Archive for February, 2007

The Market – ‘Fed Rate’ Spread to ‘Inflation Rate’

An article from Bloomberg titled “Bonds Lose `Masters of Universe’ as Volatility Falls” by Elizabeth Stanton, notes the following: “The annual inflation rate has averaged 2.8 percent since the start of 2000, down from 3 percent in the 1990s and 5.6 percent in the 1980s. Lower inflation has enabled the Fed to keep its benchmark overnight rate lower. It has averaged 3.24 percent this decade, compared with 5.12 percent in the 1990s and 9.86 percent in the 1980s.”  Using this data to do a very basic back of the envelope analysis, I derived the following:

% Spread
Inflation Rate Fed Rate Spread to Inflation
1980s             5.60             9.86 4.26 76%
1990s             3.00             5.12 2.12 71%
2000s             2.80             3.24 0.44 16%
Current             2.50             5.25 2.75 110%


Assuming this data is correct, one could interpret this data as suggesting the Fed is very concerned about any upside to inflation and thus has a very high ‘spread to inflation rate’ compared to historical averages.  Interestingly, the low spread average from 2000 to 2006 reflects the significant liquidity that has been pumped into the economy over that time period versus the prior two decades.  If anything, the current high spread may simply be an attempt to reduce the inflationary liquidity in the system.  With that said, comparing metrics for a point in time to that of historical averages can be tricky and misleading.

Add comment February 20th, 2007

The Market – Important Events that Will Shape the Market

The Bank of Japan is about to make a rate decision that could have far-reaching ramifications.  If the BOJ does raise the overnight rate to 0.50%, the Yen carry-trade could face some significant unwinding and much of the market liquidity we currently have could dry up.  Though I find this scenario above unlikely as a 0.50% rate is still comparatively cheap to that of holding other assets, any concern that the Yen could appreciate significantly could make a significant unwinding of the carry-trade more likely. 

Certainly, what would really hurt the carry-trade and global liquidity is if the Japanese economy suddenly strengthens and provides support for higher rates.  Again, though this is unlikely over the next quarter, the market would have a liquidity scare.  Now, if you add to this the Fed becoming more hawkish, then the double whammy could be very intense.

So what are the key bearish and bullish factors facing the market?  On top of a potential liquidity crunch, add the growing quagmire of the sub-prime mortgage backed market fallout (which hardly anyone seems to really think is going to be a problem as a lot of market participants feel that derivatives, CDOs in particular, have successfully spread default risk so much so that securities loss is almost unthinkable), plus add a continued housing shakeout leading to a reduction in construction jobs, tightening lending standards, and fall in consumer mortgage equity withdrawals, and you suddenly are faced with a very different environment than the one currently priced in.

Then, throw in declining earnings with somewhat mediocre outlooks, a low risk pricing environment, plus a market that is hitting new record highs, and you just have to ask, ‘who the hell wants to lead the charge in the face of this risk?’

Now if you look at what could move the market up, a falling Fed rate would be one consideration as the economy softens.  But then of course, the economy would have to soften in the tightrope goldilocks fashion because usually a softening economy is bad for the market.  Or you could consider increased liquidity, but where would the increased liquidity come from especially when most of the world’s major central banks are in the process of tightening and the BOJ certainly can’t add too much more liquidity than it currently provides.  What about a sudden increase in company earnings?  Well, companies have already guided for some mediocre quarters based on tough comps and market conditions, and if anything, a lot of companies are attempting to spruce up earnings with job cuts, but of course, those are bad for the economy as well.  We could have an earnings surprise to the upside for Q1, but that is unlikely.  Another possibility is the US economy could strengthen more than expected, but the Fed has made it pretty clear they would consider any strengthening as potentially increasing inflation of which they are eager to combat.  The subsequent increase in the Fed rate would likely not be appreciated by the market.  So what about share buybacks and PE leveraged buyouts?  Certainly, those are already providing some market support as companies have recently announced massive buyback packages and 2007 is already famed as the year of the private equity LBO.  But these two efforts are simply icing on the cake, and I don’t believe they have the firepower to make a market trend up over the medium to long term.  Finally, what about an increase in P/E multiples supporting the market?  The S&P 500 is already trading slightly above its long-term average, and as we are in the 5th year of this bull-market run, does it really seem reasonable to think multiples will continue to expand?

Basically, if one compares the probability and likely market effect of the basket of potential bearish events versus the probabilistic likelihood and effect of the basket of potential bullish events, the scales seem to tip very much in the favor of the bearish camp.  With that said, the market has a tendency to spike upward before establishing a downtrend, so the next few months should be interesting as these events pan out.

Add comment February 19th, 2007

The Market – US Mint: A Profit Making Machine

The US Mint is now issuing the new $1 coin collector series that will feature 4 presidents a year for a total of 43 presidents over 11 years. Not too long ago, the mint issued a new quarter collector series featuring all 50 states, and this series is still in the process of been introduced. The US Mint seems to be developing some business savvy.

For each series, the total value of $1 coins issued will be $43, and the total value of the twenty-five cent coins will be $12.50. If one were to assume that these two series will be collected by 5 million coin aficionados, then the dollar value of the coin collections could approach $278 million in non-tax revenue for the government. Importantly, this money in coin collections does not add to the money supply used in everyday transactions and the velocity of money within an economy.

Basically, the US government has found a nifty little way to generate revenue from printing (in this case, ‘coining’) money without increasing the amount of money in circulation and in effect the monetary effect on the inflation rate. Who says the government doesn’t know how to run a business?

