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Past Commentaries

Current Commentary, Review and Outlook
February 5, 2009

To My Clients, Friends & Observers:

At a dinner party recently a doctor asked for my assessment of the current financial mess.

“It’s either or both of two things. One, further evidence of the complete collapse of morality in America. Nobody even blinks at the barbarity of terminating human life here nine months or more after conception. Or, two, it could be deliberate. There is a pattern to the corruption.”

“So you think it’s a conspiracy?” she asked.

“Let’s just say if the crisis hasn’t been manufactured, it sure has received a lot of encouragement,” I said. “Or call it making lemonade out of lemons, making the best of a bad situation. For example, for years we’ve been trying to get the Chinese to strengthen the yuan to mitigate our trade imbalance. They refuse. They have little else to do with our dollars other than lend them back to us to finance our treasury debt.

“One effect of the $150 oil, which is priced in dollars, was to transfer enormous sums from China to the oil producer nations. That helps the OPEC gang but also Russia. That spread the dollar around a bit. The Fed has been pumping out currency to fund trillion dollar bailouts. That can only have the effect of weakening the dollar which weakens the the yuan which is fixed to the dollar. The notion of free trade with China is a farce.

“This proliferation of cheap money will be inflationary which will resolve this mess of overbuilt, overpriced housing. In ten years the average price of a house may be $1 million and that will be cheap because a dollar will only be worth 20% of what it is today. We’re going to inflate our way out of this.”

The world’s biggest debtor nation is going to pay off its debts with a much cheaper currency. This will work until the rest of the world is fed up and has a plausible alternative to the dollar. We would be wise not to abuse the privilege of the reserve currency. That’s a pretty apt description: American self-abuse.

Consider some alternatives to the $3 Trillion bailout being considered in D.C. That would be enough to give $30,000 to every one of the 100 million households in the U.S. The $700 billion spent in the first round of TARP could have paid off every single subprime loan. The TARP funds are going to banks that are holding bad loans rather than the households that could repay them. It begs the question, where the hell is the money going?

We apparently learned nothing from Long Term Capital Management in 1997. LTC had $7 billion in capital and assets of $120 billion, leverage of 17. Having bet wrong on some trades their leverage soared to 55 as capital evaporated. Although a private group, including Buffett, Goldman and AIG offered to recapitalize LTC, they were rebuffed because they insisted on replacing the existing managers completely. The Fed then convened a meeting of 14 banks and wirehouses who recapitalized LTC, allowing management and John Merriwether to stay on.

Even though no public money was spent, why was the Fed bailing out what it didn’t regulate, particularly when another private offer was on the table? The New York social network is very cozy, too cozy.

Credit Default Swaps  … ssshhhhhhhh…..

Nobody wants to talk about them. They are an embarrassing disaster and they are responsible for much of the bailouts. They are not properly called “derivatives,” “hedges” or “insurance.” They are contracts based on the market value of debt securities. A piece of the cash flow from a debt obligation is paid to the contract writer to guarantee the value of the debt within a certain range. Below that price range the contract writer becomes liable for the difference in market price. The investment banks call this a “directional bet.” A bet is exactly the right term. These contracts have nothing to do with capitalizing productive industry. The banks and insurance companies might have just as well gone to the horse races with investors money.

AIG failed because it only wrote (sold) CDS’s to collect the premiums. It did not buy offsetting positions to hedge. Its Value At Risk (VAR) models permitted this. VAR is only as good as the statistics used, and statistical anomalies are discarded from probability models because they are insignificant. For example, a great depression only occurs once a century, or a certain flood only occurs once every 200 years. VAR models generally only use stats collected since 1987.

The CDS market as of June 2008 was $62 Trillion. That, coincidentally, is the GDP of the planet. The market according to Gretchen Morgenson in the NY Times, Sunday, 1/25/08, was approximately $30 Trillion, so much of the CDS market has been unwound.

The TARP money is being used to pay off the gambling debts of our “bankers.” We are saddling up our generation and the next and the next with debt to bail out a bunch of rich, incompetent slobs who are cozy with our rich politicians. This is the greatest theft in American history.

A Dangerous Game 

If the oil price spike was miserable here it was even worse for the Chinese who must feed their energy needs with petroleum from all over the world. And everywhere they go, there’s trouble, either from resistance or aggression, from diplomacy or gunfire. Make no mistake, the world is at war for oil. Look at a globe. Iran is bracketed by Iraq to the west and Afghanistan on the east. Afghanistan touches the western China border, and more importantly, blocks access to Kazakhstan and all the other “stans” to the north, which are rich in oil and gas. China is neutralized to the south by India. Russia’s best defense from inevitable Chinese encroachment may be its prudent use of the proceeds from its natural resources, including oil and gas.

