serve as a strong backstop for stocks as rates come down in 2024. The allure of 5% interest has led to a surge in cash on the sidelines, with money market assets up 24% from last year to a record $5.88 trillion. But commercial real estate poses a significant threat to markets in 2024, with over $6 trillion in debt outstanding. Commercial real estate prices fell an estimated 20% last year, with few of these properties likely to recover their pre-pandemic value any time soon. According to the Mortgage Bankers Association, there’s about $1.2 trillion in commercial mortgage debt set to mature from now to 2025. The critical message is not to forget there is still substantial risk underlying the economy and the markets. What will be the “biggest driver” of equity prices in 2024? According to a recent survey of professional money managers, it won’t be fundamentals or corporate earnings. 59 percent said “the Fed.” And we’re not alone in suspecting the summer’s overly anticipated rate cuts may not materialize as expected.

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BCN Advantage – 2022 Annual Report

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For 2022, the S&P 500 fell -19.4% to 3,840, the Nasdaq -33.1% to 10,467, and the Dow -8.8% to 33,147. The IBD Mutual Fund Index declined -35%. The Fed initially regarded pricing pressures as “transitory,” resulting in a slow-footed response that included not only keeping interest rates near zero but maintaining asset purchases of $120 billion per month. By March 2022, inflation was raging out of control with headline CPI surging 8.6% year-over-year and core CPI rising to 6.4% – highest since the infamous stagflation of the late 1970s and early 1980s. In response, the Fed finally ended its “quantitative easing” campaign in March and announced a quarter-point rate hike. The Fed went on to increase rates by 4.25% in just 10 months. Headline CPI peaked at 9.1% year-over-year in June 2022, but has since fallen for six consecutive months to 6.4%. Core CPI peaked in September and has fallen for three consecutive months to 5.6%. Speaking in early February, Fed Chair Jerome Powell sounded optimistic on the inflation outlook: “We can now say for the first time that the disinflationary process has started.” For the full year, GDP increased 2.1% (compared to 5.9% in 2021 – the fastest pace of growth since 1984). The U.S. economy added 517,000 jobs in January, far more than the 188,000 expected. Unemployment fell to 3.4%, the lowest since 1969, and labor force participation ticked up to 62.4%, still below pre-pandemic levels. Equity markets have been on a tear to start 2023, with optimism fueled by the Fed’s downshift to smaller rate hikes and markets pricing in rate cuts later this year. Is this a textbook bear market rally or the beginning of a new bull run? Morgan Stanley’s top market strategist attributed recent gains to the January effect – a market theory that securities prices increase after a year-end sell-off for tax purposes. Announced buybacks in January more than tripled from a year ago to $132 billion, the highest total ever to start a year. Since 2011, over 40% of the market’s advance is attributable to corporate buybacks.  Are financial markets misreading the Fed? Higher equity prices and falling bond yields have complicated the Fed’s task. Since mid-October (the most recent stock market lows), the 10-year Treasury yield has fallen 50 basis points from its high of 4.25%. Continued resiliency in the labor market takes pressure off the Fed to reverse course. Market participants are expecting not only a pause in rate hikes (after a final quarter-point increase in March) but rate cuts beginning as early as November this year. That is not what the Fed is signaling. In December, the Fed increased its terminal rate to 5.1%. The message was clear: not only will they not be cutting rates in 2023, they are willing to accept a more severe economic slowdown and higher level of unemployment than initially projected. Any CPI reading that comes in hotter-than-expected will likely cause the Fed to raise rates more than what the markets have priced in. And merely pausing rate hikes isn’t going to reverse the damage already baked into the economy. The problem with rate hikes, as always, is the lag effect. It takes about nine months on average for the impact of a Fed rate increase to fully work its way through the economy. As Powell stated in November: “Monetary policy affects the economy and inflation with uncertain lags, and the full effects of our rapid tightening so far are yet to be felt. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.” Cutting rates too soon could spark a second bout of inflation, similar to what happened in the 1970s. There remains considerable uncertainty about the direction of the economy. The S&P 500 is currently trading more than 18 times estimated earnings for 2023, historically a level only seen during bubble periods. Earnings cannot, over the long term, outgrow the economy. As such, stocks remain vulnerable to significant repricing in the event of recession. As of February, S&P 500 earnings are expected to grow 11.5% year-over-year. Compare that to 2008, when earnings collapsed by -40%. The Conference Board’s Leading Economic Index declined in December for the tenth consecutive month. Treasury yields have been inverted since July 2022. All ten of the previous recessions dating back to 1955 have been preceded by an inverted yield curve. All ten were preceded by tight monetary policy and Fed rate hikes. A 5% Fed funds rate is exceptionally high for the American economy. The cost of borrowing is rising significantly and will continue increasing as the effects of tighter monetary policy filter through the economy, leading to a slowdown in spending, GDP, and corporate profits. Without a doubt, spiraling interest expense on our $31.4 trillion national debt creates a massive challenge for the Fed. From a low of $400 billion during fiscal 2015, interest paid nearly doubled to $724 billion in fiscal 2022 and is set to eclipse $1 trillion by the end of fiscal 2023 in October. The Fed has barely begun to reduce its balance sheet – by a mere $45 billion per month – from its all-time high of more than $8.9 trillion. Once this current cycle of rate hikes has ended, will the Fed then begin to accelerate quantitative tightening? And even if the Fed continues this very moderate reduction of its balance sheet, can markets climb in the absence of the massive injections of liquidity the Fed has provided over the last 15 years – since the Great Financial Crisis of 2008? The era of near zero interest rates, ultra-low inflation, and trillions of quantitative easing was an anomaly – and it’s ending.

