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Investment Process
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  by Dennis M.
 •Brae Head Total
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Past Commentaries


Current Commentary

To My Clients, Friends, & Observers

The German philosopher Georg Hegel (1770 – 1831) viewed history and time as a dialectic of events, a continual process summarized as thesis, antithesis, synthesis. And that seems to be a reasonable interpretation of some current events here in the USA that are antithetical to the last 16 years. The synthesis will out sooner or later, becoming the new thesis. No need to speculate.

The following table shows GDP growth rates over two ten-year periods, the Great Depression and the Great Recession.

1930 -8.5 2007 1.8
1931 -6.4 2008 -0.3
1932 -12.9 2009 -2.8
1933 -1.3 2010 2.5
1934 10.8 2011 1.6
1935 8.9 2012 2.2
1936 12.9 2013 1.7
1937 5.1 2014 2.4
1938 -3.3 2015 2.6
1939 8 2016 1.6
Average 1.33 1.33

The former was dramatically more volatile year-to-year, the latter smoothed by government transfers and controls created in the 1930’s, and by an expansive Federal Reserve that has added almost $10 trillion of liabilities to the national balance sheet. Both periods share a common sensibility: a palpable sensation of creeping entropy, of hopelessness and desperation for broad segments of the population.

The election gave a catalyst to a market that had returned a little less than 6% year-to-date. Anticipation of higher interest rates, less regulation, lower taxes – corporate and personal, higher defense spending and greater infrastructure construction led to almost immediate spikes in manufacturing industrials, financials, defense and construction companies. The S&P 500 ended the year up 9.5% on a price basis and 11.9% on a total return basis (including dividends). The Brae Head, Inc. average aggregate total return of all managed portfolios returned 14.5% for the year. The BHI composite exceeded the market return while only being 86.5% in the market at year end.

Overseas markets were less sanguine: Japan and emerging markets down; Europe sideways; China’s Shanghai Index down 12.5%. International institutions spent most of 2016 withdrawing from U.S. markets. Now that the dollar has strengthened (to 106 Euro today) the U.S. is again attracting foreign investment. I am cautious that the market may have gotten ahead of itself.

The S&P 500 P/E ratio is just under 26, reflecting the higher price of the Index and the still-low earnings. Earnings peaked at 105 in December 2014. They were only 89 as of the end of the third quarter. Fourth quarter earnings, which are just being released now, are critical to market strength in 2017. Indications are that the earnings recession has ended. I would like to see S&P earnings back over 105 in 2017. That would still leave the P/E at a relatively high 22.

There is significant uncertainty ahead. The Fed has indicated that it will raise interest rates as often as three times in 2017. Markets don’t respond well to 3 successive rate hikes. Globally, economic growth is still anemic, and there is speculation as to international trade protocols with the new administration. Following is a chart of the Baltic Dry Index (blue) - which is a leading indicator of global economic activity - and the S&P 500 (green).

The BDI was as low as 703 this year before climbing back to a high of 1257. It has backed off to 840 at the close today. It was 11,500 in 2008.

Whatever the market does, valuation opportunities continually present themselves. One of the biggest financial mistakes a person can make is not participating in the market. I’ve made giant steps in streamlining my stock screening and proprietary portfolio valuation tools this year and further enhancements are in the works. Finding under-valuations of companies that meet my screens in a timely fashion is crucial to our success because those low valuations don’t last in a market that is constantly being picked over.

I close with this table constructed from information gleaned from a recent Wall Street Journal.

Average Total Return on U.S. Sectors

1/1/1973 to 10/21/2016

Sector Total Return Change In Rank
Oil & Gas 13.25 -9
Industrials 8.75 1
Telcom 8.45 -6
Basic Materials 8.15 -6
Utilities 7.55 -1
Financials 7.3 2
Healthcare 7.3 7
Technology 6.4 2
Consumer Goods 5.2 2
Consumer Services 4.95 8
mean return 7.73

Least volatile sectors closest to the mean have been Industrials, Utilities and Financials, in that order, for the last 43 years.

And that is very good information.

Best regards,

Dennis M. O’Connor