The U.S. is paying for Iraq-Afghanistan with $1 trillion in off-balance sheet accounting and human life of course. The war expenditures are not included in the annual budget. Add the trillions that are being proposed for “bailouts” and “stimuli” and it’s easy to see, the U.S. currency is at risk.

Consider the stock of a corporation. The directors decide to double the number of shares and distribute them as a dividend to existing shareholders. Given the same level of output and earnings, no one is any richer. Each share is worth half as much, by dilution.

Eventually, all the dollars around the globe have to be redeemed here. If there is nothing to buy here or if the dollars are diluted they will have to be replaced by another reserve currency. Only a major global realignment can accomplish this. There is no other replacement now. China has yet to outgrow Maoism – but it will. The Euro is clearly not working as planned. In fact a Euro-A and Euro-B are being proposed.

Trading among nations eventually must balance. Trade cannot be a one-way transaction. There has to be confidence that trade can be balanced. When foreign nations purchase U.S. Treasuries they are lending us our own dollars – not a real trade at all. A devalued dollar diminishes the value of foreign earnings from U.S. trade. There has to be confidence in a currency’s underlying value. Value is derived from rules of law, respect for property rights, capability of military enforcement, and productive capacity. A nation must produce something to earn something.

America has become primarily a “service economy.” Manufacturing is only 13% of U.S. GDP.

More than 30% of earnings in the S&P 500 in recent years has come from financial products and services; lousy products and services in my opinion, fraudulent, deceptive, and reprehensible. What an export.

America has got to recover its manufacturing production. The cheaper dollar will make our products more competitive. We have to encourage more manufacturing here. We do produce much of the best in the world: Emerson, Eaton, GE, Lockheed Martin, General Dynamics, Boeing, Raytheon, Apple, Intel, Oracle, IBM, Pepsi, Coke, Nike, Proctor & Gamble, Colgate, MMM, Johnson & Johnson, Abbott, Genentech, among many others.

If America, in its greed and corruption, has lost respect for the value of its own money, then it is only a matter of time until the rest of the world, our trading partners, lose respect for America. A global realignment would be an American disaster. If we continue to abuse the privilege of the reserve currency, then sooner or later we will lose it and we will suffer.

The Changes we want to see

After the markets open every day Bloomberg television will interview a trader at the Chicago Mercantile Exchange for the daily vibe on the floor. Last week, during a quiet session, one trader responded that there was a wait and see attitude, that no one wanted to trade anything until there was some evidence that underlying structural problems were being addressed. “And right now there is no evidence of that,” he said.

That trader had it exactly right. The negative surprises, the deceit have become so chronic, so systemic, that trading has become defensive and minimal. No one can be trusted! Every trading day brings a new, monstrous revelation. Our trading has been minimal and extremely cautious; there is too little reward to take much risk. As yet, the structural problems are not being addressed seriously although finally they are starting to get named: hedge funds, credit default swaps, failure to regulate or supervise, rampant greed, lack of accountability from an over-reaching federal bureaucracy and the corruption of public officials.

Hedge funds reported terrible losses last year though no one can be sure of their veracity because they have no obligation to report the truth. It is common knowledge that many endowment fund managers regularly “re-price” their investments rather optimistically.  Some are clamoring that “mark to market” accounting should be dropped. I heartily disagree. With regard to mortgage backed securities a FASB rule could define a workable pricing mechanism. But with other derivatives, SIV’s, CDO’s, CDS’s, if they can’t be sold or redeemed, they have no value. That ought to tame the tiger. Hedge funds have far too much capacity for harm to the whole system for them to be immune to fully transparent regulation.

We will be paying for credit default swaps for generations. Existing contracts should be unwound, i.e. reversed, with the premiums repaid in the same periodic increments. Subsequently they should be illegal. They have no legitimate function in the Capital Markets.

Many are demanding new regulations. The greater problem is not lack of regulations, it’s lack of enforcement. We didn’t elect the CEO’s of Bank of America or Merrill Lynch. We elected our public officials who are charged with regulating them.

We might begin to publicly acknowledge the decay of common morality. Our leaders ought to stop paying cheap lip service to “Our Values” and start promoting some timeless values. Morality by definition doesn’t allow for a lot of “diversity” and there’s a fine line between diversity and mayhem. Ten little commandments provide far more social harmony than the 70,000 pages of regulations added each year to the Federal Register.

Since 1997 the U.S. has systematically dismantled all the protections that were created to protect the public and our capital markets after 1929. So far it has been a disaster. With the complete merger of investment banks, brokerages, and commercial banks it is apparent that the SEC will soon be redundant and likely will be replaced by the OCC as the principle financial regulator. I sincerely hope our legislators will stop and reverse this course.

Best regards,

Dennis M. O’Connor

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