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  O'Connor
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Past Commentaries

Current Commentary, Review and Outlook
November 15, 2008

To My Clients, Friends & Observers:

From the good news/bad news department:

“Migraines Cut Breast Cancer Risk 30%” – Reuters 11/6/08

That well may be, but how about this headache? I’m reminded of my brilliant and pithy English professor, Robert Farrell, who had an inimitable grasp of the subtle
distinction. “I’d rather be electrocuted than sandpapered to death,” he said. So when is the throbbing going to end?  Much of this year has been dedicated to avoiding catastrophe. Other than cash and T-bills there has been no safe harbor, no alternative, non-correlated, portfolio asset that has worked. Every asset class has declined: real estate, art, antiques, gold, oil and other commodities, and almost all stocks and bonds, including - in fact especially- muni bonds. Even money market funds got wobbly, provoking the Fed to guarantee deposits in money market funds up to $250,000 on October 3.

I spent a week recently in Florida at a series of meetings for money managers sponsored by Raymond James Financial Services (RJF – NYSE). RJ is our preferred custodian of client securities. St. Petersburg is 1,200 miles from Wall Street and light years away in terms of corporate culture - which is totally client focused and financial planning based. The culture reflects the chairman of the company, the brilliant, deliberate, and unpretentious gentleman, Tom James. He was just named Entrepreneur of The Year for 2008 by Ernst & Young.  Herewith are some pertinent highlights from the meetings.

From Sam Stovall, Chief Investment Strategist for Standard & Poors:

98% of S&P 500 stocks were down YTD, a record. As of October 10th 88% had hit 52 week lows, another record. The average bear market decline is 39%; this one is worse, at 41% to date. Volatility has increased: the average number of days per year that the S&P 500 Index declined 2% or more was 1.4 in the 1960’s, 3 in the ‘70’s, 5.1 in the ‘80’s, and 10.5 in this decade. It is 29 in the first 10 months of 2008.

The decline of housing starts may have bottomed although housing prices have not. (Nothing is less than nothing after all.) Sellers have not yet capitulated and prices may not bottom until the 4th quarter of ’09, at levels 30% lower than today.

He predicts three quarters of declining GDP: -1.6% in 4th qtr ’08; -1.7% in 1rst qtr ’09; and -0.3% in 2nd qtr ’09. Annual U.S. GDP  +1.6% for ’09. Looking to Asia he sees China slowing from 9.9% to 8.5% in ’09 and India from 7 ¼% to 7%. He noted that every $10 increase in the price of a barrel of oil trims ¼% from GDP and vice versa. Average P/E ratio for the S&P 500 since 1935 has been 15.7. In 1988 (after the October ’87 correction) it was 22.6. As he spoke on 10/21 it was 17.9. Since 1937, at the end of a bear market the P/E ratio was 12.4.

Earlier in October Stovall cited the excessive levels of price volatility, volume and
bearishness as meaningful signs of a bottom because since 1960 they occurred within one month of bear market finales. “Prices will likely turn higher before the economy or earnings do…don’t sell remaining equity holdings.” He would look for a 33% retracement to 1130 on the S&P 500 and then a retest to 1040 support. We are at 900 as I write this.

From Jeffrey Saut, the Chief Investment Stategist for Raymond James:

The 10/10 sell-off was a “panic low.” He looks for a rally and retest, which, he
asserted, held 60% of the time.

Jeff examined the potential for a consumer-led recovery. There is none. Since 1944 and Bretton Woods the U.S. has led the world in every bail-out: Mexico, the Thai bhat, Russia. Domestically, consumer credit always leads a recovery and expansion. Up until very recently the U.S. consumer was spending 110% of income. Wages have been stagnant for the last ten years. Starting in 1993 new debt surpassed total cash flow (income) as a source of new cash (to spend). In 2007, 86% of new cash came from debt. We are stuck in a credit contraction. This source of “new cash” has gone away.

Best case is that the economy muddles through. Export growth will continue. The U.S. is the world’s low cost producer for all advanced industrial products. The economy must change from housing-driven to industrial export manufacturing. Of all U.S. houses, 6.3% are for sale. The housing “affordability index” has reverted to its 20 year average of 102.2.

There is a lag of 6 to 9 months for the effects of oil price changes to be realized in
the economy.

Citing Benjamin Graham’s book “The Intelligent Investor” and an Ernst & Young study on the vulnerability of new retirees Jeff strongly favored stocks that regularly increase their dividends.

Withdrawal rates from retirement portfolios

The number one concern of retired people is outliving their income. The answer to the question “how much and at what rate can I drawdown my portfolio” will to a large extent determine the management of the portfolio. Addressing this issue was Jack Gardner of Thornburg Investment Management who gave a well illustrated review of the William P. Bengen, CFP book “Conserving Client Portfolios During Retirement.”

