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June 30, 2005

Today's Fed and the Global Search for Yield
by Chip Hanlon

Before getting into thoughts on today's Federal Reserve interest rate meeting below, I thought it important to remind investors of one simple thought I first wrote way back at Unfunds over four years ago: bear markets can take one of two forms - a price correction, or a time correction.

The bear market that rang in the Great Depression, for example, was a price correction, one that saw a savage, nearly 90% price collapse from its 1929 peak to the trough in 1933. From the late 1960's to early 1980's, however, we witnessed a time correction where stocks fluctuated for years in a wide band with Dow 1000 as the top, but essentially went nowhere over that time. Of course, that bear market was more damaging than it might seem due to the huge decline in the U.S. Dollar over that same time, something we had to deal with for a three-year piece of this bull market and may well have to again before it's through. However, investors do need to keep in mind that we're fully five years into this bear market and many stock market excesses have been at least partially worked off.

While price/earnings ratios are still near historic highs (with a P/E near 21 on the S&P 500, for example), that's certainly a far cry from the market's astounding peak valuation in 2000, which was more than double the current level. Certain forgotten sectors remain forgotten still: I imagine most investors would still snort at the idea of looking in the telecom sector for investment opportunities, which is part of what made MCI such a great investment, for example. And I've seen it written in a couple of places recently that CNBC's viewing audience is down approximately 60% from its peak in 2000; if accurate, that represents a significant decrease in frothiness, don't you think? Such are anecdotal signals that at least a few select opportunities may well exist in our market today.

Look, as my clients know I'm still quite cautious and worried about market conditions, but what I am saying is this: in the global search for yield (fixed income markets have been picked to the bone), investors may be missing a few interesting opportunities close to home.

First, it might surprise some to know that there exist quality companies (that aren't REITs, utilities, or leveraged closed-end funds) on our market that sport surprising dividend yields; indeed, two companies many of our clients have been buying carry better than 8% yields, a dividend yield I suspect most investors didn't realize could be had in our market today.

Second, as CD rates have improved on the back of the Fed's rate hikes, investors might be satisfied w/such bank offerings and neglect to do their homework. At my own bank just last week, for example, the very sweet teller told me proudly about her institution's liquid CD and its attractive 2.75% percent yield. I didn't bother to tell her about a floating rate product my clients have been buying with a 100 basis point advantage over her CD; for investors with more than $250,000, our clients get in cost-free, the product is liquid in 8 days and it's designed to ratchet up its payout along with interest rates - indeed, those who are afraid of rising rates might be interested to know this was the only class of fixed income products to provide positive returns during the last two rate hiking cycles. Further, investors with more than $1MM liquid can capture a similar holding with a 5% floating yield and no up-front cost, albeit with different back-end liquidity.

Finally, there has been a lot of interest in the energy trusts that are so prevalent on Canada's market, and with good reason. However, it may be worth digging deeper for ideas up North because it's not just energy trusts that are available; the Canadian market offers a range of similar holdings in sectors ranging from real estate, to other natural resources, to pipelines, to general business trusts such as newspapers, brewers, manufacturers and more, all built like the well-known energy trusts - to pay out high current income to shareholders. Now, it's important to do your homework or work with an advisor that provides real-time quotes, understands which companies have conservative payout ratios, aren't issuing loads of new stock and other important issues relating to these holdings, but it's worth doing some work up there in this global search for yield. Not coincidentally, we're terribly well-versed on the subject, but for those that would like another source, I suggest a wonderful new website that provides and excellent starting point for such stocks and the energy sector, in general: www.newfuelnow.com.

There are plenty of reasons for continued caution in today's U.S. market environment and we will likely have to contend with another bout of Dollar weakness in the future (though I suspect that challenge may return a little later than most believe), which is a good reason to look back at a little more foreign currency exposure than I've been advising since December and helps make the case for looking at a market like Canada's. However, investors would do well to keep in mind that, five years later, there are selected values to be found here in U.S., as well, and there remain a host of clever things to do in today's hyper-competitive hunt for yield.

Today's Fed Meeting

While I have beaten up Dollar perma-bears frequently over the course of 2005, it's actually the perma-bulls that I find entertaining at the moment. Such types fervently hope that the Fed will signal it is near the end of its rate-tightening campaign, believing this would be a bullish signal that would allow the stock market to roar once again.

I continue to disagree, thinking that we continue to live in a unique period where moderately rising interest rates are actually most bullish.

The biggest concern for our market/economy begins and ends with precisely the scenario Bill Gross outlined recently: that the Fed's rate hikes will topple our debt-dependent economy, forcing it to make the difficult choice between holding rates steady at these new levels and risking recession, or switching right back to an easing bias and sacrificing the Dollar.

