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Jeff Saut Presents: Welcome Back Mr. Bond

By a Wall Street community imbibed with lower interest rates, steady interest rates or worse yet, higher interest rates would be a shock.


Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

"The lagged impact of global central rate hikes, of which there have been roughly 200 in the past two years, have contributed to a slowing of global manufacturing. The slowdown is also apparent in world semiconductor sales. Further, house price appreciation, mortgage lending, and construction orders are slowing in the Eurozone. Bank lending growth for housing is starting slow in Japan and it looks like housing starts have peaked. It's the same kind of story in Australia. Yet, the central banks are still hawkish, and Nancy points out that there's still a risk of the BoE and ECB tightening further. Also, Japanese vehicle sales are slowing because of skepticism about wage growth. Sub prime problems continue to hit various financial companies – yesterday it was M&T Bank (MTB) and New Century. The weakness in housing means you should underweight financials. Francois believes investor sentiment has become too bullish and financials have grown to be 20% of the S&P index (much larger than its share of the economy). No other segment has held onto its heavyweight title as long as financials have and it probably won't stay there."
...Ed Hyman, International Strategy & Investment (ISI)

I met Ed Hyman in the 1970s when he was at the venerable firm of C.J. Lawrence. Little did I know that he would become Institutional Investor's #1 ranked Wall Street economist for each of the past 26 years. Over those years my firm has often recommended ISI's mutual funds, which have made our clients a lot of money. This morning I reprise Ed's comments because I think they are right to the point given last week's bond market action.

Indeed, the chart of the week has to be the bond market since T'Bonds recorded a decided price breakdown last week (read: higher interest rates), as can be seen in the following chart.

30-Year T'bond
(includes 10-DMA, 50-DMA, and 200-DMA)

Source: Reuters Bridge Station
Click chart for larger image.

Notice that the 30-year Treasury bond's price has broken below its 10-day moving average (DMA), its 50- DMA, and its 200-DMA, and in the process has traced out what appears to be a massive head-and-shoulders "top" formation, implying higher interest rates. For a finance-based economy this is NOT an unimportant point, for the mortgages of choice a few years ago were those "fancy" ones that reset their interest rates after two to three years. The T-bond's breakdown was clearly caused by last Friday's much stronger than expected employment report, which showed non-farm payrolls rising by an eye-popping 180,000 (the median forecast was +120,000), while the unemployment rate edged down to 4.4% as things continue to get "curiouser and curiouser."

I have often used this "curiouser and curiouser" phrase, from Lewis Carroll's book "Through the Looking Glass," because I have been confused about whether the economy was going to slow into recession, slow into a muddle, or actually reaccelerate. Until last Friday it appeared as if the economy's recent statistics were slowing, but that trend changed with the employment figures. Cynics will suggest that the employment numbers are a lagging indicator, which is true, but tax receipts are not. And tax receipts continue to track at high single-digit levels, which is inconsistent with 2% GDP growth.

Also worth noting is that the Federal Reserve "follows" the bond market when setting the Fed Funds interest rate rather than "leading" it. If that historical precedent holds true, it suggests the Fed is unlikely to lower interest rates anytime soon. Ladies and gentlemen, to a Wall Street community imbibed with lower interest rates, steady interest rates or worse yet, higher interest rates would be a shock. Not only would higher interest rates have negative implication for the economy, but for my firm's stock market regression models, P/E ratios, and our weaker U.S. dollar strategy. So what are we to do?

