The Fed’s Next Move
Posted by Eddy Elfenbein on August 2nd, 2006 at 4:39 pm

I wanted to help shed some light on the Fed debate Wall Street has been having. The futures market indicates that Wall Street thinks there’s a 30% chance of a rate hike coming next Tuesday. Personally, I’m surprised so many people feel that way. It seems obvious to me that the Fed will raise rates, or at least, they ought to raise rates.
Let’s take a step back and look at what’s happening. Everybody always wants to know what indicator the Fed is watching. Some people think the Fed should watch gold. Others think it’s employment and wages. Still others think it should monetary aggregates.
I think the best variable to watch is real interest rates. By real, I mean the after-inflation return of short-term Treasury bills. Here’s a graph of the real return of 90-day T-Bills going back more than 50 years (12-month rolling period):

Granted, this isn’t a perfect measurement. Monetarists will say that it’s not a cause but an effect of inflation. The biggest problem is that you never know what future inflation will look like. You only find out the real return after the fact. Still, I think it’s the best way to look at the Fed’s policies.
For example, you can see that rates were too low during much of the 1970s. Real rates were negative for nearly eight straight years. In other words, you got paid to borrow money. That’s the problem with inflation. If it isn’t stopped early, it can spiral out of control.
In my opinion, the Fed lowered rates far too much after 9/11. You can see that real rates were negative for over three years. That’s less than the recession of 15 years ago, which was much worse than the fairly shallow recession earlier this decade. I think we’re seeing the effects of the Fed’s easy money in today’s (still modest) inflation.
Ideally, real rates should be at 0% during a recession, and around 3% during an expansion. The most recent report on core CPI showed that inflation increased 2.64% over the last twelve months (that’s through June). I should also point out that the T-Bill rate is about 30 basis points below the Fed funds rate.
I’d like to see the Fed take rates up another 25 basis points, before pausing. I don’t think pausing now would be a huge error, but it’s better done sooner rather than later.
There’s another fact to keep in mind: There’s a lot of new blood at the FOMC. Two governors joined the Fed earlier this year. Plus, there are two other vacancies (Frederic Mishkin has been confirmed by the Senate but he won’t be sworn in until after Labor Day).
This means that there will be only ten voting members at the FOMC meeting. Since the Fed presidents take turns each year (the New York Fed President is a permanent member), this means that a minority of votes on Tuesday will be cast by people who never agreed to the start of the Fed’s rate hikes two years ago.
We often forget that the FOMC is in fact a committee, but I wouldn’t be surprised to see some dissension next week.

Too Much for Whole Foods
Posted by Eddy Elfenbein on August 2nd, 2006 at 11:59 am

Last December I wrote that Whole Foods Market (WFMI) was overpriced and probably due for a fall. At the time, the stock was at $76 a share (post-split). What happened? Of course, it rallied $78.
But on Wall Street, the true value of a stock will eventually come through. You just need to be patient. Yesterday, Whole Foods’ stock dropped nearly 12%. The stock is now at $51 a share. That’s a pretty nasty fall.
The company actually reported decent earnings but sales came in below expectations. It’s a good company, but the shares still look pricey.

Expeditors International Is Getting Slammed
Posted by Eddy Elfenbein on August 1st, 2006 at 2:55 pm

The transportation stocks have been getting punished hard lately. Today’s victim is our very own Expeditors International (EXPD).
The company reported earnings today of 25 cents a share, which was just a penny below expectations. The stock is currently down $6 a share, or over 13%. Frankly, the stocks strong rally during the first half of the year pushed it into overpriced territory, so some selling was due.

Happy August
Posted by Eddy Elfenbein on August 1st, 2006 at 9:24 am

Ticker Sense notes that two-thirds of the total return of this bull market has come on the first day of the month:

It’s that time of the month again – the first of the month. During this bull market, the cumulative return of the S&P 500 on the first trading day of each month is 27.04%. This blows away the cumulative return of the rest of the month which is just 13.44%. This means that 67% of the gains since the market lows of October 2002 have come on the first trading day of the month. The last two months have been especially profitable, with June 1st going up 2.05% and July 3rd going up 0.79%.

