Fed Day

Today the Federal Reserve Open Market Committee will complete their two day meeting, announcing interest rate policy and/or shifts in bias. It is widely accepted that they will raise rates by 25 basis points and maintain their measured yet accommodative stance. Oddly enough, this will coincide with the final day of the quarter, one that has been decent to investors after a rough beginning of the year.

The point of contention for most economists seems to be the yield curve. While in the grand scheme of things a quarter point increase really means nothing to the economy, the impact it has on the yield curve could be devastating. At present, the flattening yield has been interpreted to be a sign of diminished inflation expectations, at odds with the historical precedent of forecasting a weakening (if not recessionary) economy. Chairman Greenspan appears to have bought in to this theory as well, keeping the economic contraction construal under wraps (for the most part).

There is one scenario that could unfold which would be worrying. If a confluence of rising rates, easing home prices, weak consumer spending and higher oil prices were to present itself; most likely the yield curve would become inverted, which preceded the last five recessions. No amount of conundrums could cover the fallout in the credit markets and the posturing of lenders for leaner times.

Conversely, the new logic on the street seems to be looking for the FOMC to raise rates now, but then begin to lower them by the end of the year, embarking on a new campaign into 2006. Pundits point to the impact of oil on manufacturing, travel and commerce; omitting the one area of the economy getting the most ink, the housing market—which seems oblivious and invincible to prevailing headwinds. Once again, Chairman Greenspan has been careful in his handling of this topic, walking the tight-rope of identifying problematic practices (i.e. zero interest loans) while clearly avowing the lack of a national “housing bubble.”

TNX CHART




TYX CHART




While the Fed has been increasing rates, the yield on the 10 and 30 year treasury bonds has been under pressure.

The Blame Game

Blame it on oil. If you are unsure as to why a company, industry or index is under pressure; feel free to blame it on oil. In real dollar terms (inflation adjusted) a barrel of crude is well short of the $110 level it hit during the Gulf War in 1990-1991 and $93 during the OPEC crisis of the 1970’s. In addition, due to the massive productivity gains and technological advances since that time, we are able to drive multiple times the output on the same amount of oil. But since it is at a little more than half of its record high, it must be bad, right?

This is not to say that oil could not be a problem in the future—it could if a comprehensive energy policy is not in place shortly.

Oil above $60 is clearly not helping the bull’s case, but while the market had its first down week in quite some time, I believe it is masking a few other issues which figured a more prominent role in last weeks decline:

1. The CNOOC/Unocal Deal. Discussed at length in yesterday’s update. Could
be a proverbial tipping point in trade policy toward China.

2. Market Internals. Way overbought. Indexes have put together a nice rally from spring lows with little downside along the way. A breather is in order.

3. Greenspeak. The Fed meets later this week. This is a crucial meeting as the language will be under the most scrutiny yet. The impacts of oil, inflation, the soft patch and previous rate cuts are all the talk on trading floors everywhere.

4. Supreme Court. Recent ruling regarding eminent domain is worrying at best. Basically gives the state authority to purchase/repossess/reclaim property when in the “best” interest of the public. Scary.

5. Gold Price. Gold has been moving up in sympathy with the U.S. Dollar, confounding analysts everywhere. Is it inflation? A weakening dollar on the horizon? A fear gauge again? I have an idea about why which I will discuss in further detail later in the week.

DOW CHART





Doji formed on yesterdays chart. Be on the look out for a possible reversal today.

SOX CHART





Semiconductor Index forms another big red bar, however I would not rule out another attempt at resistance and/or possible breakout.

GOLD CHART




The yellow metal has been on a tear as of late. Since decoupling with euro/weaker dollar, increased skepticism continues to fuel rally.

At The Water’s Edge

Once upon a time, at the water’s edge is where politics used to stop—and I am not referring to Iraq either. China is the buzzword of the new millennium, much the way Japan Inc. owned business headlines in the 1980’s—and I have a feeling the CNOOC/Unocal Deal is going to be peanuts in comparison to the months ahead.