Well, for the past few years my firm has recommended that investment portfolios have a position in First Trust Four Corners Senior Floating Rate Income Trust II (FCT) since it benefits from higher interest rates. For those thinking FCT is too tame an investment, consider this – at year-end 2005 we pounded the table on FCT when it was selling south $17 and yielding north of 8%. Since then, on a total return basis, these shares have returned roughly 17% and in the process beaten the returns of most indices. I think FCT still deserves a weighting in portfolios as it continues to trade at a discount to net asset value (NAV) and yields 8.2%. As a hedge to FCT (in the event of lower interest rates), investors should consider an equal dollar-weighting in international REITs. International REITs were highlighted in a recent Business Week article titled "The Wisdom of Brackets" (from the 3/26/07 issue). As can be seen in the article's "decision tree," international REITs "win" the risk-adjusted investment derby. As stated in the article:

"Global REITS win (it) all. Real estate investment trusts, well developed in the U.S., are a relatively new vehicle everywhere else. They allow owners to securitize their holdings and raise funds for new projects and give investors stock-like ownership in a portfolio of properties. U.S. REITs have been on a roll for six years, and bargains are few. The global real estate boom, on the other hand, is just getting started."

Closed-end funds playing to this international REIT theme include: 6%-yielding ING Clarion (IGR), 5%-yielding C&S Worldwide (RWF), RMR Asia Pacific (RAP), and the streetTRACKS DJ Wilshire International Real Estate ETF (RWX). Open-end mutual funds that "foot" with this theme may be obtained from my firm's retail liaison desk. And while such a paired strategy (long FCT and international REITs) makes sense in the current confusing stock-market/interest-rate environment, there are many other stock investments that make sense to me because there is always a bull market somewhere.

Indeed, for five years my firm has unwaveringly stated that the secular bull market in precious/base-metals is alive and well. Accordingly, last week gold registered an upside breakout in the charts, rendering a nearterm price objective of $690/ounce, and bettering that, the reaction high of $732/ounce. While my firm owns numerous precious metal and base metal stocks, recently we have been using a smaller, more nimble, gold fund named OCM Gold Fund (OCMGX). Conveniently, given gold's upside breakout, there is a conference call with OCM's portfolio manager this Thursday at 4:10 p.m. (800.414.2828; pass code 174727). Yet while gold's 1.8% weekly rise was impressive, my firm's metal of choice, namely nickel, rose 15% on the week. We like nickel because not only is it used in the stainless steel counter-tops for the McDonald's (MCD) of the world being built in China/India, but also the fact that the normal car uses two pounds of nickel, while the hybrid car uses 35 to 40 pounds (read: batteries).

Another bullish theme my firm likes is "trash," especially the nascent trash problems in emerging countries. For example, China has a burgeoning garbage problem, for as per capita incomes rise, people consume more "stuff" and consequently generate more garbage. Moreover, China has averred that it wants to generate 30% of its electricity from non-fossil fuels in the not too distant future. Enter Outperform-rated Covanta (CVA). Simply stated, Covanta takes solid waste, burns it, and in the process produces "dirt cheap" electricity. While not a large player in China just yet, China seems like a logical extension for Covanta.

Another name my firm embraces, namely 2.4%-yielding Johnson & Johnson (JNJ), was added to the Focus List last week. This is consistent with our strategy of buying the "flops" in fundamentally sound companies. Indeed, JNJ's shares have declined roughly 15% from their October 2006 peak-price, leaving them trading in-line with the S&P 500 P/E multiple, which historically has been an attractive buy point. JNJ's free-cash-flow yield of 6.6% (historical average has been 4.0%) is the highest in 17 years and therefore should also provide a foundation of value. Johnson & Johnson's free cash flow yield is superior to the group's 5.3% yield, as well as the group's 17-year average of 3.4%. Further, the December purchase of Pfizer's (PFE) consumer business should help protect the company from patent losses in its drug business and the technological obsolescence of its medical products.

The call for this week: I have yet another interest rate play to hopefully take advantage of the current sub-prime debacle where the "throw the baby out with the bath water" environment has produced what appears to be an underpriced stock. Quadra Realty (QRR) is a "busted" IPO that is trading below its recent IPO price and is rated Outperform by my firm's research correspondent Credit Suisse. However, this story is a discussion for another time. As for the stock market, the S&P 500 broke out to the upside last Thursday and looks poised to test the reaction highs around 1460. Hopefully that will help our long trading position in the SPDR Financial Index (XLF).

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