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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:

Back in 2006 I read an interesting book by David Smick titled “The World Is Curved.” It was a response to Thomas Friedman’s book on economic globalization titled “The World Is Flat.” Smick suggested that there is still a global horizon and that there are many unpredictable events just beyond.

My 20th floor office in the MassMutual Tower, on the east side of the Connecticut River, overlooks the river and beyond, to the Hartford skyline to the south, across to West Springfield and further west to the Berkshire Hills. As I explain to my interns, it is not just a great view of the landscape, it is a great view of the economy. The view includes factories, warehouses, shopping centers, rail yards and homes, all connected by a circulation system of interstate and local highways, railroads and bridges. Everything is powered. Everything is in motion.

Looking down on this commercial microcosm can be delightful. With the perspective of height and distance all the motion appears systematic and rational, like the movement of a watch. Closer up, what is occurring is chaotic, which events are predicated by other events, and which chain reactions create recognizable feedback loops. It is called deterministic chaos. But events behind the horizon are as difficult to predict as a two month weather forecast.

Yesterday the Federal Reserve Board met and unanimously voted to suspend any further interest rate hikes pending further confirmation of a strengthening economy. The Fed also lowered its GDP forecast for 2016 from 2.2% to 2%. One assumes they are being optimistic. It is further evidence of the pathetic inefficacy of the federal government that total responsibility for the economy has been laid off on the Federal Reserve, which is a private bank owned by the Too Big To Fail banks that the government “regulates.” In fact it is a partnership of the power elite.

There is nothing at this point the Fed can do to grease the skids of a stalling economy. Actions would have to come from the legislative and executive branches which dictate regulatory and fiscal policies. They have shown no inclination to do so. The Fed cannot raise interest rates to any significant degree without drastically increasing the cost of financing the national debt, which has doubled in the last 9 years.

The problem with the national debt is that servicing it exhausts money that could otherwise be spent on social security, or the national defense, or infrastructure. The Fed is making it quite plain to the bond markets: “You can lend but we can’t pay.” That leaves just one source of revenue to finance the ever-expanding government: more taxes. In the heavily socialist European economies interest rates are negative. One has to pay for the privilege of lending to the governments of Sweden, Switzerland, Denmark, Japan and the European Central Bank. This is unprecedented.

Let me present one glaring example of the profligate mentality of the spendthrifts in the federal government. The Affordable Care Act, according to the government’s own figures, has cost an estimated $1.7 TRILLION in direct costs to cover an estimated 9.9 million new insureds. That is 2.9% of the population and a cost of $1.7 million per subscriber. This is analogous to building an Olympic swimming pool to catch a raindrop. And it doesn’t reflect all the indirect costs that the Act has caused. Obviously it would be far cheaper to simply purchase insurance policies at taxpayer expense for the indigent uninsured. And it is just as obvious that the objective of this law was not social welfare but a new, gargantuan, permanent, federal bureaucracy.

There are fools who continue to say – as they did in the 1970’s – just roll the debt over and print more money to pay for it. We have seen the results of such stupidity in the past and it doesn’t qualify as an argument. But even as our Leviathan Government continues its relentless expansion the money supply is growing with it. The year over year money supply M1 increased 8.59% the week ended May 30th; M2 increased 6.69%. This is incongruous for an economy that is growing less than 2% a year.

Meanwhile baseline budgeting continues without objection or constraint. That is the process of beginning a new annual budget at the same level as the prior year and then simply adding to it. The public sector is a financial runaway train.

A Global Picture

At their annual Boston conference last month, a team of economists from Capital Economics gave their prognosis for the global and American economies. They cited “two massive deflationary shocks last year: plummeting energy prices and the surging dollar” to describe external deflation vs domestic inflation. Wage growth is “also held down by weakness of productivity growth.” They forecast inflationary pressure from increased capacity utilization this year. “Potential U.S. economic growth is a lot lower than it used to be.”

