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Past Commentaries

Current Commentary, Review and Outlook
April 21, 2011

To my Clients, Friends & Observers:

It bears repeating, be careful what you choose to believe in the newspapers, particularly concerning investments. The first amendment gives journalists the right to say anything they want, good or bad, true or false. There is big business in financial public relations and the financial journals are full of “placed” articles, mostly puff pieces, paid for outright or favors returned for regular advertisers. Recently an article headlined “BofA Shares Could Rise 40%” appeared in Barron’s, a publication that I have loved since college, and to which I still subscribe. Now, I honestly don’t know the provenance of the article, but the analysis was so subjunctive (if, would, could, should, might) and touted such rosy prospects for America’s most disgraced financial institution - an outlook so antithetical to mine - that I couldn’t help but be suspicious.

Years ago I worked for a paper mill. (Manufacturing experience should be required of every investment professional!) One afternoon in the late ‘70s I went to lunch with the president of my company, our local bank president and one of the bank’s corporate loan officers. We were reviewing our revolving credit facility. As we ate I was talking about the expansion of the money supply, M1, M2, and M3, and its inflationary effects. “You know, Dennis,” the loan officer said, “I’ve never understood all that M stuff.” I wondered to myself if his intellectual curiosity was representative of most commercial bankers. If so, it helps explain the sale of investment banks to the commercial banks, and the subsequent domination of the acquirer by the acquired, the working dynamics of John Thain with Ken Lewis.

Like geese force-fed for fois gras the Fed is force feeding banks, guaranteeing 3% spreads. It’s a trend that’s not sustainable and not necessary either. Banks will be weaned. Quantitative easing is coming to an end and the bond market is finally hinting capitulation. The secular trend (that I described in June 2008) is still not good for banks. The derivatives business is not as lucrative and the banks now compete for the lowest profit, most competitive part of the market, retail deposits. Not that I underestimate the creative diddlings of investment bankers.

It’s certain that significant growth in the developed world is on long-term hold. The banks are still overloaded with bad debt. According to Michael Rapaport in the Wall Street Journal, as of last September 30 the top 10 U.S. banks had $361 billion of “Level 3” assets, illiquid assets that can’t be marked to market. That represents 43% of the banks’ shareholder “equity.” These are unmarketable mortgage-backed securities and CDO’s that are worth anywhere from 0 to 50 cents on the dollar. Who knows? The Fed has announced it is preparing to sell $143 billion of its “toxic asset” portfolio, which makes me immediately suspicious. If the assets are toxic, they can’t be sold, and the $143 billion is a “magical” number. I’m getting that funny tingle that the fix is in. As for the banks, the mortgage servicing fees they’ve enjoyed, typically .25% per year of the mortgage balance, will decline to .15% or less, in a shrinking market. And on April 1, FDIC insurance fees increased .10% to .45%, driving money market returns even lower.

So what about America’s biggest retail bank? The combination of Countrywide, Merrill Lynch, and “retail banking” is too perfect of a storm. Bank of America will be a bungler for as far as the eye can see. By contrast, J.P. Morgan Chase will outperform and the “Chase” is not significant.

While reviewing performance charts on our client statements, most of which incorporate the S&P 500 Index for comparison, I was struck by how weak the Index pattern is, particularly compared to our clients’ equity performance. And the Index doesn’t look good going forward. The broad market has been enjoying a bull rally in a longer-term bear market. Volume has been anemic so far this year and the rally is getting long in the tooth. Though many analysts are predicting a 1500 high on the S&P sometime this year, there is no chance in my opinion. The high of 1530 was reached in 2000 and again in late 2007. With “quantitative easing” (QE) drawing to a close, a double dip realty recession, and a fairly lame recovery in general with real unemployment still well over 10%, it is impossible for me to visualize 1500 S&P with any conviction.

What has been driving the Index are solid corporate earnings but financial earnings are overweighting the Index. Banks can lend at 3% spreads, but they aren’t lending much, and investors who lend to the banks are denied any return courtesy of the Fed’s zero interest rates, so investors have turned instead to the equity markets. They have also turned to the commodities markets, which inflation is entirely overdone, and completely a result of Fed policies. There are no shortages of metals or petrochemicals in China at this time or for the foreseeable future. I would be extremely cautious of metals here, food stuffs less so, but petroleum can still be accumulated. The emerging markets bubble is also approaching exhaustion and that deflation tends to have some duration.

