Any moment now, investors will link arms with
governors and begin humming "Kum Ba Yah." That's how enamored they appear with Chairman Alan Greenspan's ability to keep inflation low while growing the economy at the same time.
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 this week's meeting of the bank's 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 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 Fed's promise that, because inflation is under control, interest rates will rise only slowly.
Stock 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 they're only moderately higher, aren't bad for stocks.
Why the Fed May Not Keep Its Promise
Notice, though, that this optimism about 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. Demographics in the U.S., Europe and Japan argue 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 that's been the historical pattern. It is likely to be somewhat different this time, especially in the U.S., 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 Fed's room to 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 make 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 in China, 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, as well as projects that have no real promise of earning any profit, are able to attract cheap financing. And political imperatives in both countries require pedal-to-the-metal economic growth. With global economic growth and the global prices of commodities from soybeans 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. This debt is held largely by foreign central bankers and foreign investors, and it puts the U.S. economy on a tightrope. On the one hand, it's hard to see how the U.S. stands any chance of repaying this debt. Honest repayment would require saving and cuts in consumer and government spending that certainly are not in the cards in the near term. 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. On the other hand, though, 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 won't be able to deliver what it has promised and what the financial markets have now priced in? Of course not. There are too many unknowns, from terrorism to tremors in the financial markets.
We're not likely to know how successful the Fed has been at delivering on its promises until sometime 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 Fed's plan to raise rates modestly in carefully announced steps will be enough to control inflation and won't 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 and fear that the Fed won't deliver. To take advantage of this vacillation, 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 to 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. You'll get the cash to repurchase them by selling growth stocks that have hit your target prices.
Time to Move
I think we're at such a point now. I'm selling a few of the inflation, weak-dollar stocks in Jubak's Picks that have hit their near-term target prices and buying several growth stocks. You'll find a complete list of buys and sells at the end of this column.
However, you'll note that I'm not selling everything and that Jubak's Picks, even after these sells, will retain a strong inflation, weak-dollar hedge position. That's because while I'm trying to play the short-term rotation between hope and fear with one part of my portfolio and one part of my mind, I'm also building up a collection of hedge stocks to protect against the possibility that the three long-term trends I've discussed above will disrupt the Fed's plans and disappoint the financial markets.
In this part of my portfolio, I don't do any selling when hope is in the driver's seat: I'm 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 that asking investors to think both short term and long term, and to invest in both growth and hedge stocks, isn't a trivial challenge. But this is a very difficult market, and difficult markets often require difficult solutions.
Changes to Jubak's Picks
This trade with
has worked twice, and I hope to put it on again later this summer after the effects of the Fed's 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 don't expect a few 25-basis-point increases to do much to reverse the trend toward a weak dollar. Metals stocks tend to retreat on dollar rallies, and so I'm selling Inco again -- with a 20% gain this time since I added it to Jubak's Picks on May 7. (The last go-around on this trade brought a 39% gain from Sept. 23, 2003 to Dec. 23, 2003.) I'll look to repurchase Inco if the shares fall below $30 again. (Full disclosure: I will sell my Inco shares on July 2.)
Sell Teekay Shipping.
are getting close to my target price, and I don't see any reason to be greedy. With valuation on the shares now at the high end of historical measures, I think the stock is a good source of cash for the growth names I want to add to Jubak's Picks before the Federal Reserve moves on rates and before earnings season starts. I'm selling Teekay Shipping out of Jubak's Picks with a 17% gain since I added the stock to the portfolio on Feb. 24, 2004.
Buy Marvell Technology Group.
Marvell Technology Group
to Jubak's Picks. 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 company's 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, I'm setting a September target price of $60 per share.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Inco. He does not own short positions in any stock mentioned in this column. Email Jubak at