Bernanke and Brand Name Watch
(January 26, 2006)
Dear Subscribers and Readers,
First things first – this from Business 2.0 on why the housing market has topped: AvalonBay Communities, a REIT that specializes in managing apartment properties, “is converting boarded-up Massachusetts mental institution Danvers State Hospital into a 497-unit complex of high-end apartments and condos … the nuthouse-to-yuppie-house trend [is] currently sweeping North America, with such conversions also planned in Detroit, New York, Vancouver, Columbia, S.C., where the centerpiece of the development is an original brick building with the word “asylum” chiseled into the facade.” Quoting an executive from AvalonBay Communities: “If you grew up in Danvers, and you remember it as the spooky place on the hill, it might not be the right place to live.”
But then again, folks who pay up for these conversions aren't exactly sane either. In this author's opinion, Hollywood should do these folks a favor by making a couple of horror films about former mental institutions in the hope they will discourage buyers from snapping up these conversions.
We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 – giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. We switched to a 25% short position in our DJIA Timing System shortly after noon on last Wednesday at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) last Thursday afternoon at DJIA 10,900 – thus giving us an average entry of DJIA 10,870. E-mails were sent to our subscribers on a real-time basis just seconds after these short positions were initiated. This author also posted a message on our discussion form last Wednesday afternoon (EST) reminding our subscribers to check their emails. For a more detailed explanation of the background and what we are trying to achieve with our DJIA Timing System (along with historical signals), please go to the following page. Please note that this page is only available to current subscribers.
In our previous commentary (“The Ben Bernanke Grand Experiment”) discussing the policies of the new upcoming Federal Reserve Chairman, Ben Bernanke, I attempted to dispel the popular notion that he was nothing more than an inflationist. The term “Helicopter Ben” arose out of his November 21, 2002 speech in a discussion on the options of the Federal Reserve should the U.S. economy ever slips into deflation (which is in itself a low probability event) – which is unfortunate and ironic since for most of his academic and Federal Reserve career, he has argued repeatedly that Central Banks should adopt a clear, inflation-targeting policy – simply because that in the LONG-RUN, inflation is the only variable that the Central Bank can affect or have some kind of control over. Moreover, Bernanke claims that today's consensus is that even a moderate rate of inflation is harmful to economic growth. Put together, it can be argued that the new Federal Reserve, under Chairman Bernanke, would be focused solely on “inflation-fighting” – and that maintaining job growth or stable employment levels would no longer be a core responsibility of the Federal Reserve – unless an unexpected, protracted economic decline occurs such as a Japanese-style deflationary bust. Finally, as I have mentioned in our last commentary, Bernanke claims that this optimal long-term inflation target policy would only work and be credible if we are at "a point of near optimal inflation." Current inflation readings say that we are now in the "sweet spot" in terms of price stability, as Bernanke puts it, and from the speeches that he has made and written about inflation in the past, it is very likely that Bernanke will be very active in trying to maintain the U.S. economy at that "sweet spot." That is, this author will not be surprised if the new Bernanke Fed comes in and “overshoots” on the hawkish side – especially given the recent rise in gold prices and the plunge in bond prices yesterday. There is certainly a precedent – as Greenspan hiked the Fed Funds rate by 100 basis points when he came onto the scene in August 1987 in a mere two months in the midst of rising gold and plunging bond prices.
For readers who are interested, Bernanke and three of his colleagues authored an entire book on “Inflation Targeting” which was published in 1999. In that book, he discusses the limitations of monetary policy and the virtues of such an “inflation-targeting” policy – in that empirical evidence has shown that macroeconomic stability (including control of inflation) is an “important precondition for economic growth.” This is a controversial subject, as many economists have argued whether moderate rates of inflation are harmful to the economy. What is important, however, is that Bernanke himself believes that even a moderate rate of inflation is detrimental to economic growth. Quoting the book “Inflation Targeting: Lessons from the International Experience”:
- For example, because people find it difficult to adjust for inflation in their calculations, many of their decisions – particularly long-term decisions, such as how much to save for retirement and how to invest their capital – are less appropriate than they might otherwise be. And it is true, given compound interest, that over a thirty- or forty-year period, even slight differences in annual inflation rates have a large effect on the purchasing power of the dollar. Making it difficult to assess both current relative prices and the future price level, inflation can also distort the decisions of firms about production and investment.
- More sophisticated savers, investors, and managers, of course, find ways to insulate themselves from the effects of inflation. But that effort is not without its own economic costs, including costs of attention and calculation as well as the cost of resources devoted to (for example) the development of alternative financial instruments. Less sophisticated individuals are less likely to insulate their income and savings from inflation; their inability to do so represents one of several channels by which inflation induces redistribution of wealth among groups … and hence corrosive of the social compact.
