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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

It didn’t look like we were going to get a post-election rally. To the contrary, the indexes turned negative for the year until yesterday’s announcement from Fed Chair Howell that the Fed is sensitive to the effects of rate hikes on the economy and markets. We have experienced a greater than 10% correction but whether that turns into a bear market (a 20% decline) remains to be seen. Contributing factors continue to pile up. Relentless prognostication about an eventual recession may result in enough negative sentiment to affect market psychology.

Corporate earnings have likely peaked and can’t continue to grow in 2019 at the pace they have through the 3rd quarter this year. Consumer confidence is within 4% of an all-time high and that usually predicts a recession. Leading economic indicators, while still quite strong, are weakening. When the unemployment rate equals the inflation rate, typically a bear market is forecast in 6 to 18 months and a recession a year later. Those rates are currently 3.7% and 1.9% respectively. An inverted yield curve (short rates higher than long rates) precedes a recession by about a year.

The Federal Reserve continues to raise the Fed Funds rate, presently 2.25%, with another ¼ point hike in December expected and possibly three more in 2019. In addition to the aggressive rate hikes the Fed is also liquidating its trillion dollar bond portfolio accumulated during the great recession. Why then hasn’t the yield curve inverted yet?

The answer lies in economic conditions and central banks abroad. The ECB and Japanese base rates are zero. The 10-year rates are .73% in France; .4% in Germany; 1.4% in UK; 0% in Japan; 1.57% in Spain. Global investors seeking security and yield have only the U.S., where the 10-year yields 3.05% in a dollar strengthened by the relatively high yields. It is disturbing that Germany and Japan have contracted in the most recent quarter. Two consecutive quarters of shrinking GDP defines recession. For the last 12 years the three major economies that grew consistently were China, Germany and the U.S. Europe is fraught and fraying with socialist discontent in France, a disruptive Brexit, a power vacuum in Germany, immigration issues everywhere, Russian malevolence, and intractable debt issues in Greece, Italy, and Spain.

At some point our Fed governors may be constrained by considerations both foreign and domestic. The strong dollar makes oil more expensive for our trading partners along with all other American goods and services. More to the point, when the economy is as good as it is, why risk ruining it? Inflation is not the bogeyman it’s made out to be, estimated at 1.9% for this year. Why risk provoking a recession by raising rates too aggressively? A slowdown in the U.S. would doubtless drag the rest of the world down with it.

One of the most important and under-reported stories of 2018 is the speech Vice President Pence made at the Hudson Institute about China in October. He laid down a gauntlet that may someday represent the most significant event of this administration. He repeated it directly to the participants of the Asia-Pacific Economic Cooperation summit in Papua New Guinea November 15th (a group that represents 60% of the world’s GDP). In it, he charged the Chinese with attempting hegemony in the Asian Pacific economically and militarily, with predatory lending and development practices (“debt diplomacy”), with human rights violations, with industrial spying, market manipulation, forced technology transfers and intellectual property theft which violate WTO standards. Combined with the tariffs which are costing the U.S. and China, the speech is pretty much a declaration of economic cold-war. “The U.S. will not change its posture until China does.”

We’re All In This Together

The last week in October I attended the annual Schwab Impact conference in Washington, D.C. which gathers Registered Investment Advisers with speakers, seminars, and vendors of services for three days. Of the $5 trillion managed by RIA’s, $2 ½ trillion was represented by the attendees (about 3,000). This year I found the amount of new information and technology almost overwhelming. Without specific attribution I will share some of it with you.

Ninety percent of all the data/information in human history was generated in the last 2 years and is doubling every two years. Moore’s Law is close to exhaustion as circuits have reached the atomic level, i.e. one atom wide. Data that required a roomful of hardware 30 years ago is now processed in a machine the size of a grain of rice. Quantum computing is the future.

The development of Artificial Intelligence is relentless. The most powerful chess program ever was developed by AI. The extraordinary difference with this program is that the machine taught itself - in four hours. Of greater pertinence to us, AI programs now scan, listen and analyze all SEC corporate filings, earnings reports and calls. They can generate limited but important conclusions. I am experimenting with a new program that can gauge the impact of various events on specific client portfolios. I’m also reviewing some new risk management software.

By 2030 gene therapy, using CRISPR technology, will have conquered cancer and most of the aging process. CRISPR is the gene manipulation most recently used on the two embryonic twins in China. By 2035, half of all jobs will no longer exist, eliminated by technology. The average lifespan of a Fortune 500 company was 60 years in 1920. It is 15 years now.

