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Past Commentaries

Current Commentary, Review and Outlook
January 17, 2013

Current Commentary

To My Clients, Friends & Observers:

The risk of any loan is quantified by its interest rate. There are two risks that need to be paid for: the opportunity cost of having funds tied up at a particular rate of return and the ultimate risk of losing the principal. The United States has interest rates dramatically lower today than five years ago yet it is significantly less capable of paying principal and interest on its debt, a fact recognized by the major credit rating agencies which have lowered its ability to pay from AAA to AA. Yet the five-year U.S. Treasury note that yielded 5% in 2007 yields .75% today and short term T-bills yield little more than nothing. Though Modern Portfolio Theory defines the 3-month T-bill to be the “risk-free asset,” in truth it is no longer. It actually has a negative real return after inflation (the nominal rate minus the inflation rate). Welcome to post-modern portfolio theory. These are not normal times.

The consequences of a sovereign default were illustrated in October when the national three-masted sailing ship of Argentina, the Libertad, was seized while in Ghana by order of a local court. The plaintiff was NML Capital, Ltd., a hedge fund run by Paul Singer, as collateral for $350 million of defaulted Argentine bonds owned by the fund. Alas, the “Libertad” was no longer free and therein lies the lesson: nothing is. Unfortunately, Ghana is a signatory to the U.N. Convention on The Law of The Sea and as such subordinated its sovereign jurisdiction to an international tribunal in Belgium which overturned the seizure, allowing the Libertad to return to Argentina.

Argentina is the real-time result of a corrupt political class run amok pandering to its electorate while bankrupting their nation. The elect of Argentina are aware of the miserable and decaying conditions of their once great society. But most, simply and callously, do not care. The Peronistas have done everything they could to expand their constituency, including opening the borders to any and all immigrants, and providing “free” health care to any and all.

Argentina has been systematically indebted far beyond its ability to pay by people whose wealth is derived from political power; people who have no interest whatever in the poor or the middle class other than to keep them dependent on their incumbent government. The Peronista representatives belong to a great aristocracy. They are guaranteed the best health care that money can buy, a generously increasing pension for life, a minimal work week, and exemption from the laws that they themselves pass. The incumbents are increasingly desperate because they are fighting for their very existence. Argentina has finally, to recall Mrs. Thatcher’s words, run out of other people’s money.

Gee whiz, this couldn’t happen in America could it? The tyranny of aristocrats literally revolted the American founding fathers. Thomas Jefferson once opined that after two generations a people and the land they inhabit are naturally inseparable by dint of birth and death, heritage and cultivation.  In law, the “rule against perpetuities” limits the life of a trust instrument to 25 years after the death of the last person alive at the inception of the trust. Part of the rationale for this rule is to discourage perpetual aristocracies. By what right does a government impose an indenture on two, three or four generations as yet unborn? The Federal government appears to be completely out of control. The country is completely dependent on borrowed money.

Yet the shouting against any austerity is practically hysterical. It comes from pols and journalists who know nothing of economics and money but know enough to recite the party lines they are paid to recite. It also comes from better-lettered economists like Paul Krugman, a Bolshevik in my opinion. To one and all I would present two present-day, socially progressive economies which have seized austerity – not without pain - and thrived without indenturing themselves.

Iceland refused to socialize the debts of its banks, letting them fail instead. The krona plunged but the economy adjusted in due course. Trade and capital flows improved and the nation was purged of artificial finances and artificial financiers.

Germany reunited in 1990 and in 20 years has absorbed its impoverished eastern half and reconstructed itself into one of the two major economic powerhouses on earth, with trade and budget surpluses, a strong currency and low unemployment. It’s the backbone of Europe.

On the Markets

Analysts have generally been cutting estimates throughout most of 2012, at an increasing rate.
Second quarter earnings decreased for 35% of the companies in the Brae Head composite (45 out of 128). Third quarter earnings declined for 33% of our aggregate. (The good news is that earnings increased for the other 67%.) I would expect revenue growth for most of the S&P 500 to be hard come by this year, with two exceptions. The automobile fleet is over ten years old and must be replaced. House refurbishing and homebuilding are recovering, albeit from very low levels. The industries that serve these sectors should do well. One company that I have positioned in this regard is a micro-cap, Handy and Harman, HNH. Its highly profitable engineered products division dominates its markets in proprietary fasteners, decking and roofing systems. Its metals division is exceptionally well-positioned. The company is well managed and is expanding internally and by acquisition.

Despite a meager Christmas season consumer spending on staples and capital goods is improving. However, real wage growth continues to be anemic. Disposable income is declining. One has to look hard for the demand that will drive earnings growth. Europe will continue its recession throughout 2013. U.S. GDP growth is forecast at 2.3% by Standard & Poors.  Global growth is pegged at 2.9%, hence the continued rationale to invest in well-managed, large-cap multinationals. I still like Caterpillar, IBM, United Technologies, Eaton and energy stocks.

