Bernanke's Next Trick

Ben Bernanke says the Fed has an exit strategy, but it doesn't involve raising interest rates. Sounds like magic to me. One thing is for sure, the fed funds rate will not stay at zero forever.

No Slave to Fashion

I tend to be a skeptic by nature. So at a time when the economy is weak, employment numbers are terrible, consumer credit is contracting, and foreclosures are rising, I am particularly skeptical of high flying stocks whose fortunes depend on spendthrift consumers.

True Religion Apparel (TRLG) comes to mind. This is a company that sells incredibly pricey jeans to both men and women. Because I can't bring myself to pay more than $25 or $30 for a pair of Levi's, I am particularly perplexed as to why anyone in their right mind would pay $250 for one pair of jeans. My daughters say this proves I am out of touch. I prefer to think instead that it proves there are a lot of consumers out there who are not in their right minds.

It's true that I am not a slave to fashion, but I do have some appreciation for the stuff. After all, my wife subscribes to Vogue, and her brother Serge Gandzumian is a professional designer who has achieved some success and fame with his Lithuanian company SwanPh. Thanks to capitalism, those who really care about fashion have lots of choices; unlike in this parody of Soviet fashion made famous by an old Wendy's television commercial.

Don't get me wrong. I actually liked TRLG back when it was selling for $11 per share. I even recommended the stock in March 2009 to subscribers of my newsletter, the Forbes Growth Investor. However, now I have to wonder if it still makes sense to own the stock.

My concern has nothing to do with fundamentals. TRLG is selling for about two times sales and 12 times the low end of expected 2010 earnings. Furthermore, the company has lots of cash on hand and no long-term debt. Its latest financial release was actually quite good. Revenues and profits are still growing nicely. Although sales are falling in the company's U.S. Wholesale segment, they are surging in the more profitable Consumer Direct segment. This segment includes the growing number of company-owned stores where TRLG commands the highest prices for its products. Yet at the same time, the overall operating profit margin is slowly declining. It will probably go lower in the near term as the company ramps up advertising expense.

The stock jumped higher immediately after the earnings announcement. Although I remain bewildered, I have to ask. Does anyone know where I can buy some True Religion jeans for my daughters at a big discount?

Market Skeptic Needs Convincing

About three weeks ago, while many experts were growing more optimistic about economic growth and the stock market's prospects, Karen Gibbs asked why I was so skeptical. Click here to watch the interview.

Trying Too Hard to Assuage Investors

After last week's hike in the discount rate, a number of Fed officials have said that the fed funds rate will not be increased for a long time. It seems they are trying a bit too hard to convince skeptical investors.

The latest salvo came from Janet Yellen, San Francisco Federal Reserve President. Yellen said interest rates must be kept "extraordinarily low" because economic growth will fall short of its potential through 2011. Yellen and others believe interest rate hikes are not yet necessary, especially since the Fed is planning to take other measures to reduce liquidity. For example, it will stop buying mortgage-backed securities (which could result in another round of declines in housing sales and prices), and it may start reducing the size of its balance sheet by selling some of its assets, thus draining money from the economy.

While such tightening measures can be effective, an increase in the fed funds rate sends a much stronger signal. In my previous post, I argued that a modest increase in the fed funds rate should be welcome news. I continue to believe the Fed will raise the fed funds rate sooner than it is currently telegraphing. If it fails to do so, investors should worry that the economy is sicker than the Fed would like us to believe.

