Jeff Saut Presents: The 5% Solution
In this business what you see is what you get...
We titled this morning's missive "The 5% Solution" in an obvious reference to Nicholas Meyer's novel "The Seven-Per-Cent Solution." Except in this case we are not referring to Sherlock Holmes' cocaine addiction, but the American economy's addiction to the financial cocaine of low "real" interest rates and excessive monetary liquidity. Recently, much has been written regarding how the Federal Reserve is trying to wean the economy from said addiction given its nearly two-year skein of rate-ratchets, which finally caused the 10-year T'Note to travel above 5% last week. Yet, we just don't "get it" because as the Fed has been raising interest rates, it has simultaneously been talking rates down by commenting on how "contained" inflation remains. Surprisingly, concurrent with the Fed's financial tightening has been Mr. Bernanke's "printing press" gone wild with roughly $1.5 trillion additional dollars per year being added to the country's money supply, at least at the last M3 reading. And that caused one savvy seer to exclaim, "Can you spell liquidity?!" Liquidity indeed, for as Ed Hyman aptly notes, "U.S. Federal outlays in the 4Q increased to a remarkable $2.7 trillion. That's 21% of GDP and increasing at a 30% annual rate." Suspiciously, however, one month ago those M3, broad-based, money supply figures ceased to be reported because they allegedly added little additional value to the M2 figures. Hereto "we just don't get it" because M3 contained the amount of repo activity in the banking system while the M2 report does not. Repos, ladies and gentlemen, is short for repurchase agreements, which are contracts for the sale and future repurchase of a financial asset. Most often repos are used with Treasury securities. We think repo activity is pretty important since it shows the amount of "financial leverage" the Federal Reserve is attempting to introduce into the banking and brokerage system. Indeed, we just don't "get it."
Nevertheless, in this business what you see is what you get, which reminds us of that old Annapolis "saw" – you can't change the wind, but you can always adjust the sails! And currently the "winds" are blowing interest rates higher. Where this rate-rise will end is unknowable. Even the Fed has hinted that it doesn't know by commenting that things are "data dependent." However, consider this – When was the last time the Federal Reserve stopped raising interest rates with many of the equity markets at (or near) all-time highs, base and precious metals at multi-decade highs, oil within "spitting distance" of record highs, and retail sales (despite a late Easter), as well as the housing figures, stubbornly perky? Furthermore, the recent unemployment rate was at a four-year low (4.7%), while the first quarter's employment figures showed the strongest non-farm payroll growth in six years. Historically, rising employment growth has tended to lead to rising wage pressures. As the good folks at the GaveKal organization opine, "Once again, we find ourselves asking the question, can the Fed really stop at 5% in this environment?"
In addition to these questions, we would suggest that forgetting the laughable "core" inflation figures (exfood/ energy), annualizing last month's headline CPI figure of +0.7% (core was +0.2%) yields an inflationary ramp-rate of 8.4% (0.7% x 12). While clearly one month does not make a trend, even if we use this week's estimated headline CPI number of +0.4% (-0.2%E core), and average it with last month's (0.7% + 0.4% / 2 x 12 = 6.6%), we get an annualized inflation rate of 6.6%. The potential inference from this is that despite the Fed's "tightening campaign" with Fed Funds at 4.75%, overlaid with a 6%+ inflation rate, we could still be in a negative "real" interest rate environment. Given the possibility of still "free money" (a.k.a. negative real rates), it's no wonder speculation remains rampant in the various markets.
However, even if the conventional wisdom is correct, and the Fed is nearly finished raising rates, it doesn't necessarily follow that stocks are set to "soar." Indeed, typically the Fed has stopped raising interest rates because the economy was softening with an attendant slowing in corporate earnings' momentum. Intuitively participants know this. However, Comstock Partners took this intuition one step further. To wit:
"The conventional wisdom that the end of Fed tightening is immediately bullish for stocks is simply not supported by history. In looking at the last rate hikes in all 16 instances going back to 1920, we found that the Dow Jones Industrial Average declined by an average of 19.1% from the date of the last rise in rates to the eventual market bottom. In fact the Dow dropped by at least 10% in 12 of the 16 instances and by more than 20% half of the time. In only four cases did the Dow actually rise after little or no decline, and one of those times was in early 1995. That is why Wall Street likes to bring up that one case while ignoring the bulk of the evidence."
So with the 10-year Treasury now yielding more than 5%, what are the implications for the stock market? Unfortunately, cash has become a competitor to stocks, since with a 4.75% risk-free rate of return cash is now an attractive asset class. Also worth considering is that the DJIA's earnings yield (earnings/price), at 4.37%, is below the yield of the benchmark T'Note. And maybe, just maybe, that is why the equity markets' "internals" continue to deteriorate. Verily, only 50% of the S&P 500's components are above their respective 50-day moving averages. Meanwhile, the S&P 500 (SPX) has broken below its near-term support of 1295 and done so on higher volume. In the process the SPX has knifed below the upward sloping trendline that has contained every decline since the October 2005 "lows" (we were bullish). As well, the SPX now resides below its 10/30/50-day exponential weighted moving averages. Not so, however, the DJIA, which tested, and held, its similar rising trendline. Surprisingly, given crude oil's surge, the Dow Jones Transportation Average (DTX) remains in a well defined uptrend, while the Dow Jones Utility Average (DUX/382.49) continues to look abysmal . . . as the mixed trading signals endure.
Regrettably, all of this continues to leave us "predominantly defensive," to borrow a phrase from Charlie Knott of Knott Capital, who we were fortunate enough to "break bread" with last week. Indeed, in this difficult market environment it is better to lose face and save skin. And evidently the astute Lowry's service agrees, as they stated in their Friday report:
"Since early Jan '06, each new high in the major price indexes has been accompanied by steady erosion in our Buying Power Index (Demand), which dropped to a new multi-year low this week. At the same time, the Selling Pressure Index (Supply) has consistently increased, to a new multi-year high this week, showing that investors are selling into rallies with increasing resolve. During periods of weakening Demand and expanding Supply throughout our 73 year history, investors have been well served to exercise caution."
Consistent with these thoughts, we reiterate that we think the highs are "in" for the equity markets and therefore the name of the game is "not to lose money!" We continue to believe that interest rates will rise, yield curves will invert, cries will emerge that Bernanke is overdoing the monetary tightening, fallacious worries will surface about a pending recession, and this will cause the equity markets to decline by more than just a few percentage points. If correct, that environment should present a better buying opportunity later this year consistent with the four-year cycle. Manifestly, the time to be table-pounding bullish was back in October, not here.
The call for this week: Last week we told folks to ignore the stock market's action because the "players" were leaving for the holidays. Today is much the same given Europe's holiday. It will be interesting to see what happens when participants return on Tuesday and Wednesday. We worry they will show up in "sell mode." Accordingly, stop-loss points should be raised on trading positions, while under-performing stocks should be pruned from portfolios. Further, we would suggest rebalancing those stocks in the portfolio that have surged since the October 2005 lows (read: sell a partial position). Alcoa (AA) would be a good example. Alcoa was on our "buy list" in the low $20s back in mid-October. Last week Alcoa announced blow-out earnings and leapt to $35/share. Rebalancing such a stock position allows profits, and cash, to accrue in the portfolio and tends to realign Alcoa's weighting within the portfolio. As for what to buy, that was best summed up by our healthcare analyst, John Ransom, when he said, "Healthcare is 'on sale' and United Healthcare (UNH) is probably as good a name as any."
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