- The absence of complete indexation (automatic adjustments for inflation) in virtually all legal and contractual arrangements (which in turn reflects the many technical difficulties with indexation in the real world) also allows inflation, even at relatively low levels, to have adverse economic effects. The most important costs of inflation at low to moderate levels seem to come from the interaction of inflation with the tax system, which is rarely if ever fully indexed to inflation. For example, the common practice of basing capital depreciation allowances on the historical costs of investments, rather than on current values, implies that inflation erodes a key tax benefit of capital formation, reducing the incentive to invest and perhaps (because of sectoral differences in capital lifetimes and depreciation methods) leading to a misallocation of investment among sectors.
Bernanke asserts that many empirical studies have been done confirming this experience. For example, “Fisher (1994) calculates the social costs of tax-related distortions to be about 2% to 3% of GDP, at an inflation rate of 10%, and Feldstein (1997) argues that there would be social gains from reducing inflation even when initial inflation is very low … In one of the most cited articles involving cross-national comparisons of growth rates, Fischer (1993) finds that, on average, a 1-percentage-point rise in the rate of inflation can cost an economy more than one-tenth of a percentage point in its growth rate.”
In going through his speeches and his book, there are two things that stand out the most: Bernanke personally believes that a policy of a clearly-communicated, credible, long-term “optimal” target rate of inflation on the part of the Federal Reserve will be the key to long-term, optimal and stable economic growth. Secondly, the current rate of inflation suggests that we are now close enough to that rate of “near optimal inflation.” As I have hinted before, these have two immediate implications:
- Going forward, the only focus of monetary policy will be to contain inflation growth – with economic growth coming into consideration only if a severe, deflationary economic decline hits the United States.
- Since the current rate of inflation is at the “sweet spot,” Bernanke will be doing his utmost to make sure any hints of inflation or lack of credibility on his will to fight inflation be wiped away.
For retail investors, this is a very good reason to cut back on your gold holdings right now. Central Banks have historically always wanted price stability – and a rising gold price causes damage to their credibility. Bernanke in particular believes buying gold for investment purposes is a misallocation of resources. We could go on about the China and India argument all day but most of the increase in gold demand in recent months has come from folks buying GLD, the gold ETF. The retail investors' participation in gold can also be witnessed in the all-time highs being made both on the XAU and the HUI – as well as the record long positions of large and small speculators alike in gold futures. Given this background, again, this author will not be surprised to see the Fed continue its rate hikes all the way to March 28th(stopping at 4.75%), or even May 10th before pausing at a Fed Funds rate of 5.0%. Under the Bernanke Fed, the U.S. dollar should do well in the latter half of 2006.
For stock market investors, the Bernanke policy of long-term inflation targeting should be a boon for equities, assuming that such a policy succeeds. In the short-run, however, there could be some (downside) volatility, as there is a good chance that the Fed may hike rates more than the market currently expects. If anything, it is going to take weeks or even months before economists and stock market analysts alike become less uncertain with the policies of the new Fed under Bernanke (markets and consumers alike don't like uncertainty).
As many of our readers should know, this relatively cautious outlook on the stock market also jives with our “mid-cycle slowdown” scenario for 2006, as well as our primary assumption that earnings growth has peaked or is already peaking as we speak. The fact that many of the large caps only met or missed earnings estimates – and especially given revenue shortfalls – is an ominous sign, and represents the first time that this has happened in this cyclical bull market.
In our last Thursday's commentary “2006 Brand Name Watch Update” I stated that I will go further in our analysis – as well as give our subscribers an update on the latest action of the must-watch brand names. Again, this author has always believed that in a healthy, cyclical bull market (even in a small and mid cap bull market which we have been witnessing since October 2002), the shares of most of the biggest brand names or the fastest-growing brand names in America should be doing extremely well. That is, the relative strength (vs. the S&P 500, for example) of most of these companies should be rising. At the very least, the share price of these companies shouldn't be falling. We discussed, however, that this was currently not the case – especially when we take at the look at the price action of the five biggest global brand names (KO, MSFT, IBM, GE, and INTC, as ranked by Interbrand.com) since January 2004. Again, the relatively dismal price action of these five stocks in the last two years is also a sign that stocks may not perform so well this year.
