10 Feb 2006 Stocks Awash Until the Fed Plots Its Course
More than half of companies have reported their calendar fourth quarter earnings to date and they are up an average of 14%, according to the Wall Street Journal’s Total Market Index. These strong earnings suggest a continued strong economy. So far, neither the Fed’s rate hikes nor the slowing housing market have managed to sap much of the economy’s vitality. Employment indicators have been strong and consumer spending was robust during the last two months of 2005. Gross Domestic Product in the first quarter of this year could easily exceed 4%, according to experts.
Other major economies are doing quite well too. International reserves held by central banks rose 13.3% year over year to a record $4.2 trillion in November with developing countries holding a record $2.9 trillion and industrial countries holding a record $1.3 trillion. Argentina,Brazil, and Russia have been paying off their loans and their markets are soaring. German business managers haven’t been this optimistic since the start of the decade. The Bank of Japan expects that that country will end 7 years of deflation this year, based on core CPI, which is currently flat compared to a year ago. UK real GDP grew at its strongest pace in a year last quarter, while inflationary pressures subsided.
Oil remains a hot topic for investors as demand continues to strain supply, even though it is slowing somewhat. Some of the world’s major oil producers may have peaked in their production. Saudi Arabia may be unable to produce more oil and in yesterday’s Wall Street Journal, we learned that Mexico may have the same problem or worse. The world’s second biggest-producing oil field after Saudi Arabia’s Ghawar is inMexico. The article states that there are reasons to believe that its current output could drop sharply by the end of 2007. Moreover, Mexico is currently discovering only one new barrel of oil for every 14 it extracts.
Shrinking supply makes us major believers and investors in companies like Schlumberger, Nabors Industries, and TransOcean. These are businesses that help companies both find more oil and improve the production capabilities of their existing wells. As these companies see their stock price impacted by the daily wiggles in oil prices, it is apparent that traders not investors are moving the stocks. Quite simply, as oil reserves shrink these business and the services they provide will become increasingly vital and sought after.
On February 15, Ben Bernanke will testify before Congress for the first time as the new Fed chairman. Our strategists tell us that he will undoubtedly reconfirm the prior two Fed messages which have phased out the “measured approach” language. His aim will be to suggest that the Fed is close to reaching a neutral stance on monetary policy. But their concerns have now shifted towards resource utilization, which appears to be straining under the economy’s expansion.
January’s unemployment rate fell to a 4-year low and wage inflation rose to the highest rate since February 2003. Unless productivity rises back to earlier rates of growth both quickly and convincingly, the Fed likely will go further with rates. Each increase from here will heap further weight on an already laboring bull stock market. The collective hope of investors now seems to be that one or two more increases are in the cards before the Fed pauses. Maybe Mr. Bernanke will give us some clarity next week.
Meanwhile, the government seems too locked in politics to either effectively cut spending or to simplify our ridiculous tax code. An important two-year extension of President Bush’s 15% tax rates on capital gains and dividends seems dead on arrival as Democrats in the Senate plan to use a rare parliamentary move to force Republicans to raise taxes by as much as $30 billion; political suicide in an election year, while its not even a dollar for dollar proposition. Unfortunately the tired political argument against cutting taxes is simply not based in logic. Economics 101 tells us that one can sell more of a thing when its price is lowered. Likewise, taxpayers will take more capital gains when the gains taxes are lower.
If we want to improve capital investment in this country, hence job creation, higher taxes are the WRONG way to go. The tax cuts that were enacted over the past six years have greatly stimulated this economy while INCREASING the governments’ tax receipts. Tax receipts have note fallen with lower taxes, as critics continually harp.
Lethargy in the markets will likely continue for weeks to come. Clarity in oil prices is largely a thing of the past as autocratic and theocratic rulers tightly control some of the world’s leading production. And because of the ubiquitous and instantaneous nature of information, their every remark increases the duration and degree of buying or selling frenzies on the oil trading floors. The Fed may also tighten a bit further than we earlier thought on new evidence of inflationary pressures. This alone is the larger unknown for investors right now. Until the answers come from the Fed, equity markets will likely continue to back and fill, interrupted by brief spurts one way or the other on surprises good and bad.