The poorest performing sector in 2012 was utilities but they should be safe havens in 2013 with significant yield and downside protection. There are yields available at 4% and 5% at conservative payout ratios; National Grid and WGL Holdings are a couple of names.

I can’t forecast a double digit gain in the S&P 500 this year but I can’t forecast a decline either.

The Search for Safety, Growth, and ROI

One of the principles of my system of portfolio management has been to invest primarily in American multinational companies, the better to mitigate currency fluctuations. Well-managed companies hedge their global exposures with futures contracts and price transfers. Eventually, my clients and I spend our money in U.S. dollars.  So it is with alarm that I watch the Fed printing money and debasing the currency.

This has triggered a global currency war. Every nation wants to keep its products cheaper to export. Most – but not all – are trying to cheapen their currency. The yen is tanking. Brazil is struggling to sustain its exports. Even the Swiss are deliberately devaluing the franc. One currency I like that has retained its value is the Australian dollar. It has the fundamentals to support it.

Despite the recession in Europe and the bond-buying programs of the European Central Bank (money printing), the Euro has strengthened against the dollar, from $1.20 a year ago to $1.33 today. (This is not good for Germany, which reported a GDP decline of .4% in the 4th quarter. )

Still the Fed has not yet succeeded at reflating the economy. CPI increased 1.7% in 2012.
Labor weakness and the deflation of real income can’t be fixed monetarily. U.S. debt growth is greater than foreigners’ ability to buy it. China has already declared its intention to reduce or suspend Treasury purchases. In Europe, private demand for government debt has declined.

So I look at gold, as a trade and as a longer term store of value. I recently attended a commodities conference which included speaker Greg Weldon, who manages precious metals portfolios. He feels gold has significant upside and is fairly priced. Yes, it has had a significant run-up from $300 to $1800 over the last ten years but in a world oversaturated with debt, gold is still in demand. It has increased in every currency. It has pulled back to $1625 recently. Over the last 5 years, when gold has fallen to $1575 central banks have been buyers.

According to Chris Blasi of Neptune Global Holdings, a precious metals investment services company, 3rd quarter demand for gold was 1,084 tons, up 10% from the 2nd quarter. For the year, jewelry demand declined 2%, tech demand decreased 6%, investment demand increased 56%.

China, which holds most of the U.S. currency from trade and U.S. sovereign debt is hedging its positions with gold. It is the world’s largest domestic producer and its largest global buyer. China’s gold demand has increased an average of 27% a year since 2007. Demand in 2012 was 775 tons. By the way, the total value of gold held by the U.S. government is a mere $22 billion.

Mr. Blasi makes the point that in 2013 gold moves up from Tier 3 to a Tier 1 bank asset under the Basel III banking accords. This is the first time in 42 years that gold is being brought back into the banking system. He also notes that Northwest Mutual Life Insurance Company bought $400 million in gold in 2009 at an average price of $949 an ounce, the first purchase ever by an insurance company.

Price appreciation of gold is not over. The most popular gold investment is GLD, the Standard & Poors Depository Receipt for gold shares, an exchange traded fund that tracks the price of gold. The problem with this security is that in the event of a major liquidation the fund could not redeem all its shares. The safest way to invest in gold is to purchase the metal and store it safely. However, one still and always risks government confiscation. It’s happened before.

The case for investing in Australian sovereign debt

Pros

  • Australia is rated AAA. USA is rated AA and declining in credit quality
  • Aus debt is 13% of GDP and declining. USA debt is 150% of GDP.
  • Aus $ is strong, stable currency. US $ is weakening.
  • Aus unemployment rate is 5%, effectively equilibrium.
  • Aus is G20 nation.
  • Aus expected to run a budget surplus in 2013.
  • Huge wealth of natural resources including undeveloped energy
  • Natural market in China
  • Net exporter
  • Trade surplus
Cons
  • Is experiencing an inflating housing bubble, but not driven by loose credit or mortgage backed derivatives
  • Australia’s bank assets are approximately 50% other global debt, so they are not quarantined from the rest of the world’s financial pathologies


Securities bought with U.S. $, exchanged to Aus $, and vice-versa for coupon and principal. A stronger U.S. $ v. Aus $ would result in capital loss due to currency translation. A stronger Aus $ would result in capital gain.

The Australian dollar has increased in value from $.95 to $1.05 over the last 3 years or so. It appears stable at $1.05 but the trade is for the currency appreciation, not the coupon. Five year yields are approximately 2.75%; three year 2.65%.

Kind regards,


Dennis M. O’Connor