Discount Rate Hike is no Surprise

The announcement late yesterday that the Federal Reserve was raising the discount rate by 25 basis points to 0.75% came as a surprise to many investors. It shouldn't have. The Fed has been broadcasting its intentions for several weeks. For example, in its Jan. 27 press release, the Fed said, "economic activity has continued to strengthen." This was the strongest statement yet from the Fed that the crisis is over. And just a week ago, Chairman Ben Bernanke actually said in a speech that the Fed might raise the discount rate. So yesterday's action should have been fully anticipated. It should also be seen as good news. Extremely low interest rates are not good for the economy. They signal a continuing crisis. Yet the Fed has been trying to convince investors for quite some time that the worse is over. It finally figured out that actions speak louder than words. By raising the discount rate, the Fed is signaling that it actually believes what it is saying. The Fed may deny it, but it will probably start raising the more important fed funds rate before long. Contrary to popular opinion, stocks will probably hold up well on the news. A modest increase in the fed funds rate should give investors confidence that the economy really is getting stronger.

Orlando MoneyShow

I gave a couple of talks last week at the World MoneyShow in Orlando. I have spoken at this event numerous times in the past. My impression is that attendance at the MoneyShow provides a good, albeit imperfect, indicator of investors' interest in the markets. To my untrained eye, attendance looked strong. In fact, I heard registrations were up about 12% from last year's event. There were also plenty of sponsors and exhibitors around. Of course, strong interest isn't too surprising given the double-digit gains in all stock market indexes last year.

The Elephant in the Room

I'm working on putting together the next issue of the Forbes Growth Investor. I still have President Obama's State of the Union speech on my mind, so I asked Mark Stivers to draw this cartoon.

Hank Greenberg's Take

While Timothy Geithner was being grilled on Capital Hill today, former AIG CEO Maurice "Hank" Greenberg was delivering a talk at the Union League Club. He made several important points.

He said the legal system needs to be fixed. A politically ambitious attorney general (i.e., Eliot Spitzer) should not be allowed to destroy companies and reputations in order to reach higher office. Greenberg said AIG has already spent approximately $700-800 million in legal fees. Greenberg has spent almost as much himself. He asked, "For what?"

He pointed out that government officials played favorites by forcing AIG to pay Goldman Sachs 100 cents on the dollar. He said it didn't pass the smell test when former Treasury Secretary Henry Paulson fired AIG's then CEO Robert Willumstad and replaced him with Edward Liddy, who was on the board of directors at Goldman Sachs.

He said that when the government took an 80% stake in AIG, it should have immediately stated that the government's AAA credit rating also applied to AIG. However, government officials claimed they didn't have the authority to do such a thing. Greenberg found this explanation odd since the government did many things it did not previously have the authority to do. Yet it always managed to get the authority quickly whenever it wanted.

It turns out that Hank Greenberg is writing a book about all this. I can't wait to read it.

An Oldie, But a Goodie

Scott Brown's U.S. Senate victory in Massachusetts on Tuesday has certainly gotten the attention of all Democrats. Barney Frank, long-time protector of Fannie Mae and Freddie Mac, suddenly said today that these entities should be abolished in their current form. More importantly, a growing number of Senate Democrats now oppose the renomination of Ben Bernanke as Fed Chairman. I thought this would be a good time to revisit a cartoon we published in the July 2009 issue of the Forbes Growth Investor. It was in response to what seemed to me as a very lukewarm endorsement at the time by President Obama.

Pickens and Fracturing

When T. Boone Pickens tried to take over Phillips Petroleum in 1984, he was accused of not willing to make any concessions. He responded by saying he would move to Bartlesville, Oklahoma. Yesterday, I attended a luncheon at the Union League Club of New York City. Pickens was the guest speaker. Although he made his name as an oil man, more recently he has been trying to promote the use of natural gas in this country. During his talk, he was very critical of the failure of all presidential administrations to articulate a coherent energy plan.

Pickens says the United States is much too dependent on foreign oil--especially on oil imported from countries that are not particularly friendly to us. He pointed out that the U.S. has the world's largest natural gas reserves, and that we can easily decrease our reliance on imported oil by switching to natural gas for transportation purposes. He proposed mandating that all 18-wheelers (i.e., tractor-trailers) be forced to switch to natural gas over some period of time. His idea is to provide a $65,000 tax credit for the purchase of each of these vehicles. However, he did not address the safety concerns, how the trucks would be refueled, or if natural gas could even provide sufficient power to push a fully loaded semi up a mountain.

