|
If
you recall, we ended last month's letter by warning that
" a short-term shake-out is about to happen, but
unless something dramatic takes place fundamentally, the
retail investor will come back and will lead the market
higher." The question now is: "is the
shake-out over?" The last six weeks investors
have been hit with one set of "bad news" after
another, however, fundamentally nothing dramatic has
happened, yet! The Federal Reserve has raised rates five
times but the economy has grown at a remarkable rate of
6.00% the past three quarters. Last weekend, the editor
of this newsletter had a first-hand testimony to the
strength of the economy. Under the impression that
higher interest rates will result in weaker demand for
housing, he decided to dispose a rental property which
has appreciated substantially. He met with the realtor
on Friday, April 28th and he listed the house. The
realtor told him he was going to install a
"For Sale" sign and a "lock box"
sometime the following week. On Monday, May 1st
-just three days later- he received a phone call from
the realtor informing him that there were two offers,
both of them above the asking price! Most
remarkably, the potential buyers had not even seen the
interior of the house -there was no lock box- they
placed their offers based on how it looked on the
outside! As happy as he was about the quick sale of the
property, he could not help it but to think about the
stock market. He kept wondering " if demand for
housing is that strong, it will probably take a lot more
aggressive action by the Federal Reserve to tame demand
in housing and goods, which can not be all that great
for the stock market! There is no doubt in our minds the
Federal Reserve is thinking likewise looking at all the
economic data which suggest that not only the economy is
overheating but also, cyclical inflation has ceased to
be just a possible threat and it is now a reality. Given
that we are in an election year, one must assume that if
the Federal Reserve has decided to become more
aggressive it will do it sooner than later. We believe
the Federal Reserve does not want to find itself in the
position of raising interest rates beyond August, thus
the bulk of the assault should come May and June. We
also believe, that it must be evident to the Federal
Reserve that the strength of the economy is much more
based on the robust employment conditions rather than
the "wealth effect" of rising prices of
financial assets. It would be inconceivable that the
Central Bank will choose a course of action that will
seriously hurt the economy and result in a rising
unemployment rate going into the election. One then
should ask "by how much is the Federal Reserve
going to raise rates between now and July?"
Even the most pessimistic agree that worst case scenario
is 100 basis points. Thus, let's assume that short-term
interest rates will rise by 100 basis point over the
next 120 days. The real questions then are "how
much will 100 basis points shave off the GDP rate of
growth, how much corporate profits will be
affected, and by when?" In reality, the real
rate on long-term BBB corporate bonds has gone up by 100
basis points in the past year with no apparent adverse
impact on corporate profits. Indeed, Old and New
Economy companies alike have shown stellar
profits. Our econometric model indicates that an
additional 100 basis points increase in short-term
interest rates (on top of the 75 basis point since last
June) will result -at the most- in a 1.5% reduction in
GDP growth, which will not appear until September or
October. And even then, we are talking about a GDP
growth of about 4-4.5%, which can't be terribly bad for
corporate profits. Yes, they will be affected, but they
will not dissappear. The point is, corporate profits
will remain robust in the second quarter. Thus we
believe the stock market will recover in the coming
weeks. We view what happened in April as a prelude
of what might be looming 4-6 months down the road, but
for now the carnage is almost over. Our model gave us an
"unconfirmed buy" signal on May 4th.
Usually, the signal gets confirmed within ten trading
days, and in many cases within 1-3 trading days.
Thus, as we write this letter our position is formally
still neutral, but we expect to change it to BULLISH
within the next 10 trading days. We expect a rally to
last into mid-July. At that point investors will begin
focusing on the third quarter profits and the markets
will experience a decline into the fall. Whether they
will recover after that or not, it is too early for us
to make a prediction.
Our
Market Positions:
Dow: Neutral ,SP500: Neutral
NASDAQ:Neutral
|
AEGEANCAPITAL
GROUP INC.