Bernanke Is A Solid Pick

Fortunately, President Bush decided not to throw us a curve ball today with his appointment of Ben Bernanke as the next Fed Chair. Recent history clearly had the market a bit spooked with Greenspan’s successor yet to be named, but a relief rally on Wall Street is underway. Bernanke really has only been in the spotlight in recent months, as potential replacements were discussed. Nonetheless, his credentials are strong and I think the market was hoping he’d be Bush’s top choice.

I still believe Greenspan wants to “finish what he started” and will likely bring Fed Funds up to 4.5% before he moves on in late January. If this view proves true, and Bernanke doesn’t continue boosting short-term rates, we could see a nice market rally back to the upper end of the trading range between now and sometime in the first quarter, as the rate hike barrage would be over. That would certainly be welcomed by investors, myself included.

Different Year, Same Old Story

It was postulated here earlier in the year that 2005 could very well turn out a lot like 1994, the last time the Fed went on autopilot and raised interest rates consistently for an extended period of time. The result was a flat-to-down market that ended up a mere 1% for the year (only after a substantial rally late in the year). As some of us expected, 2005 has indeed played out the markets tend to do when the Fed is increasing the cost of money.

To see exactly how similar it has been I decided to construct a year-to-date chart of the S&P 500 and compare it to the same nine-month period in 1994. Below you will find both charts, 1994 first, followed by 2005.

Market Struggles As Fed Unlikely To Stop

After a mini rally in the market last week, investors were hopeful it would continue for a little while longer. However as this week has shown, such hope was overly optimistic. The S&P 500 is once again headed back down to its support levels. As much as Wall Street wants Alan Greenspan to stop raising rates, few people really think that will happy anytime soon.

The old adage “Don’t Fight the Fed” continues to hold true. The S&P 500 closed at 1,141 on June 30, 2004. That was day of the first rate increase in 4 years, when the FOMC took the Fed Funds rate from 1.00% to 1.25%. Ironically, the major support level for the S&P 500, which has held throughout 2005, is right around 1,140. Investors trying to fight the Fed have found themselves treading water in a market that has not budged since the first of the eight 25 bp rate hikes.

With earnings still growing nicely, valuations are not stretched by any means at this point. We just need a catalyst. Some economists believe Greenspan could stop right here at 3.00% Fed Funds. Others say he will go to 3.50%. While I am hoping for a stopping point at 3.50%, I truly think we are headed to 4.00%. The FOMC needs to leave itself some room to cut rates if something really bad should happen, and they have a history of going too far.

This time will most likely play out in a similar fashion. If the 10-year bond stays where it is, we might have an inverted yield curve before too long. The Fed might kill the economy trying to preempt inflation and the cool the housing market, even though inflation isn’t really a huge concern at the moment. And besides, mortgage rates are based on the 10-year, not Fed Funds.

All in all, the market will continue to be tough for most, if not all, of 2005, unless Greenspan remembers what happened last time he took rates too high (think March 2000) and decides to be more cautious this time around. Cross your fingers.

Treasury Sees Need to Reissue 30-Year Bonds

To give you an idea of how bad the Federal budget deficit has gotten, the U.S. Treasury has decided to strongly consider bringing back the 30-year treasury bond. The 30-year was retired in 2001, the first year of President Bush’s term. The Treasury now says that with so much more debt needed to fund the government’s budget, they need to issue more, and bringing back the 30-year bond will help them do that. A final decision will be made in early August. Treasury bond rates have spiked higher on the news, as more supply will lessen demand, causing interest rates to rise.

More Proof of a Housing Bubble

Kids are graduating college and immediately buying houses. Rent an apartment? What are you, crazy? Extra cash is being invested, not in stocks (by far the best performing asset class since the beginning of time), but rather in real estate.

When people reflect on the Internet stock bubble of the late 1990’s, they often recall shares of Yahoo! and being the most common topics of conversations at dinner parties. Nowadays I find myself at poker games where investing in real estate is the main topic of conversation.

A few months ago, I got an email from a University of Missouri student who had been present for one of my guest lectures during his senior year. He had moved back to St. Louis after graduation and, along with a buddy of his, wanted to meet with me to discuss investment opportunities. Maybe they wanted to take my advice and open a Roth IRA, I thought. I was thrilled to sit down with them and offer some advice.

Turns out Roth IRAs were the farthest thing from their minds. Instead, they had assembled a group of 20 or so friends, most in their early 20’s. Their plan was to pool money together and invest in real estate. They figured 20 people contributing $200 a month would net them $10,000 within three months; enough for a down payment on a $50,000 house, which they would then fix and resell for a profit.

This is the type of behavior the current real estate market has induced. Amazing really, given what we all experienced just five short years ago. The logic seems to be that stocks were just pieces of paper, but houses are a much safer asset. Houses might be more tangible, but regardless of what you are investing in, the only thing that really matters is how much you pay for it and how much it will ultimately be worth.

Below is a link to an article from Sunday’s L.A. Times (free registration required). If you don’t think there is a real estate bubble in this country after reading it, I’d be surprised. The author may be highlighting California-specific instances, but something tells me it’s happening in a lot of other states as well.

Raising Rates Like It’s 1994

The parallels between 1994-1995 and 2004-2005 are quite striking when it comes to the Fed’s interest rate policy and the stock market. History tends to repeat itself in the financial markets, and if indeed today’s situation plays out like it did a decade ago, short-term pains could very well reward investors with longer term gains.