He also failed to make a strong case that drilling for natural gas would be environmentally friendly. While the available technology may be good enough to drill safely, the natural gas industry must do a better job of conveying this message. In fact, today's Wall Street Journal featured a front-page article about hydraulic fracturing, a process of using pressurized water mixed with certain chemicals to break rock formations in order to get at the gas. Opponents claim fracturing will pollute ground water. As the article pointed out, Exxon Mobil insisted on a clause that would allow it to back out of its proposed acquisition of XTO Energy if the government decides to outlaw fracturing.

How big a role natural gas plays in the future is uncertain, but one thing is becoming clear. Oil prices are too high. There is a big push to promote the use of alternative fuels. Society will remain dependent on oil for a long time, but natural gas, nuclear, wind, battery, and solar will all play bigger roles in the future. Unless global growth suddenly surges, demand for oil, which is already down, will continue to decline.

Stocks Sell Off on Good News

For the most part, there was good news in the markets today, so the strength of the sell-off caught many investors by surprise.

Today's housing numbers from the Commerce Department bode well for the home building industry. Even though housing starts in December fell 4% from November on a seasonally adjusted and annualized basis, they were flat compared to a year ago. Furthermore, building permits, an indicator of future activity, jumped 10.9% from November to December. They were up 15.8% from a year ago. However, don't get too excited about housing. It is still a very sick industry. Almost one in four homeowners with a mortgage are believed to be underwater, and foreclosure rates are still sky high. This will keep housing prices from heating up any time soon.

Wholesale purchasing prices were up just 0.2%, and there was no change in core figure. Although I have argued that the Fed needs to begin its exit strategy, today's PPI data means it is more likely to stick to its policy of keeping rates low.

Finally, Scott Brown's victory in Massachusetts means Congress will have to take a more moderate approach to health care reform. In fact, Amedisys (AMED), a home health care stock we recommended back in September in the Forbes Special Situation Survey added to its gains today.

The sell-off in the overall market is being blamed on China's decision to reduce lending. This stoked fears that global growth might fall short of prior expectations. This kind of thinking could drive stock prices even lower.

Jobs Report Dampens Workers' Hopes

By Vahan Janjigian - Today's announcement by the Bureau of Labor Statistics that nonfarm payrolls dropped by 85,000 in December is a big disappointment, especially to the many investors who were betting that the economy was on the mend. While the headline number is bad enough, the figures down below are worse. For example, although the number of officially unemployed people fell slightly to 15.267 million, the number of employed people dropped by 589,000 because the labor force shrank. In fact, 2.5 million people are no longer considered a part of the labor force even though they want to work and they sought work during the past 12 months. They are excluded because they did not look for work during the past four weeks. In addition, 9.2 million people are working part time, not by choice, but because they can't find full time employment.

One bright spot of the labor report is that temporary jobs increased by 47,000. This is considered good news because corporations often hire temporary workers as business conditions improve before making a commitment to take on permanent employees. In fact, in recent months, at least a couple of equity analysts raised their outlook on Manpower (MAN), a leading temporary employment agency. The stock is up about 30% since November and has more than doubled since the March 9, 2009 low.

Disclosure: The author has an ownership interest in Manpower (MAN) shares.

FGI Gains 35% in 2009

The following commentary appeared in the January issue of the Forbes Growth Investor.

By Vahan Janjigian - When I was in graduate school, a marketing professor told me that investing was easy. He said,“All you need to do is buy low and sell high.” However, many investors did exactly the opposite last year. They threw in the towel at precisely the wrong time. As stocks sold off in March and the Dow dipped below 6,600, they decided stocks were too risky, so they got out of the market. They did not understand that stocks are actually less risky after that kind of selloff. Instead of selling in March, they should have been buying. Even if they had to wait a few years, chances are the returns they would have realized from stocks would have exceeded the returns generated from safer assets such as cash.

