January 12th, 1999
To My Clients, Friends & Observers:
Too many investors worry too much about the market and not enough
about themselves. "I'm in this for the long term" could be a better
epitaph than an investment strategy. In financial analysis the two
preferred methods are net present value and internal rate of return.
The weakest method is the payback method -it doesn't account for time
value of money. For an individual investor it's the acid test: how
long will it take to get my money back? Taken further, consider all
dividends and interest from an investment as repayments of principal.
Consider whatever is left over after principal has been repaid as
equity. Use the payback method first, then you can sweeten the picture
with NPV or IRR.
Consider some other arithmetic. Suppose the market returns 20% a
year for 3 years and in the 4th year declines 20%. An 80% return is
required in the 5th year to return the 5 year average to 20%.
The 5 year average return on the S&P 500 is 24% through 1998.
In November 1972 the Dow hit 1000 and then lost 40% of its value
over the next 2 years. It did not recover to 1000 for almost 10 years.
If you started withdrawing 8% a year from a $100,000 investment in
the S&P 500 in 1971 you would have nothing left in 1998.
Of course those were different times, but while we're looking in
the rearview mirror, what if they were our times? We emphasize cash
flow in Brae Head managed portfolios, from dividends and interest.
We often use fixed income instruments to provide equity as much as
cash flow and equities to provide income as much as growth. Most Brae
Head managed accounts are balanced accounts. Brae Head equity performance
for 1998 will be posted to the website on January 22.
1998 was another great year for the indexes, in a trading environment
that can charitably be called fickle. Interest rates dropped as the
market dropped. Interest rates rose, the dollar weakened, and the
market made new highs. Advance/declines were horrible for most of
the year. NYSE issues closed the year with 1850 advances and 2360
declines. The NASDAQ ended with 1711 advances and 2898 declines for
the year. Same scenario on all the indexes. 1998 gave us one of the
shortest bear markets in history, the S&P 500 dropping from 1190 July
20 to 960 first week in October, a 19% drop, before retracing to a
record 1244 at December's end for an annual gain of 26.67%.
The S&P 500 closed the year at a record P/E ratio of 33 and a record
low dividend yield of 1.3%.
The DJIA wound up +16.10%. The tech-heavy NASDAQ starred, gaining
39.63%. Small caps still lagged, down 3.45% for the year.
The domestic economy was strong. Assuming a 4th quarter GDP of better
than 3% we ll finish the year at about 3 ½% growth. A year ago we
were hoping for a 4% year, which we discounted by a point in April
resulting from the Asian Contagion. Inflation is at 1.6%. Unemployment
is 4.3% as of December, down from 4.7% a year ago. The time spent
unemployed has dropped to 14 days from 16 average. Latest production
capacity is estimated at 80.6% down from 83.3% a year ago while manufacturing
rose 4.22% for the year. Factory shipments increased 3%. Exports declined
2.3%. Imports rose 8.3% Electric power generation rose 3.56%.
The U.S balance of trade deficit, which includes services, increased
Personal income rose 4.89%. Personal consumption rose 4.75%. Consumer
installment debt rose 4.7%. Consumer confidence declined 7.4% in December.
Monthly M-1 money supply increased 2.19% year over year; M-3 up 11.94%.
The Federal Reserve "Currency in Circulation" increased 7.5%. The
monetary base +6.28%. The dollar has lost 5% of its value from a year
ago (J.P. Morgan Index vs. 19 Currencies) and over 10% since September.
U.S. public debt remains at an all time high of over 22% of federal
The price of every single significant commodity was lower, except
gold which was almost unchanged, albeit historically low.
The housing industry, by every measure, boomed in 1998 at clearly
The U.S. has the highest long-term interest rates of the developed
world. Thanks to the Fed lowering short rates we have an improved,
positive yield curve. The long bond, which touched 4.6% last summer,
yielded 5 ¼% at year end.
Financial leverage is effective only if revenues are enhanced beyond
the higher debt hurdle. Beyond corporate balance sheets, the U.S.
economy is substantially leveraged. The risk is that a sustained market
contraction would damage household balance sheets. An increase in
energy costs would hurt household income statements. A combination
of the two would degenerate consumer confidence. Such a confluence
would cause a painful contraction in consumer spending. On the other
hand the rewards that can come from such risk are "entrepreneurship,
innovation, creative destruction and economic growth" (Larry Kudlow
citing Jos. Schumpeter, WSJ, 1/29/97). The dynamic U.S. economy continues
to grow itself ahead of its debt service but for the forseeable future
the engine for growth, the source of incremental demand, continues
to be the U.S. consumer.
Electronic technology continues to drive efficiencies globally in
every sector. One of the historic themes of the fin de siecle is the
preeminence of economics over politics. Technology, and not incidentally
the death of trade unionism, continues to drive prices lower. Financial
technology continues to shrink the globe and accelerate trading, not
just of goods and services, but of financial instruments, sources
and flows of funds. We're entering a brave new world where blind and
brutal markets, instead of governments, are redistributing wealth.
To the extent that they can participate, more people than ever before
have unprecedented opportunities for wealth.
The largest economic unit in the world is now the European Union.
The euro will succeed because it exists and the markets will make
it work. International problems with currency price stability will
be managed, if not resolved, because there is the political concensus
that they have to be. The euro won't replace the dollar as the world's
reserve currency soon but it will contribute to dollar weakness. The
combination of U.S. money supply expansion and the "overhang" of U.S.
currency abroad as Eurodollars will see to that.
Andy Rooney did a short piece on "60 Minutes" a couple of months
ago about the re-emergence of the "Ugly American". Americans increasingly
are resented abroad, a reaction to American cultural hegemony and
enviable wealth. An enigmatic foreign policy doesn't help. Nationalism
isn t yet quaint history.
If most of the value has been bought out of the U.S equity markets
growth has not. The historically high valuations and increasing participation
will contribute to greater volatility ahead. The complacency of individual
investors, rational or not, with the full complicity of their institutional
codependents, reigns. Nobody wants this party to end. It appears that
the market and the yield curve have discounted the slowdown in exports
and manufacturing in '99. You can't fight the tape and it's nowhere
near the time to "throw in the sponge". Neither Europe -with its Asian
exposure, nor Asia -which is stabilizing, nor the U.S. -with its Latin
and UK exposure, has a clear cut advantage for equity investments.
Foreign investment in U.S. markets will ebb somewhat. The global economy
will slog along. It's impossible to discount political explosions
and acts of God but there's no such thing as an agorophobic investor.
It will pay to participate in the secular growth patterns of technology,
drugs, services, and U.S. global manufacturers. There remain in the
indexes many opportunities for fairly valued, dividend growing, growth
stocks that haven't participated in the last year.
We continue to position ethical pharmaceuticals, the leading technology
stocks, petroleum companies (particularly Atlantic Richfield), U.S
global manufacturers and financials. We have pretty much bailed out
of overbought cyclicals and consumer nondurables.
On the fixed income side we are favoring intermediate term agency
paper with substantial spreads to treasuries and corporates, hence
better cash flow, and low price volatility - albeit paid for with
one to two year call "features". With negligible spreads to treasuries
munis are compelling in appropriate portfolios. We would expect U.S.
interest rates to remain pretty stable for the next 3 quarters with
perhaps a 25 basis point cut in Fed Funds rate by year end, and the
long bond at 5.25% to 5.5%.
Our objective is to try to beat the S&P 500 index on the equity side,
stay ahead of inflation and taxes on an individual portfolio basis.
Our prognostication for the stock markets' return in '99 is 6% to