More disturbing than the S&P’s inability to make higher highs is the long term pattern of lower lows. The market made significant reversal lows of 970 on 10/7/98, 777 on 10/9/02, and 676 on 3/9/09. To be realistic, the likelihood is that the market is presently making a lower high. It gets worse. Everything eventually reverts to its long-term mean. The S&P has yet to revert to the single digit (7) P/E’s or low P/B’s (price to book value) of the 1970’s. Good quality companies, preferably large caps will likely prevail this year, but there are bubbles all around, inflated by the huffing and puffing of mindless herds and animal spirits. The P/E of the S&P 500 is presently 17.2. The reciprocal is the earnings yield, 5.8%. The ten year U.S. Treasury yields 3.3%, up from 2.4% in the last 6 months. The average P/E ratio for the last 130 years is 12. To get back to the average, earnings would have to increase from $77 (the last 4 quarters reported) to $111, a 44% increase; or, the Index would have to drop 400 points, from 1340 to 940, a 30% drop. While the market is not especially overvalued, it is not cheap. The equity risk premium evaporates as the 10 year treasury yield climbs, and 300 or 400 point drops in the Index are very realistic contingencies.



Here are a few of the headwinds the markets face going forward: the end of Quantitative Easing and/or more QE down the road, either one of which has made and would make the dollar cheaper; further acceleration of inflation; inability of Federal policy makers to reform fiscal behavior; supply chain disruptions from Japan; continued recession in housing; a lower U.S. credit rating and the perception of the end of the dollar as the reserve currency.

The Chinese authorities are expanding global use of the yuan for trading and exchange. As the proliferating dollar cheapens, causing more inflation, other nations are seeking alternatives. Visibility of a strengthening yuan encourages accumulation. Momentum develops.

The failure of government at so many levels is existential in degree. The Federal government’s refusal to seriously address runaway borrowing and spending is a colossal failure that, without exaggeration, puts the republic at risk. The Republican plan is anemic, relying on the same old bogus, baseline budgeting standards, pushing initial savings four years into the future and ignoring any real tax reform. The Democrat plan is an exercise in complete denial and false compassion. Taxing million dollar incomes at a rate of 100% would only raise $1 trillion, and only once. Total public debt is $14 trillion. The entitlement programs and endless, unjust wars, in various worthless dirt pits around the globe have to be addressed and curtailed. Our representatives really do not want to risk re-election. There is no initiative to actually redefine the expenses that should be borne for government, to seriously cut back the size and scope of a Leviathan bureaucracy that is out of control. There is really only one source for such an initiative: moral obligation. For that I won’t hold my breath waiting. The best that can be said is that American culture has become chronically amoral.

To illustrate the scale of the problem Mr. John Schweizer of Barrington, Illinois wrote this note to the Wall Street Journal a while back. “Look at our tax dollars as if they were units of time. One million seconds is approximately 11.5 days; one billion seconds runs nearly 32 years; and one trillion seconds represents more than 30,000 years.”

We’re stuck in the “double-dip” real estate recession that nobody wanted to predict outright. Now it’s pretty plain to see another 10% down side to housing prices. The good news is that the shrinkage in housing construction is behind us and the economy is adjusting to it. The bad news is that it will take a generation for this to get digested. Real appreciation, net of inflation, in my opinion, may be 15 years away or more, waiting for the demise of the baby boomers. What I find remarkable is the top end of the real estate market. In the million-dollar-plus zip codes that I track estate prices have rebounded significantly from their depths in 2009, telling me that inflation expectations are being priced into the market.

Is it wiser then to avoid the markets? Well, money is either growing or shrinking whether it’s in the pocket, the bank or invested in securities. Look at the two deep valleys in the chart above. There is another valley ahead, inevitably. Nobody knows exactly when. But look at the right side of each valley. Compare the amount of time the Index increased rather than declined. Not participating in the securities markets is imprudent, it’s foolish. To participate in the markets only during periods of collapse is irrational.

The Brae Head aggregate total return did not surpass the S&P 500 in 2010 because of client asset allocation considerations and the extraordinarily low yields of short duration fixed income positions. But in cumulative performance over time the Brae Head composite has outperformed the Index by a factor of 8. The reason is systematic rebalancing and a systematic sell discipline. In 2000 the systematic risk in the entire market was apparent. It was a prudent decision to sell 40% of everything we managed, taking profits from good stocks in an overvalued market. Around the same time it was prudent to sell 100% of Coca Cola stock and 60% of GE stock because Coke financial statements no longer made sense and GE had become a predominantly financial services company. These are examples of non-systematic, stock specific risk.

The systematic risks we face now are extraordinary. We are in uncharted waters and “we” are all in this together. There is far too much discretionary authority concentrated in this Federal Reserve, further evasion by Congress of its Constitutional fiscal responsibility. We are constricted by zero bound interest rates. I have expanded positions in good quality utilities in order to get more cash flowing in portfolios. Utility share prices will take a hit as interest rates rise but I don’t care, I am buying them to pay reliable, increasing dividends. Share prices will recover with time as dividends increase.

Policies of inflation and a collapsing dollar are indefensible as are the three wars the U.S. is pursuing. There are terrible costs accruing.



Kind regards,

Dennis M. O’Connor