If you look at the volume of the deals to date—Lenovo/IBM, Maytag/Chinese Private Equity and CNOOC/Unocal it is difficult to come away unimpressed. The rate and size of the combinations seems to be accelerating as time ticks away. In addition (Maytag aside), the strategic and commercial assets that come bundled with the cross-Pacific M&A is staggering and clearly will be examined from a National Security standpoint as well.

The friction essentially boils down to the following: while the U.S. Senate remains embroiled in the prelude to a trade war on a myriad of issues, ranging from currency pegging to intellectual property rights, the Chinese Government (state-sponsored ownership of acquirers) is purchasing publicly traded companies here in the States. This is a problem with no answer in sight—but it appears that people in power and those with the ability to influence legislation break into three groups:

The Free Traders. Free traders remain exactly that. They want to reform the China’s political economy through the free flow of ideas and capital with the Chinese. They believe that freer markets make for freer people, period.

Isolationists/Protectionists. They want to see a 27.5% tariff (for starters), as well as a host of other penalties/benefits linked to trade reform, human rights and a more “open” society. They feel that outside countries are responsible for the outsourcing of American jobs and seek stop the drain using the proverbial carrot and stick.

The third group refers to themselves as “Smart Traders”- who are anything but. Likening their philosophy to that of the free traders, coupled with a quid pro quo on the many of the tangible improvements from the protectionists, their stance is murky at best. They come from both sides of the aisle and represent countless viewpoints regarding domestic and foreign policy but seem to agree on one mantra: “free trade, but only with partners who are entirely free themselves.”

While one cannot be sure which way the CNOOC/Unocal deal will come out, count on congressional sub-committees, FTC hearings and a din of political grandstanding sure to make even the biggest bureaucrat cringe.

OIL CHART



Oil successfully retests gap support in the high fifties and maintains its parabolic uptrend.

DOW CHART



Dow plunges over 100 points second day in a row in a reaction to $60 Oil. Look for support along upward channel as a possible reversal.

Death to the Death Tax

The great economist Milton Friedman once said “I am favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it's possible.” In the great spirit of this, The Wall Street Journal is reporting this morning that Congress is close to brokering a deal that would repeal the estate tax for all except the extremely wealthy.

If you remember, it was written here last month that preserving the sanctity and independence of the Senate’s rules in the face of the showdown over judicial nominees was crucial considering the most pro-business legislative agenda in U.S. history.

The estate tax hit an all time high in 2001, where it stood at roughly 55% and has been coming down ever since. The tax cuts in place have this number eventually going to 0 in 2010, but upon expiration in 2011 will revert back to 50%+. While the White House says they do not support any compromise beyond 2010, it is well-known they would clearly yield to one if it met a filibuster proof majority (meaning at least 8 Democrats must be on board).

The new deal on the table sets the range between the exemption at $3million and at $1.5 million (where it is presently) and taxing the difference between 15% (capital gain tax rate) and something higher. Anyway this shakes out within the estimates (particularly on the lower end) would drastically reduce the tax over-burden placed on next of kin and continue to build on the “ownership society” President Bush spoke of during the campaign.

Source:
Senators Near Deal To Eliminate Estate Tax for All but the Richest
By Brody Mullins
The Wall Street Journal, June 22, 2005; Page A1
www.wsj.com



S&P 500 continues strong uptrend through resistance in the face of $60 Oil. This is partly due to the rise in percentage and market cap. of energy/energy service companies in the index.



The NASDAQ is yet to clear resistance but has managed an impressive 10.6% rally off the lows.

Supply vs. Demand

Quite possibly the best thing for the long term prospects of the U.S. economy is for oil prices to remain high. Yes you read that correctly. And not so congress can finally get around to passing an energy bill either. The only thing that will take care of high oil prices is simply high oil prices.

If oil prices were to retreat from these levels (once again) it would send the wrong message to the markets. It would be viewed as a passing blip, the kind that shows up every 20 years and scares the hell out of consumers, only to recede and return to normalcy. The only problem is the assumption that this time will be like the others.

