Review and Outlook
To My Clients, Friends & Observers:
September 13th, 2001
Following are two commentaries,
the first written on Monday morning and the second written on Wednesday
after America was attacked. I decided to deliver them both to illustrate
what a profound difference Tuesday has made to the course of events.
It also illustrates a type of risk, ever present, to which we have
rarely been exposed: "event risk" or "catastrophic risk."
Economic reporting has become consistently unreliable
over the last ten years, either because of the enormity of the collection
and processing of data or, perish the thought, the deliberate manipulation
of data. Two or even three revisions of government reported data are
not uncommon. It forces greater reliance on technical analysis of
the markets and, in the economy, on fairly secure data including interest
rates, money supply and commodity prices. The official definition
of a recession is two successive quarters of negative GDP. It’s
not too much of a stretch to volunteer that are we are in one now,
to be announced late spring 2002, post facto.
It is as impossible to level the waves in the ocean
as it is to stop the waves of economic effects of lower earnings,
lower growth, lower sales, lower prices, lower wealth, and slower
activity. It culminates in a crashing wave of negative sentiment and
investor psychology, the confluence of time and tides.
One of the last evidences of unrealized wealth, paper
value, is real estate. While the longer term demographic for real
estate looks positive, nearer term we are already starting to see
bubbles pop. There should be good opportunities in real estate purchasing
in six months to a year.
The price of oil, which greases everything, is recalcitrant
at $27 and is threatening $30 again, depending on what you read and
whom you believe.
The strength of the dollar is a problem without a
solution. There is no satisfactory alternative to the dollar as the
reserve currency. A strong dollar is not a bad thing and a stable
dollar is a good thing, but a drop in valuation of 10% would be sanguine.
It would raise longer lending rates, a positive for the yield curve,
and help our exports. It would delay a subsequent stock market rally
but build a better base for it. If the dollar does not slide or fall
we already have a positive yield curve and relatively low rates across
the board. Fixed income strategy: barbell overweighted at 2 to 3 year
maturities, underweighted at 8 to 10 years.
Sometimes it’s worth stating the obvious: with
a cheaper dollar America gets sold cheaper.
Only one economy in the world is growing right now,
China, with an estimated GDP growth of 5%. China now manufactures
practically everything. Therefore, practically everything would be
more expensive to a cheaper dollar.
Things that once looked cheap now look expensive at
discounts of 15, 30 and 70%. The S&P 500 Index has a P/E of 30,
according to Standard & Poors as of September 5th. Unfortunately
the very definition of "E" as in "earnings" is now being debated by
the accountants, the regulators and the corporations. Did anyone ever
finally determine what the definition of "is" is?
If we accept the given P/E of 30 and consider that
the historical average is around 15 what kind of growth in earnings
do we need for how long to get back to that? I refuse to countenance
that and would argue that low inflation and interest rates make an
S&P P/E of 20 quite rational, in fact, good value. Earnings growth
of 5% a year would get us to a 20 P/E in 9 years.
Then what price level would help us get that 20 P/E?
740. Today’s close was 1092.
Pick your poison? I think not. Last weeks increase
in volume was redolent of a climax and new NYSE lows were far fewer
than in April. Most likely is a protracted period of retrenchment,
inventory liquidations, industrial rationalization, and base building
for accelerating earnings.
It has been attributed to Sir John Templeton that
a classic bear market retraces the prior bull by 50% and lasts half
as long. We do have the latitude of defining the last bull market
and whether or not it was "classic" I suppose.
GE hit our "watch list" six weeks ago and we determined
to sell it if it broke under $40. It did and we did.
Principal support for Coca Cola’s $49 price
tag is Warren Buffet’s 8% stake. We don’t own it.
One of our few acquisitions over the last quarter
has been a small-cap, Connecticut Water Services, which surpassed
all Brae Head screens with flying colors.
The ARMS Index gave two very bullish signals over
the last three weeks, strongly suggesting an upward trading rally.
I’d welcome it in the face of very weak fundamentals. Short
interest recently hit record highs for NASDAQ, again potentially bullish.
The clues we will look for to indicate revival are:
insider buying, increased corporate share-buybacks, upside earnings
surprises, and low or falling long term rates. We may already have
the latter. If we are in fact entering two quarters of negative GDP
the market historically discounts the recovery about six months in
9/12/01 Additional Comments After The Attacks
I am shell-shocked as I write this. These television
images will scar my memory to my dying day. I worry about my children
and their fears. Three of them called me from their schools Tuesday
afternoon. Many emails and phone calls yesterday confirmed that my
personal friends in New York are OK, if badly shaken. Work is the
antidote to helplessness. There is work to be done and responsibility
I’ve reviewed the list of tenants affected in
and around the World Trade Center. I’ve spoken with friends
and professionals in the industry. I’ve reviewed all positions
in portfolios that will be impacted by the attacks and constructed
strategies to deal with them.
U.S. markets may reopen tomorrow although I would
rather they did not until Monday. The exchanges will maintain orderly
markets though there will likely be some volatility for a short time.
Some of the financial and insurance firms exposed to the World Trade
Center will doubtless take earnings hits. I would expect institutional
traders to close ranks and support the markets and our economic system
from this despicable, psychotic, evil attack on innocent civilians.
I am getting a positive sense of solidarity at other institutions
I’ve talked to. It is improbable that we will see much panic
The U.S. is entering a war economy. The Federal Reserve
will pump liquidity into the system creating cheap money for money
center banks to lend for the monumental rebuilding task and the war
effort. The "surplus" should rightly evaporate. All the petty politics
about the budget is on hold. Long bond rates will rise. The Fed will
lower short rates. The yield curve will be very positive. A war effort
will pump orders into the manufacturing base.
I’ve reviewed market behavior at the time of
Pearl Harbor, the Cuban Missile Crisis, the JFK Assassination and
the Gulf War. Market drops immediately following the events were followed
in six months to a year by significant advances.
The worst type of protracted recession would have
been preferable to us all in lieu of the slaughter Tuesday. It may
have the perverse effect of eliminating any potential for recession,
a consequence unintended by these terrorist murderers.
Join me if you will in prayer for the dead and injured,
their loved ones, and the nation. Consider with profound appreciation
the heroic, selfless acts of countless civilians and civil servants
responding to this horror. This is the very best of America and we
are common Americans all. May we all have such character when it is
our turn to sacrifice.
PS To Brae Head Clients: Tuesday’s email
bulletin stated that Morgan Stanley Dean Witter (MDW) was "headquartered"
in the south tower of the WTC. In fact their corporate offices had
been moved to Morgan Stanley’s offices in midtown. There were
about 3,500 employees at the WTC. I was told they evacuated immediately
after the first explosion.