They too are forecasting 2% GDP this year, inflation at 1.5%, and unemployment at 4.8%. They estimate the S&P 500 Index to close at 2100, the Fed Funds rate at 1.25% (now .25%), and the 10-year U.S. Treasury yield at 2.5% (now at 1.56%). I cannot concur with their rate forecasts. Fed Funds will likely be .5% and the 10-year below 2%.

There are indications that the U.S. consumer is spending again and indications of increased credit defaults. The domestic economy still relies on consumer spending. Some of the increased spending is due to real wage gains. Probably more is due from the wealth effect of higher stock and real estate markets (than 5 years ago). Our friends at Capital Economics opine that a “slowdown in the economy will drive house price growth to zero” and I concur.

Without the salutary wealth effect and low interest rates I suspect real growth would be even less than it already is which leads to the conviction that there is strong support for the markets at these levels. New highs however will require new participation at the margins and new participants are not in sight.

This chart is a good indicator of the global economic condition.

This is a chart plotting the S&P 500 Index (green line) with the Baltic Dry Index (blue line) from 1999 to the present. The Baltic Dry Index “indirectly measures global supply and demand for the commodities shipped aboard dry bulk carriers, such as building materials, coal, metallic ores, and grain. Because dry bulk primarily consists of materials that function as raw material inputs to the production of intermediate or finished goods, such as concrete, electricity, steel, and food; the index is also seen as an efficient economic indicator of future economic growth and production. The BDI is termed a leading economic indicator because it predicts future economic activity.”
(Definition from Wikipedia)

Until 2010 the S&P 500 and the BDI generally moved in the same direction. The BDI has fallen from its 11,500 high in 2008 to 703 in April this year while the S&P continued its deliberate climb from its 676 low in March 2009 to 2077 at today’s close. The chart depicts the difficulty the S&P has had holding that level and its failure to make a new high above the 2130 it hit on May 21, 2015. In fact the Index is just about where it ended 2014, at 2080.

The BDI is not this low because of a massive oversupply of ships. It is low because of a lack of economic activity globally. America is less immune to global conditions than ever before.

Suitability or Prudence: The Fiduciary Rule

My principal motivation for starting a Registered Investment Advisory back in 1997 was the determination that the distribution model of the financial services industry was very wrong. Packaging securities up into “products” to be distributed by brokers who are compensated by commissions do neither brokers nor clients much good. Clients can be misled by confusing or opaque “products” or investment ideas introduced to them by professional salespeople who are driven to meet weekly/monthly/annual commission goals.

Brokers are held to a “suitability” standard of ethical behavior. They are supposed to sell only investments that are “suitable” for the client according to the information the client has given the broker. The broker is also required to “know the customer.” Unfortunately, what is suitable for the client is not always what is best for the client. Many brokers will sell investments that, while “suitable,” are not good investments for their clients. They get paid anyway. Disputes over suitability are most often settled by mandatory arbitrations. Thousands of brokers who have long histories of suitability disputes are never disciplined to any significant extent and continue to operate the same way because they make their firms a lot of money.

Registered Investment Advisors (RIA’s) do not work for commissions. Most are compensated by a fee for assets under management. Their motivation is to protect and grow clients’ assets, and hence their fees. RIA’s are legally held to a “fiduciary standard,” of ethical behavior, i.e. to do for clients what they would do for themselves in the same circumstances. It is also known as the “prudent man rule.” It is a higher ethical and legal standard.

There have been many failed attempts in Congress to establish a fiduciary standard for the entire financial services industry and to discard the morally dubious suitability standard. Because the current administration could not get such a law out of Congress, it used the Department of Labor to mandate a fiduciary standard for all purveyors and providers of retirement plans, which include IRA’s and 401(k)’s. This has been met with hard resistance. It is extremely discouraging. It speaks again to the tenacity of entrenched political interests. Already exceptions, variances, and work-arounds are being proposed.

It seems to be just another instance of our very-well-paid bureaucrats and politicians telling the electorate that they know what’s best for them.

Best regards,

Dennis M. O’Connor