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BCN Advantage – 2021 Annual Report

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For 2021, the S&P 500 gained +26.9% to 4,766, the Nasdaq +21.4% to 15,645, and the Dow +18.7% to 36,338. Marking an important divergence: the IBD Mutual Fund Index lagged +13.5% for the year. January 2022 saw the S&P 500 fall more than 5%, its worst start since 2009. The Dow declined more than 3%, while the Nasdaq shed about 9%, nearly matching 2008 for its worst start ever. Guidance – or lack thereof – has been the biggest red flag. Streaming giant Netflix plunged 21.8% after serving up a tepid outlook. Meta Platforms, the social giant formerly known as Facebook, cratered 26.4% as investors reacted to its Q1 forecast. With the drop, Meta shed $237 billion in market cap – the biggest one-day wipeout in U.S. stock market history. Five companies (Facebook, Apple, Amazon, Microsoft, and Google) account for one-quarter of the market capitalization of the entire S&P 500. Thanks largely to ETFs and the overweight inflows into these handful of stocks, an illusion of market stability is not surprising. The small cap Russell 2000 has been a canary in the coal mine for much of the past year, lagging the S&P 500 by 25 percentage points – its worst 12-month relative return since 1999. 46% of Nasdaq companies are down at least 50% from their 52-week highs. Not since 1999 have so many stocks been cut in half while the Nasdaq held near its peak. Historically, when at least 35% of stocks are down by half, the Nasdaq has been down by an average of -47%. Consumer prices surged an annual 7.5% in January, the biggest jump since 1982. Core PCE, the Fed’s preferred inflation gauge, is at 4.7%, more than double their 2.0% target. The rate of change in Core PCE over the past year is the second fastest on record, exceeded only by 1974 – 1975. For the first time since 1974, over half of small businesses expressed their intent to raise prices. Today’s tight labor market increases the possibility that inflation will become entrenched via a wage-price spiral. Fed Chairman Powell recognized the danger during his Senate confirmation, when he stated that a smaller labor force “can be an issue going forward for inflation, probably more so than these supply-chain issues.” The specter of inflation has futures markets pricing in a full percentage point of Fed rate hikes by August, and the equivalent of six quarter-point moves in 2022. The Fed’s attention has turned squarely toward inflation, a battle they haven’t had to fight in roughly four decades. And suddenly, investors may no longer be able to count on the Fed coming to the rescue at the first sign of trouble. That guarantee – widely assumed on Wall Street – is known as the “Fed Put.” In late 2018, a 20% decline prompted the Fed to quickly reverse policy. As COVID spread in March 2020, the S&P 500 collapsed 33% and the Fed responded with 2-years of near-zero interest rates and $120 billion per month in additional “quantitative easing.” Though the Fed could temporarily suspend rate increases if markets fall this time, they’ll be much less likely to swiftly reverse course by cutting rates and ramping up QE. Not if inflation is still raging. As a result, we could see a series of rolling corrections: declines of 10% or more but without the corresponding V-recoveries investors have grown so dependent on. Interestingly, Powell has yet to specify when the Fed will begin reducing its nearly $9 trillion balance sheet – now 40% of U.S. GDP. Draining liquidity from “quantitative tightening” poses the most significant risk to U.S. markets, all the more so when there are clears signs the economy is slowing. Expectations are for GDP to grow 4.0% in the first and second quarter of 2022 and then slow to 3.3% and 2.5% in the third and fourth quarters. Mere talk of rate hikes has already pushed the front end of the yield curve higher, but the long end of the curve is low, flattening the curve – a classic precursor of recession. The effectiveness of Fed policy can only be evaluated once the policy has gone full cycle. Cutting rates to zero, holding them there for years, and creating trillions in debt through quantitative easing will prop up an economy. That much has been established. But can that stimulus be reversed, and that liquidity be drained, without pushing the economy into recession – one deeper and more damaging than any that preceded it? The S&P 500 took 7 years to reach a new high from 2000 to 2007 after a 51% decline between March 2000 and October 2002, and 6 years to notch a fresh high from 2008 to 2014 after a 58% loss between October 2007 and March 2009. Have we entered another period when investors will be happy to have been largely out of the market? We believe so – because we will have saved money by being out – while reducing risk and volatility on the round trip. Our definition of a successful bear market call.

