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Saturday, Feb. 12, 2006

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Wilkinson's Edge
The Cutting Edge of Financial Analysis

Dear MoneyNews Reader,

What would be your first port of call after you retire?

I'm betting most retirees would head for a well- earned vacation, perhaps spending their days on the golf course or at the beach – but not former Fed governor Alan Greenspan.

This week he prostituted himself to the highest bidder in his first post-Fed appearance, addressing a private dinner attended by a select few leading hedge fund managers and investment bankers.

Mr. Greenspan held court on the topic of interest rates and the economy.

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Some had already criticized him for even attending his last FOMC meeting at the end of January, saying it cramped incumbent Ben Bernanke's style and just wasn't accepted protocol.

On the one hand, financial markets gained valuable insight into Fed thinking as a result of the secondhand stories emanating from the dinner hosted by Lehman Brothers in New York City.

But on the other, investors wondered whether Greenspan wasn't violating Fed regulations with his comments.

Editor's Note: Financial Intelligence Report detailed that Greenspan's actions would lead to a coming recession and housing bust. Read more Go Here Now.

Yields on interest rate futures and short-dated treasury notes rose by 3 basis points as a direct result of the stories about what Mr. Greenspan said.

When the Fed announces changes to interest rates at its FOMC meetings, an accompanying press release explains the rationale for why rates were altered.

Since the meeting took place only eight days before the dinner function, bond traders felt that they had a fairly solid understanding of everything the Fed was thinking.

So Mr. Greenspan's comments set the cat amongst the pigeons, as he stated that the Fed would need to continue raising interest rates in order to prevent economic overheating.

That comment in isolation was enough to send shivers through the bond market.

Traders had previously believed that the interest rate express train set in motion in June 2004 was almost at journey's end.

Mr. Greenspan also resurrected the phenomenon of the so-called "Greenspan conundrum."

According to sources who heard from people at the dinner (of course, no one wants to take direct responsibility for framing the former governor), Greenspan once again highlighted the problems that the effects of globalization are causing for the Fed.

By keeping long-term interest rates low, the Fed may have to withdraw more from short-term rates.

Meanwhile, the conundrum had become widely accepted as fact, with most people saying "it is what it is."

But as a Fed official reportedly told Bloomberg news, the former chairman didn't break any rules with his comments this week.

"Board members who complete their term may meet with and speak to groups without restriction, provided they reveal no confidential information," said the official.

Of course Mr. Greenspan merely stated his views going forward.

He apparently told diners that the impact of the slowing housing market wouldn't be felt for a another six months, adding that consumption was nevertheless surprisingly strong – as evidenced in the retail and auto sales data. On the inflation front, he said, globalization was keeping a lid in place.

But was this simply a case of Greenspan stealing the limelight?

Some are now saying that the accolades bestowed upon Mr. Greenspan (he has been called "the greatest central banker that ever lived") will soon be tarnished if he continues making his remarks.

In the aftermath of this week, people are even saying that throughout his tenure at the Fed, Mr. Greenspan tried to cultivate his own persona at the expense of the institution.

The dollar

So the $64,000 question going forward is: How might Mr. Greenspan's views impact asset prices?

Here's my immediate take on events.

The very notion that short-term rates need to head higher than we'd thought means that the bond market is underestimating inflation.

From that perspective, we are likely to see yields at the short end of the yield curve move upward from the current 4.62%.

With 10-year notes yielding 4.56% at the moment (yes, the curve remains inverted with longer rates LOWER than short rates) it's the short end of the curve that will bear the brunt of a shift.

Bond traders are a savvy lot and will continue to buy longer-dated maturities, safe in the knowledge that if the Fed does follow the Greenspan view and keep pushing rates higher, they will fall sooner and harder.

The dollar experienced a flurry of strength following Greenspan's admissions.

The big issue here is the role of inflationary pressures and the need to push up interest rates.

Of course, rising rates have supported the dollar. As 2005 ended, I expected the policy-tightening baton to be handed over to the European Central Bank (ECB) as they began lifting rates – a move that would send the euro currency higher.

Now, if you stick with the Greenspan comments, the dollar will not lose its luster just yet – which explains the brief excursion below $1.20 against the euro this week. Since its January peak, the euro has lost 3% against the greenback.

But I'd urge you to think about the bigger picture.

The post-Greenspan Fed won't keep us guessing on rates and the Europeans WILL continue raising theirs. In my opinion, the dollar is facing a last hurrah here and I predict that the euro will soon appreciate.

During the week, the rising dollar sent the prices of many metals sliding. Yet again, commodity prices have surged thanks to firm underlying demand. But the $21 slide in the price of gold didn't go unnoticed.

It came hot on the heels of a drop in the price of oil, which traders saw as taking some steam out of the inflation pressure cooker.

The Greenspan comments hint at more rather than less inflationary pressures.

When the subject of inflation gets thrown back into the arena, gold always benefits. So it was no surprise to see the precious metal rebound sharply in the aftermath of the comments.

The in-house view here is that gold will have a pullback – perhaps to as low as $525 per ounce. We won't let Mr. Greenspan's comments upset our apple cart just yet.

As for the final piece of the equity market jigsaw, the inflationary element of Greenspan's comments adds credence to the notion that growth is perhaps stronger than was first believed.

So the reaction from stock indices was to head firmly upward in the days after the comments.

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S&P 500 Earnings

During the week, at least two-thirds of S&P 500 components had reported fourth-quarter earnings that went beyond analysts' estimates. At the end of January, of those reporting, 63% had exceeded estimates.

That beats the 59% average performance over the last 11 years, topping expectations, according to Thompson Financial.

But that hasn't stopped analysts from reducing their first-quarter profit projections for 70% of the 10 sectors of the economy since the year began.

However, that was before networking giant Cisco announced that revenue growth would accelerate in 2006 anywhere from 10 to 12% thanks to growth in its router business. That enables networks to deliver faster voice, video and data by computer.

An analyst upgrade for Dell from Sanford Bernstein (thanks to similar revenue and profit gains) helped the overall technology sector.

Bank of America lifted its "sell" rating on chip-maker Applied Materials, causing a flurry of frenzied buying activity on the stock.

PepsiCo announced a 15% surge in both domestic and overseas demand for Frito-Lay snacks and soft-drinks to help lift sales growth to a four-year high.

Pfizer's bid to sell off its consumer-health unit was well received by investors, who lifted their view on the stock.

Best Buy performed well and raised its profit forecast for the fiscal quarter ending February. Sales of flat-screen televisions and iPods were especially strong. Profit growth for the quarter is expected to jump 12%.

Shares in rival Circuit City reflected the good news, as did those in 3M, which manufactures film for flat-panel screens.

U.S. and Asian business travel is on the rise and that was reflected in a 25% profit growth at leading hotel chain Marriott. Shares rose as the company upped its profit forecast for 2006 by 2.6% above its October projection.

Overall, the stock market looks comfortable.

The tone set a couple of weeks ago by high-profile profit shortfalls from Google and Intel Corporation may well have been a buying opportunity.

It's highly likely that investors have run scared from the January highs, which mark a four–year peak. Once selling got underway, a snowball effect gathered steam, making a reversal in stocks more likely.

Looking at the chart of the S&P 500 index, it's too early to judge that right now. I'd say we'll see a charge back to those highs, at which point we'll learn whether the air really is too thin to sustain the climb.

Have a great week!

Andrew Wilkinson
Senior Newsletter Editor

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