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Economics: Don't Fool With The Fed
New York: June 26, 2006
By John R. Stephenson

Just what is the stock market trying to tell us? It was only a few short weeks ago that stock markets were swinging for the fences, trading at or near their five-year highs. But then something changed. For the last little while, stock markets have been in a funk. First, the market rallies and then sells-off sharply. Since early May, the S&P 500 is off some 5.1 percent. The reason? According to investors, concerns over interest rates have rattled the confidence of investors. With central banks in Japan, the U.S., Europe and China all tightening the purse strings (raising interest rates), equity investors are running scared.

Around the globe, central banks (The Federal Reserve, Bank of Japan etc.) have been leading the charge against inflation. With prices for energy and housing soaring, central bankers have become concerned that inflation will rear its ugly head. In order to control inflation, these bankers have been raising interest rates to slow down economic growth and hence control inflation. There's just one catch — if they raise interest rates too fast or the economy slows too quickly, stocks and the stock market will start to tumble — and fast.

In the past 11 weeks, this defensive stance by the Bank of Japan has managed to dry up some $175 billion (20 trillion yen) of bank reserves from the Japanese economy alone. With money fleeing the system rather than entering the system, stock markets, particularly those in developing economies, are hit and hit hard as speculators take their bets off the table. With weak stock prices across the board, the market seem to be telling us that, in their view, the Fed (U.S. central bank) is likely to overshoot on its inflation fighting mandate and raise interest rates too high. So just what would be the effect of sharply higher interest rates? It could lead to an economy that slips from growth into decline (recession) taking stocks along for the ride.

This is what is spooking stock investors around the globe. If central bankers go too far and raise interest rates much higher, then the economy could stumble which is bad for stocks which are nothing more than the an option on the profits of an individual company. But if the economy is contracting rather than expanding, then the prospects for individual companies are beginning to worsen rather than improve — a huge negative for stocks and stock investors. Not only that, but investors reason correctly that taking a chance on a company's future prospects is a riskier proposition when interest rates are on the rise and the likelihood of the economy slowing is the greatest. As well, with interest rates on the rise, suddenly boring old bonds seem like a pretty good deal. Hey, why take all that risk that somehow your companies will find a way to muddle through when bonds, which are a whole lot safer (you generally get all your money back plus regular coupon payments) than stocks are increasingly looking attractive.

For a long time now, stock investors have had it pretty good. Inflation and interest rates were low while corporate profitability has been strong. Not only that, but we witnessed one of the biggest bull markets in the last fifty years. With the ten year U.S. government bonds now above 5% for the first time in 4 years and house prices starting to roll over, now is the time to think great defense rather than offense.

So what's a savvy investor to do? For starters, start to lighten up some of the more speculative names in your portfolio — particularly those levered towards growth or those that are decidedly cyclical in nature. If you've been buying stocks or mutual funds levered to growth in developing economies, this is an area that could get zapped as interest rates rise and money supply become tight.

In general, when money becomes tight (because of rising interest rates etc.) the money that remains in the system tends to be attracted to the large blue chip equities rather than the more speculative smaller capitalization or emerging market stories. The reason is simple. When money is tight and expensive, why take a chance with something speculative when there are safe, liquid alternatives close to home.

With the market anticipating tough sledding in the months ahead, having cash in the bank is another attractive way to play the game. Not only will you earn a safe and steady return on any cash balances that you hold, but you will be in an ideal position to start buying stocks when things start to bottom in the market.

Another way to play strong defense is to include a healthy allocation towards dividend stocks. Those are stocks that you buy not for the upside through capital gains but rather to help meet your needs for income. Ideally, these should be stocks that have a strong history of paying a regular dividend, increasing those dividends and are from companies that are financially prudent.

Figure 1: High Yielding Equities

U.S. investors should give careful consideration to diversifying away from home, as it is increasingly likely that worse days lay ahead for the U.S. dollar. While gold producers have been weak of late, a small allocation toward gold (GLD a gold ETF) and gold producers can provide an effective hedge against future U.S. dollar weakness.

Investors should begin to focus on developing a portfolio which includes a substantial position in long-term high quality bonds. If and when the economy begins to slow, high quality long-dated bonds will be your investment winners.

The commodity story will once again resume its upward march but not for every commodity producer. Those that have integrated value chains (think large cap stocks) and who have the majority of their production focused in Canada, U.S. and Western Europe will outperform those producers who have the majority of their production in politically unstable regions of the world.

While the outlook for the stock market looks challenging at the moment, investors who are able to jump off the bandwagon of capital gains and think defense rather than offense should come out ahead in the months and years to come.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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