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BCN ADVANTAGE: 2020 ANNUAL REPORT

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For 2020, the S&P 500 gained +16.3% to 3,756, the Nasdaq +43.6% to 12,888, and the Dow +7.2% to 30,607. These are extraordinary gains coming in the midst of a global pandemic that precipitated economic devastation in the U.S and worldwide. What cannot be underestimated is the power of fiscal and monetary stimulus to lift asset prices, especially in the tech heavy Nasdaq. Since the Fed reversed course in January 2019, the Nasdaq has nearly doubled, up 94% from its December 2018 level of 6,635. The Fed’s balance sheet increased by more than $3.25 trillion since February 2020, once the ravages of COVID became fully apparent. Add to that $2 trillion authorized under the March 2020 CARES Act, the $900 billion supplement in December 2020, and the current Biden proposal for another $1.9 trillion, and the total fiscal and monetary response to the pandemic will be more than $8 trillion – roughly equivalent to 37% of the entire $21.5 trillion U.S. economy. The U.S. economy was humming along in mid-February 2020. There were only 15 reported COVID cases in the U.S. and as yet no deaths from this mysterious novel virus. Less than 5 weeks later, with reported cases approaching half a million and deaths nearing 700, the S&P 500 had plummeted 33.9% before bottoming at 2,237 on March 23rd. In the early days of the decline, we issued a series of notices urging our clients not to sell. “From long experience, we know that stock markets usually recover quickly from panic selloffs, especially in circumstances like we’re experiencing today, when the U.S. economy was on strong footing prior to the crisis.” By mid-August, in the face of continuing lockdowns and no real end in sight to the global pandemic, the major indexes had fully recovered and kept powering ahead despite more than 20 million reported COVID cases and 355,000 deaths in the U.S. by year-end. As of December, the economy is still 9.8 million jobs short of where it was in February before the pandemic, and more than 20 million Americans are still claiming unemployment benefits. At 6.7%, the unemployment rate remains nearly double its pre-pandemic level, and the labor force participation rate, at just 61.5%, has sunk nearly two percentage points below pre-pandemic levels. Federal Reserve forecasts show the labor market not returning to 3.7% unemployment until the end of 2023. The Fed has maintained its interest rate target at near-zero and reiterated its commitment to at least $120 billion a month in asset purchases until “substantial further progress” is made on the recovery. “Any time we feel like the economy could use stronger accommodation, we would be prepared to provide it,” Powell said on December 16th. The imprecise language, however, will keep Fed watchers and investors guessing. Markets are showing visible signs of excess speculation, with a record $272 billion flowing into stocks over the past 12 weeks. The S&P 500 is trading at a forward 12-month price-to-earnings (P/E) ratio of 22.9, well above both its five-year average of 17.6 and 10-year average of 15.8. Fund managers are underweight cash for the first time since May 2013. With cash levels so low, much of the expected growth has already been “priced to perfection”. As expectations rise, so do the opportunities for disappointment. Higher interest rates and inflation are key risks. The huge injection of liquidity (both fiscal and monetary), the Fed’s expressed tolerance of higher inflation and massive government debt (currently $27 trillion and counting) pose a structural threat of inflation greater than at any time since the 70’s. Since the 2008 financial crisis, corporate share repurchases, or “stock buybacks,” have accounted for nearly all buying in the market. The total amount of stock bought back by companies even exceeds the Fed’s bonds purchases over the same period as part of quantitative easing. Now, companies are hoarding cash and markedly decreasing share buybacks from 2015-2019 levels, at the same time they have increased outstanding shares. Notably, over the last 20 years, the only two previous periods where corporations increased shares outstanding were during the 2000 and 2008 recessions. The Biden administration could substantially raise taxes on many U.S. corporations. An increase in the capital gains tax might also put pressure on the markets. And even with targeted support, vulnerable sectors such as travel, hospitality and leisure could remain hard-hit by the outbreak, giving rise to the notion of a “K-shaped” recovery. While the vaccination program is starting to gain traction there is a window of extreme vulnerability as the number of cases and hospitalizations rise. Should the new, more transmissible variant of COVID gain a foothold here then this would increase the threat of more near-term containment measures, which would undoubtedly come at a severe economic cost.

