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Nearing the End?

December 14, 2005

The Federal Open Market Committee of the Federal Reserve raised the Federal Funds rate yesterday to 4.25%, the 13th consecutive increase in the current credit tightening cycle. The FOMC, however, changed some of the nuance language of their customary statement in a signal to the financial markets that its measured rate hikes of 25 bps per meeting for the past 18 or so months may be nearing an end. The Fed clearly left the incoming Fed Chairman, Ben Bernanke, some room to hike after the January ’06 meeting if inflationary pressures continue to build in the economy. The January FOMC meeting is retiring Chairman Alan Greenspan’s last.

In the past, the signaling that rate hikes may be nearing an end has been bullish for financial markets and in particular financial service stocks. That indeed was the case yesterday and markets rallied noticeably after the Fed released its decision. The last time the FOMC ended hiking rates was in 1994. We all know what happened to asset prices from 1994-2000…they went straight up. Many bulls on Wall Street see the same thing setting up nearly ten years later. But is it different this time?

I think that we may be entering a new phase of the “current bull market” for stocks but I think that unlike 1994 when the rising tide lifted all boats; I think that investors need to be more careful about which sectors will rise in this current environment. It is true that large caps outperform small and mid-cap stocks at the end of tightening cycles because they are perceived to have more pricing power. The reverse has been true over the past 2 years, as smaller stocks have outperformed their larger brethren.

Additionally, the numerous positive catalysts that fueled the unprecedented gains in the second half of the 90s are largely exhausted or missing. The tech and internet boom that led to huge capex investments by corporations is now more mature and in a sorting out process. Commodity prices are significantly higher across the board from energy to base metals to food to building materials to precious metals. Real estate prices are still at or near all-time highs, a run which started back in 1994. The American consumer is now more stretched than ever with floating rate and revolving debt (don’t forget that on January 1, 2006 ALL minimum credit card payments will go up significantly adding to consumers’ misery). And we have the precarious issue of the twin deficits. The ever growing federal budget deficit and the ever growing trade deficit, which today came in at $68 Billion for November – a record. The trade deficit extrapolated over a twelve month horizon means that America has an annual trade deficit of more than $710 Billion. Or in other words, we spend more than $2 Billion per day on foreign credit!! At some point this needs to be reconciled.

In the short term don’t be short the stock market. The dollar, the long bond, and gold have also corrected sharply, and predictably, since yesterday’s Fed decision. It is interesting to observe that even in the face of dollar weakness gold has corrected from $544 on Monday to $509 today. Tech stocks may under perform in here due to their relative out performance recently. Energy stocks look tired and generally are not the leadership group in good economic times. If they resurface as such then the market may run into some headwinds.

I think longer term inflation will still be a problem. It is safe to say that the new Fed Chairman will have his hands full. Wage pressures and resource utilization increases will be watched closely by Mr. Bernanke. Clearly the twin deficits are a major problem when you consider how exhausted the mortgage market has become. I think the rosy employment picture is smoke and mirrors. For now anyway the Fed is your friend. Stocks should do well into the end of the year. Fourth quarter earnings season may be another story.


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