Like the pinot noir obsession that consumed actor Paul Giamatti in this Academy Award winning movie, the stock market is obsessing over each particle of economic data that is released. The easy money party is over and investors are suffering from a hangover that just won’t go away. Over the last twelve months, 90-day Treasury bill rates have risen 217%! Even though the real (inflation adjusted) Federal Funds rate has been well below its 30 year average since 2001, they are now at their pre-Greenspan 20 year average.

The Fed has made its intentions known and the market is anticipating another 25 to 50 basis points of upward moves in the Federal Funds rate. In my opinion, however, most of the heavy lifting has been done. The 420+ basis point move in the one-year Treasury note is enough to shock our system into a slowdown. The knockout punch of a flat to inverted yield curve (i.e. short term rates equal or higher than long term rates) has not been unleashed. And given the current slowdown in the manufacturing sector, we doubt that the Fed will tighten that much.

We are now faced with a consumer slowdown caused by a large increase in short term interest rates, soaring gasoline prices, and a sour stock market. The Conference Board’s Consumer Confidence Index slipped to its lowest level since July 2003. Harley-Davidson can’t sell all its motorcycles so they’re sitting on showroom floors. The same is true for General Motors and Ford. Moreover, higher commodity-like prices are beginning to “bite”. Undoubtedly, industrial profit margins will face headwinds in this environment.

DÉJÀ VU 1994

The last rate rise of this magnitude was in1994 when the Fed decided to sharply raise the Fed Funds rate. The one year Treasury note rose by 112%, from 3.36% in September of 1993 to 7.14% by December of 1994. Industrial production growth decelerated for six months after that, and then stabilized. (We should note that the yield curve was much flatter than current levels, and so the economic backdrop was somewhat more severe than currently). Similarly, since April of 2004, the one year Treasury note has increased by 130%, from 1.43% to 3.30%. We do not yet have a flat yield curve nor are real interest rates very high. Nonetheless, rate rises do shock the economy and cause uncertainty. The same can be said for rising gasoline prices. So one should expect our non-farm business output to slow from the fast pace of the fourth quarter (3.7%) to something like 1.8% at year end. This will impact not only the top line, but also profit margins. But this qualifies as a slowdown in growth, not a recession.

If the economy does slow as expected over the next several quarters, it could dampen inflation expectations for the remainder of the year. History teaches us that inflation is much like a ship that alters its course . . . it takes a long time for meaningful changes to occur. As such, it is not the rate of inflation that is important, but the change in the rate of inflation. Since 2001, the direction of the inflation rate has been meandering upwards. For the next year, however, we believe that inflation expectations will be contained due to the slowdown. On the other hand, actual inflation could surprise on the upside in 2006. This is extremely important because the inflation rate impacts not only bond yields, but earnings yields (the inverse of the price-earnings ratio) as well!

THE OUTLOOK

The stock market has anticipated this slowdown and sold off during the first four months of the year. But those looking for an immediate bounce back to the highs of December or higher will be disappointed. At current levels the S&P 500 is priced at 16 times this year’s consensus earnings per share of $72.50. In our opinion, given current long term growth estimates, anticipated inflation and dividend payout ratios, this appears to be a low valuation for the market.

Since valuation is not a problem, then it must be the earnings outlook. The most recent data from the Institute for Supply Management indicates that new order trends slowed in April, continuing the deceleration since late last year. If the Federal Reserve continues to tighten beyond what we believe is needed, and production and new orders actually contract as they did in 1995, what impact might it have on earnings? The chart below shows earnings for each of the S&P large cap sectors for 1995, and our estimates for 2005 and 2006.

OPERATING EARNINGS
% CHANGE

On the face of it, earnings growth in 2005 and 2006 should be more positive than the market appears to be anticipating. However, the figures above do not factor in the new stock option accounting rules. It has been estimated that expensing options will reduce 2005 earnings for the S&P 500 by $1 per share and 2006 earnings by $2 per share, or 1.4% and 2.6% respectively. Our valuation models have now been adjusted for expensing options. This means that 2006 earnings will only grow by 4.3%. Because of this downward earnings adjustment and because we believe that companies such as Kellogg and Procter & Gamble are successfully passing along cost increases, inflation will be higher than is currently anticipated. If China is eventually pressured into revaluing their currency (the Yuan), it would most probably cause non-petroleum import prices to surge and long term bond prices to tumble.

Given the variables we’ve discussed here and many we have not, our expectation is for a market that goes sideways through the end of 2006 providing only modest returns from current levels. (See the chart below) Nonetheless, opportunities for buying low and selling high will be generated by typical market mood swings of about +/- 5% per quarter. The market could still trade down another 5% by June before a sustainable rally takes place, much like last summer and fall. With good timing and prescient portfolio composition, returns of 10+% should be possible by year-end.

S&P 500: 1176
10 Year Treasury Note: 4.19%
May 4, 2005