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BCN ADVANTAGE: 2019 ANNUAL REPORT

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For 2019, the S&P 500 gained +28.9% to 3,231, the Nasdaq +35.2% to 8,973, and the Dow +22.3% to 28,538. The IBD Mutual Fund Index rose +29.59%. Over the decade, the S&P 500 gained more than +250%, the 80th percentile for rolling 10-year periods. The longest economic expansion on record is well into its 11th year. Widely watched yield curve inversions had many on Wall Street fearing recession. The Fed began ratcheting the Fed funds rate lower in August. By the end of 2019, rates had been cut three times. Historically, whenever the 10-year treasury yield slips below the Fed funds rate (as happened in 2019) the Fed is too restrictive, and the economy is in danger of slowing down. At 1.57%, the 10-year Treasury rate is once again dangerously close to the effective Fed funds rate of 1.55%. If the U.S. economy continues to outperform its global counterparts, the U.S. will continue to import disinflation and force the Fed to keep cutting rates. But slowing global growth could eventually throw the U.S. into recession. Following his semiannual report to Congress in February, Jerome Powell explained why the Fed is “not comfortable” with inflation running persistently below their 2% objective: “We would have less room to reduce interest rates to support the economy in a future downturn, to the detriment of American families and businesses.” The Fed has no interest in raising interest rates anytime soon. Meanwhile, Wall Street is assigning a 65% probability for at least one more quarter-point rate cut in 2020. And the Fed is once again expanding its balance sheet, adding $400 billion in the past four months alone. Corporate buybacks have been the largest source of U.S. equity demand over the past decade, as retail and institutional investors have been net sellers of U.S. stocks for most of this bull market. Overleveraged corporations will likely curtail buybacks when the next recession hits, a factor that would intensify any downturn. 2019 was driven by multiple expansion rather than earnings growth, as the trailing 12-month P/E for the S&P 500 has now ballooned to 24.5 (vs. 20.2 on average since 1978). High valuations are not predictive of market tops but do indicate risking risk for a 20% or greater market correction. The so-called “Buffett Indicator” is the ratio of the total stock market to GDP. Its level at the end of 2019 was double its seven-decade average and higher than any other year with one ominous exception – 1999, at the top of the internet bubble. Worth noting, Buffett has built up Berkshire Hathaway’s cash pile to a record $122 billion. The sustained rally since October has caused many investors to worry that a “bubble” or “melt-up” is underway. From the October 2, 2019 closing low of 2,887 the S&P 500 has gained 17%, close to matching the 18% rally in January 2018. But we’re not seeing the excessive enthusiasm that accompanies the final stages of a blow-off rally. The most likely cause of the next major stock market decline will be the Fed’s delayed or perceived inadequate response to even a mild economic downturn. Little firepower is left in most of the developed world for QE to have more impact. Global central bank balance sheets have grown from roughly $5 trillion in 2007 to $21 trillion, equivalent to the size of the entire U.S. economy. More than $15 trillion of debt has already been issued at negative interest rates. Short of buying stocks outright (as Japan has done), there are few levers left for central banks. And fiscal stimulus would arrive too late to avoid the damage to asset prices. The two pillars of the vaunted “Goldilocks” economy are (1) reasonably robust growth and (2) subdued inflation. Wall Street consensus expects S&P 500 companies to grow earnings-per-share by 8% on top of revenue growth of 5%. Notably, the ISM manufacturing PMI rose to 50.9 in January. Since 1999, a move back above 50 has coincided with an average of 18% earnings growth for S&P 500 companies. Assuming inflation remains anchored, “Goldilocks” could be in the driver’s seat again in 2020. But we’re keeping a close eye on valuations. As the S&P approaches 3,500, a trailing 12-month P/E above 25x will be cause for concern. Yet another Fed pivot to hiking interest rates seems unlikely (especially in an election year), but market internals (most notably corporate earnings) remain especially critical this late in the economic cycle. Signs of deteriorating earnings will certainly push us into a more defensive stance.