Add comment February 17th, 2007

The Market – The Fed and Buffer Inflation

Here is a conspiracy theory for you.  Perhaps the Fed benefits by not releasing / utilizing the inflation numbers that are often higher than the Consumer Price Index (CPI) measure.  The Dallas Fed tracks inflation with a trimmed mean PCE rate and the Cleveland Fed uses a weighted median CPI, both of which usually show inflation as higher than the standard CPI measure.  By using the officially accepted CPI, which also has the benefit of usually showing a lower inflation amount when food and energy are stripped out (two things a human being really doesn’t need anyway, let alone the American consumer), the Fed is able to quietly let higher inflation flow through the economy and thus not be forced by an inflation-wary market to raise rates to combat inflation.  Raising rates would likely have a negative correlation on asset prices (real estate and the stock market) and also the unemployment rate. 

Ever since the Volker Fed in the 1970s, it has been the Fed’s objective to prevent run-away inflation, or the ‘expectation’ of higher inflation by the market and the average consumer.  But current economic theory suggests that in containing inflation, the Fed may counter economic growth and thus job growth, causing the unemployment rate to rise.  Thus, the Fed somewhat delicately has to choose between containing inflation to foster an economy based on worthless pieces of paper (the dollar) or risk raising the unemployment rate and the resulting ire of politicians.  The important concept here is that as long as the market and consumers believe that inflation is contained around 2%, then inflation will not lead to run-away inflation.  If the Fed could have an official and generally accepted inflation index that the market and the consumer have faith in, and this index just happens to track inflation at a lower rate than the actual inflation pressures in our economy, then I am sure this index would work to their benefit.  The Fed would be able to create the ‘expectation’ that inflation was contained at the unofficial sub-2% rate target, and yet let the true inflation amount act as a support to spur economic growth.  The Fed would not be forced to raise rates on a more hawkish basis because the artificial inflation number gives them some buffer, and thus the Fed prevents higher rates from potentially undermining the economy, asset prices, and job growth.  Of course, the index that helps them do this is the CPI. 

The current economic fundamentals are quite spectacular: the unemployment rate is exceptionally low, market liquidity is exceptionally high, asset prices are still high, high consumer spending is still making my jaw drop, commodity prices are high, and yet all of this is occurring with inflation somewhere around 2.4%?  I have to think that our current economy is not been sustained by 2.4% inflation but a much higher rate, perhaps around 3.0-3.5%.  This higher rate of inflation may be acceptable to the Fed, but so long as only they know it and not the market / consumer, because as I said earlier, inflation expectations can lead to higher inflation.  So perhaps we should name the CPI the “Buffer Index: Helping the Fed keep inflation expectations low when real inflation is actually higher.”

Add comment February 14th, 2007

The Market – Stock Buybacks

Stock buybacks were recently reported as $325b in 2006 vs $200b in 2004.  If you assume total market capitalization was $11 trillion in 2006, stock buybacks would represents around 2.955% of the total market value.  As I don’t have data on 2006 total share count, let’s simply assume $10 per share, or 1.1 trillion shares in the market.  Buying back $325 billion would represent 32.5 billion shares or naturally 2.95% of the share count. If you assume that the market does not increase its earnings but they keep constant at say $1.00 earnings per share before the buyback, effectively representing $1.1 trillion in earnings, once that share count falls after the buyback, you now have earnings of $1.03 per share, or an increase of around 3.04%.  So potentially more than 3% of the markets earnings growth in 2006 came simply from share buybacks and all those double-digit earnings growth rates the market has consecutively hit quarter after quarter may be more ephemeral than solid organic growth.

I think stock buybacks are a poor means of returning shareholder value.  The old argument that it spreads earnings amongst fewer shares and theoretically leads to a higher share price thus benefiting shareholders is misleading in the fact that a higher share price can quickly be lost in an irrational market or a market reacting to external circumstances such as economic and geopolitical risk (something that may be happening fairly soon).  And as an investor, I know I would prefer the cold hard feeling of cash to the feeling of the wealth effect.  I can spend $1 in cash dividend (naturally before taxes) for $1 in goods.  The wealth effect only theoretically gives me about $0.40 on that $1.00. 

The problem is, companies like stock buybacks as it improves their EPS growth rates and justifies their rampant stock option pools.  Furthermore, many companies fear that a dividend payment will create expectations of future consistent dividend payments that the company may be forced to reduce during adverse business conditions, thus engendering a public image black eye.  Frankly, I don’t believe in that theory.  I think it would be an excellent idea if more companies started adopting more dividend payment mechanisms, perhaps something like a special dividend that investors may not expect on the typical quarterly or semi-annual basis.  A special dividend might keep more investors in a stock for the long term knowing that management is going to efficiently return capital to the shareholders when the balance sheet of the company is healthy enough to do so.  Microsoft is a perfect example of a company with ample cash that decided to have a special dividend.  They may not want a regular dividend mechanism because they may not want to create an ‘income investor’ perception and risk losing their ‘growth stock’ profile.  Thus, the company could continue to manage its cash flow as needed for capex and acquisitions without having to worry about a ‘mandatory’ consistent dividend payment, and they return cash to shareholders to are patient enough to stick with the stock (thus providing a consisten and stable investor base).  That sounds so much better than a stock buyback program in which shareholder return is simply put off until tomorrow during which it will face price volatility and stock dilution (many stock buybacks are simply buying back dilutive stock options – hello Cisco).  More on that crazy charade at a later date. 

Add comment February 14th, 2007


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