The oil problems of the past largely stemmed from the supply side—think OPEC crisis of the 1970’s and Gulf War 1990. There was a fundamental disruption in the supply channel delivering crude to the world. The price went up dramatically as a result of a lack of refined oil products, leading to price gauging, mile-long lines at gas stations and work stoppages.

The problem in 2004-2005 stems from the demand side of the equation. The demand for refined oil products presently is outstripping supply by a fair margin. Consumption by the United States, Asia and the Indian Subcontinent is at a record level and is not expected to subside anytime soon. Think global real estate boom, industrialization and outsourcing.

Going back to what was stated earlier, the only prospect of solving the oil problem in my opinion is high prices. The higher prices go, the result will be threefold:

1. The higher prices go, the less people will want to consume; thereby resulting in an increased supply. This is a fundamental tenet of any free market system.

2. Capital will be directed toward building additional refining capacity. The last oil refinery was built in the 1970’s—need I say more?

3. Capital will be directed toward alternative technology, thereby creating a decreased dependence on foreign fuel and possibly a solution. In the meantime, this will provide an increase in R&D, jobs, commerce and entrepreneurial opportunities.

It would be neglectful no to mention that higher energy prices also carry the risk of recession—they do. But relying on the government, OPEC or any other body to come up with an answer is imprudent and highly unlikely.




After breaking out from a triple top around 57.5 the continuous crude contract made a new high at $60 intraday yesterday.

500,000 Barrels of Crude Irony

Typically, “increasing production” infers a greater level of output, compared to some previous level or benchmark. Using deductive reasoning, a sensible person would come to the conclusion that producing more of something would result in a larger supply.

Not so in the land of OPEC. This morning, the President of OPEC announced in Vienna that they would increase their production ceiling by 500,000 Barrels/Day to a total of 28 million beginning July 1^st. To the casual observer this would seem like positive for those countries, companies and consumers that are dependent upon black gold. After all, the common wisdom prevailing on the street is that there is a shortage of oil, largely because of increased consumption due to everything from SUVs to China’s rapid industrialization.

Let’s do some basic math here: if the total ceiling was just raised to 28 million b/d through a production increase of 500,000b/d; what was total production before the output ceiling’s increase?

If you answered 27.5 million b/d you are wrong.

The correct answer is 28million.

Using the OPEC formula: 28 million + 500,000= 28million

How can that be? What OPEC really did was legitimize the overproduction its members have already been engaged in, in reality not increasing output by one iota. Since most countries in the cartel are only blessed with one major industry linked to their one natural resource, whenever production cuts are called for; they typically do not honor the requests—which would essentially reduce GDP and employment. There is also a bit of the groupthink phenomenon prevalent, as each member knows that no one else will abide by the rules (think UN, WTO, EU, etc) – why should they?

After setting a short term bottom in the high 40’s, oil has made a move back to within $3 of its nominal high. Move is looking somewhat like a bearish wedge, possible catalyst is inventory data to be released this afternoon.

The CBOE’s Oil Index has broken its old consolidation downtrend and reversed higher (almost parabolically). A retest of the high from March looks possible.

The Philadelphia Oil Services Index has made a parabolic move through the old highs and looks to be the strongest of the three. A back test of the line may be in order but I would not count on it.

Market Review

Since late April the U.S. markets have been on a tear. Climbing several “walls of worry,” the S&P 500 is within 1% of positive territory and NASDAQ has reversed from being down 15% to roughly 5% in the last 8 weeks. The bond market has also been in rally mode, notably sending the 10 year treasury yield below 4% at the beginning of the month.

I believe there are several factors at work here:

1. Inflation has remained tame. Therefore, interest rate policy has remained highly accommodative.
2. The frenetic pace of mergers, acquisitions and LBO’s has kept a floor under the equity markets. Blockbuster deals like Proctor and Gamble’s acquisition of Gillette and private financiers Kerkorian and Icahn staking positions in companies that are perceived to be undervalued. Private equity funds and hedge funds have also been eager to put their cash to work by approaching Circuit City, Maytag, Double Click and others; eager to take them private.
3. Recent pickup in economic activity. The U.S. economy has once again showcased its resilience after skidding through a “soft patch” earlier in the year. Uncertainty concerning the future of the European Union has also lead to a rebound in the dollar, making the Dollar once again, a safe haven for foreigners seeking preservation of capital.
4. New technology. PDA’s, I-Pods and PC Upgrade Cycle have continued the technological revolution in a different direction, pushing R&D budgets up for the first time in nearly 5 years.
5. Finally, the real estate cover story. Because of the run up in home prices, the stock market’s rally has flown beneath the public’s radar. This has also benefited the consumer by giving him access to equity generated from his home and the ability to invest in other vehicles.




