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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
January 11, 2007

To My Clients, Friends & Observers:

A dollar just doesn’t buy what it used to…

As I drive around I am impressed by the numbers of new banks sprouting up everywhere, not just more branches of our local banks but also banks entirely new to the area. Playing golf with the president of one local bank recently, I asked him about their current initial public offering of stock. What would they do with the money? His answer was that they would expand their branches to maintain their fair slice of the retail banking pie. Is that a profitable niche, I asked? No, he said, but you either had to participate or forfeit. Profitability is better serving commercial and corporate borrowers.

This proliferation of banks is just more evidence of the copious amounts of currency in the economy. We are swimming in cash and capital and it makes me nervous. Investment banks, hedge funds and the pools of capital called “private equity” have had a record year. Political contributions are at positively obscene levels, e.g., for a recent fundraiser celebrating Bill Clinton’s birthday the “level of participation” was $100,000 per person to be “close to” the first tier of tables. Ultra-luxury goods, including custom clothing and autos, original artwork, private jets, and eight figure vacation homes are all wait-listed. The money flows like water. If scarcity creates value doesn’t ubiquity devalue?

Money supply (M2) growth for the twelve months ended in November was 5.1%, a rate double the 2.5% growth of GDP. We are in a war economy and war economies are inflationary as the central bank prints money for the war effort. Congressional appropriations for Iraq are over $350 billion so far and estimates of the total economic cost of the war have been between one and two trillion dollars. Yet there is no end in sight. This war has lasted longer than WWII.

Two of the best advisers in government, Henry Paulson at Treasury and Ben Bernanke at the Fed, have just returned from China where, with others in the U.S delegation, they tried to persuade the Chinese authorities to let the yuan strengthen against the dollar. The Chinese peg the yuan at an artificially low rate to the dollar, giving their exports a predatory pricing advantage. The U.S. would like to see the yuan strengthened at least 20% against the dollar to encourage Chinese purchase of American goods and services and thereby ameliorate our enormous trade deficit.

Now put yourself for a moment in the shoes of our Chinese trading partners. “These American capitalists are amazing. They pay us U.S. dollars for our goods and then want to make the dollars they gave us worth eighty cents! No wonder they love capitalism!”

What does America have that China wants to buy? Not enough in the way of merchandise, I’m afraid. Most of the accumulated U.S. dollars in China are loaned back to the U.S. by their purchase of U.S. Treasury securities, keeping our interest rates low. The trade deficit with China is $800 million a day. Who is the biggest beneficiary of our low interest rates? The borrower, the U.S. government, which has been on a spending binge like a junkie on heroin. One of the main ways junkies finance their habit is by robbing private homes and businesses. Hold on to your wallets, taxes are coming.

I’ve read comparisons between China today and Japan in the 80’s and I don’t see a lot of similarity. A strong yen that kept getting stronger against the dollar was problematic for the Japanese. Every time they would make a huge, significant acquisition in the U.S., Rockefeller Center for example, the dollar would fall another 5% or 10% immediately devaluing their acquisition. The Chinese don’t want to make that mistake. If their long-term intent is not to buy American assets then why should they care about the valuation? Eventually they may dump the dollar but have a functioning, developed economy, independent of direct trade with the U.S. This is hard to imagine but we are trading with the Middle Kingdom, an ancient civilization with economic concepts radically different from the West. I recall my friend Chris Galvin of Motorola explaining how Motorola entered manufacturing in China. The deal was simple, he said. “We’d build the factories, train the people, make the products and share the profits. If, after five years the Chinese were not satisfied with the arrangement, we would hand them the keys and leave.” There is an old expression, “Why buy the cow when the milk is free?” The Japanese didn’t have a sweet deal like that. How can you fairly deal with a totalitarian regime that can always just say “no”? With an accounting system that can always be “force balanced?” What will the Chinese trade with the U.S. and when will they do it? A trade imbalance this heavy cannot last forever.

Mark Twain said, “Sometimes I wonder whether the world is being run by smart people who are putting us on or by imbeciles who really mean it.” As I watch our politicians run around in their circles I truly wonder if anybody is minding the peoples’ business. Pat Buchanan makes this point, eloquently. According to Buchanan, China’s number one export to the U.S. in 2005 was computers and electronics. Huh? We’re importing “high-tech?” The rules of world trade are rigged and we have allowed it to happen, a la the artificial dollar/yuan rates.