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BCN ADVANTAGE: 2018 ANNUAL REPORT

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For 2018, the S&P 500 fell -6.2% to 2,507, the Nasdaq -3.9% to 6,635, and the Dow -5.6% to 23,328, breaking a streak of 9 straight years of market gains. The IBD Mutual Fund Index declined -9.1%. The average hedge fund lost 6.7%. The S&P 500 dipped into official bear market territory, declining by as much as 20.2% during the worst December since 1931. Still, this may turn out to be the shortest-lived bear market in history, as the infamous “Fed Put” is back in effect. In October 2018, the Federal Reserve started to roll off $50 billion per month, precipitating the worst quarter for stocks since 2008. Jerome Powell struck an entirely different note on January 30th, 2019, as he essentially capitulated across the board: “The Fed will now be patient in regards to interest rates.” Markets are no longer expecting 2-3 rate hikes from the Fed this year. They are expecting zero rate hikes or possibly even a rate cut. And “almost all participants” supported announcing an end to the balance sheet normalization process this year. The FOMC originally believed the balance sheet runoff could last until 2023. The ability of the Fed to bail out markets today is much more limited than it was in 2008. Then, the Fed’s balance sheet was only $915 billion, and the Fed Funds rate was 4.25%. Today, unemployment is 4%, not 10+%. Corporate debt is at record levels. The government is running $1 trillion deficits during an expansion. The economy is extremely long in a growth cycle, not emerging from a recession. Such an environment could make further interventions by the Fed less effective. America has never been so indebted. Therefore, rates don’t need to return to past levels to have a detrimental impact on the economy. Total debt today is roughly $69 trillion. This includes state, local, federal, corporate and household. At the peak in 2008, total debt was roughly $54 trillion. Debt that is not self-funding is future consumption brought forward. Because of the Fed’s decade-long measures to artificially suppress interest rates and flood the system with excessive liquidity, we have enjoyed consumption and growth that cannot happen in the future. S&P 500 earnings increased more than 26% in 2018 but are expected to grow less than 8% in 2019. Global growth Is less synchronized. The international stock index EAFE has been negative in 5 of the last 11 years, including a -14.2% drop in 2018 as trade tensions with China intensified. Market structure is one-sided and worrisome. A tenth of a percent of the stocks in the world comprise 15% of world market capitalization. Investors have been draining money out of U.S. stocks to the tune of nearly a quarter of a trillion dollars. At the same time, U.S. corporations have poured a record $1 trillion into share repurchases. As the Fed rolls $50 billion per month off its balance sheet, the onus for absorbing Treasury issuance falls to markets. The more issuance at a time when the Fed is pulling back, the less liquidity available for risk assets. Meanwhile, Fed hikes drive up the yield on cash, making it viable as an asset class for the first time in a decade. Last year, cash outperformed 90% of global assets. With the Fed acting to support asset prices, the decline that began last October is probably no longer the start of a bear market, but rather the conclusion of a significant correction. Since 1928 there have only been four cases of consecutive down years, and stocks have been higher in the 12 months following every midterm election since 1946. The Fed’s 180-degree policy shift will likely prolong the economic expansion, making a recession unlikely until mid-2020. But while we recognize the possibility of new highs, this remains a high-risk, late-stage bull market. Expect a tough back-and-forth struggle as the S&P 500 makes its way back to 2,800. But if the bulls can regain control and push prices back above the November highs, then the “bear market” correction of 2018 will officially be dead. The path will then be open for another potential run to 2,940 and new all-time highs.