As it turns out, however, those who did buy in March did not have to wait long at all. Stocks went straight up after the selloff in the beginning of the year. The Dow finished 2009 with a 19% gain, the S&P 500 rallied 23%, and the Nasdaq Composite surged 44%. Our Forbes Growth Investor Top 40 climbed 35%. While it did not outpace the tech-laden Nasdaq, it did exhibit less volatility. Since inception (Oct. 6, 2000), our stock picks have gained 75%. The three major indexes lost ground during the same period. The Dow fell 2%, the S&P plunged 21%, and the Nasdaq plummeted 32%.

However, the higher stock prices go, the more cautious I become. Investor sentiment may drive stocks higher in the short term, but fundamentals are more important over the long term. As I see it, the fundamentals are not particularly good.

While the worst of the financial crisis is probably over, the economy is still troubled. The unemployment rate may have peaked, but it will probably remain elevated for years. Housing prices may have bottomed, but they will likely remain depressed for quite some time. Retail sales during the holiday season were better than expected, but that trend will probably fade in 2010. Corporations are producing profits not by selling more goods, but by cutting expenses. In addition to all this, capacity utilization is near all-time lows, new home sales are at a standstill, government debt has surged to almost unfathomable levels, consumer credit is falling, and savings rates are rising at precisely the wrong time. A particularly worrisome trend is the growing role government is playing in the economy. It is the nation’s largest employer, it has become the largest shareholder in a number of previously blue-chip companies, and it is about to take over the healthcare system.

Given this backdrop, there are a number of things to watch for in 2010. We may have emerged from the recession, but a double dip is possible. However, a second recession, if it does indeed occur, should be less severe than the first. Gold prices could fall significantly. They have not risen to current levels because of strong demand or a lack of supply. Gold prices have climbed because of the Fed’s easy monetary policy and the resulting weak dollar. Similarly, oil prices should go lower. The recession has reduced demand for gasoline and other refined products. The big push toward alternative energy is also having an impact on the demand for fossil fuels. As for stocks, they could sell off again. A retest of the March 2009 lows is unlikely, but the Dow could easily shed a thousand points or so. If that happens, it will be time to start thinking about buying once again.

Home At Last

By Vahan Janjigian - I'm finally back from the 16th Forbes Cruise for Investors. I got off the ship in Aruba on Sunday and took a long flight home. The Internet connection on the ship was not always reliable, so I did not get a chance until now to post my comments about Jack Ablin's presentation.

Jack is the Chief Investment Officer at Harris Private Bank. We first met in 1996 when I was on the faculty at Northeastern University. I signed up for a course to prepare for the Level II Chartered Financial Analyst exam and Jack was one of my instructors. He was an excellent lecturer.

It was nice to see that he hasn't lost his presentation skills. Jack is a quantitative analyst. One of his comments should give college students majoring in business something to think about. He said he only hires people with strong quantitative skills. He especially likes engineering majors. This is because he finds it easier to teach an engineer how to do finance than to teach a business major how to do quantitative analysis.

Jack is fond of using a momentum approach to investing. There are plenty of investors who are skeptical of this approach, but it really does work. Sheridan Titman, now a professor at the University of Texas, was one of the first to document that stocks exhibit momentum. One approach Jack relies on is to compare an index or sector to its moving average. In general, he avoids buying stocks until they start moving up. He is happy to miss the opportunity to buy at the bottom until he is confident that an upward trend has begun.

Jack believes the market is currently at a fair to full valuation. He thinks inflation will eventually become a problem, but says we will have about two to three years to prepare for it. He expects the Fed to sit tight through much of 2010. He mentioned two ETFs he currently likes: The S&P International Small Cap (GWX) and the WisdomTree International Small Cap Dividend (DLS).