Still under resistance, the S&P 500 has continued its consolidation. Indicators remain healthy as Relative Strength remains over 50,




Technology has been on a great run lately, temporarily taking out its Feb/March high. INTC, AAPL, ADBE, ADSK and other large caps has been the drivers behind this move




Broker-Dealer Index has been in an uptrend too, but I would be slightly more cautious on this chart as it looks like a possible wedge

The Laffer Curve

The Wall Street Journal this morning has a piece projecting that the Deficit is set to come in under earlier forecasts by a fairly wide margin. The White House is set to announce today that the shortfall is likely to be in the range of $350 billion, compared to November’s forecasts of $425 billion +.

After trimming GDP forecasts yesterday by .1% to 3.4% and increasing non-farm payrolls gains for the year, it appears the President is delivering on his campaign promises to continue steady growth, create more jobs and cut the deficit dramatically. Many of the President’s critics cited his tax cut (and push to make them permanent) as fiscally reckless and the major contributor in our “twin deficits.”

It would seem to any casual observer that this is a new phenomenon—taxes rates go down, tax revenues go up. It sounds like something that Greenspan would refer to as a “conundrum.” It seems illogical at best, a statistical aberration at worst—but it isn’t—and it’s not new either.

Many people are unfamiliar with the work of Arthur Laffer, a supply-side economist who gained fame during the Reagan administration as a member of his Economic Policy Advisory Board. Mr. Laffer postulated his belief in the form of a simple curve:

From www.investopedia.com

Invented by Arthur Laffer, this curve shows the relationship between tax rates and tax revenue collected by governments. The chart below shows the Laffer Curve:

The curve suggests that, as taxes increase from low levels, tax revenue collected by the government also increases. It also shows that tax rates increasing after a certain point (T*) would cause people not to work as hard or not at all, thereby reducing tax revenue. Eventually, if tax rates reached 100% (the far right of the curve), then all people would choose not to work because everything they earned would go to the government.

Investopedia Says: Governments would like to be at point T*, because it is the point at which the government collects maximum amount of tax revenue while people continue to work hard.

Since tax revenues collected this past April were an all time high and tax rates are at a 15 year low, could point T* be in our midst?

S&P500 Reverses off best levels for second day in a row on lower volume. Unable to overcome resistance at 1200-1210, indicators are beginning to turn down. Would not bet against here as volatility has been on the rise as the future of rates, growth and inflation are providing an ample “wall of worry.”

Sources:

Deficit is Arriving Under Forecasts
Jackie Calmes
Wall Street Journal, June 9, 2005
http://www.wsj.com

http://www.investopedia.com

Keystone Governors

Is it too much to ask a central bank and its representatives to stay on the same page?

Over the last two weeks investors, economists and other players have been inundated with a deluge of conflicting statements from policy makers at the Federal Reserve.

It all began late last week with a comment from a non-voting member of the FOMC (Dallas Fed President Richard Fisher) comparing the latest rate initiative with a baseball game, essentially opining that this cycle had mostly run its course. Taking its cue, the market sent the 10 year yield down below 4%, flattened the yield curve and put a bid under stocks for the entire session.

Early yesterday morning, Mr. Greenspan via satellite hookup told the International Monetary Conference that he was invariably perplexed with long term rates, feeding his “conundrum” statement from a few months back. He warned of some of the trappings of low rates—“low hanging fruits” having been picked, excessive risk taking, etc. taking hold in the capital markets; but went on to say something even more curious. In typical Green-speak, he lamented that the weakness in bond yields was not due to economic weakness, rather an emerging result of globalization and other factors that would most likely only be discernable in hindsight. Translation--He has no idea why!

