Feb ’06  Bonds - Hopes for a pause in Fed interest rate hikes have been dashed, at least for the moment, by the wording accompanying the most recent increase and release of current economic data.  Headline inflation figures are 3.4% for the CPI and 6.3% for the PPI, the highest in 14 years, but not to worry, the “core” rate is only 2.1%!  Even this low-ball figure is above the new Fed chairman’s tolerance level.  Falling to 4.7%, the unemployment rate is signaling increased upward pressure on both wages and interest rates.  Movement in the price of gold has been a leading indicator positively correlated with inflation.  Its rise is seen by many as putting the kettle on the boil.  If interest rates move up, the dollar will remain firm, delaying a decline against other currencies for six to twelve months.  Eventually, dollar weakness will be a major factor in correcting the trade balance deficit.  Remarks of the acting director of the Congressional Budget Office upon the release of the most recent fiscal deficit projections are far from sanguine.  For many decades, on average, government spending has been 20% of GDP and government revenues have been 18%.  The 2% annual shortfall has been manageable, but the aggregation of debt and unfunded mandates is now becoming of concern, particularly because new spending programs place the annual shortfall on track to increase to 8% over the next decade.  The prognosis is that the economy cannot grow its way out of this cul-de-sac.  Something will have to give, and it is unlikely to be a reduction in congressional spending.  Much has been made of the idea of increasing the proportion of long term bonds in pension funds to better match liabilities.  This looks to be rather too expensive for most companies until rates become much more attractive.

 

 Equities - “Being now in a seasonally favorable period for an advance in stock prices, the next month or so will likely be more pleasant than the last two.  The picture changes early in ‘06, in our opinion.”  This quote from our last report is being confirmed.  Thoughtful commentators classify current market action as an aging cyclical bull market within a secular bear market whose inception was the top in 2000.  The decline into early 2003 was the first leg, the rise from then to date is the second leg, both in conformity with historical magnitudes of price and time.  Presumably a third down leg will follow.  Two recent failures of the DJIA to surmount 11,000 in a very favorable seasonal period give food for thought.  Interest rate trends, market breadth readings and historical cycle studies are all suggesting a more cautious approach to equities than has existed for the past three years.  Not to be forgotten is the drastic market correction which took place in 1987, two months after the appointment of a new Fed chairman.  “Sell in May and go away” would fit this pattern.  But all of the above pertains to the averages and indexes.  Individual issues will go their own way, not all unprofitably.  There is much talk of sustaining domestic demand this year through increased corporate spending as a replacement for a tapped-out consumer, but it’s difficult to determine the targets of this activity in time to take advantage.  Following the money in other ways will be a good strategy - energy, health care, gold and foreign issues garnering large sums from abroad and from their newly affluent masses.

 

William Wright