He divided a typical 30-year retirement into three ten-year periods, calling them
respectively the “go-go” years, the “slow-go” years, and finally the “no-go” years. The first and last periods require the most funding: “go-go” for enjoying the things retirement allows you to do while you’re still physically able; “no-go” for the health care maintenance we will require.

Bengen analyzed 50, 30-year retirements for a period from 1926 through 2004, and established an initial withdrawal rate and a portfolio allocation that resulted in a 100% probability of a portfolio lasting 30 years during the historical range given, which included four major bear markets, two of which occurred during the Great Depression. Bengen’s initial withdrawal rate of 4.15% was based on a particular allocation and on historical data which do not guarantee future results, so reader be cautioned, do not try this at home. Gardner showed how tweaking the portfolio with a particular allocation, a rebalancing strategy, and active management can add significant increments to the withdrawal rate. This presentation is available in our offices but can only be fairly made in person.


Staying focused

In an effort to encourage them in their studies I have told my children that my job is like having 6 hours of homework every day, homework that I enjoy. Apart from all the statistical analytics and business reading I have taken to reading a few verses from the Tao Te Ching regularly. They are meditations on the Oneness, the Great Integrity. As St. Paul told the Philippians, “Keep thinking those good thoughts!” (very loosely translated)

On the first of October I was unexpectedly put on the spot by a group of some very anxious investors at a luncheon and I share some of those remarks here. These were not Brae Head clients.

“It is not a good time to be emotional. I’m not going to tell you to ‘stay the course’ which is too easy and very possibly very wrong for some of  you. It’s best to be deliberate, rational and systematic. I can tell you that things will look better 6 months from now and five years from now. Ten years from now we will probably all be much wealthier if we manage to avoid a world war.

“But if you are worried about getting to the 6 month and 5 and 10 year marks you’d better have a system for getting there. To the extent you’re in stocks you should have a portfolio of really strong, low P/E companies that pay increasing dividends. Your portfolio should also have a significant fixed income component of short duration or cash equivalent in a secure money market.

“It doesn’t make sense to fire your portfolio for not doing something it was not
constructed to do. Being 100% in cash is plenty defensive but it may not be sensible as real interest rates are negative. Allocate according to your liquidity requirements. You should have some cash allocated because there is more volatility ahead. If you haven’t prepared for it yet, you are late.

“Our taxable fixed income composite has a duration of less than 2 ½ years and a yield over 6%. This is because of positions we’ve built in the last 7 years or so. As interest rates have declined we’ve shortened duration. It mitigates risk.

“When Goldman Sachs is paying Warren Buffett $500 million a year on a 10% preferred stock I have to pause and consider that this may be a harbinger of rates to come. As rates increase we will increase durations. Also the dilution of the dollar is so great that I’m expecting sharply higher rates ahead. Better to be investing in them than paying them. You need an allocation that allows you to do this. I pay my local bank 5% on my mortgage. JP Morgan pays me over 8 ½ % on a preferred. I like taking advantage of banks. Get rid of your credit card debt!”

Cash flow from dividends is crucial to a portfolio. We update every client portfolio quarterly for dividend yield and P/E ratio. It’s fundamental to the system. The following chart is from the November 12 Wall Street Journal, an article entitled “Is Now the Time To Buy Stocks?” by John H. Cochrane, professor of finance at the University of Chicago. The top line is the dividend yield of the stocks on the NYSE. The bottom line is the trailing 7 year return, illustrating the total return of $1 invested on a given date in seven years. “The same pattern also appears in price/earnings…and in many other
markets,” according to Cochrane. The chart suggests the potential for a double or a triple over the next seven years.



The P/E ratio of the S&P 500 is now 16.5. That translates into an earnings yield (E/P) of 6%. The dividend yield is 3.2%. The 10-year U.S. Treasury bond yields 3.75%; the 30-year, 4.23%; the 5-year, 2.35%.  There is a very healthy equity risk premium in the market. Oil has fallen to $56 a barrel. The dollar has strengthened to $1.25/euro due to the recession there. Our equity markets should be very attractive to foreign investors. Money market assets in the U.S. alone are approaching a record $8 trillion that are going to be invested. Borrowers and lenders have problems. This is a good time to be an owner. We don’t have to accept low bids if we don’t have to sell. We can choose to buy at these low offers.

The world is not going to stop growing. There are great multi-national American
companies that are going to accommodate that growth and they are selling at valuations I have not seen in 30 years. Infrastructure construction of utilities, transportation, and technology is imminent. It will require capital. There will be upward pressure on the stocks of the companies involved. Insider buying is near record highs even as the market has plunged. There is more than a whiff of opportunity about.



Kind regards,

Dennis M. O’Connor

 

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