Wednesday, January 31, 2007

Changes to the Fed Statement

The FOMC left rates unchanged for a fifth straight meeting but said the economy is "somewhat firmer".

Changes: "...Substantial cooling in the housing market" at the last meeting became "some tentative signs of stabilization."

Language from the last meeting about inflation moderating due to "reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions"...was removed. I would think that means they believe that inflation has moderated already. One could take that as hawkish in that they aren't looking for any more moderation of inflation.

Everything else is the same as the last statement.

It seems that they have a more positive view of the economy and are still more worried about inflation than growth. We still think the Fed is on hold for at least the first half of the year and maybe for much longer.

Fed Statement

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters.

Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures.

The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Cathy E. Minehan; Frederic S. Mishkin; Michael H. Moskow; William Poole; and Kevin M. Warsh.

Goldilocks in the House

The advance report on GDP for the 4th quarter 2006 was reported at +3.5%, better than the 3% expected by economists:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 3.5 percent in the fourth quarter of 2006, according to advance estimates released by the Bureau of Economic Analysis. In the third quarter, real GDP increased 2.0 percent.

The 2% growth in the 3rd quarter had convinced most that the economy would continue to slow forcing the Fed to cut rates. We argued in our last two Tactical Updates that the economy was unlikely to fall into recession:

Betting against the US economy has been a poor bet over the last 30 years and we are generally optimists about the US and world economy....We think a more likely outcome is that the economy re-accelerates and interest rates rise sometime next year.

In addition to good news about growth, the inflation numbers reported along with the GDP report were exceptionally good as well:

The price index for gross domestic purchases, which measures prices paid by U.S. residents, increased 0.1 percent in the fourth quarter, compared with an increase of 2.2 percent in the third. Excluding food and energy prices, the price index for gross domestic purchases increased 2.3 percent in the fourth quarter, compared with 2.2 percent in the third.

We also predicted this in a previous Tactical Update:

A slowdown to a more sustainable pace would actually be quite welcome as it would ease the pressure we’ve seen on natural resources (commodities) and tend to reduce inflation.

Obviously, most of the moderation in prices in the fourth quarter was due to falling energy prices as the ex food and energy numbers were in line with the previous quarter.

Another theme we have stressed is the deflationary effects of globalization and that can be seen in this report as well. Import prices fell 8.5% in the fourth quarter which probably contributed to an overall drop in imports of 3.2%. Exports were up 10%. So much for all that worrying about the trade deficit.

The big drag on the economy continues to be housing as real residential investment fell 19.2%. This was partially offset by an increase in non residential structures of 2.8%. Another drag was inventories which only increased $35.3 billion in the quarter vs $50 billion plus in the last two quarters. This may mean an added inventory build in the first quarter that will add to growth.

Overall, it seems that the Goldilocks economy is back. We continue to believe that the Fed is on indefinite hold. We see no reason to expect a rate cut or hike in the near future. We'll get a little more info this afternoon when we parse the Fed statement. We also expect growth and corporate profits to continue to surprise on the upside.

Sunday, January 28, 2007


There have been a number of articles recently about the business dealings of Bono and U2. All the articles essentially call the band hypocritical for structuring their business affairs to minimize taxes:

Bono's own dealings haven't always followed the altruistic ideals he espouses, says Richard Murphy, a Downham Market, U.K.- based adviser to the Tax Justice Network, an international lobbying group.

Minimizing Taxes

Murphy points to the band's decision to move its music publishing company to the Netherlands from Ireland in June 2006 in order to minimize taxes. The move came six months before Ireland ended an exemption on musicians' royalty income, which is generally untaxed in the Netherlands.

``This is somebody who's exceptionally rich taking the opportunity to shift his tax burden to somebody else, but then asking governments around the world to spend that tax take in the way that he would like,'' Murphy says.

U2's move to the Netherlands is wrong, says Dick Molenaar, senior partner at All Arts Tax Advisers, a Rotterdam-based tax consulting firm for artists and musicians. ``Everybody needs to pay his fair share of taxation to the government, and therefore we have roads and education and everything,'' he says.

I saw the band on their latest tour and admire Bono for his pragmatic activism. I don't think there is any conflict between what he does for the various causes he represents and how he structures his businesses. One can be a good capitalist and also be a good person concerned about the state of the world. I'd rather see him keep his hard earned money and be involved than for him to pay more taxes and be less involved.

