Federal Reserve Forum

Interest Rate Hikes, When Will They Stop?
The Federal Reserve has met twice since my last newsletter. After the May 10th meeting, Ben utters the dreaded “inflation” word causing the stock markets to sell off in lock step. Then in June, Ben says, “the moderation in the growth of aggregate demand should help to limit inflation pressures over time”. In other words, the interest rate increases are working. No kidding but when will it stop?

These most recent Fed comments revealed the first hint that we may be nearing the end of the Federal Reserve’s 17 consecutive 1/4 point interest rate increases. (In case you’re wondering, 17 quarter points is 4.25%) For the first time since it began raising rates from a low of 1%, in June of 2004, the Fed didn’t explicitly say another rate increase was under consideration. Currently, the futures market has priced in a 63% chance of a rate hike to 5.5% in August. This would give us a prime rate of 8.5%.

This is 50 basis points below the previous peak Mr. Greenspan set in 2000. In the mean time, the Fed will continue to read the economic tea leaves over the next 45 days. The Bank of Japan and the European Central Bank are set to raise rates in the next thirty days.

How might the current series of rate increases affect you? First, if you’re in the market for a new home or need to refinance, mortgage rates for fixed rate loans should reach 7% in 2007. If you have a home equity loan tied to the prime rate, your interest rate will more than double to somewhere around 8.5%. The popular interest only ARM loans will also double in rate just when the housing market has stalled. This may make it difficult to refinance when homes have not appreciated or may have even dropped. The overall impact here may be a loss of value in residential real estate between 10% and 20% from the 2005 peak. Combine this with the increases in gas and other raw materials and you may get a recession in late 2007. However, as with all recessions, we will not know until we have been in one for at least 6 months!

Is there a silver lining? Sure, six month CDS are now paying over 5.5%, nearly 4 times their low back in 2003! Also, market slowdowns generally create great buying opportunities. Remember, the economy works in cycles and we are about five years into the current economic cycle.

Asset Allocation

Buy Low, Sell High – Not As Easy As It Sounds

Small investors seem to continuously chase the market trend and use a strategy I call “recency”: What ever the most recent phenomenon of making money is, follow it. We have seen recency with dot bomb stocks, real estate, emerging markets, gold, etc. These investors are applying reverse market timing. Wait until something gets run up really high, then buy it only to watch it free fall. Then sell it! In other words, “buy high, sell low”.

Why does this happen? Most institutional investors apply an asset management strategy in their portfolios. This means that when one asset class of the portfolio grows beyond the tolerance set by the manager, they sell. It also means when an asset class falls below the tolerance level they buy. Here’s the rub: institutional investors have more money than retail investors. So when a retail investor is following a trend, and the institutional investors are selling what is high, the retail investor becomes the bug and the institutional investor becomes the windshield. So why play this game?

Fasten your seatbelts, do not panic, have patience and follow a long term plan. In its simplest form, asset allocation is a strategy with fixed percentages in cash; bonds both domestic and international, US Equities both large and small, and international stocks both large and small. The portfolio is then rebalanced periodically. This rebalancing process creates the “buy low sell high” discipline! It also removes guessing which generally creates havoc on the portfolio.

A Time For Giving

You don’t need to wait until the holiday season to start thinking of others. Warren Buffet, the world’s second richest man, announced plans to give away 85% of his fortune ($30 billion) to the foundation started by the world’s richest man, Bill Gates. The Bill and Melinda Gates Foundation will then double in size to $60 billion, making it more than twice the size of the next 3 largest foundations combined (Ford Foundation $11 Billion, Lilly Endowment $8 Billion, and Andrew W. Mellon Foundation $5.5 Billion).

Foundations must give away 5% of their assets per year to keep their tax exempt status. Thus, the Gates Foundation will need to give away over $3 billion per year to the causes of their choice. The Foundation has been spending money on research, prevention and treatment for AIDS, tuberculosis, malaria, and vaccine-preventable childhood diseases. It focuses its efforts in developing countries, primarily in Africa and Asia. This leaves plenty of good causes for the rest of us to get involved with.

According to a survey produced by the Giving USA Foundation, Americans gave $200 billion to charities and other non-profits in 2005. In addition, nearly 80% of Americans give to at least one organization at least once per year and the average contribution per family is 2.2% of after tax annual income. That’s only $3,000 per year for a family earning $200,000 per year.

What’s the point of making lots of money and not giving anything back? There are many people who are less fortunate than us, who could benefit from even the smallest donation. And with all of the charities available today, it’s easy to choose one that you feel would best benefit from your help.

Life is short. Don’t be average. Give today!

Market Summary

The 2nd quarter of 2006 was tough for virtually all market segments. The US market and international markets fell in May, but rebounded slightly in June. The S&P 500, the index measuring the 500 largest US stocks by their market capitalization, fell 2.3% for the quarter and the EAFE Index (a market value weighted index of the largest companies in Europe, Australia, and the Far East) declined .26% over the same period. Year to date, the S&P 500 and the EAFE were up 1.8% and 8.94% respectively.

What caused the drop? It started with comments made by new Fed Chair Ben Bernanke following the May 10th Federal Reserve meeting on the subject of inflation. For the first time, Ben did not speak in code as his predecessor Alan Greenspan always had, and actually used the word “inflation” in his speech. This sent the S&P 500 down 5%, while international markets got pounded nearly 10%. Then in June, the markets recovered slightly following comments where Bernanke did not specifically mention rate increases. It is amazing what a few simple words uttered by the Fed can do to world markets. As former Chair Greenspan has said, “I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said”.

Sector Performance Report 6/30/06

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