GDP Revisions
Posted by Eddy Elfenbein on August 1st, 2006 at 9:01 am

Here’s something that hasn’t got a lot of attention. Along with last week’s GDP report, the government revised all the GDP numbers going back to 2003.
Here’s what the new GDP figures look like compared with the old ones:

Here’s what the old and new quarterly growth numbers look like:

It turns out that the government had overstated economic growth from 2003 to 2005, and slightly understated growth for the last few quarters. This wasn’t a small revision either. Last month’s report of first quarter GDP was $11.316 trillion (these are annualized numbers and adjusted for inflation). The new number is $11.404 trillion. That’s a reduction of nearly 0.8% or almost $90 billion. Even a small reduction is a huge amount when dealing with the U.S. economy.
While the initial GDP report of 2.5% has received a lot of attention, keep in mind that this number will be revised twice more, at the end of August and again at the end of September. These can be large adjustments too. The initial report of first-quarter GDP was 4.8% and it was later raised to 5.6% (and lowered again from 5.64% to 5.58%).
It could turn out that all the concerns of the “weak” second quarter was much ado about nothing. We place a lot of importance on what the Federal Reserve does, but it’s always good to remember that the Fed never has a clear vision of what’s truly happening. The Fed is trying to drive on a highway by only using a a rear-view mirror. And it’s a blurry mirror at that.

Donaldson Raises Dividend
Posted by Eddy Elfenbein on August 1st, 2006 at 8:31 am

There are two small items from last week that I wanted to mention. The first is that Donaldson (DCI) raised its dividend from eight to nine cents a share. Although the dividend yield is still very low (about 1.1%), what impresses me is how regularly Donaldson has increased it. The dividend has doubled in the last three years and tripled in the last seven. For the long-term, the company has increased its dividend by an average of 14% a year. That should put the low yield into some perspective.
I also wanted to touch on Respironics’ (RESP) earnings. The company earned 43 cents a share which was very good. That beat expectations by four cents a share. This was also the end of RESP’s fiscal year so in FY 06, Respironics made $1.47 a share. For next year, the company sees earnings coming in between $1.72 a share and $1.77 a share (or 17% to 20% growth). The Street had pegged earnings at $1.63 a share. The stock didn’t react much from the announcement.

The Midday Market
Posted by Eddy Elfenbein on July 31st, 2006 at 11:28 am

The markets are mixed so far. Energy stocks are up a bit, and financials have pulled back. The yield on the 90-day T-Bill has crossed over the 5-year yield which I don’t think had happened before.
Expeditors International (EXPD) is set to report earnings tomorrow. After having a great first half, the stock has been very volatile recently.

Economy Grew By 2.5% in Q2
Posted by Eddy Elfenbein on July 28th, 2006 at 9:15 am

The govenment just reported that GDP grew by 2.5% for the second quarter, which is less than half the rate of the first quarter:

The second-quarter’s performance — which reflected the bite of high energy prices and rising interest rates on people and businesses as well as a cooling in the once red-hot housing market — was weaker than the 3 percent pace analysts were forecasting.
The 2.5 percent pace was the slowest since a 1.8 percent growth rate in final quarter of 2005, when the economy was suffering fallout from the devastating Gulf Coast hurricanes.
Even though the economy cooled in the second quarter, inflation heated up.
An inflation gauge closely watched by the Federal Reserve showed that core prices — excluding food and energy — jumped by 2.9 percent in the second quarter — far outside the Fed’s comfort zone. That was up from a 2.1 percent increase in the first quarter and marked the highest inflation reading since the third quarter of 1994, when core inflation rose by 3.2 percent.
The inflation reading was taken before the latest run-up in energy prices. Oil prices hit a record closing high of $77.03 a barrel on July 14. Gasoline prices also have marched higher, topping $3 a gallon in many areas.