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BCN ADVANTAGE: 2017 ANNUAL REPORT

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For 2017, the S&P 500 rallied 19.4% to 2,674, the Nasdaq 28.2% to 6,903, and the Dow 25.1% to 24,719. It’s been a nine-peat: nine straight years of market gains. The U.S. stock market has returned a compound 15.5% per year over that span, growing cumulatively more than 250%. January saw the best start since 2006. In four weeks the S&P 500 gained 7.5%, the Dow 7.7% and the Nasdaq 8.7%. Then came February. The Dow lost more than 1,000 points twice in one week, leaving the markets in a correction, down 10% from their January 26th record highs. While the headlines focused on the largest point drop ever for a single day, in percentage terms the Dow’s 4.6% fall was the worst since August 2011, but only the 25th largest since 1960. For perspective, the Dow plunged 22.6% on the Black Monday crash of October 19, 1987. GAAP estimates for 2018 are a whopping $145 per share, a 32% increase. Such spectacular results would go a long way to bringing stock prices in line, but a healthy dose of skepticism is warranted. Despite the recent 10% correction, the S&P 500 is still trading at 25 times trailing 12-month GAAP earnings. That’s expensive by any measure. Price discovery is lacking, replaced in the bond markets by price insensitive central banks, and in the stock market by price insensitive corporate share buybacks and passive ETF buyers. The yield on the benchmark U.S. Treasury 10-year note is 2.83%, more than double the multiyear low of 1.37% set in July 2016. Up to a certain point, rising yields are seen as the barometer of a robust recovery. But if yields rise too far, too fast, it sets up a policy conundrum. The current fed funds range is 1.25% – 1.50%, with three quarter-point hikes priced in by December. But consider the changing landscape: In the U.S., the administration has just passed a deficit-funded tax cut and budget-busting spending bill, piling fiscal stimulus atop an overheating economy at a time when the Fed is trying to hike. Past a certain point, inflation would force central banks to end their reflexive relationship with markets. No more “Fed Put.” They would need to lean against inflation irrespective of what that would entail for risk assets. 25x earnings may not seem unreasonable so long as the Fed has your back. But absent faith in continued Fed accommodation and intervention, stratospheric valuations no longer look appetizing. For the first time ever, both the Fed and Treasury will be dumping massive amounts of public debt on the bond market – $1.8 trillion in FY 2019 alone. The double whammy of government debt coupled with Fed “quantitative tightening” could spark a “yield shock” – even in the absence of inflation. As we learned during the EU debt crisis of 2010, bond investors are enticed by high yields only so long as rates are seen as stable or poised to go lower. But what if perception shifts? And bond investors become fearful that rates will not only rise, but rise rapidly. Demand even for sovereign debt can disappear overnight, creating a vicious cycle. This is what we saw in Europe before the banks stepped in. Repatriation of overseas cash by U.S. multinationals could bring $2 trillion back to the U.S, much of it used to buy back company stock. Corporate repurchases totaled $570 billion in 2017, and are expected to reach $590 billion in 2018. Stocks should rally, lifted by those share buybacks and strong earnings. But we fully expect the lows set by this current pullback to be retested, probably no later than October as the Fed and other central banks accelerate their quantitative tightening. 10-year yields rising above 3% may set the stage for sharp declines. And the “Fed Put” may not be available the next time markets take a sustained tumble. This current market selloff could be the beginning of a more serious correction, but it’s too early to tell. If the ensuing rally fails before making a new market high, subsequent declines will become increasingly more dangerous. We are already positioned for a decline as severe as -25%. But we definitely do not want to commit further to growth stocks until the pattern of this current selloff becomes clear. For us, deep corrections become buying opportunities, because we have the financial ammunition (defensive cash) to buy aggressively once the markets bottom.

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BCN ADVANTAGE: 2016 ANNUAL REPORT

