Investors are trying to figure out why the Fed continues to raise interest rates. The most important job of the Fed is to contain inflation. That is what they target their actions to. Why then, with the most recent CPI index coming in flat year-over-year, does Greenspan and Co. continue to boost short-term rates?
This contradiction could very well be explained by many folks' distrust of the government's reporting of the CPI statistics. A flat CPI index seems strange given that prices for many goods and services are rising at a very fast rate, squeezing lower and middle class workers.
Let's take a closer look at the components of the CPI index. The largest are housing (42%), transportation (17%), food (15%), and medical care (6%). These four categories of goods and services account for 80% of the consumer price index, which is showing flat to slight increases in recent months.
Does anyone see anything suspicious about this? Real estate is seeing its biggest boom ever. Oil prices are at 20-year highs on an inflation-adjusted basis. Commodity prices are rising substantially, impacting food costs. Healthcare costs have been rising at double digit rates for years now.
Are these facts being accurately recognized in the government's CPI data? I, along with many others, would argue no. And perhaps Chairman Greenspan and the FOMC feel the same way, causing them to raise the Fed Funds rate higher than some think is warranted.
Bush's Support of Free Trade Questionable
President Bush is a huge fan of markets. Rather than take meaningful action toward surging oil prices, he'll simply let the market correct itself. With the Chinese currency pegged to the U.S. dollar, the Administration is pressuring China to let it float. Let the markets determine currency values, not governments.
I think that's a great position actually. Markets do work, so we may as well let them. When it comes to free trade then, it's no surprise that Bush says he supports global free trade. After all, the global economy is a perfect example of a enormous market for goods and services at work. And it does work, very well in fact.
So it's no wonder that when the Bush Administration imposed steel tariffs in 2002, many of his supporters were irrate. The tariffs were imposed to stop cheap steel imports from flooding the U.S. market, hurting U.S. steel producers by increasing competition and lowering prices.
Dozens of U.S. steel companies had filed for Chapter 11 bankruptcy protection since the last 1990's due to an inability to compete effectively in the global market for steel. The tariffs were lifted in 2003 after the World Trade Organization pressured the U.S. and threatened to strike them down. Bush attempted to claim that the tariffs had served their purpose for a year, and now it was time to eliminate them, but everybody knew that it was simply a huge mistake, and fortunately there was enough pressure overseas that they were overturned.
However, the Bush Administration once again is attempting to close down the U.S. to free trade. The U.S. has reimposed quotas on Chinese textile imports such as cotton patnts, shirts, and underwear. How does reinstating quotas support the notion of free trade?
U.S. retailers have been urging Bush to not to reimpose the quotas. The reason is simple, prices for the U.S. consumer will go up as a result. Inflationary pressures are the sole reason the Fed has been raising interest rates. Quotas and tarriffs will only serve to increase prices, which will result in higher interest rates and lower economic growth, here and abroad.
Economic policies like these will only hurt the U.S. economy, and as a result, prevent a new bull market from getting underway anytime soon.
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.
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.
Do Elections Affect the Stock Market?
The last of the three presidential debates for 2004 concluded last evening. We've heard plenty of election coverage, so I won't get into much of the politics here, but one question is relevant to me and my clients. Will next month's election (or any presidential election for that matter) affect the stock market's future returns. And if so, how?
Much of the country has concluded during President Bush's first term that his policy of reducing taxes on income, capital gains, and dividends has helped bring investors back to the market after many portfolios were dismantled in the first three years of the new millennium. Some have worried that the market would react negatively to a Kerry victory in November due to his desire to raise taxes for those individuals earning more than $200,000 a year.
We have also heard that academics have found that the market itself performs better under Democratic Presidents, as opposed to Republican ones. Interesting contradiction, isn't it? Rather than listen to the pundits on television, I decided to take a look at the research myself and determine which, if any, political side is better for the stock market. Stock prices are proven to follow corporate earnings over the long term, and most won't argue that the best predictor of company profits is economic growth. Here is what I found.
There are two sets of numbers highlighted below. The first are the most commonly used economic statistics used to measure the health of the economy; GDP growth, unemployment, inflation, growth in federal spending, the budget deficit, and the national debt. These numbers came from research completed by the Bureau of Labor Statistics (BLS) and the Bureau of Economic Analysis (BEA), both non-partisan bodies that the White House and others rely on for unbiased data continually. This data is for the 40-year period from 1962 through 2001. The results are very interesting, especially if you favor the Republican political view that seeks to lower taxes and reduce government spending, as opposed to the "perceived" idea that Democrats prefer to "tax and spend."
From 1962-2001:
GDP Growth: 3.9% (D) 2.9% (R)
Unemployment Rate: 5.1% (D) 6.8% (R)Inflation Rate: 4.3% (D) 5.0% (R)
Growth in Federal Spending: 7.0% (D) 7.6% (R)
Growth in Federal Spending (Ex-Defense): 8.3% (D) 10.1% (R)
Yearly Budget Deficit: $36 Billion (D) $190 Billion (R)
Total Increase in the National Debt: $720 Billion (D) $3.8 Trillion (R)
(Sources: BLS & BEA)
The first point to make is that while Republicans are billed are fiscally conservative and tax reducers, over the last forty years Democratic Presidents have actually spent less and been much better balancing the U.S. budget. And while Republicans have taxed Americans less, that has not translated into better economic prosperity, as measures of inflation, GDP growth, and unemployment all have been better under Democratic leaders.
Now, that's fine, but the real question is how this relates to stock market performance. Despite what the economic numbers above reflect, what happens to stock prices while each party is in office should be the real question. If Republicans are indeed better for the markets, then you can argue that even though favorable economic statistics sound good, they won't really help grow your investment portfolio. Not surprisingly, though, the stock market did prefer better economic conditions, as you can see below.
Avg S&P 500 Returns: Democratic Presidents vs Republican Presidents (1926-1997)
15.1% (D) 10.7% (R)
(Source: Stock Traders Almanac)
For some, these statistics will be important when you go out and vote for our next President on November 2nd. For others, they won't be. However, as a money manager I was curious to see if the claims made frequently in the media are actually true, so I thought I'd share my findings.