Your Soft Landing Survival Guide
Posted by Eddy Elfenbein on July 27th, 2006 at 6:03 am

Talk of a soft landing is very in right now. It’s the new gay. No wait…I think it might be the new black. Actually, I’m not really sure. Either way, it’s here, get used to it. Even Jeremy Seigel has jumped on the Soft Landing Bandwagon.
This got us to thinking, how has the market behaved during previous soft landings? The problem is, true soft landings have been quite rare. Many landings start out soft, and become hard very fast (my apologies for the wording of that sentence).
By my count, there have been three successful soft landings of the past 40 years. The first was in 1966, then again in 1986, and again in 1995. Here’s a graph of the 10-year Treasury yield along with the 90-day yield going back to the early 1960s:

As always, I pass the graphics savings on to you the customer.
The 1966 case is probably the most relevant to us today. The country was at war. It was a mid-term election year. Short-term interest rates had been climbing for some time, and the yield curve flattened out in January in 1966. Short-term rates continued to head higher and didn’t peak until September.
Remarkably, the economy wobbled but didn’t go under. Real GDP grew by 4.3% in 1966, 2.5% in 1967 (including a flat second quarter) and ramped up to 4.9% in 1968. It wasn’t until late-1969 that the economy finally started to break.
The stock market, however, had a painful time in 1966. Stocks peaked on February 9, shortly after the 90-day yield first caught up with the 10-year yield. At its high point, the Dow came within 5 points of 1,000, although it wouldn’t close above the millennium mark for another six years. By the low point on October 9, the Dow lost 25% and the S&P 500 dropped 22%.
This was a classic bear market. I think the outlook for stocks is far better today than it was 40 years ago. P/E ratios have been coming down, and the Fed is already talking about calling off its rate increases.
Starting from January 10, 1966 (roughly when the yield curve first became flat) and measuring one year out, the best industry groups were Hardware (18.9%), Books (17.3%), Gold (15.2%) and Insurance (7.85). The worst were Health (-66.2%), Software (-39.3%), Textiles (28.8%) and Chemicals (23.4%).
In 1986, it was still Morning in America, although real GDP growth had been dropping from its blistering levels. The economy grew by 5.6% in 1984 and 4.3% in 1985. By 1986, the economy grew by just 2.8% (1.4% in the second quarter) and a recession seemed possible. Once again, it was a mid-term election year. Just like 1966, the party controlling the White House was rebuked at the polls.
The slowdown, however, was temporary and the economy accelerated again. In 1987, the economy expanded by 4.5%. Despite the market crash, the economy grew by another 3.7% in 1988.
The major difference between now and then is that the yield curve never got anywhere close to inverting. Long-term bond holders were still not convinced that Paul Volcker had won the war against inflation. The top-performing groups of 1986 had a definite defensive bias; Tobacco (50.5%), Drugs (35.7%) and Boxes (35.4%–really, that’s what it says “Boxes”). The worst groups were Health (-15.1%), Hardware (-8.6%) and Aerospace/Defense (-7%). It’s interesting to see that Hardware went from best to worst, but Health is still at the bottom.
In 1994, the Federal Reserve had raised interest rate very aggressively. By 1995, the economy began to feel the squeeze. Real GDP growth was just 2%, less than half the rate of the year before. The economy was particularly weak in the first half of 1995 when it by 1.1% in the first quarter, and 0.7% in the second quarter. Since long-term yields climbed with short-term rates, the yield curve never formally inverted.
All ten S&P 500 sectors had a good year in 1995:
Healthcare………….54.50%
Financials…………..49.64%
Tech………………….38.77%
Telecom……………..37.33%
Staples……………..36.22%
Industrials…………35.93%
Energy………………25.97%
Utilities………………25.19%
Discretionary………18.19%
Materials……………17.29%
I think history shows that defensive stocks are a good place to ride out a soft landing. You’re protecting yourself against the most severe losses, and there’s a good chance for decent capital gains.

Earnings from Varian and Fair Isaac
Posted by Eddy Elfenbein on July 26th, 2006 at 9:31 pm

After today’s close, Varian Medical (VAR) reported earnings of 41 cents a share, which was above the Street’s forecast of 38 cents a share. The company also raised its outlook for this year’s growth to 18%-19%.
Fair Isaac’s (FIC) earnings fell from 53 cents a share to 40 cents a share. That included charges of 15 cents a share, but it was still below expectations of 42 cents a share. This was a very disappointing quarter for FIC.
Respironics (RESP) will report its earnings tomorrow.