Today less than half of all 16-year-olds get drivers licenses – if they get one at all. Self-drivers will become a minority, replaced by autonomous vehicles, Uber and Lyft. Over 25,000 square miles in the U.S. (twice the size of Maryland) is for parking. One third of L.A. is roads and parking lots. Traffic everywhere is congested because of strained capacity. New roads are not being built. It is predicted that driving as we knew it will become a novelty. Car ownership and usage is already changing. Avis-Budget owns Zipcar. GM has a program in testing for car subscriptions. Why buy when you can subscribe to a new car every year?

Global car manufacturing capacity is over 130 million cars a year. Of that, 22 million are from North America. Global car sales are approximately 90 million a year and growing. Consider that most cars are made to last more than ten years on average and you can see that there is a tremendous overhang of supply. Absent pricing power, profitability suffers.

All of the above are the real reasons that Ford announced they would stop making sedans and concentrate on pickup trucks and SUV’s. It’s why GM announced cancelling models and closing factories. Most of GM’s sales are in China. Ford is talking with VW about a merger. And all manufacturers are migrating to electric vehicles.

Threatened are the auto industry, car insurance companies, energy companies, and real estate markets. In my Commentary of August 19, 2011, I detailed the demographics of the housing market, clearly showing that the generations following the baby-boomers are not large enough to absorb all the housing the boomers will be leaving behind. The October 12, 2018 Wall Street Journal Mansion Section reinforces this analysis, citing a study by Fannie Mae predicting a huge buyer’s market starting around 2026 due to a “slow moving tidal wave of housing supply.”

ESG: Environmental, Social, and Governmental Investing

Many investors are concerned with the social impact of the companies they invest in. The problem with “socially conscientious” investing has always been in the definition. What is acceptable for one person is anathema to another. I’ve always relied on the Sullivan Principles as a bare minimum. Named for Dr. Leon Sullivan, the principles support economic, social and political justice and encourage equal opportunity.

Former hedge fund manager Paul Tudor Jones II tackled the issue of “doing well by doing good” by founding Just Capital. (See Just Capital engaged the University of Chicago in 2015 to conduct a poll of 10,000 Americans to define socially responsible concerns of investors and rank them in order of importance – a kind of crowd sourced data. The poll resulted in 7 key concerns (Drivers) about how a company treats its:

  1. Worker/employees
  2. Customers
  3. Products
  4. Environemnt
  5. Local community
  6. Jobs in the U.S.
  7. Shareholders/management

Just Capital then applied the 7 Drivers and 39 associated Components which Americans define as just business behavior to the 1,000 largest capitalization companies in America (the Russell 1000) and ranked them from best to worst. Subsequent analysis showed the top 50% significantly outperformed the bottom 50% in financial performance and investment return. I have added the Just Capital rankings to my stock screening methodology.


The Washington meetings were a little disconcerting for the amount of speculation –bordering on enthusiasm- about a pending recession. In fact the Senior Managing Director for Guggenheim Partners titled his talk, “Prepare For Recession In 2020.” His argument is based on a “hawkish Fed,” an inverted yield curve, and an escalating trade war. Presented as a fait accompli, it is inflammatory and inappropriate. It is also probably wrong.

The consensus of economists I read are estimating S&P earnings of $163 in 2018, $175 in 2019, and $195 in 2020; revenue growth of 8.5% this year, 5.5% next, and 4.4% in 2020 - a slowing rate coming off record highs but not recessionary. CFRA Research, which bought S&P Capital IQ research last year, sees the S&P 500 Index at 3100 in 2019; global GDP at 3.9%; U.S. Real GDP at 2.7%; Core CPI at 2.5%; Fed Funds at 3.2% by year end 2019; the 10 year Treasury at 3.4%; Oil at $76; and a strong U.S. dollar. While there is much in the world that can go wrong, there is much that is right and these figures are not recessionary.

Housing and real estate will remain weak. Related stocks will suffer, as will high P/E stocks, particularly in Tech. Picking through stocks over the last month or so, I am impressed at the number of high quality companies selling at low – even single digit – multiples. Certain industrials, quality banks and financials, and good utilities should outperform. But “fools rush in where angels fear to tread,” so we have raised cash where appropriate and will wait for a trend to consolidate before expanding our exposure. The market has a lot to digest right now.

A note about the politics in D.C., according to Greg Valliere, Schwab’s long-time political consultant there: nobody in Congress, absolutely nobody, cares about the debt. The subject is untouchable, the condition unworkable. It will not go away.

Best regards,

Dennis M. O’Connor