Jack recently authored a book: Reading Minds and Markets: Minimizing Risk and Maximizing Returns in a Volatile Global Marketplace. He gave a copy to all attendees. I am putting it on my reading list.

Visiting St. Bart's

By Vahan Janjigian - We took two days day off from our seminars to enjoy the cruise. We also got off the ship at a couple of ports. I went on a five-mile hike today in St. Bart’s. Nonetheless, I also managed to hold a number of impromptu discussions with several attendees about the economy and markets. Most of these people are retired and have a high net worth. Many are sophisticated investors. Yet I have not spoken with anyone who I would call bullish. They are all cautious about the economy and extremely skeptical about the strength of the recent rally in stocks. They are also worried that the government’s efforts to revive the economy will ultimately fail, especially since there is so much talk about increasing both taxes and spending.

I was thrilled to meet Ed Breen, CEO of Tyco International (pictured above left). Ed and I had an interesting discussion about the interaction between equity research analysts and corporate managements. We agreed that since the SEC promulgated Reg FD, there is little value to one-on-one meetings between these two parties. Corporations are disclosing a lot more information these days in their SEC filings. I personally find that my research is much more objective if I do not meet the management team. Unlike Warren Buffett, I am not trying to marry good companies. I am just trying to buy good stocks. Nonetheless, I am glad I had the opportunity to meet Ed personally. He is doing an excellent job of bringing Tyco back from the disgrace it suffered several years ago.

Also pictured above (right) is Barry Ritholtz. He always manages to provide an original point of view on the markets. One of my friends went to law school with Barry some years ago. She claims he was one of the smartest students in the class. I can believe it.

The Voyage Continues

By Vahan Janjigian - Gary Shilling gave his talk today while we continued our voyage toward St. Croix. Gary said we will not have a V-shaped recovery as many economists expect. He talked about how household net worth has plummeted due largely to the sell-offs in stocks and residential real estate. Gary also explained that corporations are cutting wages and forcing employees to take unpaid furloughs. He says this is the first time since the 1930s that this has happened on such a large scale. Furthermore, not only has unemployment risen, but it has also become much more difficult to find a new job. Gary expects slow economic growth for several years. He projects annual growth of 2.1% for the decade ending in 2018. However, he claims that 3.3% annual growth is needed just to keep the unemployment rate constant. As a result, he expects to see the government taking much more aggressive actions in order to try to create jobs. He advised investors to stick to Treasury securities and dividend paying stocks.

There was some discussion about whether investors needed to worry more about deflation or inflation. Both Gary and I relied on the same graph that showed how capacity utilization has fallen to explain why the Fed is not worried about inflation. You do not typically see much inflation when capacity utilization is so low. Nonetheless, in my presentation, I argued that the Fed should start raising interest rates right away. A quarter-point increase in the fed funds rate will not do anything to slow economic growth, but it would send a strong signal to investors that the Fed actually believes its claim that the economy is getting better. It would also help strengthen the dollar and turn investors away from commodities such as gold and oil. By keeping rates so low, the Fed is creating another bubble in commodities.

Seminars on the High Seas

By Vahan Janjigian - As promised, I am reporting on today’s speakers on the 16th Forbes Cruise for Investors. We spent the day at sea on our way to St. Croix and listened to three excellent presentations.

Steve Forbes gave a compelling talk defending capitalism. He argued that the financial crisis was the result of misguided government policies. He explained how the Federal Reserve drove interest rates excessively low and kept them low for too long. This prompted investors to channel money to housing and commodities, causing bubbles in those asset classes. He also blamed Fannie Mae and Freddie Mac for guaranteeing $1.6 trillion worth of suspect mortgages. These two government-sponsored entities were not subject to same reporting rules that other public corporations had to abide by. He warned that the Federal Housing Administration is now falling into the same trap by guaranteeing mortgages with only 3% down payments. He even blamed George W. Bush for pushing the idea of home ownership for everyone and promoting no money down mortgages. He blamed mark-to-market accounting and government sanctioned credit agencies that were not subject to market forces. The government simply ignored contract law during the GM bankruptcy, which made investors very wary to lend. As a result, the Fed is the only entity today willing to buy mortgage-backed securities.