Buchanan illustrates that while the U.S. has a corporate tax rate our trade rivals use a value-added tax (VAT). Under global trade rules nations may rebate the VAT on exports and impose an equivalent VAT on imports. If the VAT adds up to 15% of the cost of a new car in Japan, a $20,000 Toyota exported to America will earn its manufacturer a $3,000 rebate. But each American car delivered to Japan will have a 15% VAT added to its sticker price. This is like adding five strokes to Tiger Woods’ scores while deducting five from his opponents. Why do our politicians countenance such unfairness? Buchanan blames simple ignorance and the unexamined acceptance of the ideology of globalism and free trade. Why not America first, Buchanan asks? I would ask, if not America first, why not at least equal?

Who benefits?

The DJIA and the S&P 500 had a spectacular run-up in the fourth quarter, fueled in part by speculation that the Fed, in response to a slowing economy, will start lowering interest rates in 2007. I don’t think this will happen. Mr. Bernanke has stated that he expects GDP growth in the neighborhood of 2.6% in 2007. That’s not real strong but it’s reasonable and healthy. The Fed Funds rate is at 5.25%. The Fed’s job is to provide for a stable currency, to preserve the “store of value” for our purchasing power. If the Fed lowers rates, the dollar will fall further. It has already fallen against the Euro over 30% in the last two years. The Fed cannot lower rates and expect a strong dollar. The European Central Bank continues to raise its rates (to 3.5% on December 7, the sixth increase since 2005).

My greatest fear for my clients – and myself – is a collapse of the dollar. With it would collapse our purchasing power. That’s the same as inflation which control and defeat is why we invest at all. I cannot foresee the need for the Fed to lower rates in 2007. Cui bono? The only possible benefit would be to the banks, which still borrow short and lend long. The yield curve would correct, i.e. interest rates would increase on the longer end, but at a potentially terrible price. It would not help the housing market and its ancillary construction industry. In the twenty years I have observed the yield curve I have never seen the incongruity we have today of a 60 basis point spread from Fed Funds at 5.33 to 30 day Treasuries at 4.66. The 30 year Treasury is yielding 4.75%. Of one thing we can be certain: this yield curve will not last forever.

There are other good reasons for the markets success in ’06, not the least of which was S&P 500 earnings growth of 18% year over year through the third quarter. Corporate balance sheets are generally very strong and companies are spending money on capital improvements. Mortgage rates declined to 6.3% (30 year fixed) in December, prompting new mortgage applications to increase to the most in 11 months. This is perhaps a harbinger of the end of the real estate slump. However, real estate cycles tend to be long, long to run up and long to wring out.

The most benign indicator of a sanguine stock market in 2007 is the equity risk premium. It is back after a multi-year hiatus. Since the end of the last decade investors were paying more in risk to get less of a return in the equity markets. The equity risk premium was negative. The P/E ratio of the S&P 500 is 18, with a dividend yield of 1.78%. The reciprocal of the P/E is the earnings yield, E/P, which is 5.5%. An earnings yield of 5.5% compares favorably to a ten-year Treasury yield of 4.6%, indicating a reasonable premium for taking the risk of investing in equities instead of Treasuries. With all the money that is floating around, any incremental increase in equity participation should lift the major indexes. With so much uncertainty in the bond market and money market yields approaching 5% our new portfolio fixed-income exposure is nil.

We will continue to favor strong U.S. multinational companies. We have to participate in the growing global corporatocracy, in our own defense.

Political postscript

In the U.S. there are maybe a couple thousand people in government that effectively control 300 million. In China how many Party members control over a billion? A few hundred? How do you cajole them into agreements on “free trade” or “intellectual property rights?” I can understand that China is overbuilt and underutilized, with many dislocations and inefficiencies. I know it cannot continue to grow at 9% a year without overheating. But do the Chinese know? Do economic dislocations make any difference to a government that can control the populace with an iron fist?

The only thing that protects us, or at least delays the process in the United States, from total subjugation by an ever-encroaching, ever-expanding government is the ability of a healthy middle-class to replace the legislators of one party with the legislators of another every few years. God bless America and, America, thank God.

Best regards,   
Dennis M. O’Connor


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