AEI Market Outlook

John Makin at the American Enterprise Institute has a new article about the outlook for the market in 2007:

As we enter 2007, many market commentators describe themselves as "cautious" concerning the stock market. They should not be. The major determinants of stock prices are expected profits and interest rates. Both factors are currently supportive of higher stock prices. Profits are expected to rise by about 10 percent during 2007, while interest rates should remain stable and may even fall, providing further support for stock prices.

Makin's outlook is more optimistic than ours but this article makes a good case for stocks:

Based on historical norms since 1985, the current yield on ten-year government notes (about 4.75 percent) and the projected earnings of the companies in the S&P 500 stock index over the next year suggest that the present level of that index--about 1,420--equals only about 80 percent of its "fair value." In other words, if we take our bearings from expected earnings and interest rates, if the stocks in the S&P 500 were currently valued as they have been on average over the past twenty years, the index would be at 1,775 instead of 1,420.

I'm more concerned about rates and it appears the market is as well. Expectations for a rate cut this year have essentially been removed from the market and that is the source of the recent hesitation in the market. However, I expect earnings to be better than expected as growth seems to be accelerating again and that could indeed push the market closer to fair value.

Saturday, January 20, 2007

Madeleine Albright - Hedge Fund Manager?

Jan. 18 (Bloomberg) -- Madeleine Albright, the former U.S. secretary of state, raised $329 million to invest in emerging markets, joining the ranks of former dignitaries who have entered the lucrative world of private fund management.

Think there might be a bubble in the hedge fund world? There's a lot of ex political types in the hedge fund world now, but this has to be a sign of the apocalypse or something. This is a woman who toasted Kim Jong Il and negotiated with Milosevic.The Dutch think she's got some political insight:

``We see a lot of potential in emerging markets for economic growth,'' Jelle Beenen, a portfolio manager at PGGM, said in an interview. ``The reason that investing there is always a problem is there are issues like fraud and political instability, so that's why there's value in political-risk management and the involvement of Secretary Albright is a valuable one.''

But apparently that political insight isn't expected to produce very much:

PGGM expects Albright Capital to deliver a 10 percent return over the ``long term'', Beenen said.

I don't know about you, but if I put my money in emerging markets and deal with all the political risks, such as Hugo Chavez confiscating my investments, I want a hell of a lot more than 10%.

Thursday, January 18, 2007

Bernanke Speaks

Fed Chairman Bernanke gave his biannual testimony to the Senate today. You can read his prepared statement, if you can keep your eyes open, via the title link above. The topic is entitlement spending on baby boomers and the effects on the budget, which aren't pretty. Everyone should know by now that major changes to Social Security and Medicare are necessary if we are to avoid a European level of government spending. Government expenditures are now about 20% of GDP in the US vs roughly twice that in Europe. The results, high unemployment and low growth, are plain to see.

In the question and answer period, Bernanke made clear that increasing the retirement age is probably the most likely solution to the entitlement spending problem:

He also encouraged policy makers to find ways "to make the labor market as accommodating as possible to older people who wish to continue working."

In answer to another question he put forth the notion, as Greenspan did many times, that CPI understates inflation:

"We do think...that standard CPI does overstate true inflation -- if we could measure true inflation -- by some amount between one-half and one percentage point," Mr. Bernanke said.

I wonder if Bernanke has actually been in a store recently to buy anything. If he has, he knows the absurdity of this statement. Notice too that he acknowledges that the Fed can't even measure true inflation, which should make one wonder how they are supposed to control something they can't even measure.

Tactical Update

Click on the title link to view our latest tactical update. Here's an excerpt:

Interest rates are another area of concern to us. We think the big surprise this year may be that contrary to popular thinking, rates are finally set to rise. The public and most of Wall Street is still expecting the Fed to cut rates, probably multiple times, this year. That may happen (although we don’t think so), but we think there are reasons to be concerned about long term rates regardless of Fed activity. One of the major buyers of long term Treasuries over the last several years, in addition to the Chinese, are the oil states which have reinvested the windfall from higher oil prices into the Treasury market. If oil prices continue to fall these states will have less buying power and the reduction in marginal demand could have a detrimental effect on Treasury prices.