First, let’s recap how the 1994-1995 period took shape. The stock market rallied nicely in 1992 and 1993 as rates fell and corporate earnings showed healthy gains (not unlike 2003-2004). Chairman Greenspan and the Fed began raising interest rates in 1994, using 7 rate increases to take the Fed Funds target from 3% to 6%. Rather than moving gradually and telegraphing its intentions, the Fed moved very quickly, including two increases of 50 bp and one move of 75 bp.

Many were not prepared for such rapid rate hikes, and as a result, Orange County CA, the Mexican Peso, and Wall Street firm Kidder Peabody spun into crisis. Stocks tumbled throughout much of 1994, dropping by more than 10% at one point. However, a late year rally got the market back to about break-even for the year. The last rate increase came in January of 1995. Once the Fed stopped, the stock market rallied strongly for the duration of 1995, finishing the year with a 37% return for the S&P 500.

Could this time play out similarly? Ironically, the Fed’s recent 25 bp rate hike, to 2.75%, marked the 7th rate hike since last year. A similar move to 1994 (300 bp from the lowpoint) would put interest rates at 4% when all is said and done, as the Fed Funds rate bottomed at 1% last year. Much like 1994, stock prices have struggled this year as rate increases are showing no signs of letting up.

The similarities are too noticeable to ignore. The Fed has acknowledged that it raised rates too quickly in 1994-1995 and therefore has chosen to move more slowly and steadily this time around. Whenever they decide they have stifled inflation enough, I wouldn’t be surprised to see the 1994-1995 scenario continue to play out, with the stock market finally able to make meaningful headway to the upside. Until that happens, 2005 could very well play out just like 1994; painful short-term, but paving the way for gains later on down the road.

As for specific investment strategy, it’s not surprising that financial stocks have struggled since the Fed began raising rates. This trend is likely to remain intact as long as Greenspan continues his current course of action. However, financial services stocks are getting very attractive on a valuation basis. Waiting for the last rate hike before buying them will cause one to miss part of the move upward when the Fed is done, since the market will anticipate it ahead of time.

Adding some bank stocks as the tightening cycle winds down should prove very profitable for investors. Check out the chart below of Citigroup from the aforementioned 1994-1995 period. The Fed stopped the rate hikes in early 1995, leading to a huge move in the group.

Treasury Bond Yields Soar on Fed Speak

Yields on 1o-year treasury bonds hit levels not seen since mid-2004 on Wednesday, after the Fed hinted that further interest rate hikes were on the horizon. Greenspan and Co. even added language to their policy statement that highlighted recent increases in inflationary pressures in the economy.

With oil prices over $55 a barrel and the housing market remaining robust, it’s quite possible the Fed will continue to raise rates throughout the remainder of the year. The areas impacted the most will be the fixed income and housing markets. If inflation picks up, the TIPS market should shield investors from some of that risk. Gold may do well too, but I think other commodities should outperform gold due to increased demand worldwide and limited capacity.

The stock market likely won’t be able to make any meaningful move higher until the Fed is finished raising rates. On that end it would be better if they raised 50 bp at a time, as many have suspected they might if inflation fears don’t subside, just so we get to their target rate faster. The quicker they get to a point where they can stop raising rates, the quicker investors can start to make good money in the stock market again.

Housing and Rising Interest Rates

After months of baffling investment strategists and economists, long-term interest rates have finally begun to rise. The 10-year bond rate has risen from under 4.00% to nearly 4.40% in a heartbeat. Prospective home buyers are finding their rates rising, putting pressure on them to lock in a low rate as soon as possible.

There is little doubt that higher rates will hurt the housing market. The homebuilding stocks haven’t been hit much yet, but it’s certainly dangerous to own them for the rest of the year, if this rate trend continues. If you believe rates will continue to move higher, the housing stocks could make for an attractive short (especially with the S&P 500 setting up for a potential triple top).

If you want further evidence to question the sustainability of the homebuilding sector’s tremendous run on Wall Street, below is a piece written this week by a very competent hedge fund manager:

“According to the National Association of Realtors, who should know, second homes accounted for 36% of U.S. home purchases last year, up from more than 16% in 2003. That 36% breaks down thusly: 25% of homes were bought for investment; 13% bought as vacation homes.

Think about that for a second. More than a third of all homes bought last year were bought for either speculative purposes or as vacation homes.

This doesn’t square at all with the mantra of the home building companies and their fans, which is that the U.S. has a perennial housing shortage caused by job creation, immigration and the deep-seated hunger for home ownership.It has nothing to do, they assure investors, with the recent 4% 10 year treasury yield.

It has nothing to do with adjustable rate mortgages or “IO” loans–interest only loans–in which the only thing the homeowner pays is the interest, leaving the principle for later (which to the buyer means “when I flip the thing for a big profit”).

And it has absolutely nothing to do with speculative buying, according to home builders including–and I’ve heard them all say it–Toll Brothers, Pulte, Lennar, KB and Hovnanian.

But now we know the facts: home purchases were inflated a full 20% (the jump from 16% in 2003 to 36% in 2004) by boomers snapping up spec housing and vacation homes around the country. That’s a bubble.

And not for nothing, it seems the average single-family home financed by Fannie Mae or Freddie Mac shot up almost 12% last year, the highest rate since 1979. For those who remember that far back, 1979 ushered in a couple of pretty ugly years in the housing market.”