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Profit off the Streets hopes and fears
Despite the consensus that the Fed will be able to control inflation while stimulating growth, I expect plenty of short-term volatility. Heres how to win.
By Jim Jubak
Any moment now, investors will link arms with the governors of the Federal Reserve and begin humming Kum Ba Yah. Thats how enamored they appear with Fed Reserve Chairman Alan Greenspans ability to keep inflation low while at the same time growing the economy.
Quite honestly, all this unanimity makes me nervous.
The stock and bond markets have priced in the next Fed move to raise short-term interest rates . . . and the next and the next and the next. In the days leading up to the June 30 meeting of the banks Open Market Committee, in fact, traders in the Fed Funds futures market had priced in a 2-percentage-point rise in short-term rates over the next 12 months. The financial markets were expecting that by June 2005, the Fed Funds rate, at 1% when the committee met, would be at 3%.
And the long end of the bond market, the perennial home of worrywarts who panic at the slightest whiff of inflation, is in extraordinary agreement that those interest-rate increases will be enough to contain inflation. True, the yield on the 10-year Treasury note has climbed to 4.7% or so from 3.42% on June 27, 2003. But the yield has been remarkably stable since the beginning of May 2004, ranging from a low of 4.6% to a high of 4.8%. The market for 10-year Treasury notes is certainly behaving like it believes in the Federal Reserves promise that, since inflation is under control, interest rates will rise only slowly.
Stock market investors increasingly agree. After a period of paranoia when everyone predicted that the sky would fall when interest rates headed up, the tone of the discussion has moved to the other extreme. Now, higher interest rates, as long as theyre only moderately higher, arent bad for stocks. History even suggests that higher interest rates might be good for stocks: After an initial decline, stocks tread water and then move up again. You can find a good summary of the historical record in Laszlo Birinyis recent column, Bring on the rate hikes -- it's time to buy.
3 reasons the Fed may not keep its promise
Notice, though, that this optimism on stocks, like that on bonds, rests on a belief that the Fed will deliver as promised.
There are several looming issues that could knock this rosy scenario for a loop. Here are three big ones:- An aging population in the traditional engines of global economic growth -- the United States, Europe and Japan -- that argues for slower growth in these economies. As consumers age, they need to save more for retirement and increased health-care costs, and spend less. At least thats been the historical pattern. It is likely that it will be somewhat different this time, especially in the United States where relatively less generous government-funded social programs and a relatively flexible economy are likely to make it essential for older workers to delay retirement and give them the employment opportunities to do so. Nonetheless, economic growth in these developed economies is likely to be below historic trends, and that decreases the Feds room for maneuver. Under the circumstances, it will take less of a U.S. interest-rate hike to slow global growth to unacceptable levels.
- The immaturity of the Chinese and Indian economies. The great hopes for high rates of global economic growth over the next decade makes them especially prone to boom-and-bust cycles. Both economies are still subject to heavy top-down government planning and capital allocation. That creates the risk that these central planners will get it wrong. The financial markets in both economies, but especially the Chinese economy, are very inefficient: The cost of money, especially in China again, does not accurately reflect the economic or market risk of the projects being funded. Risky projects and projects that have no real promise of earning any profit are able to attract cheap financing. Finally, political imperatives in both countries require pedal-to-the-metal economic growth. For example, estimates are that China has to grow its economy by at least 7% a year just to be able to provide jobs to workers newly entering the work force. With global economic growth and the global prices of commodities from soy beans to copper dependent on these economies, even a temporary bust in China would have a tremendous effect on U.S. economic growth.
- The massive levels of debt run up by the U.S. government and U.S. consumers, held largely by foreign central bankers and foreign investors, puts the U.S. economy on a tight rope. On the one hand, its hard to see how the United States stands any chance of repaying this debt. Honest repayment would require saving and cuts in consumer and government spending that arent in the cards in the near term certainly. That leaves inflation and a decline in the value of the U.S. dollar, which reduces the real value of the debt, as the most tempting solution. But, on the other hand, the current levels of U.S. debt and the current levels of spending that are adding to that debt every day require that foreign investors retain their willingness to hold U.S. dollars. Inflation and dollar depreciation that is too rapid will erode that willingness and foreign investors will have to be given the incentives of higher U.S. interest rates to keep owning dollars. The bias in the current situation is toward inflation, a weaker dollar and higher interest rates.
Planning for two futures
Do these three trends make it certain that the Fed wont be able to deliver what it has promised and what the financial markets consensus has now priced in? Of course not. There are too many unknowns, from terrorism to tremors in the financial markets.
Related news and commentary on MSN Money
The likelihood is that we wont know how successful the Fed has been at delivering on its promises until some time in 2005. The real test will come after the initial expected increases -- say, the ones that the Fed Funds futures market now expects to take short interest rates to 3% by mid-2005. Then, and only then, will we know if the Feds plan to raise rates modestly in carefully announced steps will be enough to control inflation and wont be too much for the economy to bear.