Funnily enough the Wall Street Journal has an article about this today:

With crude prices retreating, oil producers will have less wealth to spread around the world. That should mean lower energy prices and lower inflation, but not necessarily a drop in long-term interest rates.

Click here to read the rest of the article.

Monday, January 08, 2007

Inverted Yield Curve

The link above is to a story in the WSJ about the inversion of the yield curve and the likelihood of a recession.

The bond market is having relationship issues that are getting harder to ignore.

Normally, yields on long-term government bonds are higher than yields on short-term ones. Investors demand a bigger return for the risk that comes with holding an investment that takes longer to repay.

The relationship has been upside-down since July, however, with yields on short-term U.S. Treasury bills exceeding those on long-term Treasury notes. Late Friday, the yield on the three-month Treasury bill stood at 5.05%, well above the 4.648% yield on the 10-year note.

This unusual state of affairs -- known as an inverted yield curve -- has gone on longer than many economists expected and has some wondering whether the bond market is signaling that the economy itself could turn upside down.

Even non-Wall Street types are starting to notice. Charlotte Observer sports columnist Rick Bonnell likens an inverted yield curve to a basketball player whose shooting percentage is lower at the free-throw line than from the field. It's uncommon and nerve-wracking.

That last paragraph is the interesting one. If sportswriters in Charlotte are talking about the inverted yield curve, then it's importance must have slipped a bit. Frankly, I don't want my sportswriters to even know what a yield curve is much less that it happens to be inverted. I've been watching Shaq shoot free throws in Miami for the last two years and while it is painful, it doesn't make me think of yield curves.

I don't anticipate a recession this year. A slowdown in growth is already evident and I think that is as far as it will go. That is, of course, subject to revision.

BCA Sector Analysis

We subscribe to the Bank Credit Analyst as one of our independent research sources. BCA has been doing independent economic and investment research since 1949 and has a sterling reputation. They have just recently published their US Equity Strategy Cyclical Indicator Update.

The update overweights Technology, Healthcare and Energy.

Within technology, because they are looking for stronger captial spending relative to consumer spending, they emphasize Data Processing, Software, Computer Storage, and Communications Equipment. We will be reviewing these sectors for potential investment.

They are particularly enamored of healthcare and within that group, health care equipment. We already have an overweight in healthcare through Pharma, Biotech and general healthcare. We will be reviewing the healthcare equipment sector for potential investment.

BCA is also recommending an overweight in energy which we don't find particularly convincing. We will review the sector for possible upgrade, but for now we don't believe this sector is deserving of special attention.

Friday, January 05, 2007

Bond Guru still Bullish on Bonds

Well, I am shocked, shocked I say. Bill Gross, manager of the largest pool of fixed income assets outside of Asian Central Banks, thinks interest rates are headed lower. In other words, the largest manager of bond funds thinks you should buy bonds:

We at PIMCO look for a Fed Funds rate of 4¼% by December of 2007 with 5 and 10 year yields hovering at levels perhaps 25 basis points higher. While that by no means would be reflective of past bond bull markets in terms of magnitude, that is not to imply that 12/31/07 would mark its last gasp.

I happen to like and respect Bill Gross and his arguments in this commentary are pretty convincing. However, Bill Gross is also a bond manager in a 25 year bull market in bonds. I don't know if he's right or wrong about rates this year - I suspect not- but he'd be a fool to predict anything else.

AMT Repeal

A bill was introduced yesterday in the Senate to repeal the Alternative Minimum Tax. Of course if the Democrats get their way on paygo budgeting it will mean rasing taxes or cutting spending somewhere else to make the bill "revenue neutral". Guess which one is more likely....

Lou Dobbs basing the CS Monitor

FAIRFAX, VA. – Dear Mr. Dobbs, Congratulations on having a large new bloc of voters bear your name! Politicians ignore the "Lou Dobbs Democrats" at their peril.
Every night on CNN you claim to speak for these people. They are America's middle class: decent folks who work hard and play by the rules but who, you insist, are abused by the powerful elite. Free trade is one of the policies allegedly supported by the elite and for which you reserve special vitriol. You thunder that imports destroy American jobs, reduce wages, and make the economy perilously "unbalanced."

But you are mistaken.

