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Past Commentaries

4/29/2015

Current Commentary

To My Clients, Friends & Observers:

Whose World Is It Anyway?

One of my favorite books by one of my favorite authors is Bonfire of the Vanities by Tom Wolfe, first published in 1987. Recall that, like 2008, there was another financial cataclysm that year, a bonafide stock market crash. Bonfire explores the life and times of Sherman McCoy, a Wall Street bond trader. Tom Wolfe, like Mark Twain, employs great journalistic sensibilities to write novels that should endure as insightful revelations of their times.

Sherman McCoy is modeled after John Meriwether, the biggest bond trader at Salomon Brothers in the ‘80s. The great bull market in bonds began in 1981, when the ten-year U.S. Treasury note yielded a high of 15.84%. (Its low yield was 1.40% on 7/24/2012). It was a time when high yields and opaque markets could support huge markups or markdowns on trades. Some would describe the amount of money made as “unreal.” In fact, the money is all too real; the rest of the world is abstract. Bond traders became an insular, elite culture unto themselves, financially elevated beyond the comprehension of the other 99% of the planet. In Bonfire, Sherman’s trading is so lucrative he is nicknamed (as was Meriwether) the Master of the Universe.

But in an anxious two-page reverie, Sherman ponders his future and his cash flow with consternation. He is making just under $1 million a year (when a million was real money) and yet after he tallies the costs of the Park Avenue apartment, the house in Southampton, the two cars and their parking spaces, his daughter’s private school, the nanny, the maid, the gardener and the handyman, the car service, the subsidies for his wife’s (unprofitable) interior decorating business, and then the clothing, food and entertainment - there is nothing left! He is spending more than the $980,000 he makes! And considering taxes, to actually net a million, he needed to gross a million-six. He considers his options:

“Well, obviously he could cut down here and there – but not nearly enough – if the worst happened!…There was no turning back! Once you had lived in a $2.6 million apartment on Park Avenue — it was impossible to live in a $1 million apartment. Naturally there was no way you could explain this to a living soul. Unless you were a complete fool, you couldn’t even make the words come out. Nevertheless — it was so! It was…an impossibility!
This was the world of Sherman McCoy, Master of the Universe, the greatest bond trader in the world.

I retell this story to remind us that, without stretching any imagination, in 2008 this was also the world of many other movers and shakers in banking, finance and government. They do not have to be named to make this point: when these people are telling you that the “world’s financial system is on the verge of collapse,” consider whose world it is they are concerned about saving.

If bankers and their governments were not able to saddle generations of innocent civilians with the debt required to cover up their malfeasance, the world would be a far more peaceful place, financially and otherwise. They privatize the gains and socialize the losses.

The Bond Market

Thinking back to 1987, I recall that the 30-year U.S. Treasury Bond yielded over 10% for just two days that September. (The bond market collapse was a prelude to the stock market crash the following month). I remember because I bought as many as I could for the few clients I had. Unless you felt that sovereign, non-callable, American debt was in jeopardy, how could you not make an investment that, reinvested, would double every seven years or so?

It is inarguable that higher interest rates slow economic activity. However, when the base Fed Funds rate is zero, any positive yield ought to be sanguine. The Fed Funds rate was 4.25% in January 2008. By December that year the Fed had lowered the rate in successive steps to .25%.

Seven years later the rate is 0% and nobody knows when the Fed will raise. The overwhelming criticism of Greenspan when he was Fed chair was that he kept rates too low for too long. This time it’s different? The pace of economic recovery has been painfully slow but indicators are positive. Expect GDP of a little over 1% this year. Normalization of rates would be healthier in the long run. If a Fed funds rate of 1% would throw this economy into a recession then the economy clearly has not recovered and the economic policies of the last 7 years have been a monstrously expensive failure.

The ugly, painful fact is the Fed is constrained by the magnitude of U.S. debt run up over the last 15 years. Any interest rate hikes will result in corresponding increases in the cost of debt service – on $18 trillion, a daunting prospect. Ex-Fed chairman Bernanke regularly testified to Congress that monetary policy alone could not manage an economy without responsible fiscal policy.

Every time the stock market perceives a pending rate hike, the Indexes take a 2%-5% drop for a week or so. Looking back at the history of rate hikes, after 3 bumps the market does correct 10% or so over 6 to 8 months but then recovers to a gain within a year. The notable exception was 1999, when the market was greatly overvalued. We do not have that situation today. The Fed is choking savers to the benefit of investors, i.e. the stock market. In a 6 year period of glacial economic growth, inflation is clearly in the equity markets. Recent FOMC notes suggest that the Fed will not raise rates until fall, if at all, and I wouldn’t be surprised if there was no rate hike until after the 2016 election. That will only make solutions that much more difficult for the next administration.

The Stock Market

We are still long-overdue for a 10% correction. The S&P 500 P/E ratio is just over 20, reflecting declining earnings. The S&P 500 Index had record earnings in 2014. First quarter earnings will show a decline of 3% year over year. Expectations are for growth in (S&P) earnings of 8% in 2015. Oil prices are rising and we may have seen their lows, but there is no significant activity anywhere to reduce the glut of oil in storage, so we may not see the highs again for a long time.

The effect on consumer spending is almost immediate and that is constructive. Households are finally seeing increases in real income and consumer sentiment is positive. Consumer non-mortgage debt is also expanding though not to 2008 levels yet.

The dollar’s strength is constraining exports. Ordinarily, a 20 P/E wouldn’t be alarming in such a low-inflation environment, but it does concern because we are in such a very low-growth environment. S&P 500 earnings should be sufficient to support an Index north of 2200 from the 2100 we’re at now.

Long-time clients know that I have followed General Electric closely for my entire career. The company is such a diversified conglomerate that it is a good proxy for American industry in general. In the 4th quarter of 2014 I liquidated approximately 80% of the GE stock in our portfolios. The company is at a stage in its life cycle when it should be spinning off divisions and consolidating a core strategy. It’s not been helped by the anemic economy, the collapse in oil prices, and the relentless strangulation by incoherent regulations, particularly Dodd-Frank. GE’s most recent response is to announce that it will divest its consumer finance operations this year. It begs an examination of consumer spending in general and all other financial companies in our portfolios with consumer exposure. Total financial businesses, including GE Capital and GE credit and lending subsidiaries, accounted for 30% of GE revenues and 35% of earnings in 2014.

Stock selection has been difficult in a market that appears largely picked-over. More hedge funds closed in 2014 than any year since 2009. So I am pleased to be rewarded with gains over 30% in such mundane companies as Sturm Ruger, Olin Corporation and Cal-Maine Foods, bought in the last two quarters when they were out of favor.

More ETF Bad News

Once again, computer “glitches” are being blamed for serious mispricing of Exchange Traded Funds (ETFs) on the New York Stock Exchange Arca on March 31, the last day of the first quarter. As a result, first quarter performance figures are probably unreliable. Many custodial firms have notified their customers of possible discrepancies in their statements.

I don’t believe in “glitches” or in tooth fairies. There are serious structural issues with ETFs, how they are packaged, priced, sold, and traded. In my opinion they are the latest disaster-waiting-to-happen for an unsuspecting public who has been sold another brilliant investment “product.”

Best wishes,

Dennis M. O’Connor