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The Stock Market, The Sopranos, and My Crazy Dream About the US Fed

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With the death of James Gandolfini in the news, my troubled subconscious mind merged two of its preoccupations. Up for some dream analysis?

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Housing in the US is again on the brink, even in the face of existing homes for May (85% of the housing market) surprising on the upside two weeks ago at 5.18 million versus an estimate of 4.96 million. Prices are +12% year over year. Mortgages going from a low in December of 3.4% for a 30-year fixed to 4%+ last week is going to completely choke off investment despite Bernanke contending that housing may be the one bright spot in the economy -- plus, rates are still near 40-year lows. Moreover, Bernanke even pondered in his post-FOMC press conference on June 19 that more Americans are starting to believe in housing (again) as their number one investment

Just this week Lennar Corporation (NYSE:LEN) said, "Against the backdrop of recent investor concerns over mortgage rate increases, we believe that our second-quarter results... continue to point toward a solid housing recovery." Demand in all of the company's markets is ahead of supply, and higher interest rates have had little impact on sales or prices. This statement came after Lennar posted stellar quarterly earnings, with the obvious highlight being new home sales were up 27% year over year.

Now, you cannot own an emerging market currency and so you need to unwind and buy US dollars, but this only serves to continue pummeling emerging assets and driving the dollar to levels at which the US will never be able to compete. I had thought last summer was the end. Remember when Greece, which is in the crosshairs again, and Italy were going to sink the world? Everyone wondered if there was going to be more QE. Would Germany save the EU?

Having been in the markets for more than 19 years, it's safe to say that I have seen this before. When we begin to hit turbulence, all the sins of markets past percolate. China will become Japan, but because the world is even more globalized now, it will be worse. The EU is "again" going away. The currency unwinds are conjuring up images of Long-Term Capital Management. Forget that over time, stocks have returned 12% all in. So rates go to 5%? I say, "So what?!" Do you remember someone in your family telling you about their first mortgage at 18%? How about all that cash that corporations like Apple Inc. (NASDAQ:AAPL), Cisco Systems, Inc. (NASDAQ:CSCO), and Microsoft Corporation (NASDAQ:MSFT) are sitting on? One can presume that in a rising rate environment, these companies can now earn more interest on that cash with some yield and a little growth potential. Maybe if you were overweight the utilities or telecom sectors, you would want to pare back and get long on some growth/income stocks, along with maybe a bit more small/mid-cap exposure to offset a rising dollar. We can make money if rates continue to rise.

Insurers, in theory, can more easily offer attractive annuity products and earn more on their investment pools in a period of rising rates. Banks, in theory, can make money doing what they are supposed to do - lend - with a steeper yield curve. Yes, there are duration considerations, and to be fair, I have seen investors migrating from money center banks like JPMorgan Chase & Co. (NYSE:JPM) and Citigroup Inc (NYSE:C) to regional bank plays where there is less delta in terms of a markdown to their bond and MBS portfolios. (Note the recent relative strength of the KRE/SPY ratio versus the relative strength of the XLF/SPY ratio.)

Moreover, PIMCO's legendary portfolio manager Mark Kiesel said in Barron's recently, "When you have a company whose fundamentals are improving, those bonds can rise even when interest rates are rising." We, as retail investors, can obviously focus on higher yields and ladder our portfolio to buy the higher-yielding bonds at the back end once our shorter term bonds mature (in a rising rate scenario). This is exactly what the Fed is doing. Our markets have been operating under unprecedented policy conditions and, not to be trite, wasted investors are simply trying to adjust. Unfortunately, you cannot just have a Gatorade and take a few Advil.

Late last week, markets stabilized again. China has put a Band-Aid on the credit crunch by injecting cash. European credit has tightened back up a bit with Spain and Italy included. In the US, we have seen Nirvana-type economic data that is not too good but not too bad, a signal that the Fed may in fact continue QE longer than its forecasts indicate. The most salient example of this would have to be the most recent GDP data, which came in at 1.8% versus a survey of 2.4%. Again, not too good, but not a recession. The world is most likely not coming to an end. US Treasuries have stabilized, and what's good for bonds generally has been good for stocks of late. For instance, since June 19, the price (not yield) on 10-year US Treasury, has been roughly more highly correlated to the price action in regards to the S&P 500.
No positions in stocks mentioned.
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