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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
October 25th, 2002

To My Clients, Friends & Observers:

As a trend, better market performance runs from November through April, worse is the period May through October. Welcome, November! The mutual fund companies tend to complete tax-loss selling and portfolio adjustments in October. The clear trend since October 10th has been the reappearance of buyers –en masse- in the equity markets. This has coincided with a significant drop in the bond markets, evidenced by increases in yields from the five, ten and thirty-year treasuries. Fed Funds remain at 1¾% with no increases in sight. In fact, as recently as last month there were noises from the Fed of yet another decrease to 1½% by year-end, which was my target for this year.

So the yield curve is very positive, indicative to me of a sanguine if not ebullient economy. There is no consensus as to inflationary or deflationary probabilities and I offer no opinion. The war cry during the first Clinton campaign was, “It’s the economy, stupid!” To my investors I offer, “It’s not the economy.” It’s what you own in any economy. Corporate earnings and valuations are generally improving. The S&P 500 currently trades at a P/E of 33 and the “earnings” used in the P/E are “annualized, as-reported earnings” to quote S&P, not expected, pro-forma earnings favored by the presently disfavored analysts. In my April Commentary I noted that the S&P was trading at a P/E of 61. Prices have declined (DJIA down 18%, S&P 500 down 24%, NASDAQ down 34%, year-to-date) and earnings have improved.

One of the reports we watch closely is the Investors Intelligence Advisors’ Sentiment which is released Wednesdays. It is a poll of approximately 130 independent financial market newsletters and is a good contra-indicator. One of the problems with the stock market is that, despite the long and steady price erosion of the last 2½ years, sentiment has remained unflaggingly bullish, coining the term “perma-bulls.” Now look at the reports of the last three weeks.


  10/23 10/16 10/9
Bulls 38.9% 28.4% 31.0%
Bears 35.6% 43.2% 39.1%
Correction 25.5% 28.4% 29.9%

The figures reported reflect the survey of the prior week. So the big bearish percentage of 10/16 reflects the survey taken the prior week. October 9 was a multi-swing day of consolidation in the market and October 10th was the first of the many 200 point up days since. Ralph Bloch, the award-winning senior vice president and chief technical analyst for Raymond James Financial Services, Inc., makes the point that the bearish level of 43.2% is the highest since October 1998 and the bullish level of 28.4% is the lowest since July 1994, when it was 27.6%. In other words on exactly the day that the market commenced its buying rally the independent analysts’ sentiment reached an eight-year bullish low and a four-year bearish high. This is why the I.I. report is such a good contra-indicator and it is on such negative sentiment that bear markets can be broken. We are in the longest bear market since 1938.

Oil prices have backed off to $28 from recent highs of $31 and we should hope for a trend here. If, as and when we have a war in Iraq we should expect a few days of market free-fall, from which a victory would generate a huge rally. We can use Iraq War One as a guide.

Current Portfolio Posture

As the white noise from accounting scandals subsides it’s become a little easier to go back to screening companies for growth at fair value. Many of the pharmaceuticals represent compelling values. I have the personal observation from a former senior Washington official that the drug companies have lost much of their lobbying clout at the Capitol. That’s just her opinion of course, but if in fact the drug companies have to yield five or ten percent of their margins, many are still companies that are trading at mid-to- high-teen multiples, that return 25% to 30% return on equity year after year, and post net incomes of 15% to 20% and more. They are compelling portfolio assets. We’ve positioned additional Schering Plough at $18 and up. In other industries we’ve repositioned DuPont, Lawson Products, Questar, Superior Industries, and Diebold.

In the utilities sector we like Duke and, for aggressive speculation, El Paso.

In the fixed income sector we are standing pat awaiting yields to rise in paper rated (A-) or better. We expect an increase in new muni paper brought to market in the next 6 to 12 months. Increasingly we are using tax-free auction rate preferreds for short-term money market instruments. The spread to tax-free money funds is practically a full percentage point. Properly positioned, good things come to those who wait. Patience is a virtue and no team can keep the ball on offense for the entire game.

Best regards,