Fed Governor Susan Bies confirmed Greenspan’s statement shortly after the market open as she herself is “puzzled” as to the drop in long term rates, but stated that the Fed needs to “understand why and act on it.” Ms. Bies also observed that the Fed would only become worried if our long-term rates approached Japan’s, but don’t fret because “the U.S.’s banking system is healthier than Japan’s.”

After being bid up all morning on higher than average volume, Federal Reserve Governor Guynn took his place at the podium, curiously negating or confounding the statements of his fellow members (I am not really sure which myself) from the past few days. Mr. Guynn stated that the fed’s policy had not reached neutral yet and lamented on the housing market (particularly the South), where activity bordered on “speculative.” He essentially surmised the search for investment return is fueling the growth in home prices; lending credence to the belief that the Fed usually raises rates until something explodes (i.e. Long Term Capital, NASDAQ 5000, etc).

When the Fed’s message is not clear, only bad things can happen. If you remember when they released the minutes for the first time in 2000 (detailing a meeting from 1994 which they prematurely celebrated diffusing a bubble before it became one), the market was obliterated within minutes of the release. While all-out speculation in internet and tech stocks was clearly responsible for the lion’s share of damage to the market/economy; the lack of clear communication on the part of the fed played a key role.

If the Fed doesn’t understand why long term rates are going down, that is fine. If they are not sure where or when the tightening cycle will end, that’s fine too. I also fully understand and accept that each Governor or non-voting member is entitled to their own opinion. But when you are speaking as a member of the Federal Reserve, try and put together a coherent, cohesive statement. And do not forget the mandate of the Federal Reserve—to create and maintain price stability; nothing more and nothing less.

To Clone or Not to Clone…

Has the revolution of modern medicine begun? Apparently, as Korean scientists recently announced that they have developed an efficient way to clone human embryonic stem cells which can be used to grow tissue that may repair various organs such as the brain, pancreas, and heart.

Embryonic Stem Cells are special, they can change into numerous cell types and can be used to treat conditions such as diabetes, MS, Parkinson’s, spinal cord injuries, as well as many other diseases. The potential market for these therapies is tremendous—with approximately 100 million Americans suffering from any one of the these “treatable” conditions that may benefit from the application of stem cell therapies. Currently, no therapy using embryonic stem cells has reached clinical trials, and FDA approval appears to be years away.

Federal funding has little impact on companies who engage in stem cell research in both the public and private sectors. The money needed for research can be raised quite easily via the standard credit markets, yet conservative religious groups are lobbying against federal funding of stem cell research. Their concern is that the research in question will not only promote “cloning,” but the required destruction of embryos which have the potential to develop into living humans (aiding in the current production of such cells).

However, not all stem cell companies are using embryos--VIAC and ASTM use adult stem cells. The disadvantage in using adult stem cells is that they are not as effective as embryonic cells. Adult stem cells are more specific or less plastic in their functions and can only develop into limited types of cells. Some of VIAC and ASTM’s competitors who do utilize embryos are STEM, GERN and ACTH.OB, and their competitive edge lies in the fact that embryonic stem cells have the ability to generate any of the cell types in the human body.

Historically, there has been significant opposition to many other medical experiments that are now considered conventional medicine. Organ transplants, blood transfusions and in-vitro fertilization are among the few procedures that were labeled as “man playing God”. As the positive effects of those procedures became evident, the controversy subsided. President Bush hopes to prevent tax money from funding stem cell research, which is understandable considering the “conservative mandate” by which he governs. Unfortunately, Bush needs to acknowledge that this will not create obstacles for the researchers in the field. The private sector will fund it anyway. Cloning and embryonic research is here to stay.


