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A MarketThoughts Opportunistic Investor Portfolio and a Liquidate Update

(February 19, 2010)

Dear Subscribers and Readers,

In a bull market, everyone is a genius.  And in a bull market, any unexpected news tends to be in favor of the primary trend – in this case, the surprise 25 bps hike in the Fed's discount rate after the market closed yesterday caused another spike in the U.S. Dollar Index.  As you may recall, dear readers, we initiated a long position in the US Dollar Index on October 27, 2009 (via the March 2010 futures, which was trading at 76.58 at the time) within the MarketThoughts Opportunistic Investor Portfolio.  The reasons were outlined in a “special alert” email that we sent to our subscribers on the same day.  Following is a performance update of the MarketThoughts Opportunistic Investor Portfolio as of Thursday at the close:

The Opportunistic Portfolio
(As of February 18, 2010)
Security Description Sector Date
BBY Best Buy Common Stock Consumer Discretionary 11/14/2008 21.70 36.15     66.6%
CCL Carnival Common Stock Consumer Discretionary 1/16/2009 21.11 33.78     60.0%
DXHO US Dollar Index March 2010 Futures FOREX 10/27/2009 76.58 81.28     6.1%

The fact that the discount rate hike occurred in the midst of a rally in the U.S. Dollar index suggests that Bernanke and the Fed is willing to tolerate a stronger U.S. Dollar.  The U.S. Dollar managed to smash through numerous technical levels with the latest rally – such as 1.36 against the Euro, 1.55 against the Pound Sterling, etc.  As of the close on Thursday, the U.S. Dollar Index March 2010 futures contract has rallied 6.1% since we initiated our long position on October 27, 2009.  We still do not have a price target for the U.S. Dollar Index contract, but will most likely hold it until the end of next week (if not later).  We will provide a more detailed update on the U.S. Dollar Index in this weekend's commentary.

As for our long positions in Best Buy and Carnival, there's no doubt that an ongoing rally in the U.S. Dollar index will act as a tailwind to these two stocks, as a U.S. Dollar bull market will raise U.S. purchasing power across the board.  However, I am getting increasingly concerned about Best Buy's competitive advantage within the U.S. (their European businesses surprised on the upside last year, but a general cut in government budgets in Europe will no doubt hurt its European business), especially given the powerful competition coming from alternative distribution channels such as the internet, eBay, Wal-Mart, etc.  In addition, there is hardly any more costs to squeeze on the labor side (my personal shopping experience at Best Buy is a good testament to that), and Best Buy's private labels is also starting to have less of an effect on profit margins (private labels tend to be cheaper and provide higher profit margins than brand name electronics).  We will review these two companies further down the road.

As I am writing this commentary, the S&P 500 futures is down around 8 points, after having been down as many as 13 points soon after the Fed announced its intention to hike the discount rate by 25 basis points.  As subscribers may know, the Fed's discount rate is the rate at which financial institutions can borrow (supposedly at a punitive rate) at the Fed's discount window.  This move is largely symbolic as it currently only affects about $15 billion of U.S. banking liquidity.  Moreover, this move is merely the first step of a “renormalization” process that should take the differential between the discount rate and the Fed Funds rate back to a pre-crisis (pre late 2007) level of 1% (the Fed first lowered the discount rate without lowering the Fed Funds rate as the subprime crisis first hit in August 2007).  The lowering of the discount rate at the time was deemed a good solution to a liquidity crisis in the U.S. financial system – but which ultimately turned fruitless as it quickly emerged that the U.S. was fighting a solvency crisis – not a liquidity crisis.  Now that the vast majority of the U.S. banking system is no longer facing a liquidity or a solvency crisis, raising the discount rate to its pre-crisis differential of 1% seems to be a prudent thing to do.

Sure, the Fed's latest discount rate hike is largely symbolic, but the hike has made its intentions clear: It wants to mop up the excess liquidity within the U.S. banking system sooner rather than later.  In yesterday's email – in light of the release of the latest Fed's minutes – I mentioned that it is more important to keep track of what the Fed does, as opposed to what they say will do.  The Fed's 25 basis point hike in the discount rate is the first shot heard all around the world, if you will.  In addition, the Fed has also backed up its intentions by slamming on the brakes in its “credit easing” program.  As shown on the following chart – after the Fed made its last major purchase of $50 billion of agency debt and MBS for the week ending January 20, 2010, it has not made any net purchases (for the week ending February 10, 2010):

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - The last major purchase by the Fed under its *credit easing* program was the $50 billion purchase of agency debt and MBS or the week ending January 20, 2010 (the Fed halted its Treasury purchases last October). This was sufficient to support the financial markets till the end of the year. Going forward, I expect the Fed 's purchases to be relatively flat as the Fed has indicated that it intends to withdraw liquidity from the markets sooner rather than later. I thus expect the market to be range bound for a little more while.

So does the latest move mean that the next cycle of tightening is upon us?  I recommend a wait-and-see approach.  Sure, the Fed is not easing anymore.  It has also hiked the discount rate by 25 basis points, but it is by no means tightening just yet.  With banks still refusing to lend, with China still tightening, and with Western Europe and Japan still mired in a deflationary cycle, it is still difficult to see global inflation popping up anytime soon.  Moreover, the fact that the Fed has kept open its credit easing program suggests that the Fed still has its eyes on the trigger, especially if risky assets such as global equities or corporate bonds start to dive again.  In the meantime, I expect the U.S. stock market to be stuck in a consolidation phase for the foreseeable future, despite the strong rally we experienced over the last few trading days.

Signing off,

Henry To, CFA


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