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For 2016, the S&P 500 rose 9.5% to 2,239, the Dow 13.4% to 19,763 and the Nasdaq 7.5% to 5,383. The IBD Mutual Fund Index gained only 4.7%. Stocks began 2016 with one of the worst Januarys on record, a reaction to the Fed’s first interest rate hike in a decade. But markets quickly recovered as the Fed backed away from further rate increases, then remained mostly flat through October. An election night panic pushed Dow futures down 800 points and S&P 500 futures down to their -5% limit. But by morning stocks had reversed yet again, and charged ahead to close out the year 9% higher from Election Day. The sluggish US economy expanded 1.6% in 2016. Q4 missed estimates at 1.9%, and slowed considerably from the 3.5% rate in Q3. The Trump administration hopes to jolt the economy with a dose of fiscal spending, tax reform and deregulation. Vast new mega-projects will be required to significantly affect the $18.9 trillion U.S. economy – or even absorb the $1 trillion in planned infrastructure spending. A plan likely would not become law until late 2017. Kick-starting large projects from scratch takes two years to plan and design prior to construction, which suggests 2019-2020 before significant benefits filter through to the economy. Combined with estimated 9% earnings growth in 2017, lowering the top corporate rate from 35% to 20% theoretically could lift the S&P 500 to 2500, roughly 8% higher than today. But tax “stimulus” may not work that well in practice. According to the Government Accountability Office, the average tax rate paid by large, profitable U.S. corporations is 12.6%. Conservatives will push hard for revenue neutrality over worries about the nation’s $20 trillion debt. As a result, there may be no real impact – and possibly adverse impacts on those companies currently paying less than 20% – if existing corporate deductions are eliminated to offset the tax cut. Back in 2007 Q3, the S&P 500 Index peaked at 1,576 and sported a price-to-earnings ratio of 18.5 times earnings. Today, the S&P 500 Index just wrapped up 2016 at 2,239, with a price-to-earnings ratio of 23 times earnings. What makes the S&P 500 truly stand out is how U.S. stocks have performed versus the rest of the world. From mid-2007 through the end of 2016, the S&P 500 Index is now more than +75% above its pre-crisis highs. Developed international markets (as measured by the MSCI EAFE Index) are still lower on a nominal (non-inflation adjusted) basis. For the S&P 500, 2016 Q4 would mark the end of seven consecutive quarters of annual earnings declines. The rate of year-over-year decline troughed at -15.4% in 2015 Q4 and has since been improving to just -1.7% in 2016 Q3. If the final quarter of 2016 holds up as expected, earnings would break out with a +12.9% year-over-year increase. Investors are scrambling to get ahead of Trump’s economic proposals that many are comparing to those of Ronald Reagan. But the economic environment and potential growth of 1982 was vastly different than today (table). The U.S. stock market has been sustained all along by a steady flow of monetary stimulus (chart). As we enter 2017, monetary policy is fading at the same time that fiscal policy remains uncertain. After years of zero interest rate policy (ZIRP), the Fed has managed two 1/4 point rate hikes since December 2015. But no major economy has ever exited the ZIRP experiment successfully. In the latest report from the Institute for International Finance, global debt increased by $11 trillion in the first 9 months of 2016, hitting a new all-time high of $217 trillion. As a result, debt levels are now roughly 325% of the world’s gross domestic product. Credit binges are cyclical and the bigger the binge, the bigger the fall. The current economic expansion began in June 2009, nearly 8 years ago. The longest expansion in history lasted exactly ten years from 1991 to 2001. It was fueled by technology advances and low inflation, falling interest rates, and massive spending on technology driven by the internet. The odds of a recession grow larger as the recovery runs longer, and no one can forecast recessions with any precision. In March 2009, we moved 100% into growth stocks. Part of our rationale then: If we’re not buying stocks after they’ve fallen 50%, when would we? Conversely today, if an old, very expensive, highly leveraged stock market doesn’t make us cautious, what would? Yet the level of cash being held by individual investors is near record lows. The benefits of having capital to invest at lower valuations has produced substantial outperformance over waiting for previously destroyed investment capital to recover. The BCN Advantage service offers substantial proof of the benefits of minimizing losses in actual practice. When risks begin to outweigh the potential for reward, smart investors raise cash. They buy low and sell high. When you sell high you raise cash. And you can’t buy low if you don’t have any capital to buy with. Looking forward, we realize that patience is waning as stocks move higher. One quarter does not make a trend, but if downward pressure continues to build on S&P 500 valuations (from the 2016 Q3 peak of 24 x earnings), we will move more aggressively into stocks – likely 70% by summer. But don’t be surprised if a significant market correction occurs before then.

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BCN ADVANTAGE: 2015 ANNUAL REPORT