"A major source of objection to a free economy is precisely that it [...] gives people what they want instead of what a particular group thinks they ought to want. Underlying most arguments against the free market is a lack of belief in freedom itself."
Milton Freedman

ADDITIONAL DISCLOSURES: The information contained in this publication is based on sources considered to be reliable but are not represented to be complete and its accuracy is not guaranteed. The opinions expressed reflect the judgment of the author as of the date of publication and are subject to change without notice. This publication does not constitute an offer to sell or a solicitation of an offer to buy any securities. E1 Asset Management, Inc., and its officers, directors, and employees, and affiliates and members of their families may have positions in these securities and may, as principal or agent, buy and sell such securities before, after or concurrently with the publication.

Aggorniamento

The Houghton Mifflin American Dictionary defines Aggorniamento as “The process of bringing an institution or organization up to date; modernization.” In Italian, the expression literally means “to let in a breath of fresh air.”

Aggorniamento is unequivocally the best term to describe the changing of the guard announced at the Securities and Exchange Commission last week. The nomination of Representative Chris Cox (R-CA) to be the new Chairman of the S.E.C. to replace William Donaldson represents a welcome transition.

While Mr. Donaldson performed admirably during the corporate crisis and helped stem the outflow of capital and confidence from the tenure of the previous (and highly ineffective) Chairman Harvey Pitt; his installation was plagued by a reactionary ethos—with overregulation and superfluous legislation dominating the agenda. Despite his close ties with the free-trading Bush clan and financial background (Mr. Donaldson was head of the NYSE and started the brokerage firm DLJ Securities -that bears his surname) he consistently came down on the side of Congress, rather than commerce.

While we cannot be sure what the future will bring for Rep. Cox in his new post, if the past is any indication—Wall Street can look forward to further deregulation and the upending of needless red tape, i.e. the “trade through rule.”

We commend Chairmen Donaldson for his hard work in getting our financial markets through the darkest period in corporate corruption. His term will surely be remembered as a pivotal one, in the echelon of Joseph Kennedy (the first Chair) and Arthur Leavitt (Champion of the small investor). But the time has come to pass the torch, ignore the urge to over-regulate (as Washington certainly has a knack for) and return to business as usual.




While the S&P 500 remains overbought (as we all know—overbought gets more overbought) we still have not overcome resistance from 1200-1210. Look for a test of this level in the short term.




The Commodities Research Bureau’s Index is a prized indicator of the Fed for inflation. Keep an eye on the 310 level to see if this move is corrective or the beginning of a new uptrend.

Everything is Coming up Tulips for The E.U.

After dropping hard from France’s no vote, the Euro is set for another key day following Wednesday’s Dutch vote on the new constitution. But is that the only reason for the precipitous fall earlier in the week?

I believe there are several other factors at work here, considering that it was all but a given that France would vote “non.”

For instance, many seem to be overlooking the sheer size of the “no” vote. Most pundits thought 51-52%, but 55%? That is an overwhelming majority that speaks not only to the rejection of the constitution, but a massive black eye to their leadership, mainly President Chirac and what many label an “elitist” world view.

Second, the EU-US trade war brewing over subsidies to their aerospace industry. Most likely this will end up at the WTO where nothing will happen, but it is just a crescendo of the drumbeat of the looming global trade war.

Finally, no one seems to be speaking to the actual value of the Euro itself. What is the value of a currency representing a federation of countries with low growth, double digit unemployment (in some cases), budget deficits and an increasing level of political instability?

For several years the never fail trade was to short the dollar and buy the euro, based on the dovish monetary policy of the Federal Reserve, taking rates to historic lows. Since those days, much has changed—The U.S. economy re-emerged as a global growth engine after enduring a vicious bubble being popped while Europe remained preoccupied with inflation (thus keeping rates high).

While the yield curve (U.S.) continues to flatten and the first 5 months for the year have been negative for the market, growth has been robust in many areas—corporations are sitting on record amounts of cash and the S&P 500 is at an eight year low relative to earnings and total dividend yield. Conversely, the European bourses have managed an encouraging first half to the year, they are unlikely to attract new (much needed) foreign capital and likely to see the continued defeat of constitutional referendums put a damper on sentiment.

Look for the Dollar Index to challenge the 90-92 level before this run is over. While it remains overbought on a daily basis the news cycle has the potential to keep it in bullish waters.