Let's now get on with our “Brand Name analysis.” Like I mentioned before – out of the five “brand name stocks” that we have been keeping track, GE has been the best performing of them all since our last September 2005 update. Even so, the technical action of GE has not been so great, since the 20-week moving average of GE had been trading below its 40-week moving average since July 2005. However, we also noted in our last update that the 20-week MA was on the verge of breaking out its 40-week MA – thus negating this weak technical condition. We then stated: “Therefore, the GE earnings report tomorrow (January 20th) morning and investors' subsequent reaction should be very important – not only for GE but for the entire stock market going forward.” Following is the weekly chart showing the action of GE from January 1, 2002 to the present:
As everyone should now know, GE missed its revenue estimates and only met its earnings estimates in its latest earnings report last Friday morning. This is a significant development – given that GE has nearly always beat estimates by one penny. Please note that the chance of the 20-week MA breaking back above its 40-week MA is now slim. And given that GE is the fourth most valuable global brand name and given that its business spans across nearly every aspect of the global economy, it is probably safe to say that the action of GE does not bode well for the stock market going forward.
Let's now expand our analysis and take a look at the sixth most valuable brand name on our list – as ranked by Interbrand.com. Make no mistake, Citigroup is important, as it is truly a global financial powerhouse as well as an innovator in its fields. Note that even though Citigroup made a new all-time high in late 2005, the stock has essentially been stuck in a trading range since the beginning of 2004. The latest negative reaction its earnings report last Friday brings the stock back below its 20-week MA, and has it just sitting above its 40-week MA. While the action of Citigroup doesn't look overly bearish, readers should note that the stock price is sitting just above support, and unless the Fed stops hiking after its January 31st meeting, chances are that we have not seen the end of the correction of Citigroup just yet. Note that relative strength of the stock has broken below its 20-week EMA:
Of course, a complete discussion of “brand name stocks” cannot end without at least a mention of Google – which is definitely one of the best growth stories we have seen in business history. Keep in mind that while the weekly charts still look pretty good here, the only to watch right now is the Google earnings report which is due to be released after the market closes on January 31st (right after the Fed meeting). Given that analysts have been continuously adjusting their expectations upwards, and given its 50% rise since the last quarterly earnings report was released, there is a lot of room for Google to disappoint here. In the meantime, the recent stock market action and relative strength of GOOG still looks good:
Again, last week's downside action may eventually proved ominous – as the huge downside price action and volume most probably signals distribution by insiders and hedge funds alike. GOOG will need much better than blow-out earnings to convince these same hedge fund managers to buy back those shares that they unloaded at $425 to $475 last week. More than ever, GOOG is now a daytrader stock, and should be avoided for most retail investors. Should GOOG struggle after its earnings report, there is a good chance that speculative activity in the stock market will decline significantly or cease altogether. In the short-term, this will not bode well for the stock market.
Another favorite company of the public in recent years has been Apple. Please note that while the stock is still holding up well (it is still very much above both its 20-week and 40-week moving averages), the action subsequent to its earnings report last week may proved to have been a significant reversal:
Going forward, AAPL is definitely another brand name to watch – given its huge, fast-growing brand name and given that the stock is a speculative favorite of the public. Just like GOOG – should AAPL stumble going forward, there is a good chance that speculative activity will go down significantly in the stock market.
Let's now end with a discussion of Starbucks – which is one of this author's favorite companies and definitely one of the most reliable leading indicators of discretionary consumer spending. This is a company that has opened more than 200 stores in Mainland China and in Hong Kong. In a country that is known for its paltry wages and for drinking tea, this is nothing short of amazing– given that the price of a Starbucks latte or a Cappuccino is the same no matter which part of the world one is in. Please note that the price action of Starbucks, however, has not been too impressive since December 2004 – even as the stock made another all-time high just last month:
Conclusion: To successfully navigate the financial markets in 2006 and beyond, it is essential to study the past writings of Ben Bernanke, the new upcoming Federal Reserve Chairman. While none of his policies should be ground-breaking, it is probably safe to say that such policies (adopting a clearly-communicated, long-term inflation target policy) really have not been put into practice outside of the classroom. Make no mistake: We are in uncharted territory, and times are going to get exciting going forward. Given that Ben Bernanke should be more hawkish on inflation than Greenspan (in normal times as opposed to times of great financial distress – in which case, he would not hesitate to “drop money from helicopters”) there is a good chance that the Fed will continue its current rate hike policy up until March 28th, and possibly even right into the May 10th Fed meeting. Holders of gold or gold mining shares should be careful here.
Again, the major brand names, as well as the highest-growth brand names continue to exhibit dismal performance, and given our 2006 mid-cycle slowdown scenario, the inevitable uncertainty surrounding the new Fed, and the current overbought conditions in the stock market – this author is still signaling “caution.” The longer these brand names underperform and the longer the stock market goes by without a significant correction (in the order of 10 to 20%), the more dangerous the market becomes. In the immediate future, the MSFT earnings report (tonight) along with the GOOG earnings report on January 31st will remain all-important. For now, we will remain 50% short in our DJIA Timing System (our maximum allowable short position in the DJIA).
Henry K. To, CFA