The article is written by Don Boudreaux, a free market economist at George Mason University, who also blogs at Cafe Hayek.

I am an unapologetic free trader who believes, as does Mr. Boudreaux, that a trade deficit is not a bad thing. How is it bad for Asians to supply Americans with cheap manufactured goods? Tariffs will only raise the price of those goods and hurt the poorest of Americans. How is it bad to allow Asians to pull themselves out of poverty through the free exchange of goods across borders? Free trade is a win/win situation that benefits buyers and sellers. Lou Dobbs is either a first class xenophobe who has little understanding of economics or he's a populist pumping up his ratings by playing to the fears of the economically illiterate.

Maybe this is why oil prices have been falling?

A source close to Pajamas Media has learned that Iran’s Supreme Leader, Ayatollah Ali Khamenei, has apparently succumbed to the cancer that hospitalized him last month, as exclusively reported by Pajamas Media, at age 67. He has been Iran’s most powerful figure since replacing Ayatollah Khomeini in the role of Supreme Leader in 1989.

Not exactly a mainstream source, but if true major changes could be coming in Iran.

Standing O for Ethics Reform

WASHINGTON (CNN) -- On the same day that the 110th Democratic-led Congress convenes with a plan to immediately pass lobbyist and ethics reforms, the Congressional Black Caucus Thursday gave a standing ovation to Rep. William Jefferson, the Louisiana Democrat who faces an FBI probe into bribery allegations.

Jefferson is the Louisiana Rep. that kept $100,000 in cool cash in his freezer. I guess ethics reform is for the other party.

Wharton on Japan

Wharton's on line magazine has a special section on Japan this month. I have been and remain bullish on the Japanese economy and stock market. 2006 was a bit of a disappointment, but not surprising considering the dramatic withdrawal of liquidity from the banking system. I suspect 2007 will be a good deal better.

Tax Changes

Here's a good article about various tax changes that take effect in 2007. Prominent among them:

1. Changes in maximum contribution limits for 401(k) accounts as well as income limit changes for contributions to IRAs.
2. Changes in mileage rates if you use your car for business.
3. Rise in the maximum amount of income subject to the Social Security Tax.

Nardelli/Grasso Connection

I'm sure by now most of you have heard about Bob Nardelli, CEO of Home Depot, resigning and receiving a $210 million golden parachute. The outcry over the amount of money paid to someone who was a miserable failure is understandable, but HD agreed to these amounts back when they hired the man. Furthermore, the pay package was fully disclosed to shareholders, so I don't have a lot of sympathy for the HD board or shareholders.

Here's an interesting aside though; Ken Langone, who sat on the compensation committee at the NYSE back when Dick Grasso's pay package was approved, also happens to be on the Home Depot board. Further, in 2000, he was the lead director and sat on the Executive, Stock Option and Human Resources committees. Langone also serves on the boards of GE, Choicepoint, YUM! Brands, and Unifi.

Employment Report

Nonfarm employment increased by 167,000 in December, and the unemployment
rate was unchanged at 4.5 percent, the Bureau of Labor Statistics of the U.S.
Department of Labor reported today. Job gains occurred in several service-
providing industries, including professional and business services, health care,
and food services. Average hourly earnings rose by 8 cents, or 0.5 percent, in

I guess this means that ADP, even while processing a slew of paychecks for corporate America, has no more clue about the monthly job figures than anyone else. On Wednesday, ADP predicted a decline in December payrolls of 40,000. Maybe ADP needs some new customers as theirs don't seem to be doing very well.

Today's report has good news and not so good news. Overall employment was up due to the increase in service sector jobs which more than offset the continued decline in manufacturing jobs (down 12,000). Construction declined only 3000 after losses in October and November of 53,000. Maybe the housing market really is starting to bottom out. Or maybe warm weather and seasonal adjustments are making things look better than they actually are.

The one piece of bad news, at least if you're worried about inflation, was the continued rise in average hourly earnings to $17.04 (or 0.5%). Average hourly earnings were up 4.2% for the year which has to make the Fed uneasy and explains the stock market selloff this morning. The market has been anticipating a rate cut and this number certainly reduces the chances. By the way, with average hourly earnings at $17.04 why are the Democrats so hot to raise the minimum wage? Another topic for another time....