Bond expert Marilyn Cohen explained how corporate balance sheets are getting stronger. Several years ago, corporations were engaging in share repurchases. Today, they are issuing stock, paying down debt, and rolling over high interest rate debt at much lower rates. At the same time, municipalities around the country are struggling with lower tax revenues. As a result, she considers corporate bonds safer than municipals right now. She also explained how the Build America Bonds (BABs) are crowding out traditional municipals. BABs are taxable municipal bonds. The interest rates are higher, but the municipality gets a subsidy from the federal government. As a result, there are fewer traditional municipals bonds available. This has caused investors to bid up their prices and reduce their yields even though credit quality has deteriorated.

Barry Ritholtz also gave a compelling talk. Barry is a political independent and is frequently criticized by members of both major parties. Barry believes tax rates in the U.S. are low in comparison to rates in most other countries. He thinks this is not compatible with the high level of spending. This is why the government has had to borrow so much money. He argued that either tax revenues must go up or spending must go down. He is worried about the employment situation. Average work hours per week have fallen to just 33. This means that we are likely to have a jobless economic recovery. Corporations will not have to hire new workers for a long time because they could easily ask their current employees to put in more hours. Barry also argued that from a historical perspective, the current rally in stocks is only about three-quarters of the way through. He expects the stock market to eventually roll over and go lower, but until it goes higher first.

All Aboard the Crystal Serenity

By Vahan Janjigian - I just arrived in Miami and boarded the Crystal Serenity for the 16th Forbes Cruise for Investors. The Internet connection is not always reliable, but I will try to keep you up to date on the discussions aboard. Steve Forbes gives his talk tomorrow morning.

Thanksgiving in the U.S. and Turkeys in Dubai

By Vahan Janjigian - Dubai shook global financial markets today when it announced its intention to delay payment on some of its debt. This caused investors worldwide to suddenly demand greater compensation for taking on risk. They sold stocks all over the world. U.S. markets were closed due to the Thanksgiving holiday, but all the European indexes closed at least 3% lower. This is the kind of event that could shake confidence in the hope that global economies were beginning to recover. If Dubai were to actually default on any of its debt, stocks worldwide will go much lower.

Trade Deficit Climbs; Sentiment Falls

By Vahan Janjigian - Two pieces of economic data that came out this morning were not particularly encouraging. First, the Commerce Department said September's trade deficit rose to a greater-than-expected $36.5 billion. The good news is that exports were up from $128.3 billion in August to $132.0 billion in September. However, imports surged from $159.1 billion in August to $168.4 billion in September. While it is certainly nice to see that world trade is picking up, we still are a long way from where we were a year ago. In September 2008, exports and imports amounted to $152.0 billion and $212.1 billion, respectively. Furthermore, given the tremendous devaluation in the U.S. dollar, it is extremely disappointing that exports are not rising faster than imports.

The second item was November's Michigan Sentiment Index, a measure of consumer confidence. This metric was expected to climb marginally to 71.0, but instead dropped to 66.0. The rising stock market, which typically makes consumers feel better, wasn't enough to offset their anxiety over the lack of jobs. As yesterday's initial claims report showed, corporations are still laying off workers at a rapid clip.

All in all, there is not much economic news to explain the strong rally we've seen in stocks. Things might be getting worse at a slower rate, but they are getting worse nonetheless. A few corporations are reporting year-over-year revenue gains, but most are telling us that business is down. They are squeezing out profits by cutting costs. In other words, they are eliminating jobs. With more and more people out of work, I don't see where the consumer spending that is needed to revive the economy is going to come from.