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Interest Rates and Earnings


there are two things that move stock prices meaningfully: the level (and direction) of interest rates and earnings


"Economics is extremely useful as a useful form of employment for all economists " -George Bernard Shaw (1856-1950)

This commentary shall be short, sweet, and hopefully to the point. For those that have not read my commentary dated February 10, 2006, entitled, What The Rest of The Year May Bring Us. This commentary is meant mostly as a continuation of that look into the future, which, thankfully, has proven on the mark.

Basically, my view was that yields, particularly in the longer-end of the yield spectrum would rise, perhaps dramatically, with a high in yield (low in price) occurring in the late-April timeframe with 10 year Treasury yields peaking, at least temporarily, in the 5-5.25% yield. At the time, yields were in the 4.5% area and are now pushing 5.10%. By correctly anticipating this move, I have been fortunate to outperform my benchmark indices by a range of 1-2.5% during the first quarter alone and it has allowed me to generally avoid capital losses in fixed income. Now that rates have, for the short-term, at least come close to reaching my goals, and by definition protecting client capital, I will look to gently extend portfolio duration. Something tells me this upcoming rally that we envision beginning in the April 24-May 1 range will be shallow and more of a trade than an investment unfortunately. When I make this portfolio transition, I will anticipate extending from T-Bills to 5-10 year Treasury notes - nothing esoteric or risky as I have other fears about credit risk that shall be explained later.

Also in my commentary I stated that a stock market high would be reached in the April 1-15 timeframe based on seasonal factors that must be kept proprietary. The S&P500 peaked on April 7th intraday at 1314 and now has fallen to a closing level as of April 14th of 1270, a fall of 44 points or 3% or so. I hate to say this, but I think this is just the beginning of the cyclical bear market that I envision to last (with bounces along the way, of course) into an October low. How far could the decline take us? One never knows, and that sort of prediction is EXTREMELY DANGEROUS to make. This century the typical cyclical bear market has lasted around 20% in stocks which would take us to the 1050 area in the S&P500. Bulls will jump up and down and say that is ridiculous as the P/E ratio of the index would have fallen to 12 or so if earnings held up, while bears would focus on a yield of 2.5% or so at 1050. So it could be quite the catfight.

What could cause all of this movement??

Those of you that have read my work know that I am not afraid of making 'educated guesses about the future' - some might even call them predictions. If there is anything I have learned over the last 25 years, there are two things that move stock prices meaningfully - the level (and direction) of interest rates and earnings. We can throw in sentiment, cyclicality and other items I follow, but rates and earnings drive stock prices. Period.

Let's address interest rates first. Personally, we find 6 month Treasury Bill rates pushing 5% VERY competitive compared to 1.78% stock yields. I also find 5.10% Treasury notes competitive as well. So, let's face it, while I have actually heard people on TV lately say that 'high rates are good for stocks' because it vindicates a strong economy, they should be running a car wash, not money, in my humble opinion. It is a proven fact that when 6 month Treasury Bills get into the 2.5:1 ratio to S&P500 dividend yields, it is time to be cautious - and I am.

Secondly, how can we expect companies to hit the 'analysts' and 'strategists' earnings numbers with the following scenario? Higher commodity prices, starting with oil and gas, are starting to make their way into the cost structure of corporations. Higher interest rates are beginning to make their inevitable 'creep' into corporate cost structures. I don't even care to go into how higher rates will affect the Interest-Only rate ARM's and other exotic financing supporting housing prices out there will do - it is rhetorical and not worth going into in my opinion. On top of that, most corporations, including the very important banking sector, are experiencing record high profit margins, so tell me - what direction do they have to go but down? This could make for some difficult earnings comparisons later in the year, which would be the culprit of falling stock prices in the first place. As mentioned previously and in past reports, if the quality of earnings (which I find shaky to begin with) or the general level of corporate earnings fell to any great extent, I could easily (and do) expect corporate spreads to widen, perhaps dramatically, ushering in a rough period for corporate bonds as well.

Conclusion to what we think lies ahead for the balance of 2006

I promised to make this short and sweet (well maybe short but a little sour in places). I foresaw the decline in bond prices, and while my returns were positive, I beat out benchmarks by large enough margins to make quite a difference in both fixed income only and balanced portfolios. As I mentioned earlier, I expect to extend duration even if only for a short to intermediate period of time. As for stocks, I am maintaining a much lower than normal allocation to stocks as capital preservation has been the key to my success over the years, even if I have a chance of missing some upside (and I don't see any difference in this cycle than past cycles outside of huge debt levels that I have mentioned in the past). Further, the equities my firm owns will be of high quality, focusing more on large rather than small capitalization shares. If I get the sell-off I envision, I will change risk profiles dramatically.

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No positions in stocks mentioned.

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