So what do you do?
The task requires a kind of split in your mindset and in your portfolio. With one part of your brain and one part of your portfolio, you need to play the near-term volatility of this market as it vacillates between belief in the Fed to fear that the Fed wont deliver. To take advantage of this vacillation between hope and fear, you need to set up a very simple style rotation with part of your portfolio.
When the market moves toward hope, shift some of your portfolio toward growth stocks. At the same time, sell some of the low-risk hedges in industrial metals, land, energy and other sectors that do well when everyone is worried about a weaker dollar and inflation, but that fall back when the dollar rallies. Selling these stocks gives you the cash to buy those earnings-growth stories.
When the hope cycle looks like it is topping, switch back to defensive inflation and weak-dollar plays. Youll get the cash to repurchase them by selling growth stocks that have hit your target prices.
Time to move
I think were at such a point now. Im selling a few of the inflation, weak-dollar stocks in Jubaks Picks that have hit their near-term target prices and buying several growth stocks. Youll find a complete list of buys and sells at the end of this column.
However, youll note that Im not selling everything and that Jubaks Picks, even after these sells, will retain a strong inflation, weak-dollar hedge position. Thats because at the same time Im trying to play the short-term rotation between hope and fear with one part of my portfolio and one part of my mind, Im also building up a collection of hedge stocks to protect against the possibility that the three long-term trends Ive discussed above will disrupt the Feds plans and disappoint the financial markets.
In this part of my portfolio, I dont do any selling when hope is in the drivers seat: Im willing to take some short-term punishment in my inflation, weak-dollar hedge positions in order to keep the protection that these positions offer. In fact, when the hope cycle has reached its peak and the inflation, weak-dollar hedge stocks are trading lower, I look to gradually add to my positions in these stocks. I expect to be able to do that when the current hope cycle reaches its peak in six weeks or so.
I realize asking investors to think both short term and long term, and to invest in both growth and hedge stocks isnt a trivial challenge. But this is a very difficult market, and often difficult markets require difficult solutions.
In my next column Ill tackle another difficult situation: how to find safe income in this stock market.
Changes to Jubaks Picks
Sell Inco
This trade with Inco (N, news, msgs) has worked twice, and I hope to put it on again later this summer after the effects of the Federal Reserves interest rate increases wear off. I expect that the U.S. dollar will strengthen temporarily on any interest-rate hikes. All things being equal, higher U.S. interest rates do make foreign investors more willing to hold dollar-denominated investments. But given the huge, long-term U.S. budget and trade deficits, I dont expect that a few 25-basis-point increases will do much to reverse the trend toward a weak dollar. Metals stocks tend to retreat on dollar rallies, and so Im selling Inco again -- with a 20% gain this time since I added the shares to Jubaks Picks on May 7. (The last go around on this trade brought a 39% gain from Sept. 23, 2003, to Dec. 23, 2003.) Ill be looking to repurchase Inco if the shares fall below $30 again. (Full disclosure: I will be selling my shares of Inco three days after this column is posted.)
Sell Teekay Shipping
Teekay Shipping (TK, news, msgs) is getting close to my target price, and I dont see any reason to be greedy. With valuation on the shares now at the high end of historical measures --trading at 113% of net asset value, the shares are near the 130% top of the range -- I think Teekay Shipping shares are a good source of cash for the growth stocks I want to add to Jubaks Picks before the Federal Reserve moves on rates and before earnings season starts. Im selling Teekay Shipping out of Jubaks Picks with a 17% gain since I added the stock to the portfolio on Feb. 24, 2004.
Buy Marvel Technology Group
Marvell Technology Group (MRVL, news, msgs) was one of the stocks I named in my column 3 techs that could buck the market trend. Im going to add the shares to Jubaks Picks as a way to add more exposure to the second-quarter earnings story for the reasons I outlined in that June 28 column. Wall Street earnings projections for the quarter that ends in July went to 36 cents from 33 cents a share in the last 30 days, but I think the actual earnings report will supply even more good news. I also think the Wall Street consensus, which has pegged earnings growth at 21% for fiscal 2006, after projecting 56.5% growth for the year that ends in January 2005, is low-balling the companys long-term growth story. The stock trades at 135 times trailing 12-month earnings per share but just 35 times projected earnings for fiscal 2005. As of June 28, Im setting a September target price of $60 a share.
New developments on past columns
My hell-in-a-hand-basket portfolio
The fundamentals are still moving in Newmont Minings (NEM, news, msgs) direction, even if some lower-grade-than-expected ore and slower-than-expected production increases in Nevada have pushed the pay-off a little bit into the future. Gold prices cracked $400 an ounce again on June 24, and I expect them to stair-step higher into 2005. My new target price for Newmont shares is $55 by December 2004. (Full disclosure: I own shares of Newmont Mining.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Inco and Newmont Mining. He does not own short positions in any stock mentioned in this column.
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