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For 2015, the S&P 500 declined a fractional -0.7% to 2,044, the Dow fell -2.2% to 17,425 and the Nasdaq rose 5.7% to 5,007. Stocks around the world began 2016 with one of the worst Januarys on record, as slumping oil prices, deepening concerns over China, and the Federal Reserve’s first interest rate hike in a decade all combined to spook investors. The S&P 500 and Dow Industrials posted their worst weekly start ever. At the end of 2007 global debt stood at $142 trillion. By mid-2014 an additional $57 trillion had been added, and the data this year will show another record high. All the talk about deleveraging was only talk. Debt grew at a 5.3% annualized rate from 2007-2014. China’s total debt has quadrupled, rising to $28 trillion by mid-2014, from $7 trillion in 2007. Throughout 2015, U.S. corporations spent$1 trillion on share repurchases and dividends, most of it borrowed.Household debt grew 2.8%. Financial sector debt grew 2.9%. Corporate debt grew 5.9%. Government debt grew 9.3%. GDP grew just 0.7% in the fourth quarter, despite 7 years of zero interest rates, $3.7 trillion of Fed money printing and $9 trillion added to our Federal debt. Global stock markets lost nearly $8 trillion in January. Remember that stocks are the only true leading indicator of economic expansion and contraction. Jobs peak after stocks and the economy have already begun to decline, with a lag of 6 – 9 months. Stocks peaked in May 2015. The weakness in the Dow Transports, down -30% from its November 2014 high, shows the U.S. could already be in recession. The index is one of the most economically sensitive and should benefit from low oil prices. Instead it’s collapsing. A repeat of 2008-09 is unlikely – but the monetary and fiscal stimulus needed to battle even a mild recession is no longer available. The Fed typically needs 3.5% of rate cuts to work its magic. The world has never seen a full-blown recession with interest rates this close to 0% in both the US and Europe. For all of 2015, the U.S. added 2.65 million jobs, down from 2014’s 3.12 million but still the second-best since 1999. The unemployment rate currently holds at 4.9%.At its December meeting, the Fed raised interest rates for the first time since 2006 and signaled four additional quarter-point rate increases throughout 2016. Wall Street, though, is pricing in almost no chance of a move for the remainder of 2016, with the first increase not fully priced in until June 2017. Expectations for rising rates are putting upward pressure on the dollar, and the implications for earnings are significant. Over 30% of the revenues for S&P 500 companies come from outside of the U.S. Former Dallas Fed president Richard Fisher thinks the Federal Reserve is out of tools to help markets. “I don’t think there can be much more accommodation,”Fisher said. Fear is gripping the bond market. The yield on the U.S. 10-year Treasury note recently dropped below 1.8%. At $30 per barrel, oil prices have fallen to their lowest levels since 2003. Lower energy prices were expected to benefit other sectors of the U.S. economy. Now that tune has changed. December showed an unexpected drop in retail sales and a continuing fall-off in industrial output. Long-term debt for oil exploration and production exploded by 70% since 2010 to $353 billion. In December, the high-yield bond market came under pressure as worries abounded that energy-related companies would default – potentially impacting the broader markets. Officially, the U.S. economy has endured seven recessions over the last 50 years. In every instance except 1974, S&P 500 earnings had peaked and were in decline immediately prior. Q4 2015 earnings are on track to decline 4.1%, the biggest drop in six years and following on the heels of Q3’s 0.8% dip. Revenue is headed for a 3.5% decline after sinking 4.4% in Q3. If profits finish negative, it would be the first earnings recession since the 2-year slump that began in Q4 2007. There is mounting evidence the U.S. stock market is being decimated by a “stealth” bear market. The S&P1500 index – a broad basket of large, mid and small company stocks – shows that the average stock has fallen -26.9% from its 52-week high. Energy stocks – the worst-performing sector – are down 52.1%. All indications suggest a late-stage top of the third speculative bubble in 15 years, with the major U.S. indexes facing -20% to -40% declines before finally bottoming in early 2017. Stocks are collapsing for a myriad of reasons: Negative earnings, the end of QE and zero interest rates, rapidly diminishing stock buy-back plans, collapsing oil and commodity prices signaling weak global growth, an imminent U.S. recession that even if mild, comes at a time when the Fed is powerless to do much more than NOT raise rates. Central bank interventions will become increasingly ineffective as the time-tested law of diminishing returns rears its ugly head. Central banks have waged a desperate battle against weakening consumer demand with policies that, in the long run, will only exacerbate it. By artificially lowering interest rates (through QE, ZIRP and now negative interest rates), central banks have encouraged massive government and corporate borrowing. By definition, borrowing draws otherwise future consumption forward, and in the short run does provide a brief (but unsustainable) economic boost. But then poof! All that’s left is the hangover: mountains of debt with the bills coming due and no wherewithal to buy more. Global economies wake up to slackening demand and systemic long-term deflation. Without the promise of a boost from capital spending by corporations, an infrastructure program financed by the federal government, and/or reform of the tax code, there is virtually no chance that self-sustaining growth in the economy can be achieved. And none of those things are likely to happen during 2016.

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