The longer the economy can hold up in the face of these rate hikes, the better it is for the Dollar and, I believe, our economy as a whole. Is this a dangerous game, the Fed's idea that it can engineer the elusive "soft landing?" You bet, and it's likely to end with a recession or financial accident, but those outcomes may just occur later in this tightening campaign than most of us initially thought.

What, then, should investors expect from Greenspan & Company today? Personally, I expect more of the same: we all believe another 25 basis point hike is coming, but I also believe the Fed will leave its post-meeting language intact, that rate hikes will continue at a "measured pace." Here's why:

1. The Dollar - I continue to believe that the primary reason for this latest tightening cycle was a defense of the U.S. Dollar. As long as the economy isn't buckling under rising rates (though there are indeed signals from important leading indicators suggesting a slowdown could be coming), I think the Fed will take advantage and continue to cautiously move rates up in order to hoist the Greenback. We may have actually come dangerously close recently to the long-feared revolt by our foreign creditors - they seemed to say so clearly as they began to speculate about diversifying out of Dollars - and as the world tries to manage its way out of these gross economic imbalances, the Fed is likely to give them what they demand, a currency that isn't feeding them consistent losses on their holdings, at least for now.
2. Gold - We all know the Fed Chairman eyes the yellow metal in his laughable quest to determine the Dollar's "appropriate" level. It simply wouldn't be credible for Greenspan to signal that we've now seen enough rate hikes to contain inflation given the recent performance of gold, oil and other commodities. This latest inflationary surge, by the way, was nailed dead-on by Clif Droke, an excellent newsletter editor who contributes frequently on this and other websites - keep an eye on his stuff... he's balanced and makes a lot of interesting, accurate market calls.
3. Real Estate - I just sense an actual measure of resolve on the part of the Fed Chairman this time around. He seems genuinely confused that despite his tightening campaign and a halt to money supply growth, credit continues to flow like water, continuing to buoy the housing market. Consequently, he also seems to be clearly indicating that he sees this as dangerous and that he may indeed be willing to risk recession in order to shut down speculative excess in real estate. Remember, he has been "bubble juggling" for 5 years, and he appears to see this as time to prick this latest bubble.
4. The Euro - Actually, I don't believe the Euro is at all on the Chairman's mind, but I thought it worth mentioning. How would you like to head the European Central Bank at the moment? On one side, you have certain member nations facing recession and starting to make noise for a weaker currency; indeed, it isn't difficult to get inside the minds of politicians elsewhere around the world and suspect they actually see our recent performance as positive, thinking, "The U.S. dramatically cut rates and is now seeing healthy growth, we should pursue the same course." Never mind that our growth is unhealthy in its imbalance, it's easy to see this sentiment perking up more and more from economically illiterate politicians everywhere. On the other hand, you have another segment in Europe that, since it just felt a big recent inflationary jolt thanks to the Euro's breakdown in terms of gold and oil, would not at all be open to the idea of a rate cut from the already-low level of 2%. Talk about conundrums! While we continue to hike, in a sense we do at least some of the Euro's work for it, strengthening our Dollar against it and perhaps delaying the day the ECB will be forced to more seriously consider changing its policy stance.

And while I'm on the subject, a final thought: the Euro's recent performance, from a technical perspective, has been awful, just awful. Having a month ago reached not only a grossly oversold extreme and measurable chart support, the Euro hasn't been able to budge an inch while working off part of that oversold condition - bad sign. I wouldn't have said this a month ago, but a further breakdown in the Euro looks quite possible, and an interest rate hike today followed by strong words from the Fed might be the match which lights that fire.

The risk to my outlook for today's meeting is this: that the Fed does indeed signal the end of the latest round of rate hikes is near. Such an outcome would hurt the Dollar, might finally allow the Euro to bounce measurably from its technical support zone and would force a re-consideration of portfolio balances in terms of non-dollar exposure. For the reasons outlined above, however, I suspect we'll deal with such shifts a little further down the road.

I'm expecting more of the same and investors should, too. If the Federal Reserve does indeed tighten while leaving the phrase "measure pace" in place, long rates may continue to hold firm or decline, flattening the yield curve and making the search for yield even more difficult. Even in such a difficult environment yield environment, however, there are plenty of clever ways for investors to achieve healthy returns.

Chip Hanlon
President
Delta Global Advisors
800-485-1220
info@deltaga.com
www.deltaga.com

Currently the President of Delta Global Advisors and the founder of Green Faucet, Chip Hanlon is regularly featured in the national media for his global economic viewpoints and is a contributing writer for Real Money, the subscription service from TheStreet.com. Previously, Hanlon has served as the C.O.O. at Euro Pacific Capital, as the President of Unfunds, Inc., and as Vice President of Investments and Syndicate Manager with Sutro & Co.

Copyright © 2005-2008 Chip Hanlon

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