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

Current Commentary, Review and Outlook
August 15, 2007

To My Clients, Friends & Observers:

From the banks of the Federal Reserve.

If money flees uncertainty, as the saying goes, then some measure of the stock market's attraction in the first half of '07 has been the certainty that the Federal Reserve will do nothing in the foreseeable future with interest rates. That's a great deal of uncertainty removed from the field. There is little the Fed could do: raise rates and choke a modestly growing GDP; lower rates and further devalue the dollar. Chairman Bernanke's recent remarks suggesting that a rate cut was unlikely promptly sparked a dollar-strengthening rally. However, revelations of growing sub-prime mortgage defaults, new uncertainty in the credit markets, and subsequent market volatility has prompted renewed speculation on "the Street" for a Fed rate cut. I expect the Fed will resist cutting rates. The threat to the dollar is too great. By the way money supply M1 has declined 1/2% year over year but M2 has increased over 6%.

The bleakest - but wittiest- assessment of the real estate market was given to a Bloomberg television reporter in June by a money manager whose name and firm I did not catch. Asked about his firm's prospects for real estate he intoned, "We are basically looking at an L-shaped curve," in other words, straight down and then sideways, with no capitulation in sight.

Let's review. For the last four years or so the mortgage lending business has bloomed like mushrooms in warm spring loam, dewy with the vapors of rising real estate values and low interest rates. More people than ever before could afford the American Dream - a home financed with their own debt. Mortgage companies enabled higher-risk borrowers with low "teaser" rates and 100% loan-to-value packages because the mortgages could subsequently be sold to investment bankers who packaged them in various tranches for further sale to whoever would - or could - buy them: institutional investors, pensions, endowments and hedge funds - buyers chasing higher yields and for whom transparency is not legally requisite. Bottom line, everybody's "livin' the dream" until property values decline and rates increase.

These mortgages should never have been securitized as "collateralized debt obligations," CDO's, because these sub-prime mortgages are worth no more than second liens with no underlying collateral, no security other than a promise to pay from a borrower who can't. There has to be a moral basis for securities structured and packaged for sale to investors. There is little difference between selling mortgages that have no likelihood of being paid and selling stolen property. Neither has equity.

The Mortgage Bankers Association announced last week that 15.8% of sub-prime loans were delinquent in the first quarter and that figure is rising. In a presentation to investors recently, AIG, the insurance giant, said that delinquency rates for all first mortgages had risen to 3.9% in June. predicts delinquencies to peak at 3.6% of all mortgages and 10% of sub-prime ARM's in mid-2008.

These pools of mortgage-backed investments have been sold around the world. This is a bad product out of America, something we really didn't need just now. The entities that own them have had to write down the value of these "assets," diminishing their balance sheets and their ability to borrow any further. This is a margin call for the big boys, a de-leveraging, a shrinking of the credit markets. The central banks around the globe have all stepped up and guaranteed liquidity to the credit markets. What this means is that only the little people are subject to foreclosure. The con-artists and quick-buck facilitators - the big political contributors - are immune.

And speaking of politics, the most cynical prophylactic for the mortgage mess came from Congress last week, where several lawmakers called for Freddie Mac and Fannie Mae to pick up the slack in the mortgage market, putting the burden ultimately onto the taxpayers, who guarantee Freddie and Fannie loans.


To the banks of the Connecticut River

The closer I look at local and regional banks the less I see in terms of value, not just in New England but all over the country. Some are just beginning to take their first real estate defaults. Most are barely profitable - a condition of intense competition. Some appear to be the private clubs of the officers and directors. One local/regional bank has average salary and benefits per employee of $74,000. It's not hard to venture that the differential in pay between the top five officers and their entry-level employees is 20 to 1, minimum. With these banks currently trading at 40 or 50 times earnings, and with no significant earnings in sight, one can only conclude that these stocks might be priced at an 80% discount before too long. Most of the regional and local banks are perfectly sound institutions for depositors and many are exceptionally well run institutions. The victors in the long run will be those with the best technology that best control their costs and best serve their customers. The group as a whole is overpriced.

In July we liquidated all bank stocks in all discretionary portfolios with the exception of Bank of America, which has mastered retail banking nationally, trades at a fair multiple (10), has sustainable earnings and a secure dividend of better than 5%.

On the volatility

The de-leveraging in the credit markets has forced institutions to raise cash any way they can, including liquidating equity portfolios. However there are other factors contributing to the turbulence that has punished the indexes the last two weeks. Volume has been remarkably high, approaching 5 billion shares one day last week, and pretty regularly hitting 2 billion. There has been a surge in short selling activity.

The purpose of short sales is to sell borrowed shares of a stock that is falling with the intent of buying the borrowed shares back at a lower price before returning the shares to the lender. Since 1938 the SEC has enforced an "uptick" rule for short sales. Short sales could be executed only after an uptick in the price of a stock. In July the SEC discontinued the uptick requirement. Without an uptick rule, short sellers are free to throw more sell orders on a falling stock - accelerating downward momentum.

The SEC also amended (tightened) certain requirements for a short-seller to have the reasonable expectation of availability of borrowed shares to sell before execution. There are rumors, pretty good ones too, that there has been a lot of "naked shorting" going on (short selling without the borrowed shares). Shocking. All of this volume and volatility reflects more trading for the institutional market makers, who make money trading up and down, on buys and sells.

Our trading system has weathered the last month with flying colors, outperforming significantly. Second quarter corporate earnings have again exceeded expectations.

The trade deficit unexpectedly shrunk last month which is a positive change. However, I am now about 80% convinced that the only way the U.S. will recapture some of the trillions of dollars abroad is by a continued devaluation of the dollar. Increasing influence on the U.S. economy, if not control, will come from abroad.

Best regards,
Dennis M. O'Connor


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